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BCA Unit 3 Theory of Consumer Behaviour
BCA Unit 3 Theory of Consumer Behaviour
Unit: 3 (Three)
Theory of Consumer Behavior
3.1 Concept of Cardinal and Ordinal Utility Analysis
Generally, the characteristics of a commodity are known as utility. But in economics ‘utility
is the capacity of a commodity and services to satisfy human wants.’ So, consumers
consume goods and services according to their utility. According to Marshall, “Utility is
the measure not of usefulness, not of satisfaction, but of the intensity to desire.”
Utility refers to the benefit derived from the consumption of commodities. It is the
subjective approach because it is different on the basis of time, place and person to person.
This is because due to consumption of same amount of commodity one may get high
satisfaction and other may get less satisfaction. Thus, when defining utility, the following
should be kept in mind:
a) There is different between utility and usefulness.
b) Utility is not synonymous with pleasure.
c) Utility is subjective.
d) Utility varies in different situation.
Approaches of Utility Analysis
There are two basic approaches to study the consumer behaviors.
1. Cardinal Approaches
2. Ordinal Approaches
1. Cardinal Approaches: The cardinal utility approach was developed by neo-
classical economists like Marshal, Pigou, Robertson, etc. It is based on quantitative
measurement of utility or satisfaction.
2. Ordinal Approaches: Ordinal utility approach was developed by Pareto, W. E.
Johanson, Slutsky, J. R. Hicks and R.G.D. Allen. It is based on qualitative
measurement of utility or satisfaction. It does not measure quantitatively the utility
derived from consumption of commodity. Under this method consumer ranks the
alternative combinations available for him by a simple comparison of the
satisfaction obtained from the given combination of goods and services.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
which assume that utility is measurable and additive. It is expressed as quantity measured
in hypothetical units, which is called utils. If a consumer imagines that one mango has 8
utils and an apple 4 utils, it implies that the utility of one mango is twice that of an apple.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
for more units of commodity; its M.U derived from each additional unit diminishes in
comparison to the previous unit. Hence the law of diminishing marginal utility implies that
consumption of each successive units of a particular commodity gives less and lesser
satisfaction to the consumer if a consumer consumes it in a certain time period.
According to Marshall, “The additional benefit which a person derives from a given
increase in the stock of a thing diminishes, other thing being equal, with every increase in
the stock that he already has.”
According to K.E. Boulding, “As a consumer increases the consumption of any one
commodity, keeping constant the consumption of other commodity, the marginal utility if
the variable commodity must eventually decline.”
According to prof. Briggs, “The marginal utility of a stock of similar goods decreases with
an increase in the number of unit of the stock.”
According to the definitions given above, it can be concluded that the marginal utility of
the commodity decreases with the increase of each additional unit of such commodity. The
reason is that the human wants are unlimited.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
We can explain this law by the help of given table and figure:
Units of commodity Marginal Utility (M.U.) Total Utility (T.U.)
1 10 10
2 8 18
3 6 24
4 4 28
5 2 30
6 0 30
7 -2 28
On the above table, when the consumer consumes one unit of commodity then marginal
utility is 10. When consumption of commodities gradually increases from 1st to 7th, unit of
commodity the marginal utility decreases from 10 to -2. When consumer consumes 6th units
then at that time marginal utility is 0. We can explain the same table by the help of following
figure:
12
10
6
Marginal utility
Marginal
Utility(M.U.)
4
0
1 2 3 4 5 6 7
-2
-4
Units of commodity
On the above graph x and y-axes measures units of commodity and M.U respectively.
Marginal utility curve is derived on the basis of above table which is negatively slopped
and tends to negative. It indicates when consumer consumes more and more commodity
M.U starts to decline and it tends to the negative.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
3.1.1.3.2 Consumer Equilibrium: Two Commodity Model
Consumer Equilibrium under One Commodity Model can be explained by the help of law
of Substitution:
This law is developed by Herman Heinrich Gossen so it is also called the second law of
Gossen. We know human wants are unlimited but the resources to fulfill the wants are
limited. A rational consumer always tries to maximize his satisfaction by spending his
limited money income. Consumer can maximize his satisfaction if he is able to equalize the
marginal utility derived from the consumption of different units of several commodities by
spending his all limited money income so that this law is known as law of maximum
satisfaction or law of equi-marginal utility.
