The Theory of Consumer Behaviour

What do we understand by “want” in economics?

In economics, the term “want” refers to a wish, desire, or motive to own or/and use goods and services that give satisfaction. Want may arise due to physical, psychological, or social factors.  We must choose between our urgent wants and our less urgent wants because resources are limited.

In economics, wants are classified into three categories, viz., necessaries, comforts, and luxuries. 

let us understand  each one of these wants separately:

• Necessaries: Things that are essential for living are considered necessities. The subcategories of necessities for efficiency and conventional necessities are necessities for life or existence. The minimum amount of food, clothing, and shelter are examples of necessities for life. Other examples include goods required to meet the minimum physiological needs for the maintenance of life. Man requires something more than the necessities of life to maintain longevity, energy, and efficiency at work, such as  nourishing food, adequate clothing, clean water, a comfortable dwelling, education, recreation, etc. Conventional necessities arise either due to the pressure of habit or due to compelling social customs and conventions. They are not necessary either for existence or for efficiency.
• Comforts: comforts make life more satisfying and comfortable, while necessities make life possible. Compared to necessities, comforts are less urgent. Life is more comfortable when there is decent food, a nice home, clothes for various situations, and labor-saving tools, among other things. Luxuries are wants that are superfluous and expensive. They are not necessary for living. This category includes things like pricey clothing, rare vintage automobiles, elegant furniture, and objects for vanity, among others.

However, the important point to be noted is that the aforementioned classification is flexible since something that is a luxury or comfort for one individual at one point in time may later on become a need for another person. As we are all aware, today’s pleasures and necessities were once thought of as luxuries in the past.

Having understood the classification of wants, let us understand the nature of human wants:

The Nature of Human Wants:

1. All the wants of human beings exhibit some characteristic features.
2. All the wants can not be satisfied as they are unlimited in number.
3. wants differ in intensity. Some are urgent, while others are less intensely felt.
4. Each of the want is satiable
5. Wants are competitive. They compete with each other for satisfaction because resources are scarce in relation to their wants.
6. Wants are complementary.   Some wants can be satisfied only by using more than one good or group of goods.multiple items or groups of things.
7. There are alternative ways of satisfying a particular want.
8. Wants are subjective and relative.
9. Wants vary with time, place and person.
10. Some wants occur again and again whereas some wants do not occur again.
11. Wants may become habits and customs
12. Income, taste, fashion, advertisements, social norms and customs do affect wants.
13. Wants arise from multiple causes, such as physical and psychological instincts, social obligations, and an individual’s economic and social status.

After having a brief idea about wants, now let us understand what do we mean by utility?

Utility:

Neo-classical economics uses the concept of utility to explain how the law of demand works. Following Jeremy Bentham, John Stuart Mill, and other nineteenth-century British economist-philosophers, economists apply the term utility to “that property in any object, whereby it tends to produce benefit, advantage, pleasure, good, or happiness.” A utility is thus the want satisfying power of a commodity. The utility of a consumer is a measurement of the satisfaction that the consumer expects to obtain from consumption of goods and services after spending money on a stock of commodities that has the capacity to satisfy his wants. Utility is hence the consumer’s anticipated satisfaction, and satisfaction is the tangible satisfaction derived. Even if an item is not consumed, a commodity has utility for a consumer. Utility is a relative and subjective entity and varies from person to person. A commodity has different levels of utility for the same person at different places or at different points of time. It should be noted that utility and usefulness are not the same. Even harmful things like alcohol may be considered to have utility from an economic perspective since people want them. Because of this, the concept of utility in economics is ethically neutral. The basis of the theory of consumer behavior is the utility hypothesis. From time to time, different theories have been advanced to explain consumer behavior and, thus, consumer demand for a product. Alfred Marshall’s Marginal Utility Analysis and J.R. Hicks’ and R.G.D. Allen’s Indifference Curve Analysis are the two important theories.

