Theory of consumer behaviour

Cardinal Utility Analysis/Approach:

Definition and Explanation:

Human wants are unlimited and they are of different intensity. The means at the disposal of a man are not only scarce but they have alternative uses. As a result of scarcity of recourses, the consumer cannot satisfy all his wants. He has to choose as to which want is to be satisfied first and which afterward if the recourses permit. The consumer is confronted in making a choice.

For example, a man is thirsty. He goes to the market and satisfy his thirst by purchasing coca cola instead of tea. We are here to examine the economic forces which make him purchase a particular commodity. The answer is simple. The consumer buys a commodity because it gives him satisfaction. In technical term, a consumer purchases a commodity because it has utility for him. We now examine the tools which are used in the analyzes of consumer behavior.

Concept of Utility:

Jevon (1835 -1882) was the first economist who introduces the concept of utility in economics. According to him:

"Utility is the basis on which the demand of a individual for a commodity depends upon".

Utility is defined as:

"The power of a commodity or service to satisfy human want".

Utility is thus the satisfaction which is derived by the consumer by consuming the goods.

For example, cloth has a utility for us because we can wear it. Pen has a utility who can write with it. The utility is subjective in nature. It differs from person to person. The utility of a bottle of wine is zero for a person who is non drinker while it has a very high utility for a drinker.

Here it may be noted that the term ‘utility’ may not be confused with pleasure or unfulness which a commodity gives to an individual. Utility is a subjective satisfaction which consumer gets from consuming any good or service.

For example, poison is injurious to health but it gives subjective satisfaction to a person who wishes to die. We can say that utility is value neutral.

 

Assumptions of Cardinal Utility Analysis:

The main assumption or premises on which the cardinal utility analysis rests are as under.
 

(i) Rationality. The consumer is rational. He seeks to maximize satisfaction from the limited income which is at his disposal.
 

(ii) Utility is cardinally measurable. The utility can be measured in cardinal numbers such as 1, 3, 10, 15, etc. The utility is expressed in imaginary cardinal numbers tells us a great deal about the preference of the consumer for a good.
 

(iii) Marginal utility of money remains constant. Another important premise of cardinal utility of money spent on the purchase of a good or service should remain constant.
 

(iv) Diminishing marginal utility. It is also assumed that the marginal utility obtained from the consumption of a good diminishes continuously as its consumption is increased.
 

(v) Independent utilities. According to the Cardinalist school, the utility which is derived from the consumption of a good is a function of the quantity of that good alone. If does not depend at all upon the quantity consumed of other goods. The goods, we can say, possess independent utilities and are additive.
 

(vi) Introspection method. The Cardinalist school assumes that the behavior of marginal utility in the mind of another person can be judged with the help of self observation. For example, I know that as I purchase more and more of a good, the less utility I derived from the additional units of it. By applying the same principle, I can read other people mind and say with confidence that marginal utility of a good diminishes as they have more units of it.

Criticism:

Pareto, an Italian Economist, severely criticized the concept of cardinal utility. He stated that utility is neither quantifiable nor addible. It can, however be compared. He suggested that the concept of utility should be replaced by the scale of preference. Hicks and Allen, following the footsteps of Pareto, introduced the technique of indifference curves. The cardinal utility approach is thus replaced by ordinal utility function.

Total Utility and Marginal Utility:

Difference Between Total Utility and Marginal Utility:

 

People buy goods because they get satisfaction from them. This satisfaction which the consumer experiences when he consumes a good, when measured as number of utils is called utility.

 

It is here to necessary to make a distinction between total utility and marginal utility.

 

Total Utility (TU):

 

Definition and Explanation:

 

"Total utility is the total satisfaction obtained from all units of a particular commodity consumed over a period of time".

 

For example, a person consumes eggs and gains 50 utils of total utility. This total utility is the sum of utilities from the successive units (30 utils from the first egg, 15 utils from the second and 5 utils from the third egg).

 

Summing up total utility is the amount of satisfaction (utility) obtained from consuming a particular quantity of a good or service within a given time period. It is the sum of marginal utilities of each successive unit of consumption.

Formula:

 

TU_x = ∑MU_x

 

Marginal Utility (MU):

 

Definition and Explanation:

"Marginal utility means an additional or incremental utility. Marginal utility is the change in the total utility that results from unit one unit change in consumption of the commodity within a given period of time".

For example, when a person increases the consumption of eggs from one egg to two eggs, the total utility increases from 30 utils to 45 utils. The marginal utility here would be the15 utils of the 2nd egg consumed.

Marginal utility, thus, can also be described as difference between total utility derived from one level of consumption and total utility derived from another level of consumption.

Formula:

 MU = ∆TU

          ∆Q

It may here be noted that as a person consumes more and more units of a commodity, the marginal utility of the additional units begins to diminish but the total utility goes on increasing at a diminishing rate.

When the marginal utility comes to zero or we say the point of satiety is reached, the total utility is the maximum. If consumption is increased further from this point of satiety, the marginal utility becomes negative and total utility begins to diminish.