According to Marshall, “If a person has a thing which he can put to several uses, he will
distribute it among these uses in such a way that it has the same marginal utility in all.”
According to Watson and Getz, “The best or optimum allocation is one that causes the
marginal utilities in each use to be equal.”
This law is also known as law of substitution because consumer can maximize his/her
satisfaction when he/she substitutes the commodities having high marginal utility instead
of commodities having the low marginal utility. Mathematically it is expressed as:
In the above equation, MUx and MUy represent the marginal utilities of commodities
respectively. Px and Py represent prices of commodities X and Y respectively. MUm is the
marginal utilities of money. Here, MUm is taken as constant according to the concept of
cardinal utility. This law is based on the following assumptions:
We can describe this theory by the help of given table and figure: Suppose income of
consumer is Rs.24. There are two commodities i.e. X and Y for consumption. Price of per
unit of X and Y commodity is Rs.2 and Rs.3, respectively.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
Units M.U of x M.U of y MUX/PX MUY/PY
1 20 24 10 8
2 18 21 9 7
3 16 18 8 6
4 14 15 7 5
5 12 12 6 4
6 10 9 5 3
In the given table, the consumer will be in equilibrium when s/he purchases 6 units of X
and 4 units of Y because it satisfies the following condition required for consumer’s
equilibrium.
At the 6th unit of X and 4th unit of Y
𝑀𝑈𝑋 𝑀𝑈𝑌
=
𝑃𝑋 𝑃𝑌
10 15
𝑂𝑟, =
2 3
∴5=5
The same concept can be explained by given figure:
equilibrium when s/he purchases 6 units of X and 4 units of Y. No any other combinations
will yield him/her greater utility than this combination.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
Suppose, if the consumer purchases one unit less of Y, i.e., 3 units and one unit more of X
i.e., 7 units, this will lead to the decrease in total utility than before. When s/he purchases
one unit less of Y i.e., 3 units, there is a loss in utility by the shaded area ABCD and when
s/he purchases one unit more of X i.e., 7 units, there is a gain in utility by the shaded area
STUV. Here, area of loss is greater than area of gain, i.e., ABCD>STUV. So, the consumer
𝑀𝑈𝑋 𝑀𝑈𝑌
is in equilibrium at the point where 𝑃𝑋
=
𝑃𝑌
=MUM. this condition is satisfied when the
In the upper portion of the figure, MU curve represents the diminishing marginal utility of
the commodity X. initially, the consumer is in equilibrium at point E1 where price of
commodity X is P1 and MUX = P1 (MUm). At the equilibrium position, the equilibrium
quantity is OQ1 unit. It the price of the commodity X falls to P2, the consumer will be in
equilibrium at point E2 where MUX =
P2 (MUm). Here, the equilibrium
quantity is OQ2 units. Similarly, the
consumer will be in equilibrium at
point E3 when price falls to P3. At this
price the equilibrium quantity is OQ3
units.
The lower portion of the figure shows
the relationship between price and
quantity demanded for X commodity.
When price is P1, consumer purchase
OQ1 unit of commodity. It is indicated
by J. Similarly, when price fall to P2
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
and P3, the quantity purchases increase to OQ2 and OQ3 units, respectively which are
marked by points K and L respectively. It we join all these points, we get downward sloping
demand curve DX.
Let us suppose that the price of commodity X falls whereas price of Y commodity and
𝑀𝑈𝑋 𝑀𝑈𝑌
income of the consumer are constant. will become greater than due to fall in price
𝑃𝑋 𝑃𝑌
Assumptions
The ordinal utility analysis is based on the following assumptions:
1. The consumer must be rational: A consumer is assumed to be rational. S/he
always tries to maximize his/ her utility, given his/her income and market prices. It
is assumed that he has full knowledge of all relevant information.
