Chapter 2 — Theory of Consumer Behaviour

Cardinal Utility Analysis, which assumes utility can be expressed in numbers, and Ordinal Utility Analysis, which ranks bundles through indifference curves without assigning numerical utility values.

Utility is the want-satisfying capacity of a commodity. It is subjective — different individuals can derive different levels of utility from the same commodity, and the utility a person gets can change with place and time.

The law states that marginal utility from consuming each additional unit of a commodity declines as its consumption increases, while keeping consumption of other commodities constant. MU becomes zero when TU is at its maximum, and turns negative when TU starts falling.

Marginal Utility of the nth unit equals TUn minus TUn-1. Equivalently, TU from n units equals the sum of marginal utilities of all units from 1 to n. Total utility increases at a diminishing rate as more units are consumed.

An indifference curve joins all bundles that give the consumer equal satisfaction. Its features: (1) it slopes downward from left to right, (2) a higher indifference curve gives greater utility, and (3) two indifference curves can never intersect each other, as that would lead to contradictory conclusions.

MRS is the rate at which a consumer substitutes one good for another — the amount of mangoes given up per additional banana — while keeping total utility constant. MRS diminishes because as the consumer gets more bananas, the MU of bananas falls and the MU of mangoes rises, so the consumer is willing to sacrifice fewer mangoes for each extra banana.

The budget line represents all bundles that cost exactly the consumer's entire income M. Its equation is p1x1 + p2x2 = M, with slope –p1/p2. The horizontal intercept M/p1 shows the maximum quantity of good 1 affordable, and the vertical intercept M/p2 shows the maximum of good 2.

A change in income causes a parallel outward shift (income increase) or inward shift (income decrease) with no change in slope. A change in the price of one good rotates the budget line around the other good's intercept — a price increase makes the line steeper (for good 1) or flatter, and the horizontal intercept shrinks.

The optimum bundle is located at the point where the budget line is tangent to an indifference curve. At this point, the MRS (the rate at which the consumer is willing to substitute goods) equals the price ratio p1/p2 (the rate at which the consumer is able to substitute goods in the market).

The Law of Demand states that, other things being equal, there is a negative relation between the demand for a commodity and its price. The demand curve is derived by observing that as the price of a good falls, the budget set expands and the consumer's optimal bundle moves to a higher indifference curve with more of that good.

For normal goods, demand increases as income increases. For inferior goods, demand falls as income increases — examples include low quality food items like coarse cereals. A good can be normal at some income levels and inferior at others.

Substitutes are goods that can replace each other (e.g., tea and coffee): demand for a good moves in the same direction as the price of its substitute. Complements are goods consumed together (e.g., tea and sugar, pen and ink): demand for a good moves opposite to the price of its complement.

A change in the price of the good itself causes a movement along the demand curve. A shift in the demand curve is caused by changes in other factors — consumer income, prices of related goods, or tastes and preferences. For a normal good, rising income shifts the curve rightward; for an inferior good, it shifts leftward.

Market demand at any price is the sum of demands of all individual consumers at that price. Graphically, the market demand curve is derived by horizontal summation of individual demand curves — adding the quantities demanded by each consumer at every price.

Price elasticity of demand eD equals the percentage change in quantity demanded divided by the percentage change in price. When eD > 1 the demand is elastic (demand for luxury goods); eD < 1 is inelastic (demand for necessities like food); eD = 1 is unit elastic. For a linear demand curve, elasticity varies from 0 at the horizontal axis to infinity at the vertical axis, equalling 1 at the midpoint.

If demand is elastic (eD > 1), expenditure moves in the opposite direction to the price change. If demand is inelastic (eD < 1), expenditure moves in the same direction as the price change. If demand is unit elastic (eD = 1), expenditure remains unchanged when price changes.

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