by Consumer behavior is one of the most important topics in managerial economics because business firms produce goods and services for consumers. A firm cannot decide production, pricing or marketing policy without understanding how consumers make purchasing decisions. A consumer has limited income but unlimited wants, therefore he must choose among many alternatives. The problem of choice leads to the concept of consumer’s equilibrium.
Consumer’s equilibrium explains how a consumer allocates his limited income among various goods in such a way that he gets maximum satisfaction. Economists have explained this equilibrium using two major approaches:
-
Utility (Cardinal) Approach
-
Indifference Curve (Ordinal) Approach
Both approaches aim to explain the same problem but use different methods and assumptions.
(A) Utility (Marginal Utility) Approach
Utility refers to the want-satisfying power of a commodity. Any good or service that satisfies human wants possesses utility. For example, food satisfies hunger, clothes protect the body and a mobile phone satisfies communication needs.
In the utility approach, satisfaction is assumed to be measurable in numerical units called utils. A consumer derives satisfaction whenever he consumes a commodity. The more the satisfaction, the greater the utility.
There are two types of utility:
(i) Total Utility (TU): Total utility is the total satisfaction a consumer receives from consuming a certain quantity of a commodity.
(ii) Marginal Utility (MU): Marginal utility is the additional satisfaction obtained from consuming one more unit of a commodity.
Thus, marginal utility helps the consumer decide whether to buy an additional unit or not.
Law of Diminishing Marginal Utility
The law of diminishing marginal utility states that as a consumer consumes more and more units of a commodity, the marginal utility derived from each additional unit gradually decreases, keeping other factors constant.
For example, the first slice of pizza gives high satisfaction, the second gives less satisfaction, and the fourth or fifth slice gives very little satisfaction.
This law occurs because a particular want becomes gradually satisfied. After a certain point, the consumer does not need more of the same commodity. This law is the foundation of the consumer equilibrium in the utility approach.
Consumer’s Equilibrium with One Commodity
If a consumer spends his entire income on only one commodity, equilibrium is achieved when:
Marginal Utility of the commodity = Price of the commodity (MU = P)
The consumer compares the satisfaction from the last unit with the price paid for it.
-
If MU > Price → consumer gains extra satisfaction and will buy more
-
If MU < Price → consumer feels loss and will buy less
Therefore, equilibrium occurs when the utility obtained from the last unit equals the sacrifice made in terms of money.
Consumer’s Equilibrium with Two Commodities (Law of Equi-Marginal Utility)
In real life, consumers buy many goods. Therefore, economists developed the Law of Equi-Marginal Utility, also known as the law of substitution.
According to this law, a consumer distributes his income among different commodities in such a way that the marginal utility per rupee spent on each commodity is equal.
MUx / Px = MUy / Py
This means the last rupee spent on each good provides equal satisfaction.
If the satisfaction from one good is greater, the consumer will spend more on that good and less on the other until equality is achieved. At this point, the consumer reaches equilibrium and total satisfaction becomes maximum.
Assumptions of Utility Approach
-
Utility is measurable in numbers
-
Consumer is rational
-
Consumer aims at maximum satisfaction
-
Income is fixed
-
Prices of goods are constant
-
Marginal utility of money remains constant
-
Goods are divisible and independent
These assumptions simplify analysis but may not always hold true in real life.
Limitations of Utility Approach
Although useful, the utility approach has several limitations:
Utility cannot be measured accurately because satisfaction is psychological. Different consumers may experience different levels of satisfaction from the same product. The assumption of constant marginal utility of money is unrealistic because income changes purchasing power. The approach also ignores consumer preferences, habits and social influences. Due to these limitations, economists developed a more realistic method called the indifference curve approach.
(B) Indifference Curve Approach
The indifference curve approach was developed by J.R. Hicks and R.G.D. Allen. It does not measure utility numerically but ranks preferences. Satisfaction is considered ordinal, meaning it can only be compared (more or less), not measured.
An indifference curve shows various combinations of two goods that give equal satisfaction to the consumer. The consumer is indifferent among all combinations on the same curve because each provides the same level of satisfaction.
A higher indifference curve represents a higher level of satisfaction.
Assumptions of Indifference Curve Analysis
-
Consumer is rational
-
Consumer prefers more goods to less
-
Preferences are consistent
-
Goods are divisible
-
Consumer can rank combinations of goods
-
Diminishing marginal rate of substitution operates
These assumptions make the analysis more realistic than the utility approach.
Properties of Indifference Curves
Indifference curves have the following features:
They slope downward from left to right because if the consumer gets more of one good, he must give up some of the other to maintain the same satisfaction.
They are convex to the origin due to diminishing marginal rate of substitution. As the consumer substitutes one good for another, willingness to sacrifice decreases.
Two indifference curves never intersect because each curve represents a different satisfaction level.
Higher indifference curves represent higher satisfaction since they contain more quantity of at least one good.
Marginal Rate of Substitution (MRS)
The marginal rate of substitution is the rate at which a consumer is willing to sacrifice one good to obtain an additional unit of another good while keeping satisfaction constant.
MRSxy = units of Y sacrificed for one more unit of X
The MRS diminishes because as the consumer consumes more of good X, its importance decreases, and he is willing to sacrifice less of good Y.
Budget Line
A budget line represents all combinations of two goods that a consumer can purchase with a given income and given prices.
The slope of the budget line equals the price ratio:
Slope = Px / Py
The budget line shows the consumer’s purchasing power. Any point on the line is affordable, points inside are affordable but unused, and points outside are unaffordable.
Consumer’s Equilibrium through Indifference Curve
Consumer equilibrium occurs where the budget line is tangent to an indifference curve.
At this point:
MRSxy = Px / Py
Here, the slope of the indifference curve equals the slope of the budget line. The consumer cannot move to a higher indifference curve because income is limited. Moving to a lower curve reduces satisfaction. Therefore, this tangency point gives maximum satisfaction.
Conditions of Equilibrium
There are two conditions:
First Order Condition: Marginal rate of substitution equals the price ratio.
Second Order Condition: Indifference curve must be convex to the origin.
These conditions ensure stable equilibrium.
Superiority of Indifference Curve Approach
The indifference curve approach is considered superior because it does not require measurement of utility. It recognizes substitution between goods and considers consumer preferences. It also explains the effect of price and income changes on consumer choice. Therefore, it is more practical and closer to real consumer behavior.