2. Ordinal Measurement of utility: it is assumed that the consumer can rank his
preferences according to the satisfaction derived from each bundle of goods. He
does not need to know the amount of satisfaction.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
3. Diminishing Marginal rate of Substitution: The Marginal rate of Substitution is
the rate at which a consumer is willing to substitute one commodity (X) for another
∆𝑌
(Y) so that his total satisfaction remains the same. This rate is given by . The
∆𝑋
∆𝑌
assumption is ∆𝑋 goes on decreasing, when the consumer continues to substitute X
for Y.
4. Transitivity and Consistency of choice: Consumer’s choice are assumed to be
transitive. Transitivity of choice means that if a consumer prefers A to B and B to
C, he must prefer A to C.
Symbolically, If A>B and B>C, then A>C.
It is assumed that a consumer is consistent in choice. Consistency of choice means
that if the consumer prefers A to B in one period, he must not prefer B to A in
another period.
Symbolically, If A>B in one period, then B≯A in another.
5. Non-Satiety: Non-satiety means that the consumer has not reached the point of
saturation in case of any commodity. Therefore, a consumer always prefers a large
quantity of all the goods.
We know that one commodity serves as a substitute for another. It provides an opportunity
to substitute one commodity for another. Therefore, a consumer can make various
combination of two goods which give him/her same level of satisfaction. When such
combinations are plotted graphically it gives a curve. This curve is known as indifference
curve. It is also called iso-utility curve or equal utility curve.
In the words of Dominick Salvatore, “An indifference curve shows the various
combinations of two goods that give the consumer equal utility or satisfaction.”
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
Thus, indifference curve is the locus of different combinations of two goods which
represent equal satisfaction or utility.
Assumptions:
1. Two Commodity: It is assumed that the consumer has fixed amount of money, all
of which is to be spent only on two goods. It is also assumed that prices of both the
commodities are constant.
2. The consumer should be rational.
3. Utility is ordinally measurable.
4. The marginal rate of substitution diminishes when one commodity is substituted for
another.
5. The consumer does not reach to the point saturation in case of any commodity.
6. There is consistency and transitivity in choice.
A table shows the various combination of two goods that yield the same level of satisfaction
to the consumer is called indifference schedule. The given example of is of indifference
schedule which shows 5 different combinations A, B, C, D, and E of two goods Mangos
and Oranges. All these combinations yield the same level of satisfaction to the consumer.
Therefore, the consumer is indifferent between them.
Combinations Commodity X (Mangos) Commodity Y (Oranges)
A 1 14
B 2 9
C 3 6
D 4 4
E 5 2.5
The above table shows all the combinations of Commodity X (Mangos) and Commodity Y
(Oranges) goods gives the same level of satisfaction to the consumer. When indifference
schedule is plotted in the graph, we will get an indifference curve as shown in the figure.
In the given figure, Mangos are
measured in X-axis and Oranges are
measured in Y-axis. The points A, B,
C, D, and E are different combination
of Mangos and Oranges which gives
the same level of satisfaction to the
consumer. When we join these
combinations, we will get a smooth
and continuous curve. This curve is called indifference curve (IC).
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
3.1.2.2 Indifference Map
A set of indifference curves is called indifference map. An indifference map shows different
indifference curves which rank the preference of the consumer. Combinations which lie on
an indifference curve give the same level of satisfaction to the consumer. However, higher
indifference curve represents higher level of
satisfaction than a lower indifference curve.
An indifference curve far from the origin is
called higher indifference curve and near to
the origin is called lower indifference curve.