The relationship between total utility and marginal utility is now explained with the help of following schedule and a graph.

Schedule:

Units of Apples Consumed Daily	Total Utility in Utils Per Day	Marginal Utility in Utils Per Day
1	7	7
2	11	4  (11-7)
3	13	2  (13-11)
4	14	1  (14-13)
5	14	0  (14-14)
6	13	-1  (13-14)

The above table shows that when a person consumes no apples, he gets no satisfaction. His total utility is zero. In case he consumes one apple a day, he gains seven units of satisfaction. His total utility is 7 and his marginal utility is also 7.

In case he consumes second apple, he gains extra 4 utils (MU). Thus given him a total utility of 11 utils from two apples. His marginal utility has gone down from 7 utils to 4 utils because he has a less craving for the second apple.

Same is the case with the consumption of third apple. The marginal utility has now fallen to 2 utils while the total utility of three apples has increased to 13 utils (7 + 4 + 2). In case the consumer takes fifth apple, his marginal utility falls to zero utils and if he consumes sixth apple also, the total showing total utility and marginal utility is plotted in figure below:

Diagram/Curve:

(i) The total utility curves starts at the origin as zero consumption of apples yield zero utility.

(ii) The TU curve reaches at its maximum or a peak of M when MU is zero.

(iii) The MU curve falls through the graph. A special point occurs when the consumer consumes fifth apple. He gains no marginal utility from it. After this point, marginal utility becomes negative.

(iv) The MU curve can be derived from the total utility curve. It is the slope of the line joining two adjacent quantities on the curve. For example, the marginal utility of the third apple is the slope of line joining points a and b. The slope of such given by the formula:

MU = ∆TU

         ∆Q

Here MU = 2.

Law of Diminishing Marginal Utility:

Definition and Statement of the Law:

The law of diminishing marginal utility describes a familiar and fundamental tendency of human behavior. The law of diminishing marginal utility states that:

“As a consumer consumes more and more units of a specific commodity, the utility from the successive units goes on diminishing”.

Mr. H. Gossen, a German economist, was first to explain this law in 1854. Alfred Marshal later on restated this law in the following words:

“The additional benefit which a person derives from an increase of his stock of a thing diminishes with every increase in the stock that already has”.

Law is Based Upon Three Facts:

The law of diminishing marginal utility is based upon three facts. First, total wants of a man are unlimited but each single want can be satisfied. As a man gets more and more units of a commodity, the desire of his for that good goes on falling. A point is reached when the consumer no longer wants any more units of that good. Secondly, different goods are not perfect substitutes for each other in the satisfaction of various particular wants. As such the marginal utility will decline as the consumer gets additional units of a specific good. Thirdly, the marginal utility of money is constant given the consumer’s wealth.

The basis of this law is a fundamental feature of wants. It states that when people go to the market for the purchase of commodities, they do not attach equal importance to all the commodities which they buy. In case of some of commodities, they are willing to pay more and in some less. There are two main reasons for this difference in demand. (1) the linking of the consumer for the commodity and (2) the quantity of the commodity which the consumer has with himself. The more one has of a thing, the less he wants the additional units of it. In other words, the marginal utility of a commodity diminishing as the consumer gets larger quantities of it. This, in brief, is the axiom of law of diminishing marginal utility.

Explanation and Example of Law of Diminishing Marginal Utility:

This law can be explained by taking a very simple example. Suppose, a man is very thirsty. He goes to the market and buys one glass of sweet water. The glass of water gives him immense pleasure or we say the first glass of water has great utility for him. If he takes second glass of water after that, the utility will be less than that of the first one. It is because the edge of his thirst has been blunted to a great extent. If he drinks third glass of water, the utility of the third glass will be less than that of second and so on.

The utility goes on diminishing with the consumption of every successive glass water till it drops down to zero. This is the point of satiety. It is the position of consumer’s equilibrium or maximum satisfaction. If the consumer is forced further to take a glass of water, it leads to disutility causing total utility to decline. The marginal utility will become negative. A rational consumer will stop taking water at the point at which marginal utility becomes negative even if the good is free. In short, the more we have of a thing, ceteris paribus, the less we want still more of that, or to be more precise.

“In given span of time, the more of a specific product a consumer obtains, the less anxious he is to get more units of that product” or we can say that as more units of a good are consumed, additional units will provide less additional satisfaction than previous units. The following table and graph will make the law of diminishing marginal utility more clear.

Schedule of Law of Diminishing Marginal Utility:

Units	Total Utility	Marginal Utility
1st glass	20	20
2nd glass	32	12
3rd glass	40	8
4th glass	42	2
5th glass	42	0
6th glass	39	-3

From the above table, it is clear that in a given span of time, the first glass of water to a thirsty man gives 20 units of utility. When he takes second glass of water, the marginal utility goes on down to 12 units; When he consumes fifth glass of water, the marginal utility drops down to zero and if the consumption of water is forced further from this point, the utility changes into disutility (-3).

