Theory of Consumer Behaviour

THEORY OF CONSUMER BEHAVIOUR
The traditional theory of demand starts with the examination of the behaviour of the
consumer, since the market demand is assumed to be the summation of the demands of
individual consumers. Thus, we will first examine the derivation of demand for an individual
consumer. The consumer is assumed to be rational. Given his income and the market prices
of the various commodities, he plans the spending of his income so as to attain the highest
possible satisfaction or utility. This is the axiom of utility maximisation. In the traditional
theory it is assumed that the consumer has full knowledge of all the information relevant to
his decision, that is he has complete knowledge of all the available commodities, their prices
and his income. In order to attain this objective, the consumer must be able to compare the
utility (satisfaction) of the various 'baskets of goods' which he can buy with his income.
There are two basic approaches to the problem of comparison of utilities, the cardinalist
approach and the ordinalist approach.
The cardinalist school postulated that utility can be measured. Various suggestions have been
made for the measurement of utility. Under certainty (complete knowledge of market
conditions and income levels over the planning period) some economists have suggested that
utility can be measured in monetary units, by the amount of money the consumer is willing to
sacrifice for another unit of a commodity. Others suggested the measurement of utility in
subjective units, called utils.
The ordinalist school postulated that utility is not measurable, but is an ordinal magnitude.
The consumer need not know in specific units the utility of various commodities to make his
choice. It suffices for him to be able to rank the various 'baskets of goods' according to the
satisfaction that each bundle gives him. He must be able to determine his order of preference
among the different bundles of goods. The main ordinal theories are the indifference-curves
approach and the revealed preference hypothesis. In examining the above approaches, we will
first state the assumptions underlying each approach, derive the equilibrium of the consumer,
and from this determine his demand for the individual products. Finally, we point out the
weaknesses of each approach.
THE CARDINAL UTILITY THEORY
Assumptions
I. Rationality. The consumer is rational. He aims at the maximisation of his utility
subject to the constraint imposed by his given income.
2. Cardinal utility. The utility of each commodity is measurable. Utility is a cardinal
concept. The most convenient measure is money: the utility is measured by the monetary
units that the consumer is prepared to pay for another unit of the commodity.
3. Constant marginal utility of money. This assumption is necessary if the monetary unit
is used as the measure of utility. The essential feature of a standard unit of measurement
is that it be constant. If the marginal utility of money changes as income increases (or
decreases) the measuring-rod for utility becomes like an elastic ruler, inappropriate for
measurement.
4. Diminishing marginal utility. The utility gained from successive units of a commodity
diminishes. In other words, the marginal utility of a commodity diminishes as the consumer
acquires larger quantities of it. This is the axiom of diminishing marginal utility.
1
5. The total utility of a 'basket of goods' depends on the quantities of the individual
commodities. If there are n commodities in the bundle with quantities x 1, x 2, •••, xn,
the total utility is U = j(x, Xz, ..., Xn)
In very early versions of the theory of consumer behaviour it was assumed that the total
utility is additive, U = V 1(x 1) + V 2(x 2) + · · · + Un(xn) The additivity assumption was
dropped in later versions of the cardinal utility theory. Additivity implies independent utilities
of the various commodities in the bundle, an
assumption clearly unrealistic, and unnecessary for the cardinal theory.
Equilibrium of the consumer
We begin with the simple model of a single commodity x. The consumer can either buy x or
retain his money income Y. Under these conditions the consumer is in equilibrium when the
marginal utility of x is equated to its market price (P x>· Symbolically we have MUx = px If
the marginal utility of x is greater than its price, the consumer can increase his welfare by
purchasing more units of x. Similarly, if the marginal utility of x is less than its price the
consumer can increase his total satisfaction by cutting down the quantity of x and keeping
more of his income unspent. Therefore, he attains the maximisation of his utility when MUx
= Px 1 If there are more commodities, the condition for the equilibrium of the consumer is the
equality of the ratios of the marginal utilities of the individual commodities to their prices.
THE INDIFFERENCE-CURVES THEORY
Assumptions
I. Rationality. The consumer is assumed to be rational- he aims at the maximisation of his
utility, given his income and market prices. It is assumed he has full knowledge (certainty) of
all relevant information.
2. Utility is ordinal. It is taken as axiomatically true that the consumer can rank his
preferences (order the various 'baskets of goods') according to the satisfaction of each basket.
He need not know precisely the amount of satisfaction. consumer expresses his preference for
the various bundles of commodities. It is not necessary to assume that utility is cardinally
measurable. Only ordinal measurement is required.
3. Diminishing marginal rate of substitution. Preferences are ranked in terms of
indifference curves, which are assumed to be convex to the origin. This implies that the slope
of the indifference curves increases. The slope of the indifference curve is called the marginal
rate of substitution of the commodities. The indifference-curve theory is based, thus, on the
axiom of diminishing marginal rate of substitution.
4. The total utility of the consumer depends on the quantities of the commodities consumed
5. Consistency and transitivity of choice. It is assumed that the consumer is consistent in
his choice, that is, if in one period he chooses bundle A over B, he will not choose B over A in
another period if both bundles are available to him. The consistency assumption may be
symbolically written as follows: If A > B, then B :> A Similarly, it is assumed that consumer's
choices are characterised by transitivity: if bundle A is preferred to B, and B is preferred to C,
then bundle A, is preferred to C. Symbolically we may write the transitivity assumption as
follows: If A > B, and B > C, then A > C.

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THEORY OF CONSUMER BEHAVIOUR

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