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S6 Economics

Consumer Behaviour

A consumer is either an individual who uses goods and services to satisfy his wants, a household or government.  A consumer is said to be rational i.e. whose major aim is to maximize utility.

Basic approaches to consumer behaviour

A. Cardinal utility theory Utility is the satisfaction or pleasure derived from consumption of goods and services. It is assumed that, a consumer can know exactly how much satisfaction is derived from consumption of a good and such satisfaction is measured subjectively in units known as utils.  

Assumptions of cardinal utility

  1. It assumes that a consumer is a rational being who calculates and measures, chooses and compares utilities of different units of goods thus maximizing utility.
  2. It assumes that a consumer possesses perfect knowledge of the choices open to him.
  3. It assumes that all commodities available to a consumer are perfectly divisible into smaller units.
  4. It assumes that as more a single commodity is consumed, total utility increases, reaches maximum level and then falls.
  5. It assumes that there are no perfect substitutes, and that utilities are measurable in terms of money.  

Categories of utility

1. Total utility. Total utility is the total satisfaction derived from consuming all different units of a given commodity in a particular period of time. For example, when a consumer buys apples, he receives them in units of 1, 2, 3, and 4. Two apples have more utility than one apple, three apples have more utility than two apples, and four apples have more utility than three apples.  

2. Marginal utility. Marginal utility is the additional satisfaction derived from consumption of an extra unit of a commodity in a particular period of time. For example, the total utility of two apples is 35 utils, and when a consumer consumes the third apple total utility becomes 45 utils. Therefore, the marginal utility of the third apple is 10 utils (45-35 = 10).

Marginal utility is given as:  𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑢𝑡𝑖𝑙𝑖𝑡𝑦 = Change in total utility / Change in quantity of a good

3. Marginal utility of income; is the additional satisfaction derived from expenditure of an extra unit of income on goods and services.  4.  Marginal  utility  of  money:  this  is  the  change  in  total  satisfaction  derived  from  money  that results from one unit of change in the quantity of money. 

3. Marginal utility of income; is the additional satisfaction derived from expenditure of an extra unit of income on goods and services.  

4.  Marginal  utility  of  money:  this  is  the  change  in  total  satisfaction  derived  from  money  that results from one unit of change in the quantity of money.  

 

   Table showing the relationship between total utility and marginal utility 

The units of apples which a consumer chooses are in descending order of their utilities. The first apple  is  the  best  out  of  the  lot  available  to  him  and  hence  gives  him  the  highest  satisfaction measured as 20 utils. The second apple is naturally the second best with lesser amount of utility than the first and has 15 utils.

i. When total utility is increasing, marginal utility is decreasing  

ii. When total utility is at maximum i.e. point X (satiety/bliss point), marginal utility is at zero i.e. point Y.(point of saturation)

iii. When total utility starts falling but still positive, marginal utility goes into negative (disutility) 

 

THE LAW OF DIMINISHING MARGINAL UTILITY 

The law of diminishing  marginal utility states that as more  and more units of a commodity are consumed, the satisfaction derived from each additional unit diminishes. The law of diminishing marginal utility is based on the following assumptions: 

  • It assumes that there should be a single commodity with homogeneous units wanted by an individual consumer. 
  • It assumes that there should be continuity in consumption of a commodity i.e. units of a commodity should be consumed in succession at a particular time. 
  • It assumes that there should be no change in taste, habit and income of a consumer. A change in any of the mentioned factors is likely to increase rather than diminish utility  
  • It assumes that prices of different units of a commodity should remain the constant.
  • It assumes that a consumer should be rational i.e. with a calculating mind, aims at maximizing utility.
  • It assumes that all units of a commodity are of a standard size e.g. a sizeable glass to quench thirst and not a spoon.  
  • It assumes that a commodity should be divisible to allow successive consumption of a commodity.
  • It assumes that the commodity should be of an ordinary type i.e. not superior good or goods of ostentation or addictive goods.  

 

IMPORTANCE OF THE LAW OF DIMINISHING MARGINAL UTILITY 

1.  It explains the phenomenon in the value theory that price of a commodity falls when its supply  increases,  because  with  increase  in  stock  of  a  commodity  marginal  utility diminishes. 

2.  The  principle  of  progressive  of  taxation  is  based  on  this  law.  As  a  person’s  income increases, his/her rate of tax rises because marginal utility of money to him/her falls with rise in income. 

3.  It explains the diamond-water paradox of Smith. Because of its scarcity, diamond possesses a  high  marginal  utility  and  therefore  commands  high  price,  since  water  is  relatively abundant,  its  marginal  utility  is  low,  it  commands  low  price  yet  is  more  useful  than diamond. 

