THEORY OF CONSUMER

THEORY OF CONSUMER NOTES

Introduction

It touches on satisfaction other than a customer desire from consuming a
particular commodity’s. The satisfaction the consumers derives from
consumption of commodity is called utility. Average utility is the
satisfactory per unit consumed on average. Marginal utility is the
incremental satisfaction brought about by consuming an extra unit of a
commodity. All this is assessed by two schools thought

Cardinality / Marginal utility Approach
Ordinals Approach Indifference

3.2 Cardinalist Marginal Utility Approach

This school of taught believes that utility satisfaction is measurable
by use of cardinal numbers. This theory assumes that the consumer’s
satisfaction can be measured in a unit known as utils. An individual
demands for a particular commodity because of the satisfaction/utility
received from consuming it. The cardinalist approach assumes that the
consumer’s satisfaction or utility received from consuming a
product/service. Up to a point, the more units of a commodity the
individual consumes per unit time the greater the total utility
received. Total utility is the total satisfaction received from
consuming a commodity. Marginal utility is the extra utility derived
from the consumptions of one more unit of a commodity, the consumption
of all other goods remaining unchanged. It explains that individual
demand slopes downwards from left to right because of law of diminishing
marginal utilities.

The Law of Diminishing Marginal Utility (DMU)

This law states that holding other factors constant as more and more
units of a product are consumed one after another the marginal utility
falls as the total consumption increases..

Assumptions

The consumer is a rational being. As he/she consumes a commodity he
goes for those commodities that give maximum satisfaction.
Price of commodity is constant hence marginal utility of money in constant
Quality of the commodity should be consumed in suitable and
responsible unit hence consumption should process commodity
Trend of the consumer’s consumption should remain constant.

Exemption of the law of DMU

1) Desire for money, the more money one gets the more satisfaction.
2) Use of liquors-the more and more it is take the more the satisfaction
derived
3) Desire for knowledge
4) Personal hobbies/ habits, more and more of this will give high
satisfaction.

Application of the law

It is applied on the bases of customers‟ behavior analysis.
It is applied in money whereby utility of money for poor people is
greater than for the rich.
It used in the base of progressive taxation whereby the higher the
income the higher the tax which led to dissatisfaction
N/B The law applies in many practical situations. For example a person
on an exotic holiday to the Maasai Mara will experience increasing in
total utility as his holiday proceeds but he is likely to derive greater
satisfaction during the earlier days of his
holiday than during the late days.

The law of diminishing utility applies provided other factors affecting
the consumer’s level utility, apart from the quantity consumed, remain
constant. If any of these factors such as taste of fashion change, the
law may be temporarily inapplicable until a stable
situation is re-established. For example a person may progress from an
occasional buyer of paintings into an obsessive collector or art.

The above illustration shows the relationship between total and marginal
utility.
A saturation point is reached when the utility is maximum and the
marginal utility is at minimum beyond which the total utility starts to
decline while marginal utility becomes negative yielding dissatisfaction.

The Limitation of Utility (Cardinal Utility)
1) It is difficult to make inter-personal comparison of utility since
satisfaction is subjective
2) Measurement of utility is difficult since utility is a mental
phenomenon even by the help of any instrument hence difficult to
determine equilibrium position of a customer.
3) It dose not consider other factors that determine utility such as
environment
4) Indivisibility of commodities is not possible to divide some goods
into small units in order to equalize marginal utility
5) Ignorance of individual who are some times not aware of the
substitute or different goods, e.g. cheap substitute leading items to
have low satisfaction from the commodity they consume.
6) Different behaviour of individual due to different customs and fashion

3.3 Consumer Equilibrium

A consumer is in equilibrium position when he/she achieves maximum
satisfaction out of the available resources. A consumer in an
equilibrium position when he/she distributes expenditure on purchase of
different goods in such a way that marginal utility of a different good
is equal to that of the good. This behaviour of customers is called the
law of equal marginal utility. Based on the mention assumption the
consumer will maximize this utility if he allocates his income in such a
way that a shilling spent on one good yield as much satisfaction as a
shilling spent to any other goods. The marginal utility per shilling
spent on good X equals to the marginal utility spent on good Y hence
consumer equilibrium is obtained when
Marginal utility x = Marginal Utility of Y
Price of X Price of Y
Mux =Muy
PX PY
The law of diminishing marginal utility is also based on the assumption
that the consumer is rational. An economic agent is said to be rational
when the agent exhibits behaviour which is consistent with a set of
rules governing preferences. In the context of consumer behavior this
would imply the following assumption or axioms;

The axiom of dominance which implies that consumers will always
prefer more goods or less. This is also known as the axiom of non-
satiation
The axiom of selection which relates to the idea that the consumer
aims for his or her most preferred state.
The axiom of completeness states that the consumer is able to order
al the available combinations of goods according to his or her
preferences.
The axiom of transivity states that if in some combination of goods;
A is preferred to B and B is preferred to C then (by transivity) A
is preferred to C.

Importance of Law of Equal Marginal Utility

1) It is application in consumption .A consumer can achieve maximum
satisfaction when utility of different commodities is equal since the
objective is to achieve maximum satisfaction.
2) Application in production. Objective of the firm is to maximize
profit achieved when cost of production is minimal and when marginal
productivity of all factors is equal.
3) Application is distribution. When share of different factors of
production are determine, they are determined according to the principal
of marginal utility
4) Application in saving and spending. A special part of the income is
spent on purchase of consumer good and the remaining saved for future use.

