Theory of Demand and Supply - Part 2

Table of Content:

1. Theory of Consumer Behaviour
2. NATURE OF HUMAN WANTS
3. RELATIONSHIP BETWEEN TU & MU
4. INDIFFERENCE CURVE ANALYSIS
5. Consumer Equilibrium
6. CONSUMER SURPLUS

NATURE OF HUMAN WANTS

In economics, the term ‘want’ refers to a wish, desire or motive to own or/and use goods and services that give satisfaction. Wants may arise due to physical, psychological or social factors. Since the resources are limited, we need to make a choice between the urgent wants and the not so urgent wants.

 All wants of human beings exhibit some characteristic features. 
 Wants are unlimited in number. All wants cannot be satisfied. 
 Wants differ in intensity. Some are urgent, others are less intensely felt 
 “Utility” depends on intensity of wants.
 In general, Utility is satisfaction. But in economic sense, Utility is a want satisfying power of a commodity. 
 Each want is satiable

 The two important concepts of utility are Total Utility (TU) and Marginal Utility (MU) which are useful in theories of consumer behaviour.
 TU refers to the sum total of utilities derived from the consumption of all the units of a commodity consumed by a consumer at a given time. In other words, it is a sum of 
marginal utilities up to the units consumed by a consumer. TU = ∑ MU
 MU is the additional utility derived from the consumption of an additional unit of the commodity. MU = TUn – TUn-1 Or MU = ∆TU /∆N

RELATIONSHIP BETWEEN TU & MU

There is a unique relationship between TU and MU which can be explained with the help of below schedule and diagram.

 Both TU and MU are interrelated.
TU = ∑ MU & MU = TUn – TUn-1
 At first unit, TU = MU.
 Initially, when TU is increasing at decreasing rate, MU is decreasing but remains positive.
 When TU is maximum and constant, MU = 0 (zero).
 When TU starts decreasing, MU becomes negative.

CONSUMER SURPLUS

The concept of consumer surplus was propounded by Alfred Marshall. Consumer surplus is a measure of welfare that people gain from consuming goods and services. It measures the benefits buyers receive from participating in a market. This concept occupies an important place not only in economic theory but also in economic policies of government and in decision-making of business firms.

The demand for a commodity depends on the utility of that commodity to a consumer. If a consumer gets more utility from a commodity, he would be willing to pay a higher price and vice-versa. The willingness to pay of each individual consumer based on his utility determines the demand curve. When price is less than or equal to the willingness to pay, the potential consumer purchases the good. 

Marshall defined the concept of consumer surplus as the “excess of the price which a consumer would be willing to pay rather than go without a thing over that which he actually does pay”, is called consumers surplus.”
Thus, consumer surplus = what a consumer is ready to pay - what he actually pays. 

INDIFFERENCE CURVE ANALYSIS

In the last section, we have discussed the marginal utility analysis of demand. A very popular alternative and a more realistic method of explaining consumer demand is the ordinal utility approach. This approach uses a different tool namely indifference curve to analyse consumer behaviour and is based on consumer preferences. The approach is based on the belief that that human satisfaction, being a psychological phenomenon, cannot be measured quantitatively in monetary terms as was attempted in Marshall’s utility analysis. Therefore, it is scientifically more sound to order preferences than to measure them in terms of money. The consumer preference approach is, therefore, an ordinal concept based on ordering of preferences compared with Marshall’s approach of cardinality.

Assumptions Underlying Indifference Curve Approach

(i) The foundation of consumer behaviour theory is the assumption that the consumer knows his own tastes and preferences and possesses full information about all the relevant aspects of economic environment in which he lives. 

(ii) The consumer is rational and tends to take rational actions that result in a more preferred consumption bundle over a less preferred bundle.

(ii) The indifference curve analysis assumes that utility is only ordinally expressible. The consumer is capable of ranking all conceivable combinations of goods according to 
the satisfaction they yield. Thus, if he is given various combinations say A, B, C, D and E, he can rank them as first preference, second preference and so on. However, if a 
consumer happens to prefer A to B, he cannot tell quantitatively how much he prefers A to B.

(iii) Consumer choices are assumed to be transitive. If the consumer prefers combination A to B, and B to C, then he must prefer combination A to C. In other words, he has a 
consistent consumption pattern.

(iv) If combination A has more commodities than combination B, then A must be preferred to B. This is sometimes referred to as the “more is better” assumption or the assumption of non-satiation.

The Budget Line 

From the ordinal utility analysis discussed above, we have understood one part of a person’s consumption behavior namely, consumer preference. A higher indifference curve shows a higher level of satisfaction than a lower one. Therefore, a consumer, in his attempt to maximize satisfaction will try to reach the highest possible indifference curve. But in his pursuit of buying more and more goods and thus obtaining more and more satisfaction, he has to work under two constraints: first, he has to pay the prices for the goods and, second, he has a limited money income with which to purchase the goods.

Consumers maximize their well-being subject to constraints. The most important constraint all of us face in deciding what to consume is the budget constraint. In other words, consumers almost always have limited income, which constrains how much they can consume. A consumer’s choices are limited by the budget available to him. As we know, his total expenditure for goods and services can fall short of the budget constraint, but may not exceed it.

Algebraically, we can write the budget constraint for two goods X and Y as:
                     PXQX + PYQY ≤B

Where
PX and PY are the prices of goods X and Y and QX and QY are the quantities of goods X and Y chosen and B is the total money available to the consumer.

The requirement illustrated by the equation above that a consumer must choose a consumption bundle that costs no more than his or her income is known as the consumer’s budget constraint. A consumer’s consumption possibilities are the set of all consumption bundles that can be consumed given the consumer’s income and prevailing prices.
We assume that the consumer in our analysis uses up his entire nominal money income to purchase the commodities. So that his budget constraint is 
                     PXQX + PYQY = B
The following table shows the combinations of Ice cream and chocolates a consumer can buy spending the entire fixed money income of `100, with the prices ` 20 and `10 respectively.

The budget constraint can be explained by the budget line or price line. In simple words, a budget line shows all those combinations of two goods which the consumer can buy spending his given money income on the two goods at their given prices. All those combinations which are within the reach of the consumer (assuming that he spends all his money income) will lie on the budget line. The consumer could, of course, buy any bundle that cost less than ` 100.(e.g. Point K ) 

It should be noted that any point outside the given price line, say H, will be beyond the reach of the consumer and any combination lying within the line, say K, shows under 
spending by the consumer.

The slope of the budget line is determined by the relative prices of the two goods. It is equal to ‘Price Ratio’ of two goods i.e. PX /PY i.e. It measures the rate at which the consumer can trade one good for the other.

The budget line will shift when there is:
 A change in the prices of one or both products with the nominal income of the buyer (budget) remaining the same.
 A change in the level of nominal income of the consumer with the relative prices of the two goods remaining the same.
 A change in both income and relative prices 

Consumer Equilibrium

Having explained indifference curves and budget line, we are in a position to explain how a consumer reaches equilibrium position by choosing his optimal consumption bundle, given the constraints. A consumer is in equilibrium when he is deriving maximum possible satisfaction from the goods and therefore is in no position to rearrange his purchases of goods. We assume that:

(i) The consumer has a given indifference map which shows his scale of preferences for various combinations of two goods X and Y.

(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 given and are fixed.

(iv) All goods are homogeneous and divisible, and 

(v) The consumer acts ‘rationally’ and maximizes his satisfaction.