Consumer Behaviour
3.5 Indifference Curve
3.1 Utility
In Economic terms, utility
is the benefit or satisfaction derived by consumer, on consumption of a
commodity.
Thus,
utility is want satisfying power of a commodity. For example, Rice has the power to satisfy hunger; water
fulfills our thirst. Liquor, satisfies
the wants of drunkards. Utility is subjective. It varies from person to person.
Marginal
Utility
-
Marginal utility is the additional utility derived from consumption of
additional unit of a commodity. Marginal utility approach was given Alfred
Marshall.
-
Marginal utility curve of a consumer is also his demand curve.
Total
Utility
Total utility is the sum of
utilities derived from the consumption of different units.
Number of
|
Total Utility
|
Marginal Utility
|
|
1
|
40
|
40
|
|
2
|
65
|
25
|
|
3
|
85
|
20
|
|
4
|
100
|
15
|
|
5
|
110
|
10
|
|
6
|
115
|
5
|
|
7
|
115
|
0
|
|
8
|
110
|
-5
|
|
9
|
100
|
-10
|
|
10
|
85
|
-15
|
Characteristics of Utility
i) The marginal utility,
before the point of satiety (full satisfaction), remains positive, but diminishes
with the consumption of every additional unit of a commodity.
ii) Upto the point of satiety,
the total utility increase with each additional unit of consumption.
iii) At
the point of satiety, the marginal utility falls to zero and the total utility does
not increase further from this point onward. So, the total utility becomes
maximum when the marginal utility falls to zero.
Assumption of Utility
The
concept of utility is based on following basic assumptions.
a) Cardinal measurability: Utility
is a cardinal concept. Utility is measured by the amount of money the consumer
is willing to sacrifice, for another unit of a commodity. Cardinal theory of utility
is proposed by Marshall.
b) Constancy of the marginal
of utility of money: The marginal utility of money remains constant
throughout.
c) Independence
d) Rationality: Every
consumer is rational. He seeks maximisation of his utility within the constraint
of available resources, as explained by:
i) Law
of Diminishing Marginal Utility
ii) Law
of Equi-Marginal Utility.
3.2 Law of Diminishing
Utility
The
law of Diminishing Utility is a generalisation drawn from the characteristics
of human wants. The want of a human being for a particular commodity diminishes
as its consumption increases. The want of a thirsty man for water may be
intense, but after he takes one glass, his intensity of desire for another
glass becomes less.
Law of diminishing marginal
utility is called Gosen’s first law.
Diminishing Marginal
Utility
The
desire for a particular commodity or service can usually be satisfied in full
(i.e., it is satiable). We cannot consume an infinite quantity of a commodity
or services. The first few units consumed gives a positive marginal utility. As
consumption increases, a time comes when no further utility is obtained. at
this stage, marginal utility is zero. Between this stage, and the stage of a
positive marginal utility, there is a downward variation of marginal utility.
3.2.1 Limitations of the
law of diminishing marginal utility
Like
other economic laws, the law of Dimishing Marginal Utility is subject to
certain limitations, as follows:
i) Constancy of Attributes: The
law is true only when all other things, in respect of the consumer (e.g.
habits, tastes, temperament, income) remain uncharged.
ii) Initial stages and small
increments: The law may not apply in the initial stages for very
small increments of the commodity. For example, if a thirsty man is offered
water in teaspoons, the utility he gets from the second teaspoon of water may
conceivably be greater than that from the first one.
iii) Substitutes and
complements: The utility of a commodity also depends on the
supply of its substitutes and complements. For example, if more coffee (at
cheaper prices) is available, the utility of tea may fall. If petrol becomes
scarce, the utility of automobiles will sharply decline.
iv) Possession of other people:
Utility of a commodity sometimes depend on the amount of the commodity
which other people possess. For example, in a rich locality, if every householder
except one, has two cars, the intensity of his desire for a second car may be
higher than that for the first car.
3.2.2 Law of equi-marginal
utility
A
consumer will maximize his utility when he spends money in such a way that the
utility derived from last rupee spent is equal.
(i) Law of equi-marginal is
also known as the law of Substitution, or the law of Economy in Expenditure, or
the Law of maximum satisfaction propounded by H.H. Gossesn. For single
commodity, consumer, maximizes utility where MU = P (MU represents value of
Marginal Utility of a commodity & P Represents Price of the commodity)
(ii) For more than one
commodity, the consumer maximizes his total utility by allocating his given
money income among various commodities in such a way that the marginal utility
of money spent on each commodity is equal, i.e, the ratio between marginal
utility & price becomes the same for every commodity.
