Consumer Behaviour & Marginal Utility CA Foundation Notes | EduRev

Business Economics for CA Foundation

Created by: Sushil Kumar

CA Foundation : Consumer Behaviour & Marginal Utility CA Foundation Notes | EduRev

The document Consumer Behaviour & Marginal Utility CA Foundation Notes | EduRev is a part of the CA Foundation Course Business Economics for CA Foundation.
All you need of CA Foundation at this link: CA Foundation

LEARNING OUTCOMES 
At the end of this Unit, you should be able to:

  • Explain the meaning of utility.
  • Describe how consumers try to maximize their satisfaction by spending on different goods.
  • Explain the Law of Diminishing Marginal Utility with examples.
  • Describe the concept of Consumer Surplus with examples.
  • Describe the meaning of Indifference Curve and Price Line and how these help in explaining consumer equilibrium. 

NATURE OF HUMAN WANTS 
All desires, tastes and motives of human beings are called wants in Economics. Wants may arise due to elementary and psychological causes. Since the resources are limited, we have to choose between the urgent wants and the not so urgent wants. All wants of human beings exhibit some characteristic features.
1. Wants are unlimited in number. They are never com pletely satisfied.
2. Wants differ in intensity. Some are urgent ,others are felt less intensely.
3. Each want is satiable.
4. Wants are competitive. They compete each other for satisfaction because resources are scarce to satisfy all wants.
5. Wants are complementary. Some wants can be satisfied only by using more than one good or group of goods.
6. Wants are alternative.
7. Wants are subjective and relative.
8. Wants vary with time, place, and person.
9. Some wants recur again whereas others do not occur again and again.
10. Wants may become habits and customs.
11. Wants are affected by income, taste, fashion, advertisements and social customs.
12. Wants arise from multiple causes such as natural instincts, social obligation and individual’s economic and social status 

Classification of wants 
In Economics, wants are classified into three categories, viz., necessaries, comforts and luxuries.
Necessaries
Necessaries are those which are essential for living. Necessaries are further sub-divided into necessaries for life or existence, necessaries for efficiency and conventional necessaries. Necessaries for life are things necessary to meet the minimum physiological needs for the maintenance of life such as minimum amount of food, clothing and shelter. Man requires something more than the necessities of life to maintain longevity, energy and efficiency of work, such as nourishing food, adequate clothing, clean water, comfortable dwelling, education, recreation etc. These are necessaries for efficiency. Conventional necessaries arise either due to pressure of habit or due to compelling social customs and conventions. They are not necessary either for existence or for efficiency.
Comforts
While necessaries make life possible comforts make life comfortable and satisfying. Comforts are less urgent than necessaries. Tasty and wholesome food, good house, clothes that suit different occasions, audio-visual and labour saving equipments etc .make life more comfortable.
Luxuries 
Luxuries are those wants which are superfluous and expensive. They are not essential for living. Items such as expensive clothing, exclusive motor cars, classy furniture, goods used for vanity etc fall under this category.
The above categorization is not rigid as a thing which is a comfort or luxury for one person or at one point of time may become a necessity for another person or at another point of time. As all of us are aware, the things which were considered luxuries in the past have become comforts and neces saries today.
What is Utility?
The concept of utility is used in neo classical Economics to explain the operation of the law of demand. Utility is the want satisfying power of a commodity. It is the expected satisfaction to a consumer when he is willing to spend money on a stock of commodity which has the capacity to satisfy his want. Utility is the anticipated satisfaction by the consumer, and satisfaction is the actual satisfaction derived.
A commodity has utility for a consumer even when it is not consumed .It is a subjective entity and varies from person to person. A commodity has different utility for the same person at different places or at different points of time. It should be noted that utility is not the same thing as usefulness. From the economic standpoint, even harmful things like liquor, may be said to have utility because people want them. Thus, in Economics, the concept of utility is ethically neutral.
Utility hypothesis forms the basis of the theory of consumer behaviour. From time to time, different theories have been advanced to explain consumer behaviour and thus to explain his demand for the product. Two important theories are
(i) Marginal Utility Analysis propounded by Marshall, and
(ii) Indifference Curve Analysis propounded by Hicks and Allen.

