6 Consumer Behaviour Theory and Cardinal Utility

Monika Mehta

 

1.  Learning Objectives

 

After having studied this Module , the students may be able :

 

1. To know the concepts of Cardinal utility analysis and its implication in Managerial economics.

2. To understand the Law of Diminishing Marginal Utility.

3. To understand how the Law of diminishing marginal utility helps the consumer to know the fall in utility on account of continuous consumption.

4. To understand the Law of Equi- Marginal Utility.

5. To know how the Law of Equi- Marginal Utility helps the consumer to get maximum utility from the expenditure of his limited income.

6. To understand the concept of consumer equilibrium.

  1. The Theory of Consumer Behavior

 

The theory of consumer behavior describes how consumers buy different goods and services. Furthermore, consumer behavior also explains how a consumer allocates its income in relation to the purchase of different commodities and how price affects his or her decision. One of the theories used to explain consumer behavior is utility theory.

  1. The Utility Theory

 

The utility theory aims to explain the situation of consumer behavior in regard to the satisfaction that a consumer gets from the consumption of a commodity.Utility theory was developed and introduced in 1870 by a British Economist, William Stanley Jevons.The term utility refer to the satisfaction or benefit that a consumer derives consumption of the commodity. The utility can be measured in utils.

  1. Utility Analysis

 

Utility analysis, attempts to explain consumer behavior, on the basis of satisfaction derived from the consumption of commodities. Of course, the utility derrived from the consumption affects the consumer’s purchase and consumption decision. The concept of utility can be explained with the help of various examples:

  1. A person who is on fasting for two days when offered food will get utility (satisfaction)
  2. A kid when crying is offered toys to play also gets satisfaction.

 

Thus, both examples referred above offers satisfaction owing to the satisfaction of needs and wants

  1. Types of Utility

 

There are two types of utility:

  1. Total Utility
  2. Marginal Utility

 

Total Utility

 

The term total utility means the total satisfaction derived from the consumption of commodities.

 

Marginal Utility

 

Marginal utility be defined as the additional utility derived from the consumption of an additional unit of a commodity. Therefore ,we can say that Marginal utility is the extra satisfaction gained from an one more additional unit of that particular commodity.

 

Marginal utility may be calculated as follows:

 

 

6. Cardinal Utility Analysis

 

Cardinal utility analysis is based on the cardinal measurement of utility which assumes that utility is measurable and additive. This theory was developed by neo-classical economists like Marshall, Pigou, Robertson etc. It is expressed as a quantity measured in hypothetical units which called utils. If a consumer imagines that one mango has 8 utils and an apple 4 utils, it implies that the utility of mango is twice than of an apple.

 

Assumptions of Cardinal Utility Analysis:

 

1. Rational consumer

 

Cardinal utility analysis assumes that consumer is rational. He makes every effort to maximize his total utility under the income and price constraint. while going for the purchase or consumption of good ,a consumer will act rationally to maximize his level satisfaction.

 

2. Cardinal measurement of Utility

 

The utility of each commodity is measurable and quantifiable i.e. Utility is cardinal concept. The most convenient measure is money. Thus utility can be measured quantitatively in monetary units or cardinal units.

 

Therefore whenever a person consumes any commodity,he can express or measure his satisfaction in cardinal term. For example, a person having a glass of milk can say that he got 10 utils from it.

 

Moreover cardinal measurement of utility enables the comparison of utilities derived from two different goods. For example, a person can say that the utility he gets from the consumption of milk is twice the utility he gets from the consumption of Juice.

 

3. Constant Marginal Utility of Money

 

The utility derived from commodities are measured in terms of money. According to Marshall, money is the measuring rod of money. So, money is a unit of measurement in cardinal approach. Marshall argues that that the amount of money which a person is prepared to pay for a unit of a good rather than go without it is a measure of utility he derives from that good. According to him measurement of marginal utility of good in terms of money is only possible if the marginal utility of money itself remains constant. Hence, marginal utility of money should be constant.

 

4. Diminishing Marginal Utility

 

If the stock of commodities increases with the consumer, each additional stock or unit of the commodity gives him lesser and lesser satisfaction. Every additional intake of good will yield less utility as compared to the utility obtained from the previous unit of the good. It means utility increases at a decreasing rate.

  1. Independent Utilities

 

It means utility obtained from one commodity is not dependent on utility obtained from another commodity. In other words, it means that the utility which a consumer derives from the consumption of that commodity is the function of the quantity of only that good. It is not affected by the consumption of other commodities.

  1. Approaches to Cardinal Utility Analysis

The two approaches of Cardinal utility analysis are as follows:

  1. Law of Diminishing Marginal Utility
  2. Law of Equi-Marginal Utility

 

7.1 Law of Diminishing Marginal Utility

 

The fundamental assumption of utility theory of demand is that the satisfaction that a person derives in consuming a particular product diminishes or declines as more and more of a good is consumed. In other words, as successive quantity of goods is consumed, the utility we derive diminishes. This is called the law of diminishing marginal utility.