MUx
/ Px = MUy / Py = MUz / Pz
= ……. = MUn / Pn
This
equality is known as Law of equi-marginal utility
Example : If utility of last rupee spent on wheat is twice the utility of last
rupee spent on rice, then a person will increase the utility spent as last
rupee by switching from rice to wheat. As the consumption of wheat increases,
its utility diminishes. The person will continue switching from rice to wheat
till the state of equilibrium. At this stage, Marginal Utility of Wheat / Price of Wheat = Marginal Utility of Rice /
Price of Rice.
3.3 Marginal rate of
Substitution (MRS)
Marginal rate of
substitution (MRS) is the rate at which one commodity is substituted by the
other, to derive same amount of utility. So, it is the rate at which the
consumer is prepared to exchange goods x and goods y.
Example
|
Combinations
|
Apples
|
|
Diminishing Marginal Rate of substitution (DMRS)
|
|
M
|
1
|
12
|
5
|
|
N
|
2
|
7
|
4
|
|
O
|
3
|
3
|
2
|
|
P
|
4
|
1
|
-
|
The
above table explains the Marginal Rate of Substitutions (MRS). Initially, at
combination N, the consumer takes up 5 units of orange to get an additional
unit of apple. Here, the MRS in 5. Similarly, at combination O, the consumer is
willing to spare 4 unit of oranges and at combination P, he is willing to agree
to spare 2 units of oranges. Thus, MRS goes on diminishing.
Reasons for declining MRS
(a) As the consumer goes on increasing
consumption of Apples, the intensity of desire for it declines. Thus, the stock
of oranges reduce and the intensity of desire of it increases. Therefore, the
consumer seeks to sacrifice less and less quantity of oranges, for every
increase in the apples.
(b)
It
is assumed that the goods (Apples & Orange) are imperfect substitutes of
each other. Had they have been perfect substitutes, the increase and decrease
would affect each other and MRS would remain same.
3.4 Consumer’s Surplus
Consumer’s surplus
is the excess of utility derived by the consumer over lost or disutility
suffered. It is measured by the difference between the maximum price, which the
consumer is willing to pay for a commodity, and that which he actually does
pay.
Consumer Surplus =
(What a consumer is ready to pay) – (what he actually pays)
a.Example Data of Consumer Surplus
|
No. Of units
|
Marginal utility
(Ready to pay)
|
Market Price
(Actual paid)
|
Consumer’s surplus
|
|
1
|
38
|
30
|
8
|
|
2
|
35
|
30
|
5
|
|
3
|
34
|
30
|
4
|
|
4
|
32
|
30
|
2
|
|
5
|
30
|
30
|
0
|
|
6
|
27
|
30
|
-3
|
|
7
|
25
|
30
|
-5
|
b.Consumer Surplus Graph
c.Assumptions about
concept of consumer surplus.
(i) Utility is measurable.
(ii) The marginal utility of money is same.
(iii) The utility of a commodity depends on its
supply.
(iv) The commodity has no close substitute.
Limitations to
concept of Consumer’s Surplus
i) The Consumer’s Surplus obtained from a
commodity is affected by the availability of substitutes.
ii) Consumer’s Surplus cannot be measured precisely, as Marginal Utilities of
different units of a commodity consumed by a person cannot be measured
accurately.
iii) The assumption that Marginal Utility of money is constant is unrealistic. As
more purchases are made, and the consumer’s stock of money diminishes, the
Marginal Utility of money also will undergo a change.
iv) Rule of consumer’s surplus does not apply in
case of prestigious goods (e.g. diamond).
3.5 Indifference Curve
An indifference
curve shows all the combinations of two goods, which give the same level of satisfaction
to the consumer.
J.R. Hicks and R.G.D. Allen
proposed the concept of indifference curve analysis.