Here it may be noted that the utility of then successive units consumed diminishes not because they are not of inferior in quality than that of others. We assume that all the units of a commodity consumed are exactly alike. The utility of the successive units falls simply because they happen to be consumed afterwards.

Curve/Diagram of Law of Diminishing Marginal Utility:

The law of diminishing marginal utility can also be represented by a diagram.

In the figure (2.2), along OX we measure units of a commodity consumed and along OY is shown the marginal utility derived from them. The marginal utility of the first glass of water is called initial utility. It is equal to 20 units. The MU of the 5th glass of water is zero. It is called satiety point. The MU of the 6th glass of water is negative (-3). The MU curve here lies below the OX axis. The utility curve MM^/ falls left from left down to the right showing that the marginal utility of the success units of glasses of water is falling.

Assumptions of Law of Diminishing Marginal Utility:

The law of diminishing marginal utility is true under certain assumptions. These assumptions are as under:

(i) Rationality: In the cardinal utility analysis, it is assumed that the consumer is rational. He aims at maximization of utility subject to availability of his income.

(ii) Constant marginal utility of money: It is assumed in the theory that the marginal utility of money based for purchasing goods remains constant. If the marginal utility of money changes with the increase or decrease in income, it then cannot yield correct measurement of the marginal utility of the good.

(iii) Diminishing marginal utility: Another important assumption of utility analysis is that the utility gained from the successive units of a commodity diminishes in a given time period.

(iv) Utility is additive: In the early versions of the theory of consumer behavior, it was assumed that the utilities of different commodities are independent. The total utility of each commodity is additive.
 

U = U¹ (X¹) + U² (X²) + U³ (X³)………. Uⁿ (Xⁿ)

(v) Consumption to be continuous: It is assumed in this law that the consumption of a commodity should be continuous. If there is interval between the consumption of the same units of the commodity, the law may not hold good. For instance, if you take one glass of water in the morning and the 2nd at noon, the marginal utility of the 2nd glass of water may increase.

(vi) Suitable quantity: It is also assumed that the commodity consumed is taken in suitable and reasonable units. If the units are too small, then the marginal utility instead of falling may increase up to a few units.

(vii) Character of the consumer does not change: The law holds true if there is no change in the character of the consumer. For example, if a consumer develops a taste for wine, the additional units of wine may increase the marginal utility to a drunkard.

(viii) No change to fashion: Customs and tastes: If there is a sudden change in fashion or customs or taste of a consumer, it can than make the law inoperative.

(ix) No change in the price of the commodity: there should be any change in the price of that commodity as more units are consumed.

Limitations/Exceptions of Law of Diminishing Marginal Utility:

There are some exceptions or limitations to the law of diminishing utility.

(i) Case of intoxicants: Consumption of liquor defies the low for a short period. The more a person drinks, the more likes it. However, this is truer only initially. A stage comes when a drunkard too starts taking less and less liquor and eventually stops it.

(ii) Rare collection: If there are only two diamonds in the world, the possession of 2nd diamond will push up the marginal utility.

(iii) Application to money: The law equally holds good for money. It is true that more money the man has, the greedier he is to get additional units of it. However, the truth is that the marginal utility of money declines with richness but never falls to zero.

Summing up, we can say that the law of diminishing utility, like other laws of Economics, is simply a statement of tendency. It holds good provided other factors remain constant.

Practical Importance of Law of Diminishing Marginal  Utility:

The law of diminishing utility has great practical importance in economics. The law of demand, the theory of consumer’s surplus, and the equilibrium in the distribution of expenditure are derived from the law of diminishing marginal utility.

(i) Basis of the law of demand: The law of marginal diminishing utility and the law of demand are very closely related to each other. In fact they law of diminishing marginal utility, the more we have of a thing, and the less we want additional increment of it. In other words, we can say that as a person gets more and more of a particular commodity, the marginal utility of the successive units begins to diminish. So every consumer while buying a particular commodity compares the marginal utility of the commodity and the price of the commodity which he has to pay.

If the marginal utility of the commodity is higher than that of price, he purchases that commodity. As he buys more and more, the marginal utility of the successive units begins to diminish. Then he pays fewer amounts for the successive units. He tries to equate at every step the marginal utility and the price of the commodity, he must lower its price so that the consumers are induced to buy large quantities and this is what is explained in the law of demand. From this, we conclude that the law of demand and the law of diminishing are very closely inter-related.

(ii) Consumer’s surplus concept: The theory of consumer’s surplus is also based on the law of diminishing marginal utility. A consumer while purchasing the commodity compares the utility of the commodity with that of the price which he has to pay. In most of the cases, he is willing to pay more than what he actually pays. The excess of the price which he would be willing to pay rather than to go without the thing over that which he actually does pay is the economic measure of this surplus satisfaction. It is in fact difference between the total utility and the actually money spent.