“Marginal Utility” Analysis:

The marginal utility theory, formulated by British economist Alfred Marshall, seeks to explain how a consumer chooses how to spend his income on different goods and services in order to maximize his utility. Marginal utility theory treats consumers as striving to maximize utility, which is a quantitative measure of the consumer’s well-being or satisfaction. Marshall defines utility as the numerical score in terms of “utils” that represents the satisfaction a consumer obtains from the consumption of a particular good. (Utils refer to the hypothetical measuring unit of utility). This theory is based on a number of assumptions. Let’s first understand the meaning of the terms “total utility” and “marginal utility” before stating the assumptions.

• Total utility: Total utility may be defined as the sum of utility derived from different units of a commodity consumed by a consumer, assuming that utility is quantitatively measurable and additive. The sum of the marginal utilities derived from the consumption of different units is known as the total utility.

TU= MU1+MU2+…. +MU

Where, 

MU1, MU2, etc., are the marginal utilities of the successive units of a commodity.

• Marginal Utility: The change in total utility generated by consuming one additional unit of that good or service is the marginal utility of that good or service. In other words, it is the utility derived from the marginal or one additional unit consumed or possessed by the individual. Marginal utility is equal to the addition made to the total utility by the addition of consumption of one more unit of a commodity.

Symbolically,

MUn = TUn – TUn-1

Where, 

MUn is the marginal utility of the nth unit, TUn is the total utility of the n^th unit, and TUn-1 is the total utility of the (n-1)th unit.

Assumptions of Marginal Utility Analysis:

The marginal utility analysis is stated with respect to certain conditions. It simply means that this law has certain assumptions, and without these, the law may not hold true.

The following are the assumptions of marginal utility analysis:

1. Rationality: A consumer is rational and makes an attempt to get the most satisfaction from the limited amount of money income that they have.
2. Cardinal Measurability of Utility: According to Neoclassical economists   utility is a cardinal concept and utility  is a measurable and quantifiable entity. It implies that utility can be measured using cardinal numbers such as 1, 2, or 3, and may be assigned a cardinal number. Marshall and some other economists used a psychological unit of measurement of utility called utils. Thus, a person can say that he derives utility equal to 10 utils from the consumption of 1 unit of commodity A and 5 from the consumption of 1 unit of commodity B. Since a consumer can quantitatively express his utility, he can easily compare different commodities and express which commodity gives him greater utility and by how much. Utilities from different units of the commodity can be added as well.
3. Money is a measuring rod of utility: According to this theory, money is a measuring rod of utility. A measure of the utility that a person derives from a good is the amount of money he is willing to spend on a unit of it rather than forgo it.
4. All other factors are constant: This theory assumes all other factors are constant, such as the price of the commodity, taste and preferences, income, habits , temperament, and fashion.  If there is a change in any of these factors, the marginal utility may not decline and the law would not hold true.
5. Continuity in consumption: This theory assumes continuity in consumption and there is no gap or interval between consumption of different units.
6. Units are assumed to be identical or homogeneous in nature: the different units of the commodity consumed are assumed to be homogenous or identical in nature. If successive units are of superior quality, then the law of diminishing marginal utility may not occur. Or if the units show variation or differ in taste, quality, or any other similar aspect, then the law may not hold true. 
7. Units are of standard units: The different units consumed should be of standard units. For eg. if a person is served with a spoonful of cold drink or juice that is too small as compared to a glass full. Another important assumption is that the commodity should be divisible in nature.
8. Constancy of marginal utility of money: When a person is spending money, it is assumed that the marginal utility of money remains constant. This assumption, though, is not realistic, but it has been made in order to facilitate the measurement of the utility of commodities in terms of money. As income changes, if the marginal utility of money changes then the measuring rod of utility becomes unstable and would be inappropriate for measurement.
9. Hypothesis of Independent utility: Implies that the total utility which a person derives from the whole collection of goods purchased by him is simply the sum total of the separate utilities of the goods. This theory ignores complementarity between goods.