In the given Figure, Goods X is measured on
X-axis and Y Goods on y-axis indifference
curve shows those combinations of two goods
that yield the same level of satisfactions to the
consumer. IC3 yields the higher satisfaction than IC2 IC1 yields the lowest level of
satisfaction. This is because higher IC contains more units at least one Goods.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
2. Convex to the origin: Indifference curves for normal goods are convex to the
origin. This implies that the two goods are imperfect substitutes for one another and
the marginal rate of substitution between the two goods decreases as a consumer
moves along an indifference curve. Diminishing marginal rate of substitution means
that as the quantity of X increased by equal amount, the quantity of Y diminishes
by smaller amount.
3. Higher indifference curve represents higher level of satisfaction that the lower
ones: A higher indifference curve represents higher level of satisfaction than the
lower one. The reason is that an upper indifference curve contains larger quantity
of one or both the goods than the lower one.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
In the given figure, two indifference curves IC1 and IC2 are intersecting to each
other at point A. Point A lies on both indifference curves where point B and C lie
on IC1 and IC2 curves respectively. Points A and B lie on the same indifference
curve IC1. It means that points A and B give the same level of satisfaction.
Similarly, points A and C lie on the same indifference curve IC2 It implies that
points A and C give the same level
of satisfaction. It shows that utility
from points B and C will also be the
same. But it is a conflicting result
because higher indifference curve
yields higher level of satisfaction
than lower one. Thus, two
indifference curves cannot intersect
to each other.
5. Indifference curves are not necessarily parallel: Though indifference curves are
falling downward, the rate of fall will not be the same for all indifference curves. In
other words, the diminishing marginal rate of substitution between the goods is not
the same in the case of all indifference schedules. Therefore, no necessary to be
parallel of two indifference curves.
6. Indifference curve does not touch either axis: Indifference curve approach is a
two commodity model. Therefore, we must have to two commodities. If IC touches
any axis, it implies that consumer purchases single commodity.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
If indifference curve IC2 touches X-axis as
shown in the given Figure at M, the consumer
will be having OM units of good X and no Y.
Similarly, if an indifference curve IC1
Commodity Y
touches the Y-axis at L, the consumer will be
having only OL units of good Y and no X.
Such curves violate the assumption that the
consumer buys two goods in a combination. Commodity X
Therefore, indifference curves do not touch
either of the axes.
Let us suppose that the consumer substitutes X for Y without affecting total utility. When
the consumer sacrifices some units of Y, his stock of Y decreases by ΔY and he loses a part
of his total utility. His loss of utility may be expressed as -ΔY.MUY
On the other hand, as a result of substitution, his stock of X increases by ΔX. His gain of
utility from X equals +ΔX.MUX
The total utility remains the same only when -ΔY.MUY = +ΔX.MUX
∆𝑌 𝑀𝑈𝑋
𝑀𝑅𝑆𝑋𝑌 = − =
∆𝑋 𝑀𝑈𝑌
∆𝑌
Here is simply the slope of the indifference curve, which gives the MRSXY when X is
∆𝑋
substituted for Y.
∆𝑋
Similarly, ∆𝑌 gives MRSYX when Y is Substituted for X. Symbolically,
∆𝑋 𝑀𝑈𝑌
𝑀𝑅𝑆𝑌𝑋 = − =
∆𝑌 𝑀𝑈𝑋
Principle of Diminishing MRS
The marginal rate of substitution is the amount of one good that an individual a willing to
give up for an additional unit of another good without affecting the level of satisfaction.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
For example, the marginal rate of substitution of good X for unit of good Y (MRSXY) is the
amount of Y that an individual is willing to exchange per unit of X by maintain the same
level of satisfaction.
Marginal rate of substitution of X for Y diminishes as more and more units of good X is
substituted for Y. In other words, as a consumer has more and more units of goods X, he is
willing to forgo less and less units of good Y. The principle of diminishing MRS can be
explained with the help of table and figure.