(iii) Importance to the consumer: A consumer in order to get the maximum satisfaction from his relatively scare resources distributes his income on commodities and services in such a way that the marginal utility from all the uses are the same. Here again the concept of marginal utility helps the consumer in arranging his scale of preference for the commodities and services.

(iv) Importance to finance minister: Some times it is pointed out that the law of diminishing marginal utility does not apply on money. As a person collects money, the desires to accumulate more money increases. This view is superficial. It is true that wealth is acquired for the procurement of goods and services and man is always anxious in getting more and more of money. But what about the utility of money to him? Is it not a fact that as a person gets more and more wealth, its utility progressively decreases, though it does not reach to zero?

For example, a person who earns $90,000 per month attaches less importance to $10. But a man who gets $1000 per month, the value of $10 to him is very high. A finance minister knowing this fact that the utility of money to a rich man is high and to poor man low bases the system of taxation in such a way that the rich persons are taxed at a progressive rate. The system of modern taxation is therefore, based on the law of diminishing marginal utility.

Theory of Ordinal Utility/Indifference Curve Analysis:

Definition and Explanation:

The indifference curve indicates the various combinations of two goods which yield equal satisfaction to the consumer. By definition:

"An indifference curve shows all the various combinations of two goods that give an equal amount of satisfaction to a consumer".

The indifference curve analysis approach was first introduced by Slustsky, a Russian Economist in 1915. Later it was developed by J.R. Hicks and R.G.D. Allen in the year 1928.

These economist are the of view that it is wrong to base the theory of consumption on two assumptions:

(i) That there is only one commodity which a person will buy at one time.

(ii) The utility can be measured.

Their point of view is that utility is purely subjective and is immeasurable. Moreover an individual is interested in a combination of related goods and in the purchase of one commodity at one time. So they base the theory of consumption on the scale of preference and the ordinal ranks or orders his preferences.

Assumptions:

The ordinal utility theory or the indifference curve analysis is based on four main assumptions.

(i) Rational behavior of the consumer: It is assumed that individuals are rational in making decisions from their expenditures on consumer goods.

(ii) Utility is ordinal: Utility cannot be measured cardinally. It can be, however, expressed ordinally. In other words, the consumer can rank the basket of goods according to the satisfaction or utility of each basket.

(iii) Diminishing marginal rate of substitution: In the indifference curve analysis, the principle of diminishing marginal rate of substitution is assumed.

(iv) Consistency in choice: The consumer, it is assumed, is consistent in his behavior during a period of time. For insistence, if the consumer prefers combinations of A of good to the combinations B of goods, he then remains consistent in his choice. His preference, during another period of time does not change. Symbolically, it can be expressed as:

If A > B, then B > A

(iv) Consumer’s preference not self contradictory: The consumer’s preferences are not self contradictory. It means that if combinations A is preferred over combination B is preferred over C, then combination A is preferred over combination A is preferred over C. Symbolically it can be expressed:

If A > B and B > C, then A > C

(v) Goods consumed are substitutable: The goods consumed by the consumer are substitutable. The utility can be maintained at the same level by consuming more of some goods and less of the other. There are many combinations of the two commodities which are equally preferred by a consumer and he is indifferent as to which of the two he receives.

Example:

For example, a person has a limited amount of income which he wishes to spend on two commodities, rice and wheat. Let us suppose that the following commodities are equally valued by him:

Various Combinations:

a)      16 Kilograms of Rice          Plus          2 Kilograms of Wheat

b)      12 Kilograms of Rice          Plus          5 Kilograms of Wheat

c)      11 Kilograms of Rice          Plus          7 Kilograms of Wheat

d)      10 Kilograms of Rice          Plus          10 Kilograms of Wheat

e)      9   Kilograms of Rice          Plus          15 Kilograms of Wheat

It is matter of indifference for the consumer as to which combination he buys. He may buy 16 kilograms of rice and 2 kilograms of wheat or 9 kilograms of rice and 15 kilograms of wheat. All these combinations are equally preferred by him.

An indifference curve thus is composed of a set of consumption alternatives each of which yields the same total amount of satisfaction. These combinations can also be shown by an indifference curve.

Figure/Diagram of Indifference Curve:

The consumer’s preferences can be shown in a diagram with an indifference curve. The indifference showing nothing about the absolute amounts of satisfaction obtained. It merely indicates a set of consumption bundles that the consumer views as being equally satisfactory.

In fig. 3.1 we measure the quantity of wheat along X-axis (in kilograms) and along Y-axis, the quantity of rice (in kilograms). IC is an indifference curve.

It is shown in the diagram that a consumer may buy 12 kilograms of rice and 5 kilograms of wheat or 9 kilograms of rice and 15 kilogram of wheat. Both these combinations are equally preferred by him and he is indifferent to these two combinations. When the scale of preference of the consumer is graphed, by joining the points a, b, c, d, e, we obtain an Indifference Curve IC.

Every point on indifference curve represents a different combination of the two goods and the consumer is indifferent between any two points on the indifference curve. All the combinations are equally desirable to the consumer. The consumer is indifferent as to which combination he receives. The Indifference Curve IC thus is a locus of different combinations of two goods which yield the same level of satisfaction.

