Business Economics

Chapter 4 – Consumer
Demand Analysis
• Explain the concept of consumer demand
• Discuss utility as a basis for consumer demand
• Elaborate on total utility and marginal utility
• Explain the law of diminishing marginal utility
• Discuss cardinal utility approach
• Shed light on ordinal utility approach
• Explain the concept of budget line
• Discuss consumer equilibrium effects
• Describe the revealed preference theory

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 Introductory caselet: consumer demand for bottled water

• According to a study conducted by IKON Marketing Consultants India, an Ahmedabad-based

market research firm, the bottled water market in India is estimated to be INR 8,000 crores.
The bottled water market is growing at a compound annual growth rate (CAGR) of 19%,
which is expected to grow over four-folds by 2020.
• According to the report, consumers’ increasing awareness for health and safety, scarcity of
safe drinking water, and aggressive expansion by market players are the reasons behind the
expansion of the bottled water industry during the past decade.
 Introductory Caselet: consumer demand for bottled water

• Because of an outburst of waterborne diseases, consumers have become

concerned about their health and safety. They do not mind spending on bottled
water in spite of its higher per unit cost against tap water. The awareness about
the need for safe drinking water has spread even in rural areas and small towns,
which has aggravated the sale of bottled water all over the country.

• Apart from this, factors, such as increased disposable income of consumers,

growth of organised retail, and focus on product extension and quality, may
further stimulate the growth of the industry.
 Concept of Consumer Demand

• Consumer demand analysis is a process of assessing consumer behaviour based

on the satisfaction of wants and needs generated by a consumer from the
consumption of various goods.
• The study and analysis of consumer behaviour is based on three main
assumptions:

Decisiveness

Transitivity

Non-satiation

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 Utility as a Basis of Consumer Demand

• Utility can be defined as a measure of satisfaction received by a consumer on the consumption

of a good or service. Utility is a relative term which means that a product may give
satisfaction to one individual while be of no use to the other.

• The concept of Utility can be looked upon by two perspective :

• Product Perspective
• Consumer’s Perspective
 Utility – Concept Building

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 Total Utility (TU)

• Total utility is defined as the sum of the utility derived by a consumer from the different
units of a commodity or service consumed at a given period of time.
• If an individual consumes five units of a commodity X at a given period of time and derives
utility out of the consumption of each unit as U1, U2, U3, U4, and U5.
TU = U1 + U2 + U3 + U4 + U5
• If an individual consumers commodities X,Y and Z and their respective utilities are Ux, Uy,Uz
,then the total utility is expressed as follows:
TUn= Ux+Uy+Uz
 Marginal Utility

• Marginal utility is defined as the utility derived from the marginal or additional unit of a
commodity consumed by an individual.
• It is the addition to the total utility of a commodity resulting from the consumption of an
additional unit.
• Marginal utility, MU of a commodity X, is the change in the total utility, Δ TU, attained from
the consumption of an additional unit of commodity X.
• Marginal Utility= Change in Total Utility/ Change in Quantity
• Marginal Utility= TUn –TUn – 1
 Law of Diminishing Marginal Utility

• When an individual continues to consume more and more units of a commodity per unit of
time, the utility that he/she obtains from each successive unit continues to diminish.
• For example, the utility derived from the first glass of water is high, but with successive
glasses of water, the utility would keep diminishing.