Combination Goods X Goods Y MRSXY
A 1 12 -
B 2 8 4
C 3 5 3
D 4 3 2
E 5 2 1
In given table, the rate of substitution of good X for good Y is shown. In the beginning, as
the consumer moves from A to B, he is ready to give up 4 units of Y for the one extra unit
of good X. In this process, his level of satisfaction remains same. It follows that one unit
gain in X fully compensates him for the loss of 4 units of Y. At this stage, marginal rate of
substitution of X for Y is 4.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
Why does MRS Diminish?
The following three factors are responsible for diminishing MRS.
1. The particular want is satiable: The want for a particular commodity is satiable
so that as the consumer has more and more units of a commodity, the intensity of
his want for those good goes on falling. Due to this reason, when the stock of a
commodity, say X, increases with the consumer, he is willing to forgo less and less
of another commodity, say Y, for every increase in X. In the beginning, when the
consumer's stock of good Y is relatively large and his stock of good X is relatively
small consumer's Marginal significance for good Y will be low while his marginal
significance for good X will be high. Therefore, the consumer will be willing to
give up a larger amount of Y for a unit increase in good X.
But as the stock of good X increases the marginal significance for good X will
diminish. On the other hand, as the stock of good Y decreases, the marginal
significance for good Y will go up. As a result, as the individual substitute more
and more of X for Y, he is prepared to give up less and less of Y for a unit increases
in X.
2. Goods are not perfect substitute for each other: Marginal rate of substitution
diminishes because goods are not perfect substitute for each other. If the two goods
are perfect substitute of each other, they are to be regarded as the one goods and
decrease in the quantity of the other goods would not make any difference in the
marginal rate of substitution of the goods. Hence, in case of perfect substitutability
of goods, the marginal rate of substitution remains the same and does not decline.
3. Increase in the quantity of one good does not increase the want satisfying of
the other: The principle of diminishing marginal rate of substitution will hold good
only if the increase in the quantity of one good does not increase the want satisfying
power of the other. If with the increase in the stock of good X, the want satisfying
power of good Y increases, the greater and greater amount of good Y will be
required to be given up for a unit increase in good X. As a result, the consumer's
satisfaction remains same.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
budget line shows different combinations of two goods, which a consumer can purchase by
spending his/her given money income and market prices. A consumer can purchase any
combination of two goods that lies on the budget line with his/her given money income and
market prices of goods.
Budget line can be presented by a budget equation. If the X and Y commodity are multiplied
by their respective price and add, we get budget line. Consumer has a limited income
(budget constraint). Due to the budget constraint, consumer needs to decrease one
commodity to increase another commodity. So, budget line is downward sloping. Slope
means change. So, the slope of budget line is the change in budget due to change in its
determinants. Slope of the budget line is the first order derivative of budget equation. The
budget constraint may be expressed as
𝑃𝑋 ∙ 𝑄𝑋 + 𝑃𝑌 ∙ 𝑄𝑌 = 𝑀 … (𝑖)
Where,
PX = Price of the commodity QX = Quantity of X Commodity
PY = Price of the commodity QY = Quantity of Y Commodity
M = Money income (Budget)
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
combinations. The combinations lying to the left of the budget line are attainable but not
desirable.
The intercept of OB on the Y-axis equals the amount of this entire income divided by the
𝑀
prices of commodity Y, i.e., 𝑂𝐵 = . Likewise, the intercept OL on the X-axis measures
𝑃𝑌
𝑀
the total income divided by the price of commodity X. Thus, 𝑂𝐿 = . If the consumer
𝑃𝑋
𝑀
spends all his income on Y commodity, then 𝑄𝑌 = (Since X = 0). Similarly, if he spends
𝑃𝑌
𝑀 𝑀
whole income on X commodity, then 𝑄𝑋 = (since, Y = 0). shows the amount of
𝑃𝑋 𝑃𝑌
𝑀
commodity Y that can be purchased if the quantity of X is zero. shows the amount of
𝑃𝑋
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
the purchase of commodity X, S/he would by 3 units of X. If s/he spends all his income on
the purchase of Y, he would buy 4
as shown in Figure.