An Indifference Map:

A graph showing a whole set of indifference curves is called an indifference map. An indifference map, in other words, is comprised of a set of indifference curves. Each successive curve further from the original curve indicates a higher level of total satisfaction.

In the fig. 3.2 three indifference curves IC¹, IC² and IC³ have been shown. The various combinations of goods of wheat and rice lying on IC¹ yield the same level of satisfaction to the consumer. The combinations of goods lying on higher indifference curve IC² contain more both the goods wheat and rice. The indifference curve IC²gives more satisfaction to the consumer than IC¹. Similarly, the set of combinations of two goods on IC³ yields still higher satisfaction to the consumer than IC². In short, the further away a particular curve is from the origin, the higher level of satisfaction it represents.

It may here be noted that while an indifference curve shows all those combinations of wheat and rice which provide equal satisfaction to the consumer but it does not indicate exactly how much satisfaction is derived by the consumer from these combinations. It is because of the fact that the concept of ordinal utility does not involve the qualitative measurement of utility.

Properties/Characteristics of Indifference Curve:

Definition, Explanation and Diagram:

An indifference curve shows combination of goods between which a person is indifferent. The main attributes or properties or characteristics of indifference curves are as follows:

(1) Indifference Curves are Negatively Sloped:

The indifference curves must slope down from left to right. This means that an indifference curve is negatively sloped. It slopes downward because as the consumer increases the consumption of X commodity, he has to give up certain units of Y commodity in order to maintain the same level of satisfaction.

In fig. 3.4 the two combinations of commodity cooking oil and commodity wheat is shown by the points a and b on the same indifference curve. The consumer is indifferent towards points a and b as they represent equal level of satisfaction.

At point (a) on the indifference curve, the consumer is satisfied with OE units of ghee and OD units of wheat. He is equally satisfied with OF units of ghee and OK units of wheat shown by point b on the indifference curve. It is only on the negatively sloped curve that different points representing different combinations of goods X and Y give the same level of satisfaction to make the consumer indifferent.

(2) Higher Indifference Curve Represents Higher Level:

A higher indifference curve that lies above and to the right of another indifference curve represents a higher level of satisfaction and combination on a lower indifference curve yields a lower satisfaction.

In other words, we can say that the combination of goods which lies on a higher indifference curve will be preferred by a consumer to the combination which lies on a lower indifference curve.

In this diagram (3.5) there are three indifference curves, IC¹, IC² and IC³ which represents different levels of satisfaction. The indifference curve IC³ shows greater amount of satisfaction and it contains more of both goods than IC² and IC¹ (IC³ > IC²> IC¹).

(3) Indifference Curve are Convex to the Origin:

This is an important property of indifference curves. They are convex to the origin (bowed inward). This is equivalent to saying that as the consumer substitutes commodity X for commodity Y, the marginal rate of substitution diminishes of X for Y along an indifference curve.

In this figure (3.6) as the consumer moves from A to B to C to D, the willingness to substitute good X for good Y diminishes. This means that as the amount of good X is increased by equal amounts, that of good Y diminishes by smaller amounts. The marginal rate of substitution of X for Y is the quantity of Y good that the consumer is willing to give up to gain a marginal unit of good X. The slope of IC is negative. It is convex to the origin.

(4) Indifference Curve Cannot Intersect Each Other:

Given the definition of indifference curve and the assumptions behind it, the indifference curves cannot intersect each other. It is because at the point of tangency, the higher curve will give as much as of the two commodities as is given by the lower indifference curve. This is absurd and impossible.

In fig 3.7, two indifference curves are showing cutting each other at point B. The combinations represented by points B and F given equal satisfaction to the consumer because both lie on the same indifference curve IC₂. Similarly the combinations shows by points B and E on indifference curve IC₁ give equal satisfaction top the consumer.

If combination F is equal to combination B in terms of satisfaction and combination E is equal to combination B in satisfaction. It follows that the combination F will be equivalent to E in terms of satisfaction. This conclusion looks quite funny because combination F on IC₂ contains more of good Y (wheat) than combination which gives more satisfaction to the consumer. We, therefore, conclude that indifference curves cannot cut each other.

(5) Indifference Curves do not Touch the Horizontal or Vertical Axis:

One of the basic assumptions of indifference curves is that the consumer purchases combinations of different commodities. He is not supposed to purchase only one commodity. In that case indifference curve will touch one axis. This violates the basic assumption of indifference curves.

In fig. 3.8, it is shown that the in difference IC touches Y axis  at point C and X axis at point E. At point C, the consumer purchase only OC commodity of rice and no commodity of wheat, similarly at point E, he buys OE quantity of wheat and no amount of rice. Such indifference curves are against our basic assumption. Our basic assumption is that the consumer buys two goods in combination.

Price Line or Budget Line:

Definition and Explanation:

The understanding of the concept of budget line is essential for knowing the theory of consumer’s equilibrium.