Units of Commodity X Total Utility (TUx) Marginal Utility (MUx)

0 0 -
1 8 8
2 14 6
3 18 4
4 19 1
5 19 0
6 17 -2
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 Law of Diminishing MU
• The pattern of Utility implies that the MU of the consumption goes on falling and
becomes negative after certain level of consumption

• The law implies why the demand curve slopes downward

• This Law is based on assumptions like – utility is measurable, utility can be added,
marginal utility of money remains constant, consumers are rational

• The law of diminishing marginal utility does not hold true in some cases. For
example, in cases, such as individuals accumulating wealth, pursuing hobbies (such
as collection of stamps, coins, or antiques, songs, rare paintings, etc.).
 Law of Diminishing Marginal Utility

• The downward sloping MUx curve shows that the

marginal utility of a commodity consistently decreases as
its consumption increases. When the consumption reaches
to 4 units of commodity X, TUx reaches its maximum
level (the point of saturation) marked as M. Beyond the
point of saturation, MUx becomes negative and TUx
begins to decline consistently. The downward slope of
MUx explains the law of diminishing marginal utility.
• Exceptions – Individual accumulating wealth ,pursuing
hobbies – collection of stamps, coins,paintings etc.)

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 Concept Building

• Can You take a real world example of

diminishing marginal utility ??
 Law of Diminishing Marginal Utility-Assumptions
• ‰Rationality: The law of marginal utility assumes that a consumer is a rational being who
aims at maximising his/her utility at the given income level and the market price.
• ‰‰Measurement of utility: The utility of a commodity can be measured using quantifiable
standards like a cup of tea, a bag of sugar, a pair of socks, etc.
• ‰‰Constant marginal utility of money: The marginal utility of consumer’s income is
constant.
• ‰‰Homogeneity of commodity: The successive units of a commodity consumed are
homogenous or identical in shape, size, colour, taste, quality, etc.
• ‰‰Continuity: The consumption of successive units of a commodity should be continuous
without intervals.
• ‰‰Ceteris paribus: Factors, such as the income, tastes and preferences of consumers; price
of related goods; etc. remain unchanged.

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 Cardinal Utility Approach - Neo Classical Approach

• Neo-classical economists believed that utility is cardinal or quantitative like other

mathematical variables, such as height, weight and temperature. They developed a unit of
measuring utility called utils.
• For example, according to the cardinal utility concept, an individual gains 20 utils from a
pizza and 10 utils from coffee. In the measurement of utility, neo-classicists assumed that one
util equals one unit of money
• A consumer reaches his/her equilibrium when the last unit of his/her money spent on each unit
of the commodity yield the same utility.
• Therefore, the consumer would spend his/her money income on commodity X so long as:
MUx > Px (MUm) Where Px is the price of the commodity, MUx is the marginal utility of the
commodity and MUm is the marginal utility of money.

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 Ordinal Utility Approach – modern economists Indifference
Curve Analysis

• According to the ordinal theory, utility is a psychological phenomenon like happiness,

satisfaction, etc. It is highly subjective in nature and varies across individuals. Therefore, it
cannot be measured in quantifiable terms.
• As per the ordinal utility approach, utility can be measured in relative terms such as less than
and greater than.
• The approach advocates that consumer behaviour can be explained in terms of preferences or
rankings.
• For example, a consumer may prefer ice-cream over soft drink. In such a case, ice-cream
would have 1st rank, while 2nd rank would be given to soft drink.

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 Ordinal Utility Approach – modern economists Indifference
Curve Analysis

As per the ordinal approach ,a consumer identifies several pairs of two commodities which would
provide him/her the same level of satisfaction.

Among these pairs, one can prefer one commodity over the other based on how one ranks them in
order of utility .This implies that utility can be ranked qualitatively and not quantitatively.

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 Ordinal Utility Approach – Concepts

Meaning of Indifference Curve

• An indifference curve can be defined as the locus of points each representing a different
combination of two substitutes, which yield the same level of utility to a consumer.
• The consumer is indifferent to any combination of two commodities if he/she has to make a
choice between them.
• This is because an individual consumes a variety of goods over time and realises that one
good can be substituted with another without compromising on the satisfaction level.
• When these combinations are plotted on the graph, the resulting curve is called indifference
curve. This curve is also called the iso-utility curve or equal utility curve.

