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Theory of Consumer Behaviour

Cardinal Approach and Utility Analysis, Total Utility and Marginal Utility

Objectives

After going through this chapter you shall be able to understand the following concepts

  • Consumer Behaviour Theory- Ordinal Approach and Cardinal Approach
  • Total Utility, Marginal Utility, Relationship between Total Utility and Marginal Utility
  • Law of Diminishing Marginal Utility
  • Utility Analysis and Consumer Equilibrium- One Good Case and Two Goods Case

Consumer- Who is a Consumer?

Anyone who purchases and consumes any goods and services for the satisfaction of his/her wants is called a consumer. A consumer spends the money available to him for purchasing different goods and services with the sole motive of attaining the highest possible level of satisfaction. 

Consumer Behaviour Theory

Under the Consumer Behaviour Theory, we examine the behaviour of a rational consumer in the market of goods and services. This theory basically analysis the decision making process of a consumer. It examines how a consumer makes choice among different available goods and services with his/her fixed income and given market prices of the goods and services. In Traditional Consumer Behaviour Theory, it is assumed that a consumer has complete knowledge of all the available goods and services, their respective prices and all other relevant information required to decide among different alternatives. In other words, the essence of consumer behaviour theory is to analyse how a consumer chooses among different available goods and services, with his given income and prices of goods and services, in order to achieve the highest possible satisfaction level.

It should be noted that in order to attain the highest possible level of satisfaction, a consumer must be able to compare the satisfaction derived from the consumption of various goods and services that he can purchase with his/her income. The question then arises is that how will a consumer do so. There are two approaches to answer this question- The Cardinal Approach and the Ordinal Approach.

The Cardinal Approach and the Ordinal Approach

Ordinal Approach

Ordinal Approach postulates that a consumer cannot measure the satisfaction that he/she derives from the consumption of a particular good or service. Further, it asserts that measurement of satisfaction in specific units is not required. In fact, a consumer ranks different goods and services as per his/her preferences. In other words, it asserts that a consumer takes his consumption decisions on the basis of the ranks assigned in order of his/her preferences. (This approach is explained in the next lesson)

Cardinal Approach

On the contrary, the Cardinal Approach postulates that it is possible for a consumer to measure (assign value to) the level of satisfaction that he/she derives from the consumption of a particular good or service. This valuation of satisfaction can be done in various ways such as, in terms of a subjective units called 'utils',  in terms of money (monetary terms) or in terms of sacrifice of other goods and services (opportunity cost).   

Utility Analysis and Optimal Choice of the Consumer

Utility refers to the satisfaction that a consumer expects to derive from the consumption of a particular good. It is a subjective concept and varies from person to person and from time to time. For example, a commodity, say, apples provide different level of satisfaction to different persons. Also, the same person can derive different level of satisfaction from consumption of apples at different points of time (for example, at the time of illness the apples may provide a consumer with a higher level of satisfaction).

The concept of Cardinal Approach is based on the assumption that a rational consumer can express his/her utility in terms utils. As utility can be cardinally (or numerically) expressed in terms of utils, so this approach has been named as Cardinal Approach. A util is a single unit of utility. Utils refer to the cardinal numbers that are assigned to different consumption bundles to represent the expected level of satisfaction derived from them. The numerical values are assigned by the consumer in such a manner that the more preferred consumption bundles are given higher values than the lesser preferred ones

Important Note: It should be noted that the concept of util has no standard unit such as, centimeters, grams, kilometers, etc. A consumer himself defines utils for different consumption bundles and accordingly assigns cardinal numbers (say 1, 2, 3, etc.) to them in the order of his/her preferences.

Total Utility and Marginal Utility

Total Utility refers to the aggregate utility or summation of utility derived from the consumption of all the units of a commodity. Algebraically,

TU = TU1 + TU2 + TU3 + ...............+ TUn

For example, assume that a particular consumer consumes two apples one after another. The consumption of first apple provides him a satisfaction of 3 utils, while, the consumption of the second apple provides him a satisfaction of 5 utils. Thus, the Total Utility derived from the consumption of two apples is 

TU = TU1 + TU2

TU = 3 utils + 5 utils = 8 utils

Marginal Utility (MU)

Marginal Utility refers to the addition to the total utility due to the consumption of an additional unit of a commodity. Algebraically,

MUn = TUn – TUn – 1

In the above example, the utility derived from the consumption of first apple (TU1) is 3 utils and the utility derived from consumption of second apple (TU2) is 5 utils. The Marginal Utility (i.e. the additional utility derived from the consumption of second apple) is

MU2 = TU2 – TU2 – 1

MU2 = TU2 – TU 1

MU2 = 5 utils 3 utils = 2 utils

Numerical Example- Schedule 1:

Number of Units Consumed of Commodity X

Total Utility 

(TU)

(utils)

Marginal Utility (MU)

MUn = TUn – TUn – 1

(utils)

1 50 50 – 0 = 50
2 100 100 – 50 = 50
3 130 130 – 100 = 30
4 150 150 – 130 = 20
5 160 160 – 150 = 10
6 160 160 – 160 = 0
7 150 150 – 160 = – 10

Note: Total Utility is the sum of Marginal Utility

i.e. TUn = MU1 + MU2 + MU3 +..............+ MUn = ∑MU

TU7 = MU1 + MU2 + MU3 +.MU4 + MU5 +.MU6 + MU7 = ∑MU

or, TU7 = {50 + 50 + 30 + 20 + 10 +0 + (– 10)} = 150

This implies that consumption of 7 units of the commodity X enabled the consumer to derive 150 utils of utility.

Relationship between Total Utility and Marginal utility

To understand the relationship between Total Utility and Marginal Utility, consider the Schedule 1 (given above). The following are points that we can analyse from the above schedule.  

1. As more and more units of the commodity are consumed, the Marginal Utility derived from the consumption of each additional unit of the commodity tends to fall. With the consumption of the successive units, the Marginal Utility becomes zero and consequently becomes negative. (As per the schedule, MU is zero at the consumption of 6th unit and becomes negative at 7th unit consumed).

2. As long as MU derived from the consumption of additional units of the commodity is positive, TU continues to rise. (MU is positive till the consumption of the 5th unit of the commodity.) 

3. When TU becomes maximum (also known as Saturation Point), MU becomes zero. (TU is maximum at 160 utils and MU is zero at the 6th unit.) 

4. When TU starts falling, MU becomes negative.(For the consumption of 7th unit, MU becomes negative and accordingly the TU falls from 160 utils to 150 utils)

5. MU is derived from TU as:

MUn = TUn – TUn – 1

and TU is defined as the summation of all the Marginal Utility as:

 TUn = MU1 + MU2 + MU3 +..............+ MUn = ∑MU

6. Diagrammatically, the relationship between the TU and MU can be expressed as follows.  

In the above figure, TU is the Total Utility curve, while MU in the lower part of the figure is the Marginal utility curve. Initially TU increases but at a decreasing rate. Correspondingly, the MU is falling. This happens till point A. At point A, TU has reached its maximum and correspondingly in the lower part MU becomes zero (point B). The point where TU is maximum and MU is zero is called the saturation point. Beyond point A, TU falls and MU becomes negative.

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Law of Diminishing Marginal Utility

Law of Diminishing Marginal Utility states that as a consumer consumes more and more units of a commodity at succession, then Marginal Utility derived from the consumption of each additional unit of the commodity falls.

Assumptions

The Law of Diminishing Marginal Utility is based on the following two basic assumptions.

  1. Standard Units and Reasonable Size of Units- A consumer consumes only standard units of the commodity. For example, a whole of an apple and not half of it. Similarly, glass of water and spoon of water.
  2. Successive Consumption- Consumption of the successive units of the commodity takes place continuously (i.e. without any time lag). This is because if the consumption takes place with a time lag say of an hour or a week (i.e. consumption of one unit of the commodity takes place today and the consumption of the second unit takes place after one week) then, in the next week the consumer will start a fresh valuation of the utility without taking into consideration the utility derived from the consumption of the previous unit of the commodity in the previous week.
  3. Homogeneous Units- The law also assumes that the quality of the commodity remains the same throughout the process of consumption. In other words, all the units of a commodity should be homogeneous and identical in terms of shape, size, colour, quality, etc. That is, if a consumer is consuming water, then a glass of normal water should not be followed by a glass of cold water or a glass of sweet water.
  4. Rational Consumer- The law is applicable only if the consumer is a rational human being. That is, he should make rational consumption decisions.
  5. No Change in Consumer's Tastes and Preferences- There is no change in the tastes and preferences of consumers.   
  6. Utility can be measured- The law only holds if the consumer is able to express his utility in terms of utils. That is, utility can be measured cardinally (or numerically).

Exceptions to the Law of Diminishing Marginal Utility

The Law of Diminishing Marginal Utility fails to operate in the following situations.

  1. Money- The Law of Diminishing Marginal Utility fails in case of earning money. Due to the greed of earning money, people tend to earn as much money as they can.
  2. Knowledge- The law also fails in case of acquiring knowledge. An individual feels more pleasure and derives higher level of utility with greater degree of knowledge and higher education.
  3. Liquors and Cigarettes- The consumption of such products like liq...

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