Suppose, price of X
commodity falls from Rs. 12 to
Commodity Y
6, keeping the price of Y
commodity and budget
constraint, consumer increases
the purchases of X commodity
from 3 units to 6 units without
reducing Y commodity. As a
result, price line swing upward
Commodity X
from LM to the position LN.
Similarly, if price of X commodity rises from Rs. 12 to Rs. 18, the consumer decreases the
purchase of X commodity from 3 units to 2 units. Consequently, the price line swing
downward to the position from LM to LP.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
consumer's income increases to Rs. 100 then the initial budget line LM shifts rightward to
JK, where consumer can purchase 10 units of X commodity and 20 units of Y commodity.
On the other hand, when consumer's income decreases to Rs 20, the initial budget line LM
shifts leftward to NQ where the consumer purchases 2 units of X commodity and 4 units of
Y commodity.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
the budget line will swing rightward to PL3 where consumer purchases OX3 units
and OY3 units of X and Y goods respectively. If the price of X rises, budget line
will swing downward to PL1 and the consumer is in equilibrium at point E1. If we
join these equilibrium points E1, E2 and E3, we will get downward sloping price
consumption curve (PCC). PCC is downward sloping because goods X and Y are
substitutes. It indicates that the demand for commodity X is elastic. PCC explains
price effect on the consumer's equilibrium.
Price Effect on Giffen Goods: Those good are Giffen goods which have positive
price effect. it means that price and demand for Giffen goods are positively related.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
For example, let us suppose that X is a Giffen goods. Therefore, as the price of X
falls, the purchase of X decreases but the purchase of Y increases. Hence, PCC
slopes backward in case of Giffen goods as shown in the Figure.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
Positive Income Effect (Income Effect on Normal goods): Those goods are
normal goods whose income effect is positive. It means that when income of a
consumer increases, the quantity purchase also increases and vice-versa. Therefore,
in case of normal goods, income consumption curve (ICC) is upwards sloping as
shown in the given figure below. Income consumption curve is the locus of
equilibrium points at different level of income.
Negative Income Effect (Income Effect on Inferior Goods): Those goods are
inferior goods, whose income effect is negative. It means that with the increase in
income, the quantity purchase of inferior goods decreases because the consumer
substitutes the inferior goods by superior goods. In case of inferior goods, the
income consumption curve slopes backward to the left or downward to the right as
shown in the Figure.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
In the Figure, X-axis
represents quantity of
good X, which is
assumed to be inferior
and Y-axis represents
quantity of Y good. P2
L2 is the initial budget
line and the consumer
is in equilibrium at
point E2 on
indifference curve IC2.
At this equilibrium point, the consumer purchases OX2, units of good X and OY2
units of good Y. When money income of the consumer increases, the initial budget
line P2 L2 will shift upward to P3 L3. The new equilibrium is obtained at point E3 at
the higher indifference curve IC3. At this point the purchase of good X decreases to
OX3 units and the purchase of good Y increases to OY3 units. Similarly, when
income decreases, the initial budget line will shift downward to P1 L1 and new
equilibrium is established at point E1 at the lower indifference curve IC1. At this
point the purchase of good X increases to OX1 unit and the purchase of good Y
decreases to OY1 unit. By joining equilibrium points, we get backward bending,
income consumption curve (ICC).
Thus, if we assumed good X is inferior and it is measured on X-axis, the ICC will
bend backward or toward the Y-axis as shown in Figure. Similarly, if we assumed
good Y is inferior good and it is measured on Y-axis, the ICC will bend downward
or toward the X-axis.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
is compensated by a simultaneous change in money income, but how? we have two
different approaches suggested by two different economists (i) Hicks and (ii) Slutsky.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
Movement from E1 to E3 on the same indifference curve is due only to the relative fall in
price of X. At point E3, the consumer purchase X1 X3 more of goods X than at E1 and Y1Y3
less of good Y than at point E1. Thus, the movement from E1 to E3 represents the
substitution effect.