"A budget line or price line represents the various combinations of two goods which can be purchased with a given money income and assumed prices of goods".

For example, a consumer has weekly income of $60. He purchases only two goods, packets of biscuits and packets of coffee. The price of each packet of biscuits is $6  and the price of each packet of coffee is $12. Given the assumed income and the price, of the two goods, the consumer can purchase various combination of goods or market combination of goods weekly.

Schedule:

The various alternative market baskets (combinations of goods) are shown in the table below:

Market Basket	Packets of Biscuits Per Week	Packets of Coffee Per Week
A	10	0
B	8	1
C	6	2
D	4	3
E	2	4
F	0	5
Income $60 Per Week = Packets of Biscuits Costs $6 = Packets of Coffee is Priced $12 Each

(i) Market basket A in the table above shows that if the whole amounts of $60 is spent on the purchase of biscuits, then the consumer buys 10 packets of biscuits at a price of $6 each and nothing is left to purchase coffee.

(ii) Market basket F shows the other extreme. If the consumer spends the entire amount of $60 on the purchase of coffee, a maximum of 5 packets of coffee can be purchased with it at a price of $12 each with nothing left over for the purchase of biscuits.

(iii) The intermediate market baskets B to E shows the mixes of packets of biscuits and packets of coffee that the cost a total of $60. For example, in combination of market basket C, the consumer can purchase 6 packets of biscuits and 2 packets of coffee with a total cost of $60.

Budget Line:

The budget line is an important element analysis of consumer behavior. The indifference map shows people’s preferences for the combination of two goods. The actual choices they will make, however, depends on their income. The budget line is drawn as a continuous line. It identifies  the options from which the  consumer can choose the combination of goods.

Diagram/Figure:

In the fig. 3.9 the line AF shows the various combinations of goods the consumer can purchase. This line is called the budget line.

It shows 6 possible combinations of packets of biscuits and packets if coffee which a consumer can purchase weekly. These combinations are indicated by points A, B, C, D, E and. Point A indicates that 10 packet of biscuits can be purchased if the entire income of $60 is devoted to the purchase of biscuits. Similarly, point F shows the purchase of 5 packets of coffee for the entire income of $60 per week.

The budget line AF indicates all the combinations of packets of biscuits and packets of coffee which a consumer can buy given the assumed prices and income. In case, a consumer decides to purchase combination of goods inside the budget line such as G, then it involves  a total outlay that is smaller then the amount of $60 per week. Any point outside the budget line such as H requires an outlay larger than the consumer’s weekly income of $60.

The slope of the budget line indicates how many packets of biscuits a purchaser must give up to buy one more packet of coffee. For example, the slope at point B on the budget line is ∆Y / ∆X or two packets of biscuits 1 = packet of coffee. This indicates that a move from B to C involves sacrificing two packets of biscuits to gain an additional one packet of coffee. Since AF budget line is straight, the slope is constant at -2 packets of biscuits per one packet of coffee at all points along the line.

Shifts in Budget Line:

The price line is determined by the income of the consumer and the prices of goods in the market. If there is a change in the income of the consumer or in the prices of goods, the price line shifts in response to a exchange in these two factors.

(i) Income changes: When there is change in the income of the consumer, the prices of goods remaining the same, the price line shifts from the original position. It shifts upward or to the right hand side in a parallel position with the rise in income.

A fall in the level of income, product prices remaining unchanged, the price line shifts left side from the original position. With a higher income, the consumer can purchase more of both goods than before but the cost of one good in terms of the other remains the same.

In the fig. 3.10 (a), a change in income is shown when product prices remain unchanged. The rise in income results in a parallel upward shifts in the budget line from L^/ M^/ to L₂M₂. The consumer is able to purchase more of both the goods A and B.

(ii) Price changes. Now let us consider that there is a change in the price of one good. The income of the consumer and price of other good is held constant. When there is a fall in the price of one good say commodity A, the consumer purchases more of that good than before. A price change causes the budget line to rotate about point L fig. 3.10 (b).

It becomes flatter and give the new budget line from LM^/ to LM₂. A flatter budget linemeans that the relative price of the good A on the horizontal axis is lower. If the greater amount is spent on the purchase of good A, the consumer can buy increased OM₂ amount of good A.

Consumer's Equilibrium Through Indifference Curve Analysis:

Definition:

"The term consumer’s equilibrium refers to the amount of goods and services which the consumer may buy in the market given his income and given prices of goods in the market".

The aim of the consumer is to get maximum satisfaction from his money income. Given the price line or budget line and the indifference map:

"A consumer is said to be in equilibrium at a point where the price line is touching the highest attainable indifference curve from below".

Conditions:

Thus the consumer’s equilibrium under the indifference curve theory must meet the following two conditions:

First: A given price line should be tangent to an indifference curve or marginal rate of satisfaction of good X for good Y (MRS_xy) must be equal to the price ratio of the two goods. i.e.

