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Consumer Preferences and Choice
(Utility)
Lecture plan
• Objectives
• Consumer Choice
• Cardinal Utility Analysis
• Marginal Utility and Demand Curve
• Ordinal Utility Analysis
• Diminishing Marginal Rate of Substitution
• Consumer’s Equilibrium
• Revealed Preference Theory
Objectives
• To introduce the crux of consumer behaviour,
choices and preferences.
• To explain the nuances of utility analysis, marginal
utility, total utility and law of diminishing marginal
utility.
• To explain the difference between cardinal and
ordinal utility analyses of consumer behaviour.
• To discuss how consumer equilibrium is attained
subject to budget constraint.
• To illustrate the concept of consumer surplus and its
application in decision making.
Consumer Choice
• Given the prices of different commodities, consumers
decide on the quantities of these commodities
according to their paying capacity, and tastes and
preferences.
• Consumers’ choices, tastes and preferences rests on
the following assumptions:
– Completeness: A consumer would be able to state own
preference or indifference between two distinct baskets of
goods.
– Transitivity: An individual consumer’s preferences are
always consistent.
– Non-satiation: A consumer is never satiated permanently.
More is always wanted; if “some” is good, “more” of the
good is better.
Consumer Choice
• Commodities are desired because of their utility
– Utility is the attribute of a commodity to satisfy or satiate a
consumer’s wants
– Utility is the satisfaction a consumer derives from
consumption of a commodity
• Mathematically: utility is the function of the
quantities of different commodities consumed:
U= f(m1, n1, r1)
Cardinal Utility Analysis
• Marshall and Jevons opined that Utility is a cardinal concept and
is measurable (in utils) like any other physical commodity
• Total Utility (TU)
– Sum total of utility levels out of each unit of a commodity consumed within
a given period of time
• Marginal Utility (MU)
– Change in total utility due to a unit change in the commodity consumed
within a given period of time. dTU
dQ
– MU=TUn -TUn-1 or MU=
Unit of Consumption
TU
MU
0
0
-
1
20
20
2
36
16
3
46
10
4
52
6
5
55
3
6
55
0
7
50
-5
Cardinal Utility Analysis
• Law of Diminishing Marginal Utility
• Marginal utility for successive units consumed goes on decreasing.
• When the good is consumed in standard quantity, continuously and in
multiple units and the good is not addictive in nature.
• The following diagrams show Total Utility (TU) and Marginal
Utility
(MU) curves
MU of X
TU of X
MU
TU
O
O
Quantity of X
Quantity of X
Cardinal Utility Analysis
• Law of Equimarginal Utility
– Marginal utilities of all commodities should be equal
• The consumer has to distribute his/her income on different
commodities so that utility derived from last unit of each
commodity is equal for all other commodities in the
consumption basket.
• Mathematically:
MU M MU N