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 Ordinal Utility Approach – Indifference Curve Analysis

Indifference Schedule for Substitutes X and Y

Combin Units of Units of Total Utility

ation Commodity Commodity
Y X
a 25 3 U
b 15 5 U
c 8 9 U
d 4 17 U
e 2 30 U

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 Ordinal Utility Approach – Marginal Rate of Substitution

• Marginal rate of substitution (MRS) refers to the rate at which one commodity can be
substituted for another commodity maintaining the same level of satisfaction.

Diminishing MRS between X and Y

Indifferen Combinatio Change in Change in MRSy,x

ce points ns Y+X Y (ΔY) X (ΔX) (ΔY/ ΔX)
a 25 + 3 - - -
b 15 + 5 -10 2 -5.00
c 8+9 -7 4 -1.75
d 4 + 17 -4 8 -0.50
e 2 + 30 -2 13 -0.15

As the consumer moves from combination a to b on IC, he/she sacrifices 10 units of

commodity Y and gets 2 units of commodity X.
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 Properties Of Indifference Curve

• ICs are negatively sloped and convex to the origin- As a consumer increases the
consumption of commodity X, he/she sacrifices some units of commodity Y in order to
maintain the same level of satisfaction.
• Higher IC represents higher satisfaction level
• ICs do not intersect
 Criticism Of Indifference Curve

• Ignorance towards market behaviour: IC analysis considers only two commodities in the
market. However, the market is full of a large number of commodities. For example, a change
in the price of other commodities in the market may affect the purchase of the commodities
being considered.
• ‰Two commodities model- Considering more than two commodities in IC analysis makes
the calculations more complex. This may further make it difficult to predict consumer
behaviour.
• Ignorance towards demonstration effect- The demonstration effect states that an
individual’s consumption pattern is affected by the level of consumption of other individuals.
This is ignored by IC analysis limiting its use to understand consumer behaviour.

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 Criticism Of Indifference Curve

• ‰Indifference towards risks and uncertainties- IC analysis has no ability to analyse

consumer behaviour in the midst of several risks and uncertainties that prevail in the market
and real life.
• Unrealistic assumptions: IC is based on an assumption that a consumer is fully aware of
his/her preference for various commodities.
 Consumer’s Budget Line
• It is a constraint or limitation faced by a consumer in satisfying his wants

• IC represents consumers taste and budget line represents their limitations

• Budget constraint is either due to the limited income or due to the given prices of goods

• Changes in Income or in the prices of goods will bring about change in the budget line

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 Budget Line

The slope of the budget line indicates how

many units of commodity Y a consumer would give
up to buy an additional unit of commodity X or vice
versa.
 Utility Maximization
• Inorder to maximize utility ,an individual tries to reach to the highest possible IC
with his budget line.

• This occurs when IC (MRSxy)is tangent to the budget line ( Px/Py) so that the
slopes of IC is equal to the slope of the budget line.

• This is called as the consumer’s equilibrium or optimization.

Utility Maximization – Concept
Utility Maximization
 Consumer Equilibrium Effect
Income Effect on Consumer Equilibrium :
• It is the effect caused by changes in consumer’s
income on her /his purchases while the prices of
the commodities remains unchanged
• At point E ,the indifference curve IC1
is tangent to the budget line MN
• In case the consumer’s income increases
,the budget line would shift from MN to M1N1
and then to M2N2
• As the result ,the point of equilibrium shifts
from E to E1 and thenE2.The ICC can be obtained
by joining all the points of the consumer’s equilibrium
E,E1 and E2
 Consumer Equilibrium Effects
• A consumer reaches a state of equilibrium when
he/she attains maximum total utility at the given
income level and market price of commodities. The
consumer is at
equilibrium at point E.
• As the IC2 curve is tangent to the budget line AB,
IC2 is the highest indifference curve that a
consumer can attain at the given income level and
market price

of commodities.
• At point E, the consumer consumes quantities OQx
of X and OQy of Y to yield maximum satisfaction.