 

Law of DMU has universal applicability and applies to all goods and services. This law was first given by a German economist H.H. Gossen. That is why, it is also known as ‘Gossen’s first law of consumption’.

 

Utility refers to the amount of satisfaction a person gets from consumption of a certain item and marginal utility refers to the addition made to total utility, we get after consuming one more unit.

 

An individual’s wants are unlimited in number yet each individual’s want is satiable. Because of this, the more we have a commodity, the less we want to have more of it. This law state that as the amount consumed of a commodity increases, the utility derived by the consumer from the additional units, i.e marginal utility goes on decreasing.

 

The marginal utility of a commodity diminishes at the consumer gets larger quantities of it. Marginal utility is the change in the total utility resulting from one unit change in the consumption of a commodity per unit of time.

 

Assumptions of Law of Diminishing Marginal Utility:

 

The law of DMU operates under certain specific conditions. Economists call them the ‘assumptions’ of this law. Following are the assumptions of the law of diminishing marginal utility:

 

Cardinal measurement of utility:

 

It is assumed that utility can be measured and a consumer can express his satisfaction in quantitative terms such as 1, 2, 3, etc.

  1. Monetary measurement of utility:

 

It is assumed that utility is measurable in monetary terms.

  1. Consumption of reasonable quantity:

 

It is assumed that a reasonable quantity of the commodity is consumed. For example, we should compare MU of glassfuls of water and not of spoonful’s. If a thirsty person is given water in a spoon, then every additional spoon will yield him more utility. So, to hold the law true, suitable and proper quantity of the commodity should be consumed.

  1. Continuous consumption:

 

It is assumed that consumption is a continuous process. For example, if one glass of juice is eam is consumed in the morning and another in the afternoon, then the second glass may provide equal or higher satisfaction as compared to the first one.

  1. No change in Quality:

 

Quality of the commodity consumed is assumed to be uniform. A second cup of ice-cream with nuts and toppings may give more satisfaction than the first one, if the first ice-cream was without nuts or toppings.

  1. Rational consumer:

 

The consumer is assumed to be rational who measures, calculates and compares the utilities of different commodities and aims at maximising total satisfaction.

  1. Independent utilities:

 

It is assumed that all the commodities consumed by a consumer are independent. It means, MU of one commodity has no relation with MU of another commodity. Further, it is also assumed that one person’s utility is not affected by the utility of any other person.

  1. MU of money remains constant:

 

As a consumer spends money on the commodity, he is left with lesser money to spend on other commodities. In this process, the remaining money becomes dearer to the consumer and it. increases MU of money for the consumer. But, such an increase in MU of money is ignored. As MU of a commodity has to be measured in monetary terms, it is assumed that MU of money remains constant.

  1. Fixed Income and prices:

 

It is assumed that income of the consumer and prices of the goods which the consumer wishes to purchase remain constant.

  1. Goods are divisible:

 

It is assumed that whatever the goods are consumed they must be divisible. If the goods are not divisible the comparison of utility is not possible.

  1. Homogeneity:

 

Another important assumption is that goods consumed should be homogeneous in regard to quality size, taste, flavors, colour etc.

 

Explanation of Law of DMU:

 

The Law of Diminishing Marginal Utility can be explained with the help of table and diagram:

 

Table : Law of Diminishing Marginal Utility

 

In the diagram, units of ice-cream are taken on the X-axis and MU on the Y-axis. MU from each successive ice-cream is being represented by the points A, B, C, D and E. From the diagram it is clear that, level of satisfaction as represented by the rectangles become smaller and smaller with every increase in consumption of ice-creams.

 

MU falls from 20 to 16 and then to 10 utils, when consumption is increased from 1st to 2 nd and then to 3rd ice-cream. 5th ice-cream has MU= 0 i.e. no utility at all and this point is known as the ‘Point of satiety’. When 6th ice-cream is consumed, MU becomes negative. MU curve slopes downwards showing that MU of successive units is falling.

 

 

7.2 Law of Equi Marginal Utility

 

The law of equi marginal utility was presented in 19th century by an Australian economists H.

 

H. Gossen. The Law of equimarginal Utility is another fundamental principle of Economics.

 

This law is also known as the Law of substitution or the Law of Maximum Satisfaction.

 

A consumer has number of wants. He tries to spend limited income on different things in such a way that marginal utility of all things is equal. When he buys several things with given money income he equalizes marginal utilities of all such things. The consumer can get maximum utility by allocating income among commodities in such a way that last rupee spent on each item provides the same marginal utility.