 ...  MU I
PM
PN
Law of Equi -marginal utility
• A person can get maximum utility with his given
income when it is spent on different commodities in
such a way that the marginal utility of money spent
on each item is equal".
• It is clear that consumer can get maximum utility
from the expenditure of his limited income. He
should purchase such amount of each commodity
that the last unit of money spend on each item
provides same marginal utility.
Assumptions
• There is no change in the prices of the goods.
• The income of consumer is fixed.
• The marginal utility of money is constant.
• Consumer has perfect knowledge of utility obtained
from goods.
• Consumer is normal person so he tries to seek
maximum satisfaction.
• The utility is measurable in cardinal terms.
Consumer has many wants.
Suppose Arwin has an income of Rs.37 and the price of goods P,Q,R are Rs.
5, Rs. 1 and Rs. 4 respectively.
Quantity
Product P
Product Q
Product R
TU
MU/P
TU
MU/P
TU
MU/P
1
21
4.2
7
7
16
4
2
41
4
13
6
30
3.4
3
59
3.6
18
5
42
3
4
74
3
22
4
50
2
5
85
2.2
25
3
55
1.25
6
91
1.2
27
2
58
0.75
• There are two possible comibinations:
• Combination 1: 2P, 4 Q and 1 R
• Combination 2 : 4 P, 5Q and 3 R
Limitations
• The law is not applicable in case of knowledge.
Reading of books provides more satisfaction and
knowledge to the scholar.Different books provide
variety of knowledge and satisfaction.
• The law is not applicable in case of indivisible
goods. The consumer is unable to divide the goods
to adjust units of utility derived from consumption
of goods.
• There is no measurement of utility. It is
psychological concept. It is not possible to express it
into quantitative form
• The law does not hold well in case fashion and
customs.
• The does not hold well in case of very low income.
The maximization of utility is not possible due to
low income.
• he law fails when goods of choice are not available.
The consumer is bound to use commodity, which
provides low utility due to non availability of goods
having high utility.
• The law of equi marginal utility is helpful in the field
of production. The producer has limited resources.
He uses limited resources to purchase production
factors. He tries to equalize marginal utility of all
factors. He wishes to get maximum output and
profit.
• The law is used in the field of exchange. The people
like to exchange a commodity having low utility
with a commodity having high utility. There is
maximum benefit from exchange of commodities.
• The law holds well in case of saving and spending.
The consumer can make choice between present
wants and future wants.
Marginal Utility and Demand Curve
• MU curve is downward sloping.
• For any given amount of income when price of the
commodity is PC, the consumer would consume QC
quantity of the commodity (point C on the MU curve,
where MU= PC)
• When price increases to PB, the consumer has to
readjust consumption to restoring level of utility.
• the new equilibrium is at point B on the MU curve
where MU= PB
• As price goes on increasing, the desired consumption
of the commodity for the consumer goes on
diminishing and vice versa.
• Points A, B, C, and so on, would thus lie on the
demand curve of the consumer for the commodity.
MU, P
A
PA
B
PB
C
PC
MU=D
O
QA
QB QC
Quantity
Ordinal Utility Analysis
• Edgeworth, Fisher and others negate the physical measurement
of utility.
– A consumer is able to rank different combinations of the commodities in
order of preference or indifference.
– Utility is not additive but comparative.
• Indifference Curve Analysis (J.R. Hicks and R.G.D. Allen )
– Indifference curve: Locus of points which show the different combinations
of two commodities among which the consumer is indifferent, i.e. derives
same utility.
• Since all these points render equal utility to the consumer, an
indifference curve is also known as an isoutility (“iso” meaning equal)
curve.
Properties of Indifference Curves
• This is because of the assumption of nonsatiation.
• Higher indifference curve represents
higher utility.
• Indifference
intersect.
curves
can
never
• Indifference curves are convex to the
origin.
• This is because two goods cannot be
perfect substitutes of each other.
Y
A
Good Y
• Indifference curves are downward
sloping.
B
C
D
IC2
IC1
O
Good X
X
Exceptional Shapes of Indifference Curves
QY
Perfect Substitutes
Perfect Complements
QY
O
O
QX
QX
QY
Irrational
Behaviour
O
QX
QY
Social Bads
O
QX
Diminishing Marginal Rate of Substitution
• MRS is the proportion of one good (M) that the consumer would be
willing to give up for more of another (N)
• MRS is the ratio between rates of change in M and N, down the
indifference curve :
N
MRS MN  
M
…..(1)
• To increase consumption of M, the consumer has to reduce consumption
of N and hence the negative sign. MRSMN goes on diminishing as we move
down the indifference curve.
MU M
N more units of one commodity must
• Gain in utility due to consumption
  of
MU N
M
be equal to the loss in utility due to consumption of less units of the other
MU M
commodity
 MRS
MU N
MN
Consumer’s Equilibrium
• Consumer would reach equilibrium point, i.e. highest level of
satisfaction given all constraints at the highest indifference curve
he/she can reach.
• Budget line of a consumer, consists of all possible combinations of
the two commodities that the consumer can purchase with a
limited budget:
• Budget constraint depends upon income of the consumer and
prices of the commodities in the consumption basket.
Mathematically
PM.QM+PN.QN=I
(Where PM is price of commodity M, QM quantity of M, PN price of N, QN
Consumer’s Equilibrium
• Conditions for consumer’s equilibrium:
– Consumer spends all income in buying the two commodities; hence
point of equilibrium will always lie on the budget line.
– Point of equilibrium will always be on the highest possible indifference
curve the consumer can reach with the given budget line.
• Consumer is able to maximize utility at a point where the budget line is
tangent to an indifference curve
– This is the highest possible curve attainable by the consumer, subject to
budget constraint.
• Budget line may
– shift either upwards or downwards due to any change in income of the consumer
while price of the commodities remaining same
Consumer’s Equilibrium
Quantity of N