If reduced money from his/her money income is given back, the consumer would move
from E3 to E2. So, the movement from E3 to E2 represents income effect. Thus, price effect
is the sum of substitution effect and income effect.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
In order to find out slutsky's substitution effect, consumer's real income is so reduced (by
way of taxation) that he returns to the original equilibrium point E1 and s/he is able to
purchase the original combination of goods X and Y at new price, if he so desires. For this
purpose, a price line AB parallel to PL2 has been drawn which passes through the original
equilibrium point E1. It means that income equal to PA in terms of Y or L2B in terms of X
has been taken away from the consumer. As a result, s/he can purchase the original
combination E1, if s/he so desires. But the consumer will not purchase the original
combination E1 because X has become relatively cheaper and Y has become relatively
dearer than before. The imaginary price line AB is tangent to the indifference curve IC 1 at
point E3. Therefore, the consumer will be in equilibrium at a point E3 on a higher
indifference curve IC3. The movement from equilibrium point E2 to E3 shows a fall in the
purchase of X by X2 X3. This is income effect. We can easily find out the substitution effect
by subtracting the income effect from price effect as shown below:
In the Figure, the movement from E1 to E3 and consequent increase in the quantity
purchased of good X (i.e., X1 X2) is the substitution effect and movement from E3 to E2 and
the consequent increase in the quantity purchased of good X (i.e., X3 X2) is the income
effect.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
measured in X and Y axis
respectively. The initial budget
line is PL2 where consumer is
equilibrium in IC2 at point R.
which determine OY2 of
commodity Y and OX2 unit of
commodity X. it gives the
combination ‘A’ at the lower
portion of the figure where
consumer consume OX2
commodity at OP2 price. If we
allow the price of X to fall
continuously, the budget line will
swing rightward to PL3 and new
equilibrium points S will be
obtained. Where consumer
consume OX3 and OY3 units of X
and Y commodity respectively.
It gives the combination ‘B’ at the lower portion of the figure where consumer consumes
OX3 units at OP3 price. If the price of X increases, budget line swing downward to PL1
where consumer is equilibrium at point Q. it gives the combination C where consumer
consumes OX1 commodity at OP1 price. If we join all those combination A, B, C we get
one downward sloping curve Dx which is a demand curve of a consumer for commodity X.
In the upper port of the figure, Commodity X and Commodity Y measured in X and Y axis
respectively where, commodity X is Giffen Goods. Similarly, in the lower part of the figure,
commodity X and Price of X measured in X and Y axis respectively. Due to fall in price of
X, the price line swing from PL1 to the position PL2 and PL3 which causes to change the
consumer’s equilibrium from E1 to E2 and E3 respectively.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
In the lower part of the figure,
consumer consumes OX1
units of X commodity at OP3
price with the help of initial
equilibrium E1 which gives
combination A. if price
decreases consumer
consumes OX2 unit of X
commodity at OP2 price
which gives the combination
B. Again, the price decreases
to P1, consumption also
decreases to OX3 which gives
the combination C. By
joining combination, A, B
and C we get one upward
sloping curve Dx which is a
demand curve of commodity X.
In the given Figure, A2 B2 is the initial budget line, which is tangent to the indifference
curve IC2 at point E2. Hence, initial equilibrium point is E2. Let us suppose, the income of
the consumer increases. As a result, the initial budget line A2B2 will shift rightward to A3B3.
With the budget line A3B3, the consumer is in equilibrium at point E3 on higher indifference
curve IC3, which shows OX3 units of good X and OY3 units of good Y purchased by the
consumer. Again, when income of the consumer decreases, the consumer will be in
equilibrium at point E1 on lower indifference curve IC1, which shows OX1 units of good X
and OY1 units good Y purchased by the consumer. If equilibrium points E1, E2 and E3 are
joined, a curve is obtained, which is known as the income consumption curve (ICC).