3.4 Ordinalist / Indifference Curve Approach

This school of thought is opposed to the law that utility is measurable
through cardinal numbers. This school of thought maintains that customer
behaviour can be explained in terms of preference so that customers need
to state the commodity they prefer without assigning numeral values
without the strength of their preferences. Consumers are expected to
value their preferences of the entire service market of goods and
service in order to choose i.e. combination of two goods that can be
chosen if the two goods are ranked. This is explained by the use of
indifference curves. The assumptions of this approach are:

Price of goods is constant
Consumers are rational
Consumer can rank his/her preferences over time
Their behavior must be transitive i.e. if a consumer prefer A to B to
l C then he can prefer A to C (axiom of transitivity)
Customer always prefer more to less of every commodity (axiom of
non-station)
The slope of indifference curve gives the marginal rate of situation
(M.R.S)
The consumer is able to order all the available combination (axiom
completeness)

Indifference Curve
This is curve joining together all different combination of two goods
that yield the same amount of utility to a consumer. It is a locus of
point of possible combination of two alternative good that yield the
same level of utility. The shape of indifference curve is
called the marginal rate of situation (MRC) i.e. the rate at which good
Y can be substituted for by good X leaving the consumer at the same
level of utility.

Indifference map indicate different indifference curves drawn on the
same plane price with different level of utility.

Properties of Indifference

Indifference has a negative slope. This shows if the quality of one
good say decrease the quality of other good must increase if the
consumer has to remain on the same level of satisfaction
Indifference curve do not intersect. This is because if they did the
point of intersection implies two levels of satisfaction which is not
possible. consider the Figure 3.4

Since combination A and C are on the same indifference come u2 the
consumer must be indifferent between them. Band C are on the same in
difference curve u, the consumer must be indifferent between then. If
the consumer is indifferent between A and C then the he must be
indifferent between A and B (considering the rule of transitivity). This
is however, absurd since the combination A contains more of Y and more
of X and thus preferring A to B. To be consistent with consumption
assumption of rationality it can be concluded that indifference curve
cannot intersect.

They are convex to the original This implies that if the slope of
indifference decrease in absolute terms as we move longs the curve from
left downwards to the right therefore the marginal rate of the substance
will be decreasing or diminishing as show in Figure 3.6.

The theory of diminishing marginal rate of substitute expresses the
observed behavior that as people consume more of a good, the utility
they gain from each excessive unit decline. As the number of units of X
the customer is will to sacrifice in order to obtain
additional unit of Y decrease as the quantity of Y rises. Therefore it
is difficult to substitute X for Y as the customer consume more of y and
vice verse.

3.5 Consumer Equilibrium

To explain the concept of consumer equilibrium the price of the two
commodities should be given as well as the customers‟ income so as to
derive the budget line. Budget line is a curve or a line showing
combination of two goods that can be afforded with a given level
of income. A consumer will be at equilibrium where the budgets line is a
tangent to an indifference curve as shown in Figure 3.7.

Point B is the equilibrium point where the consumer is maximizing the
utility subject to his budget constraint. At point A the consumer has
unutilized income and cannot derive maximum satisfaction. Point C is an
attainable since the consumer’s income is limited by the marginal rate
of substitution at the point B which is also the slope of budget line.

3.6 Income Consumption Curve

Increase in consumer income leads to an upward shift in the budget line
such that it remains parallel to the original one and vice versa. Income
consumption curve is a locus of points of consumer equilibrium resulting
when only the consumer income is varied or the consumer income change.
It is also referred to as effects on an income change. The income
consumption curve can be used to derive the Engel curve which
illustrates the amount of a good a consumer will purchase per unit of
time at various leave of income holding the price constant.

Illustration of indifferent curve for perfect substitute and perfect
complimentary goods
The assumption that indifference curves are convex to the original
implies that the goods are substitute but not perfect substances. In
case goods are perfect substances the indifference curve is represented
by a strait line with negative s lopes parallel to one another. For
perfect substitutes goods the marginal rate of substitution is constant
complimentary goods have indifference curves that are L shape if only
they are perfect compliments as illustrated in Figures 3.10 and 3.11

Point A, B and C are o the same indifference curve yet at point C it
involves the same amount of commodity Y but more of commodity X than at
point B. This implies that the customer is saturated with commodity Y
and therefore the MRS=0 for both X and Y. Similar case applies at point
A involving same amount of X and more of commodity of Y indicating that
the consumer is saturated with commodities X and therefore the Marginal
Rate of Substitution (MRS) of X and Y =0

Application of Indifference Curves
1) It provides an explanation of the underlying reasons why change in
price led to change in quality demand by distinguishing between
substitution and income effects of price change.
2) It enables the derivation of normal and abnormal demand curve through
price consumption curve
3) It is applied in labor economics to measure the trade off between
income and leisure
4) It is used to examine the welfare affect of different Government
Policy like taxes, subsidies for comparative welfare effects of direct
and indirect taxes.
5) It enables assessment of the impact of change in the cost of living
on welfare E.g.., the effect of change in money income and price of the
welfare can be analyzed.