Feasible set is the area
OAB. All points below and
on budget line AB are
attainable.
Point C, D are feasible but
on
lower
indifference
curves
IC2
and
IC1
(Rationality assumption).
Area beyond budget line
AB is infeasible area;
therefore higher IC4 is
beyond reach of the
consumer.
A
C
QN
E
D
O
QM
IC3
IC2
IC1
B
Quantity of M
• Equilibrium is attained at point E where AB is tangent to curve IC3
(highest attainable indifference curve).
• Equilibrium quantities of commodities M and N are QM and QN.
Revealed Preference Theory
• Indifference curves analysis had limitations in terms of its
highly theoretical structure and simplifying assumptions.
• Samuelson came up with an approach to assessing consumer
behaviour and introduced the term ‘revealed preference’.
• The basic hypothesis of the theory is ‘choice reveals
preference’.
• Demand for a commodity by a consumer can be ascertained by
observing the actual behaviour of the consumer in the market
in various price and income situations.
• This gives us a demand curve for an individual consumer on
the basis of observed behaviour.
Revealed Preference Theory


AB is the budget line. OAB is the feasible set, given the price and
income constraints for two goods M and N.
If out of all the possible combinations of two goods M and N, the
consumers chooses C, it may be deduced that the consumer has
revealed his/her preference for C over all other possible combinations
(say D, L, R).

Quantity of N
A
A1
D

C C’
N

L

R
O
B1
M
B’
B Quantity of M
Demand increases when
price falls money income
remaining same and vice
versa.
Fall in price of M will shift the
budget line to AB’.
New preference will be at C’
Remaining on the same
point C will imply a fall in
income (budget line) to A1 B1
Consumer Surplus
• The difference between the price consumers are
willing to pay and what they actually pay is called
consumer surplus.
• Individual consumer surplus measures the gain that a
consumer makes by purchasing a product at a price
lower than what he/she had expected to pay.
• In a market the total consumer surplus measures the
gain to the society due to the existence of a market
transaction.
Consumer Surplus
Price
• Equilibrium market price (P*) and
quantity (Q*) are at point E.
D
P1
• If there is a customer who is willing to
pay as high as P1 but actually pays only
P*, the area P*P1AE represents the
surplus of the first consumer.
• If a second consumer is willing to pay P2
and actually pays P* gains a surplus of
P*P2BE.
• Total consumer surplus in the economy
is given by the triangular area P*DE for
all the consumers.
A
Consumer
Surplus
B
P2
S
E
P*
D
S
O
Q1
Q2
Q* Quantity
Summary
– Utility is the measure of satisfaction a consumer derives from consumption of a
commodity; it is an attribute of a commodity to satisfy a consumer’s needs.
According to cardinal school, utility is measurable like any other physical
commodity.
– As per law of diminishing marginal utility, as you one consumes more and more
units of a commodity, total utility would goes on increasing, but at a diminishing
rate.
– As per law of equimarginal utility, a consumer will maximize utility when the
marginal utility of the last unit of money spent on each commodity is equal to
the marginal utility of the last unit of money spent on any other commodity.
– According to ordinal school, utility cannot be measured in physical units; it is
possible to rank utility derived from various commodities.
– Indifference curves are downward sloping and convex to the origin; a higher
indifference curve would represent higher utility and two indifference curves do
not intersect each other.
Summary
– Marginal Rate of Substitution (MRS) shows the amount of a good that a
consumer would be willing to give up for an additional unit of another
commodity.
– Budget constraint to the consumer includes income of the consumer
and prices of the commodities in the consumption basket. A change in
any of these constraints would lead to a shift in the budget line. Such a
shift can be of three types: upwards, downwards and swivelling.
– The consumer will be at equilibrium at a point where the budget line is
tangent to the highest attainable indifference curve.
– According to the theory of revealed preferences, demand for a
commodity by a consumer can be ascertained by observing the buying
pattern of the consumer.
– Consumer surplus is equal to the difference between the price a
consumer is willing to pay and the price he/she actually pays for a
commodity.