The Law of Diminishing Marginal Utility: One of the important laws under marginal utility analysis is the law of diminishing marginal utility.

The Law of Diminishing Marginal Utility:

The law of diminishing marginal utility, which states that each successive unit of a good or service consumed adds less to total utility than the previous unit, is based on the important fact that while an individual’s total wants are virtually unlimited,  each individual want is satiable, i.e., each want is capable of being satisfied. Due to the fact that every want is satiable, when a consumer consumes more and more units of a good, the intensity of his want for that  good  continues to decline until a point is reached  where the consumer no longer wants  it. As a result, a consumer’s perceived value of an additional unit decreases as they own more of a given commodity. I.e., the  greater the amount of a good a consumer has, the less an additional unit is worth to him or her.

The law, stated by Marshall, who was the  exponent of the Marginal Utility analysis, is as follows:

“ The additional benefit which a person derives from a given increase in the stock of a thing diminishes with every increase in the stock that he already has”. In other words, “ as a consumer increases the consumption of one commodity while keeping the consumption of all other commodities constant, the marginal utility of the variable commodity must eventually decline.”  

This law describes a very fundamental tendency  of human nature. Simply put, it asserts that as a consumer consumes more units of a good, the additional satisfaction he derives from a unit of that good continues to decline. It should be noted that as a good is used more frequently, marginal utility decreases rather than total utility increases.

Consider the following example to have a better understanding of the law. The total utility and the marginal utility derived by a person from the consumption of ice cream consumed per day have been illustrated with the assumption that all other factors that affect utility are constant.

Total and Marginal Utility Schedule:

Explanation: The total utility derived by the person from consuming one unit of icecream  is 20 utils ( unit of utility), and the marginal utility derived  is also 20 utils. The total utility increases to 34 after eating the second ice cream,  and the corresponding marginal utility is 14. The consumer enjoys greater  total utility with the second ice cream,  but the extra utility derived from the second unit of ice cream consumed is smaller than that derived from the consumption of the first unit of ice cream. We observe that the marginal value of the additional ice cream  continues to decline until the consumption of ice cream increases to four. (i.e., the total utility goes on increasing at a diminishing rate). Since the fifth icecream  does not increase utility, the total utility remains the same at 50. When consumption reaches this point, the consumer has achieved the “satiation” point and further consumption provides no more satisfaction or utility. Once this point of satiation is reached, the consumer would refuse any extra unit of ice cream, even if it were free. However, if he consumes six ice creams,  the sixth one will not provide positive marginal value but instead provide negative marginal utility, which could be uncomfortable for him. In fact, we discover that consuming the sixth ice cream  lowers the consumer’s total utility from 50 to 46. The above table shows that the marginal utility is equal to the change in total utility for every one unit increase in consumption. Until the customer reaches satiation, total utility increases with each consecutive ice cream consumed, but the additional utility he derives  from subsequent ice cream gets smaller as he consumes more.  Putting it differently, the rate at which total utility increases gets smaller and smaller as consumption increases. Additionally, we can see from Let us understand some well defined relationships between total utility and marginal utility with the help of the above table. 

1. As long as marginal utility   remains positive, total utility rises, but at a diminishing rate because MU is diminishing.
2. The marginal utility diminishes throughout.
3. The maximum total utility is reached when marginal utility is zero. It is the satiation point.
4. Total utility starts to diminish when the marginal utility is negative.
5. MU is either the slope of the TU curve or the rate of change of total utility.
6. MU can be positive , zero, or negative

A graphical representation of the data to show the relationship between marginal utility and total utility:

Total Utility Diagram:

Marginal Utility Diagram:

The above figure shows that the graph of total utility  and the corresponding graph of marginal utility have a close relationship . Diminishing marginal utility is seen in both  of the above figures. However, in the above figure of total utility, it is seen  by the positive but decreasing slope (flattening out) of the total utility curve, and in the marginal utility figure, it is seen by the downward sloping marginal utility curve. The marginal utility curve shows how marginal utility It It depends on the quantity of a good or service consumed. As can be seen from the above figure, the marginal utility curve goes on declining throughout. The principle of diminishing marginal utility is not always true. Some economists have, however, noted a few exceptions. However, it is generally accurate, so it can be used as a  foundation for the analysis of consumer behavior.