4.  It helps in bringing variety in production and consumption since consumption of the same good brings about boredom, hence its utility diminishes thus the desire for variety. 

 

LIMITATIONS OF THE LAW OF DIMINISHING MARGINAL UTILITY

1.  It  does  not  apply  to  commodities  like  diamond  or  hobby  goods  like  paintings,  stamp collection whose satisfaction increases as more is consumed e.g. the utility of additional paintings is greater than earlier pieces bought. 

2.  It  does  not  apply  to  indivisible  durable  commodities  e.g.  T.V  sets,  furniture  etc  whose consumption extends over a long period of time. 

3.  It does not apply for habitual or addictive commodities e.g. cigarettes, alcohol, opium, etc, whose marginal utility may not diminish instead the more one takes, the more he/she will need it. 

4.  It  assumes  homogeneity  such  that  all  units  of  a  good  should  have  the  same  quality  and weight which is not the case.  

5.  It  assumes  that  units  of  a  commodity  should  be  consumed  in  succession.  However  if consumption for a commodity is spaced or at random, utility will increase and the law will not apply. 

5.  It  assumes  that  units  of  a  commodity  should  be  consumed  in  succession.  However  if consumption for a commodity is spaced or at random, utility will increase and the law will not apply. 

6.  It assumes there should be no change in habits, customs, fashion and income of consumers and when this happens the utility will increase instead of diminishing. 

 

Relationship between the law of diminishing marginal utility and the demand curve

The relationship is that, as marginal utility falls, a consumer is willing to consume more units of a commodity at successively lower prices. Therefore, it is this law that explains the downward slope of a demand curve form left to right. 

An illustration of the Marginal utility and the demand Curve:

 

 

 

 B. Ordinal utility theory (indifference curve theory/Approach)

An  indifference  curve  is  one  joining  all  those  combinations  of  two  goods  that  give  equal satisfaction to a consumer. The curve explains consumer behaviour in terms of his/her preferences for different combinations of two goods e.g. X and Y.  

An indifference curve is drawn from an indifference schedule.

 An  indifference  schedule  is  a  list  of  combinations  of  two  goods  such  that  a  consumer  is indifferent (having no particular interest in one of the said goods) to those commodities.

 A table showing an indifference schedule of goods X and Y 

The consumer is indifferent whether to buy the first combination of units 18Y and 1X, or the fifth combination of 4Y and 5X or any other combination. All combinations give equal satisfaction to a consumer. When various combinations are plotted on a diagram and joined by a line, they form an indifference curve. 

An illustration of an indifference curve: 

Assumptions of indifference curve theory

1. It assumes that there are two goods X and Y with their prices being known and given.

2. It assumes that the consumer acts rationally so as to maximise utility.

3. It assumes that a consumer has perfect knowledge about prices of goods in the market.

4. It assumes that consumer’s tastes, habits and income remain constant throughout the analysis.

5. It assumes that a consumer prefers more of X to less of Y, which implies a negatively downward sloping indifference curve that is convex in nature.

6. It assumes that utility is ordinal i.e. the consumer ranks his preferences according to satisfaction

7. The indifference curve can move to the right or to the left which means that there is an increase or decrease in both commodities X and Y respectively. 

8. The indifference curve never touches either axes. 

9. It assumes that two indifference curves can never intersect/ meet.  

 

A graph showing an indifference Map: 

THE BUDGET LINE 

This  refers  to  a  line  which  shows  various  combinations  of  two  different  commodities  that consumers can purchase using a fixed income. 

Example:  If  the  price  of  commodity  Y  is  shs.10  and  that  of  commodity  X  is  Shs.  5,  then  the budget line for the consumer who has fixed income of shs.100 would look like the one below. 

 

An illustration of the budget line 

              Characteristics of a budget line: 

  • It has a negative slope from left to right.
  • It is determined by the commodity’s price and the income of the consumer. If the price and income   changes the budget line rotates or shifts respectively.
  • Combinations along the budget line are attainable while those below the  budget line are attainable but do not provide the necessary satisfaction/ not all the income is used.
  • Combinations above the budget line cannot be attained because of the limited income 

 

CONSUMER’S EQUILIBRIUM USING THE INDIFFERENCE CURVE APPROACH 

The consumer’s equilibrium is reached by using the indifference curve and the budget line. 

The consumer reaches the equilibrium at a point where the budget line is tangent to the indifference curve. 

THE CONCEPT OF MARGINAL RATE OF SUBSTITUTION (MRS) 

Marginal rate of substitution is the rate at which a consumer is willing to substitute one good for another along the same indifference curve. E.g. X for Y. It is a ratio of change in good Y to a given change in another good X. It is given by:  

𝑀. 𝑅. 𝑆 =  dy / dx

Discussion

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