 

Assumptions of the law:

 

1. Consumer has limited income or limited stock of a given commodity.

2. The marginal utility of money is constant.

3. Consumer has perfect knowledge of utility obtained from goods.

4. Consumer is normal person and rational, so he tries to seek maximum satisfaction.

5. The utility is measurable in cardinal terms.

6. The consumer has more than one want to satisfy. This he can do either by purchasing the required number of commodities out of a given income or putting a given commodity to various uses to satisfy his different wants.

7. The goods have substitutes.

 

Explanation:

 

The law of equi-marginal utility states that, other things being equal, a consumer gets maximum total utility from spending his given income, when he allocates his expenditure to the purchase of different goods in such a way that the marginal utilities derived from the last unit of money spent on each item of expenditure tends to be equal, that is, to say that the consumer maximizes his satisfaction, which he obtains equi-marginal utility from all the goods purchased at a given time.

 

The Law of Equi-Marginal utility can be explained with the help of table and diagram:

 

The law of substitution can be explained with the help of an example. Suppose consumer has six rupees that he wants to spend on apples and bananas in order to obtain maximum total utility. The following table shows marginal utility (MU) of spending additional rupee of income on apples and bananas:

 

 

The above schedule shows that consumer can spend six rupee in different ways:

  • Re.1 on apples and Rs.5 on bananas. The total utility he can get is: [(10) + (8+7+6+5+4)] = 40.
  • Re.2 on apples and Re.4 on bananas. The total utility he can get is: [(10+9) + (8+7+6+5)] = 45.
  • Re.3 on apples and Re.3 on bananas. The total utility he can get is: [(10+9+8) + (8+7+6)] = 48.
  • Re.4 on apples and Re.2 on bananas. This way the total utility is: [(10+9+8+7) + (8+7)] = 49.
  • Re.5 on apples and Re.1 on bananas. The total utility he can get is: [(10+9+8+7+6) + (8)] = 48.

 

Total total utility for consumer is 49 utils that is the highest obtainable with expenditure of Re.4 on apples and Re.2 on bananas. Here the condition MU of apple = MU of banana i.e 7 = 7 is also satisfied. Any other allocation of the last rupee shall give less total utility to the consumer.

 

The same information can be used for graphical presentation of this law:

 

 

The diagram shows that consumer has income of six dollars. He wants to spend this money on apples and bananas in such a way that there is maximum satisfaction to the consumer.

 

8.  Consumer’s Equilibrium

 

Consumer’s Equilibrium may be defined as the situation when a consumer derrives maximum satisfaction with his limited income and doesn’t want to make any change in his pattern of expenditure . since the consumer has to pay a price for the commodity he is going to purchase. Therefore he cannot consume unlimited quantity.According to the Law of DMU, utility derived from each additional unit goes on falling and his income is also limited. Therefore a rational consumer will try to have that consumption patteren which offers him maximum satisfaction with limited income. The position that achieves is called the position of equilibrium. At the point of equilibrium, consumer does not intend to make any change in it.

 

“ A consumer is in equilibrium when he regards his actual behavior as the best possible under the circumstances and feels no urge to change his behavior as long as circumstance remain unchanged.”–Tiber Scitovosky

 

Assumptions:

 

The various assumptions to explain concept of consumer equilibrium trough utility analysis are as follows:

  • Cardinal measurement of utility
  • Monetary measurement of utility 3.Continuous consumption
  • No change in Quality
  • Rational consumer
  • MU of money remains constant
  • Goods are divisible:
  • Fixed Income and prices:
  • Homogeneity

 

The concept of Consumer’s equilibrium can be explained under two set of situations:

 

1.  Consumer spends all his income on a Single Commodity:

2.  Consumer spends all his income on two Commodities:

 

In case of Single Commodity:

 

In case of single commodity,the Law of DMU can be used to explain position of consumer’s equilibrium. Therefore, all the assumptions of Law of DMU are taken as assumptions of consumer’s equilibrium in case of single commodity.

 

A consumer purchasing a single commodity will be at equilibrium, when he is buying such a quantity of that commodity, which gives him maximum satisfaction. The number of units to be consumed of the given commodity by a consumer depends on 2 factors:

 

1.  Price of the given commodity;

2.  Expected utility from the successive unit.

 

For the determination of the equilibrium point, consumer often compares the price of the given commodity with its utility derived from it. Being a rational consumer, he will be at equilibrium when marginal utility is equal to price paid for the commodity.

 

Condition of consumer Equilibrium:

 

In case of single commodity consumption by a consumer (say, “a”) will be at equilibrium when:

 

Marginal Utility (MUa) is equal to Price (Pa) paid for the commodity; i.e. MU = Price

 

There are two possibilities in this regard:

 

i. If MUa > Pa,this is not the situation of consumer equilibrium as utility is greater than price. Therefore consumer will buys more, untill MU becomes equal to price and then consumer gets the maximum benefits and will be in equilibrium.

 

ii.if when MUa < Pa, then this is also not the situation of equilibrium and to achieve the same a consumer will reduce consumption of commodity to raise his total satisfaction till MU becomes equal to price.