Limitations and exceptions to the law of diminishing marginal utility: 

The principle of diminishing marginal utility is applicable to the consumption of the majority of goods and services by the majority of people. The concept of diminishing marginal utility does, however, have some exceptions and is only applicable under certain circumstances:

1. The cardinal measurability of utility, the constancy of the money’s marginal utility, continuous consumption, and the homogeneity of the units consumed are just a few of the rigorous assumptions that the law of diminishing marginal utility is based upon. If these unrealistic presumptions were met then only the law of diminishing marginal utility would operate. 
2. In actuality, utility is not independent of The existence or absence of articles that serve as complements or substitutes may have an impact on the utility curve’s shape. If there is no sugar available, the utility of tea may be seriously affected  and the availability of fresh juice will have an impact on the utility of bottled soft beverages.
3. Law is not always applicable,i.e., the law is not universal. In many situations, an increase in consumption or stock obtained does not cause the marginal utility to decrease. On the contrary, it may even rise. These situations are regarded as exceptions to the rule. For instance, the law may not apply in the following situations:

However, it is important to keep in mind that none of the aforementioned instances actually qualify as exceptions in the true sense of the word because none of the fundamental assumptions required for the law to function are satisfied.

Consumer Equilibrium in Single Commodity:

The law of diminishing marginal utility helps us to understand, in the case of a single commodity, how a consumer reaches its equilibrium. As the quantity of the goods increases, the marginal utility of the goods decreases. Thus, the marginal utility curve is a downward sloping curve. Now the question arises, till what time will the consumer buy goods? A rational consumer will continue to buy goods till the marginal utility of the good equals the market price. When would a consumer be said to be in equilibrium? A consumer will be in equilibrium when i.e., will be deriving maximum satisfaction in respect of one good when marginal utility of the good will be equal to its price. 

Diagrammatic Presentation of consumer equilibrium in the case of a single commodity:

Explanation:

In the above Fig. The consumer is in equilibrium at point E with an OQ quantity of a commodity . We find that at point E, the marginal utility of the good for the consumer is equal to its price. ie MUx=Px.

Impact of Price Change:

Consider a situation if price changes? When the price of the good falls, the equality between marginal utility and price is disturbed. More goods will be consumed by the consumer in order to restore the equality between   price and marginal utility.As he consumes more of the good, the marginal utility will fall.  He will keep on consuming more until the new lower price is equivalent to the marginal utility. However, if the price of the goods increases, he will buy fewer units in order to equate the higher price with the  marginal utility. We can infer that the downward sloping demand curve is directly derived from the marginal utility curve.  The figure shown above illustrates this case. At price P, the consumer is at equilibrium at E; MUX = P. When the price falls to P1, the consumer extends his consumption to reach E1, where his MUX = P1.

The marginal utility of money spent on X MU m= MUX.

                                                                               ______=1

                                                                                Px

 The Law of Equimarginal Utility:

A consumer actually spends his money on more than one good in reality.  In these circumstances, the law of Equi-Marginal Utility is used to explain consumer equilibrium. This law states that a customer would be in equilibrium when he spends his money on different goods and services in a way that  each good’s marginal utility is proportional to its price and ensures that the last rupee spent on each commodity yields him an equal marginal utility. This law states that the consumer is in equilibrium when the following condition is met:

MUx

____ =MUy

Px        ____ = MUm

               Py

Consumer Surplus: consumer surplus was propounded by Alfred Marashall.Consumer surplus is a measure of welfare that people gain from consuming products and services.   It measures the benefits the buyers receive   from participating in a market. This concept plays a significant role not just in economic theory but also in government economic policies and business firm decision-making.The utility of a given commodity to a consumer depends upon the demand for that commodity.  A consumer will be willing to pay more for a commodity if it provides them with more value, and  vice-versa. The willingness to pay each individual consumer based on his utility determines the demand curve.  The potential buyer purchases the goods when the price is less than  or equal to their willingness to pay. As is well known, consumers are often willing to pay more than what they actually pay for certain  goods.  This extra satisfaction, which consumers get from their purchase of a good, is referred to as consumer surplus by Alfred Marshall. Consumer surplus is defined as the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e., the market price). Marshall defined the concept of consumer surplus as the “excess of the price which a consumer would be willing to pay rather than go without a thing over and above that which he actually does pay.”Thus, consumer surplus = what a consumer is ready to pay – what he actually pays. The concept of consumer surplus is derived from the law of diminishing marginal utility.   As we all know, the law of diminishing marginal utility states that a thing’s marginal utility diminishes as we have more of it. In other words, the marginal utility of a good decreases as we buy more of it. When a good’s marginal utility and price are equal, the consumer is in equilibrium because he purchases the same number of units of the good at the price at which marginal utility is equal. to its price. (It is assumed that perfect competition prevails in the market). He receives extra utility for all of the units of the good he consumes, with the exception of the one at the margin, because the price is the same for all of the units he buys. Consumer surplus refers to this extra utility or extra surplus for the consumer.

Consider the below table, in which we have illustrated the measurement of consumer surplus in the case of commodity X. There is only one price for a commodity in the market at a particular point of time. The price of X is assumed to be Rs. 20.

A table showing the measurement of consumer surplus:

Explanation: The table above demonstrates that the consumer’s marginal utility decreases from 30 to 28 as his consumption increases from 1 to 2 units. His marginal utility continues to diminish  as his consumption of good X increases. Since the market price is assumed to be Rs. 20, the marginal utility of a unit of a good indicates the price the consumer is willing to pay for that unit, and the consumer enjoys  a surplus till the 6th unit on every unit of purchase. Because the price fixed is Rs. 20 and the marginal utility is Rs. 30, the consumer makes a surplus of Rs. 10 when purchasing one unit of X. Similarly, when he purchases 2 units of X, he enjoys a surplus   of 8 [28 – 20]. This keeps happening, and from the third, fourth, and fifth units, he receives consumer surpluses of 6, 4, and 2 accordingly. When he buys 6 units, he is in equilibrium since he has no surplus because his marginal utility is equal to the market price or he is willing to pay the market price. Thus, given the price of Rs 20 per unit, the total surplus that the consumer will get is worth 10 + 8 + 6 + 4 + 2 + 0 = 30. The concept of consumer surplus and the demand curve for a product are closely related. The demand curve represents the willingness of the buyer to pay; it can also be used to calculate the surplus of the consumer. As is well known, the height of the demand curve measures the value buyers place on the good as measured by   their willingness to pay. The difference between the willingness to pay and the market price is each buyer’s consumer surplus. The difference between his willingness to pay and the price that he actually pays is the net gain to the con- sumer, the individual consumer surplus.

A graphical representation of consumer surplus:

Explanation: The region below the market demand curve but above the price corresponds to the total consumer surplus in a market, which is the sum of all individual consumer surpluses in a market. Both individual and aggregate consumer excess are frequently referred to as “consumer surplus.” As a result, the total area above the price and below the demand curve represents the combined consumer surplus of all market participants. On the X-axis we measure the amount of the commodity, and on the Y-axis the marginal utility and the price of the commodity. MU is the marginal utility curve, which slopes downwards, indicating that as the consumer buys more units of the commodity, its marginal utility falls. Marginal utility shows the price which a person is willing to pay for the different units rather than go without them. If OP is the price that prevails in the market, then the consumer will be in equilibrium when he buys OQ units of the commodity, since at OQ units, marginal utility is equal to the given price OP. The last unit, i.e., the Qth unit, does not yield any consumer surplus because the price paid is equal to the marginal utility of the Qth unit. For all units before the Qth unit, the marginal utility is greater than the price, and thus these units fetch consumer surplus for the consumer. In the above figure,the total utility is equal to the area under the marginal utility curve up to point Q, i.e., ODRQ. But, given the price is equal to OP, the consumer actually pays OPRQ. The consumer derives extra utility equal to DPR, which is nothing but consumer surplus. (The portion of demand curve RD1 is not relevant for our consumer as MUx is less than Px in this part and therefore, the consumer will not buy any quantity beyond Q.)

Graphical Representation of Consumersurplus due to a fall in price:

Explanation: The benefit a customer receives from consuming a good, less the cost the consumer paid to purchase the good, makes up the consumer welfare obtained from that good. The buyer’s net gain from a purchase is known as the consumer surplus. In a graph, it is represented as the triangle that lies above the price line and below the demand curve. The size of the consumer surplus triangle depends on the price of the goods. A rise in the price of a good reduces consumer surplus; a fall in the price increases consumer surplus. Thus, a higher price results in a smaller consumer surplus, and a lower price generates a larger consumer surplus. The change in consumer surplus on account of a fall in prices is  illustrated in the above figure. A fall in price from P to P1 increases consumer surplus from APE to A P1F. The increase in consumer surplus has two components.

1.  The increase in consumer surplus of existing buyers who were earlier paying price P (the rectangle marked b).
2.   The consumer surplus is now available to the new buyers who started buying the commodity due to lower prices (the triangle c)

Applications: The concept of consumer surplus has important practical applications. A few such applications are listed below:

1. The welfare that people obtain from consuming goods and services is measured by the concept of consumer surplus. It is crucial for a business firm to reflect the amount of consumer surplus enjoyed by different segments of their consumers who perceive a large surplus are more likely to repeat purchases.
2. It helps business managers to set prices more effectively if they are aware of the nature and extent of surplus. Firms can profitably employ price discrimination if they can identify consumer groups with different demand elasticity within their market and the market segments that are willing and able to pay higher prices for the same products.
3. Cost-benefit analyses are used to make large-scale investment decisions, and they take into account the extent of consumer surplus that the projects will produce.
4. Knowledge of consumer surplus is also important when a firm considers raising its product prices. Customers who enjoyed only a small amount of surplus may no longer be willing to buy products at higher prices. Firms making such decisions should expect to make fewer sales if they increase prices.
5. Finance ministers typically use consumer surplus as a reference when determining which products must be subject to taxes and how much a commodity tax must be raised. It is usually desirable  to impose taxes or increase tax rates on commodities that yield high levels of consumer surplus because, by doing so the loss of welfare to citizens will be minimal. 

Limitations: It is often argued that this concept of consumer surplus is hypothetical and illusory. In real life, surplus satisfaction cannot be measured accurately.

The following are the limitations of consumer surplus:

1. Because it is difficult to measure the marginal utilities of different units of a commodity that an individual consumes, consumer surplus cannot be measured with precision.
2. The marginal utilities of the earlier units are infinitely large in the case of necessities. The consumer surplus is always infinite in such a situation.
3. The consumer surplus derived from a commodity is affected by the availability of substitutes.
4. The utility scale of articles which are used  for their prestige value cannot be determined by a single, straightforward rule (e.g., diamonds).
5. Because the marginal utility of money changes as purchases are made and the consumer’s stock of money diminishes, the consumer surplus cannot be expressed in terms of money. (Marshall made the assumption that the marginal utility of money remains constant.) However, this assumption is unrealistic.
6.  The concept can be accepted only if it is assumed that utility can be measured in terms of money or otherwise. Many modern economists believe that this cannot be done.

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