Example
There are two commodities X
and Y, and a person consumes 20 units of Y and 1 unit of X. Let us assume that
he is ready to sacrifice 8 units of Y for an additional unit of goods X, to
maintain same level of satisfaction. Thus we have two combination (1,20) and
(2,12). In this way, we may get a number of combinations as below:
Combination
|
Commodity-X
|
Commodity-Y
|
Diminishing Marginal
Rate of Substitutes
|
|
A
|
1
|
20
|
-
|
|
B
|
2
|
12
|
8:1
|
|
C
|
3
|
8
|
4:1
|
|
D
|
4
|
6
|
2:1
|
3.5.1 Properties of
Indifference Curve
|
i) An Indifference Curve is
convex to the origin: An indifference curve is always convex to the origin due to the
diminishing marginal utility.
ii) Indifference curve has a
negative slop: As a consumer increases one unit of a commodity, he reduces the
consumption of the other commodity to maintain the same level of
satisfaction.
iii) Diminishing Marginal
Rates of substitutes: The consumer seeks to sacrifice lesser quantity of Y for every
increment in the quantity of X.
iv) A
higher indifference curve will give higher level of satisfaction, than the
lower one.
v) Two
Indifferent Curves do not intersect, but they may not be parallel to each other.
Indifference
Map is group of more than one ICs.
|
 |
3.5.2 Indifference Curve
Analysis
Every consumer has
a scale of preference between alternative combinations of two or more things, giving
the consumer the same amount of satisfaction. Consumer is rational and aware of
his preference. Since all the alternative combinations of the two goods give
the consumer the same satisfaction, he may choose any one alternative being indifferent
about to the other combinations.
3.6 Budget Line
A budget line (also
known as Consumption Possibility Curve)
represents the different possibilities of two goods, which the consumer can
afford with his limited income.
Example
A consumer has Rs.200 to
spend on Egg roll and cold drinks which cost Rs.10 and Rs.20 respectively. He
has 3 alternative possibilities before him:
(i)
He may buy only 10 cold drinks.
(ii)
He may buy only 20 Egg roll.
(iii)
He may buy both Egg roll and cold drinks are following combinations:
|
Egg roll @10
|
6
|
8
|
10
|
12
|
4
|
2
|
|
Cold drinks @20
|
7
|
6
|
5
|
4
|
8
|
9
|
3.7 Consumers
Equilibrium
A consumer is in
equilibrium when he is deriving maximum possible satisfaction from the goods
and is in no position to rearrange his purchases of goods.
a.Assumptions
i) the consumer has different selection
for various combinations of two goods X and Y (i.e. gets same amount of
satisfaction).
ii) he has a fixed money income
which he has to spend wholly on goods X and Y.
iii) prices of goods X and Y are
fixed.
b.Consumers Equilibrium Graph
The following graph shows
the combination of two goods X and Y the consumer will buy to be in
equilibrium, (the indifference map) and budget line together.
c.Interpretation of Indifference graph
The indifference map
depicts the consumer’s preference scale between various combinations of two
goods (IC1, IC3) and the budget line (PL) shows various
combinations which he can afford to buy with his given money income and prices
of the two goods. Every combination on budget line PL costs the same. Thus
combinations R, S, Q, T and H cost the same to the consumer. The consumer’s aim
is to maximise his satisfaction and for this he will try to reach highest
indifference curve.
But since there is a budget
constraint, he will be forced to remain on the given budget line.
Suppose he chooses R, which
lies on a lower indifference curve (IC1). But he can very well afford S, Q or T lying on
higher indifference curve. Similarly he has other combinations On IC1,
like H. This way he can choose other points like S, T etc. on other lines,
lying on budget line. Now we find that Q is the best choice because this
combination lies not only on his budget line but also puts him on highest
possible indifference curves matching his money income. Thus the consumer will
be at equilibrium at point Q on IC3. At this point, his budget line
PL is tangent to the indifference curve IC3. In this equilibrium
position (at Q), the consumer will buy OM of X and ON of Y.
d.Marginal Rate of Substitution
At the tangency point Q,
the slopes of the price line PL and indifference curve IC3 are
equal. The slope of the indifference curve shows the Marginal Rate of Substitution of X for Y (MRSxy) which
is equal to MUx/MUy, while the slope of the price line
indicates the ratio between the prices of two goods Px/Py
e.Equilibrium Point
At equilibrium point Q,
MRSxy = MUx/MUy
= Px/Py
Where,
MRSxy is
Marginal rate of Substitution of X for Y
MUx and MUy
are Marginal Utility of X and Y
Px & Py
are price of product X & y respectively.
f.Condition for equilibrium
(i) Price line must be tangent
to the indifference curve.
OR
(ii) The marginal rate of
substitution of good X and Y must be equal to the ratio between the prices of
the two goods.