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 Consumer Equilibrium Effects
• When the consumer is at point J and moves to point K there
is no difference in the satisfaction level at both points that lie
on the same indifference curve (IC1).
• Indifference curve IC3 is impossible to reach for the
consumer due to budgetary constraints. His/her income does
not permit the consumer to purchase any combination of
commodities X and Y on indifference curve IC3.
• The above explanation of the consumer equilibrium is based
on an assumption that the income of the consumer and the
market price of commodities remain unchanged.
 Consumer Equilibrium Effect
Substitution Effect on Consumer Equilibrium

• Suppose a consumer’s money income is Rs.15000. He/she needs to purchase two commodities

X and Y.

• Assume that the price of commodity Y increases and the price of commodity X decreases.

• In such a case, the consumer would tend to purchase more units of commodity X and fewer

units of commodity Y, which implies that the consumer substitutes commodity X for Y. This is

known as the substitution effect.

 Substitution Effect on Consumer Equilibrium

• AB is the original budget line. OM is the quantity of

commodity X and OB is quantity of commodity Y.
• Price of commodity Y increases and that of
X decreases. The new budget line shifts to B1A1
• The new equilibrium position changes to Q1 from Q.
The consumer cuts down the units of

commodity Y to ON to ON1 and purchases

more units of X, OM to OM1. This movement along

indifference curve from Q to Q1 is known

as the substitution effect.
 Quiz (True/False)
1. Transitivity means the ability of a consumer to reveal their preferences

2. Utility as a measurable variable is an assumption of ordinal utility analysis

3. Two indifference curves can not intersect

4. Change in income of a consumer brings about change in the slope of indifference curve

5. Change in the price of any commodity ,brings about a change in the slope of IC
 Quiz –Answers
1. False
2. False
3. True
4. False
5. True
 Revealed Preference Theory

• The theory states that consumers’ preferences can be revealed by the purchases they make
under different income and price circumstances. The revealed preference theory gives a more
realistic assessment of consumer’s behaviour. This theory does not take into account utility
approaches or indifference curve to explain consumer behaviour.
• According to the revealed preference theory, the demand for a commodity by a consumer can
be determined by observing the actual behaviour of the consumer with the varied levels of
income and market price of commodities.
• The basic hypothesis of the revealed preference theory is that ‘choice reveals preference’.
The theory explains the demand curve on the basis of consumer’s behaviour.
• Assumption is consumer’s choices are are always consistent.
Revealed Preference Theory
 Let’s Sum Up

• Utility can be defined as a measure of satisfaction received by a consumer on the consumption

of a good or service.
• The law of diminishing marginal utility states that as the quantity consumed of a commodity
continues to increase, the utility obtained from each successive unit goes on diminishing,
assuming that the consumption of all other commodities remains the same.
• A budget line represents various combinations of two commodities, which can be purchased
by a consumer at the given income level and market price.
 Quiz
1. According to ________________preferences of an individual consumer are always consistent.
• Decisiveness
• Transitivity
• Non-satiation

2. Marginal utility is defined as the utility derived from the marginal or additional unit of a
commodity consumed by an individual. (True/False)

3. According to the ordinal theory, utility can be measured quantitatively. (True/False)

4. Which of the following explains the situation where a consumer would tend to purchase more
units of commodity X and fewer units of commodity Y?
a) Price effect on consumer’s equilibrium
b) Income effect on consumer’s equilibrium
 Quiz
1. According to ________________preferences of an individual consumer are always consistent.
• Decisiveness
• Transitivity
• Non-satiation

2. Marginal utility is defined as the utility derived from the marginal or additional unit of a
commodity consumed by an individual. (True/False)

3. According to the ordinal theory, utility can be measured quantitatively. (True/False)

4. Which of the following explains the situation where a consumer would tend to purchase more
units of commodity X and fewer units of commodity Y?
a) Price effect on consumer’s equilibrium
b) Income effect on consumer’s equilibrium
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