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
With the help of consumers'
equilibrium points shown is
figure (A), income demand
or Engel curve for normal
good X has been derived in
Figure (B). According to
initial equilibrium point E2,
at income OY2, the demand
for X good is OX2 unit. It is
denoted by point 'B'.
Similarly, according to the
equilibrium point E3, at
income OY3, the demand for
good X is OX3 units. It is
denoted by point 'C'. Again,
similarly, according to
equilibrium point E1, we get
point 'A'. When points A, B
and C are joined, income demand curve or Engel curve DD is derived.
In the Figure A, X-axis represents quantity of good X, which is assumed to be inferior and
Y-axis represents quantity of Y good. A2B2 is the initial budget line and the consumer is in
equilibrium at point E2 on indifference curve IC2. At this equilibrium point, the consumer
purchases OX2, units of good X and OY2 units of good Y. When money income of the
consumer increases, the initial budget line A2 B2 will shift upward to A3B3. The new
equilibrium is obtained at point E3 at the higher indifference curve IC3. At this point the
purchase of good X decreases to OX3 units and the purchase of good Y increases to OY3
units. Similarly, when income decreases, the initial budget line will shift downward to A1
70
Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
B1 and new equilibrium is
established at point E1 at the
lower indifference curve IC1. At
this point the purchase of good X
increases to OX1 unit and the
purchase of good Y decreases to
OY1 unit. By joining equilibrium
points, we get backward bending,
income consumption curve
(ICC).
Thus, if we assumed good X is
inferior and it is measured on X-
axis, the ICC will bend backward
or toward the Y-axis as shown in
Figure. Similarly, if we assumed
good Y is inferior good and it is
measured on Y-axis, the ICC will X3 X2
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
2. Wrong assumption of rational consumer: The indifference curve analysis
assumes that the consumer acts rationally. But in this modern changing situation, it
is very difficult for consumer to gather all necessary information. It is time
consuming, and costly. So, they are behaving whatever way they like. Therefore,
consumers may not be rational.
3. No Newness: professor Robertson does not find anything new in the indifference
curve technique and he regards it simply the old wine in a new bottle, it replaces
introspective cardinalism by introspective ordinalism instead of the cardinal
numbers such as 1, 2, 3 etc. ordinal numbers I, II, III, etc., are used to indicate
consumer's preference. It substitutes marginal utility by marginal rate of
substitution. Thus, this technique is failed to bring a positive change in the utility
analysis and merely gives new name to the old concept.
4. Income, preference and habit change: The ordinal utility analysis is based on the
assumption that income, preference and habit of the consumer remain same. But in
this changing world, it is very hard to find a constant income, preference and habit
of the consumers. It means that these elements change with the change in time.
5. Cannot explain about uncertainty: The ordinal utility theory is not capable of
formulating consumers' behavior when their preferences involve risk or uncertainty
in expectations.
6. Unrealistic assumption of perfect competition: The indifference curve technique
is based on the unrealistic assumptions of perfect completion and homogeneity of
good, in reality, consumer is confronted with differentiated products and
monopolistic competition. Since, the indifference curve analysis is based on
unwarranted assumption, it becomes unrealistic.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
Rather indifference technique analyzes the income effect when the income of the
consumer changes.
3. As pointed by cardinalists, utility can be measured in terms of number, But the
ordinalists rejected this assumption. The ordinal approach doesn't say that utility
has to be measured by using cardinal number. It says that utility cannot be measured
quantitatively.
4. The ordinal approach explains price effect into income effect and substitution effect
which is not possible under cardinal utility analysis. It discusses the price of a good
changes. Thus, it discusses dual effect in the form of the income and substitution
effect. But cardinal approach cannot explain dual effect.
5. Ordinal approach explains that the two-commodity model which discuss about the
consumer's behavior in the case of substitutes, complementary and unrelated goods.
But cardinal approach explains that single commodity model.
6. The ordinal analysis explains the law of demand more realistically by considering
inferior and different goods as well. This makes the IC technique definitely superior
to the cardinal utility analysis.
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