MRS_xy = P_x / P_y

Second: The second order condition is that indifference curve must be convex to the origin at the point of tangency.

Assumptions:

The following assumptions are made to determine the consumer’s equilibrium position.

(i) Rationality: The consumer is rational. He wants to obtain maximum satisfaction given his income and prices.

(ii) Utility is ordinal: It is assumed that the consumer can rank his preference according to the satisfaction of each combination of goods.

(iii) Consistency of choice: It is also assumed that the consumer is consistent in the choice of goods.

(iv) Perfect competition: There is perfect competition in the market from where the consumer is purchasing the goods.

(v) Total utility: The total utility of the consumer depends on the quantities of the good consumed.

Explanation:

The consumer’s consumption decision is explained by combining the budget line and the indifference map. The consumer’s equilibrium position is only at a point where the price line is tangent to the highest attainable indifference curve from below.

(1) Budget Line Should be Tangent to the Indifference Curve:

The consumer’s equilibrium in explained by combining the budget line and the indifference map.

Diagram/Figure:

In the diagram 3.11, there are three indifference curves IC¹, IC² and IC³. The price line PT is tangent to the indifference curve IC² at point C. The consumer gets the maximum satisfaction or is in equilibrium at point C by purchasing OE units of good Y and OH units of good X with the given money income.

The consumer cannot be in equilibrium at any other point on indifference curves. For instance, point R and S lie on lower indifference curve IC¹ but yield less satisfaction. As regards point U on indifference curve IC³, the consumer no doubt gets higher satisfaction but that is outside the budget line and hence not achievable to the consumer. The consumer’s equilibrium position is only at point C where the price line is tangent to the highest attainable indifference curve IC² from below.

(2) Slope of the Price Line to be Equal to the Slope of Indifference Curve:

The second condition for the consumer to be in equilibrium and get the maximum possible satisfaction is only at a point where the price line is a tangent to the highest possible indifference curve from below. In fig. 3.11, the price line PT is touching the highest possible indifferent curve IC² at point C. The point C shows the combination of the two commodities which the consumer is maximized when he buys OH units of good X and OE units of good Y.

Geometrically, at tangency point C, the consumer’s substitution ratio is equal to price ratio P_x / P_y. It implies that at point C, what the consumer is willing to pay i.e., his personal exchange rate between X and Y (MRS_xy) is equal to what he actually pays i.e., the market exchange rate. So the equilibrium condition being P_x / P_y being satisfied at the point C is:

Price of X / Price of Y = MRS of X for Y

The equilibrium conditions given above states that the rate at which the individual is willing to substitute commodity X for commodity Y must equal the ratio at which he can substitute X for Y in the market at a given price.

(3) Indifference Curve Should be Convex to the Origin:

The third condition for the stable consumer equilibrium is that the indifference curve must be convex to the origin at the point of equilibrium. In other words, we can say that the MRS of X for Y must be diminishing at the point of equilibrium. It may be noticed that in fig. 3.11, the indifference curve IC² is convex to the origin at point C. So at point C, all three conditions for the stable-consumer’s equilibrium are satisfied.

Summing up, the consumer is in equilibrium at point C where the budget line PT is tangent to the indifference IC². The market basket OH of good X and OE of good Y yields the greatest satisfaction because it is on the highest attainable indifference curve. At point C:

 MRS_xy = P_x / P_y

Consumer's Surplus:

Definition and Explanation:

The concept of consumer’s surplus was introduced by Alfred Marshall. According to him:

"A consumer is generally willing to pay more for a given quantity of good than what he actually pays at the price prevailing in the market".

For example, you go to the market for the purchase of a pen. You are mentally prepared to pay $25 for the pen which the seller has shown to you. He offers the pen for $10 only. You immediately purchase the pen and say ‘thank you’.

You were willing to pay $25 for the pen but you are delighted to get it for $10 only. Consumer’s surplus is the difference between the maximum amount a consumer is willing to pay for the good and the price he actually pays for the good. In our example given above, the consumer’s surplus is $15 ($25 – $10).

Demand Curve and Consumer’s Surplus:

The consumer surplus can be easily found out by consumer’s demand curve for the commodity and the current market price which we assume a purchaser cannot change. In the words of Alfred Marshall:

“The excess of the price which he (consumer) would be willing to pay rather than go without the thing over that which he actually does pay is the economic measure of this surplus satisfaction”.

In the words of A. Koutsoyannis:

“Consumer’s surplus is equal to the difference between the amount of money that consumer actually pays to buy a certain quantity rather than go without it”.

The concept of consumer’s surplus is the result of two important phenomena:

(i) Characteristic of consumer’s behavior.

(ii) Characteristic of market.

The characteristic of consumer’s behavior is that as he buys more and more of a particular commodity, the marginal utility of the successive units begins to decrease. A rational buyer continuous purchasing the commodity up to the unit which equates his marginal utility of the good to the price he pays for it.

The second phenomenon is that there is perfect competition among sellers and a single price prevails in the market for a particular commodity at a particular time. The buyer is able to get the first unit of the commodity at the same price as the second or pay any other unit thereafter.

Schedule:

The concept of consumer’s surplus is now explained with the help of a schedule and a demand curve.

Quantity	Willing to Pay ($)	Price ($)	Consumer’s Surplus ($)
1	25	10	15 = (25 – 10)
2	20	10	10 = (20 – 10)
3	15	10	5 = (15 – 10)
4	10	10	0
Total	75	10 x 4 = 40	30

Diagram/Figure:

In this figure 3.20, the individual demand curve DD^/ shows the maximum amount a consumer is willing to pay for each unit of the good. An individual is not willing to purchase any pen at a price of $30 per month. He will, however, is willing to purchase one pen at a price of $20 per pen, he is willing to purchase 2 pens. The surplus diminishes with the decline in the marginal utility of pens.

In case the price comes down to $15 per pen, the consumer purchases 3 pens. By using this demand curve, we measure the surplus which a consumer gets from the purchase of pens. The current market price of a pen $10, which we have assumed the purchaser cannot change. The consumer was willing to pay $25 per pen but he actually pay $10 only, the consumer’s surplus for the first pen is $15 = (25 – 10).

For the second pen, it is $10 = (20 – 10) and for the third consumer’s surplus is $5 = (15 – 10).

There is no surplus on the fourth unit as the market price for the pen is the same what he would have paid for the pen. The total consumer’s surplus from the purchase of four pens is $15 + $10 + $5 = $30. It is the sum of surpluses received from each pen. The shaded area in the graph shows the total consumer’s surplus.

Criticism:

The Marshallian concept of consumer’s surplus has been severally criticized by modern economists Allen and Hicks. According to them, the concept is based on assumptions which are unwarranted. Utility, according to them, is a psychological feeling. It cannot be exactly measured in term of money.

In Marshallian analysis, the marginal utility of money is assumed to remain constant. The fact is that when a consumer spends money on goods, his income decreases and the marginal utility of money to him rises. Analysis ignores this basic fact.

Consumer’s surplus is said to be imaginary as it assumes that utilities derived from various goods are independent. In real life, this is not true. The fact is that utilities derived from various goods are independent.

Measurement of Consumer’s Surplus with the Help of Indifference Curves (Hicksian Method):

Professor J.R. Hicks, has explained the concept of consumer surplus with the help of indifference curve technique . According to Hicks when there is fall in the price of a commodity, it has two main effects:

First, the consumer can purchase more of the good whose price has fallen.

Secondly, he can purchase the same quantity of the good as he was buying before but with a lesser amount of money. He spares some money in the bargain. This is a form of rise in the real income of the consumer.

Diagram/Figure:

The Hicksian method of measuring consumer’s surplus is now explained with the help of diagram below.

In figure 3.20 commodity X is measured on OX axis and money income of an individual on OY axis. We assume here that a consumer does not know the price of the commodity X and has OR quantity of money. The indifference curve IC¹represents various combinations of income and X of commodity X which yield the same level of satisfaction to the consumer.

The indifference curve IC¹ originates from point R. It shows the stage when the consumer retains all of his income and zero units of commodity for a given level of the utility. The consumer moves down along the curve IC¹. The consumer at point P buys OT amount of commodity X and has OE amount of money income. In other words, the consumer is ready to sacrifice RE amount of money for getting OT units of commodity X.

We now assume that the consumer is informed of the price of commodity X. The RL is the budget line. The budget line touches the indifference curve IC² at point N which is the point of equilibrium. The consumer now has the OT commodity of X and OF amount of income. He gives up RF amount of money to buy OT units of commodity X. Previously he was ready to pay RE amount of income which is higher than the amount he pays now. We infer from this that RE – RF i.e., FE is the consumer surplus.

FE is the difference between the amount of income the consumer was willing to pay and what he actually pays. The surplus has also shifted the consumer on the higher level of satisfaction from IC¹ to IC².

Importance of Consumer’s Surplus:

The concept of consumer’s surplus has both theoretical as well as practical importance.

(i) Theoretical importance: The idea of consumer’s surplus reveals the benefits which we derive from our purchase of the commodity in the market.

For example, when we purchase salt, or a match box, we are willing to pay the amount much higher than their market value. For example, a consumer would be willing to pay $10 for a match box rather than go without it but he actually pay Re one only on the purchase of a match box. Consumer’s surplus on the purchase of match box thus is $ 9.0.

(ii) Practical importance: A monopolist can charge higher price for his product if the consumers are enjoying large consumers surplus on the use of his product.

(iii) The inhabitants of a country derive consumer's surplus when they import commodities from abroad. They are usually prepared to pay more for than what they actually pay.

(iv) A finance minister imposes taxes of the commodities yielding consumer's surplus.

(v) An entrepreneur before investing capital in a project evaluates the consumer's surplus to be derived from it. If the benefits to the obtained are greater than the costs, the investment is undertaken.