MARGINAL UTILITY ANALYSIS
This theory which is formulated by Alfred Marshall, a British economist, seeks to explain how a consumer spends his income on different goods and services so as to attain maximum satisfaction. This theory is based on certain assumptions. But before stating the assumptions, let us understand the meaning of total utility and marginal utility.
Total utility: Assuming that utility is measurable and additive, total utility may be defined as the sum of utility derived from different units of a commodity consumed by a consumer. Total utility is the sum of marginal utilities derived from the consumption of different units i.e.
TU= MU1 +MU2 +.....+MUn
Where MU1 , MU2 ,.....,MUn etc are marginal utilities of the successive units of a commodity.
Marginal utility: It is the addition made to total utility by the consumption of an additional unit of a commodity. In other words, it is the utility derived from the marginal or one additional unit consumed or possessed by the individual. Marginal utility = the addition made to the total utility by the addition of consumption of one more unit of a commodity.
Symbolically,
MUn  = TUn   - TUn-1 
Where,
MUn  is the marginal utility of the nth unit,
TUn  is the total utility of the nth unit, and
TUn-1 is the total utility of the (n-1)th unit

Assumptions of Marginal Utility Analysis
(1) Rationality: A consumer is rational andattempts to attain maximum satisfaction from his limited money income
(2) Cardinal Measurability of Utility: According to neoclassical economists, utility is a cardinal concept i.e., utility is a measurable and quantifiable entity. It implies that utility can be measured in cardinal numbers and assigned a cardinal number like 1, 2, 3 etc. Marshall and some other economists used a psychological unit of measurement of utility called utils. Thus, a person can say that he derives utility equal to 10 utils from the consumption of 1 unit of commodity A and 5 from the consumption of 1 unit of commodity B. Since a consumer can quantitatively express his utility, he can easily compare different commodities and express which commodity gives him greater utility and by how much. Utilities from different units of the commodity can be added as well.
According to this theory, money is the measuring rod of utility. The amount of money which a person is prepared to pay for a unit of a good, rather than go without it, is a measure of the utility which he derives from the good.
(3) Constancy of the Marginal Utility of Money: The marginal utility of money remains constant throughout when the individual is spending money on a good. This assumption, although not realistic, has been made in order to facilitate the measurement of utility of commodities in terms of money. If the marginal utility of money changes as income changes, the measuring-rod of utility becomes unstable and therefore would be inappropriate for measurement.
(4) The Hypothesis of Independent Utility: The total utility which a person gets from the whole collection of goods purchased by him is simply the sum total of the separate utilities of the goods. The theory ignores complementarity between goods
The Law of Diminishing Marginal Utility
One of the important laws under Marginal Utility analysis is the Law of Diminishing Marginal Utility.
The law of diminishing marginal utility is based on an important fact that while total wants of a person are virtually unlimited, each single want is satiable i.e., each want is capable of being satisfied. Since each want is satiable, as a consumer consumes more and more units of a good, the intensity of his want for the good goes on decreasing and a point is reached where the consumer no longer wants it. Thus, the greater the amount of a good a consumer has, the less an additional unit is worth to him or her.
Marshall who was the exponent of the marginal utility analysis, stated the law as follows:
“The additional benefit which a person derives from a given increase in the stock of a thing diminishes with every increase in the stock that he already has.” 
In other words, as a consumer increases the consumption of any one commodity keeping constant the consumption of all other commodities, the marginal utility of the variable commodity must eventually decline.
This law describes a very fundamental tendency of human nature. In simple words it says that as a consumer takes more units of a good, the extra satisfaction that he derives from an extra unit of a good goes on falling. It is to be noted that it is the marginal utility and not the total utility which declines with the increase in the consumption of a good

Table 6 : Total and marginal utility schedule

Quantity of chocolate bar consumedTotal utilityMarginal utility
13030
25020
36515
47510
5838
6896
7934
8963
9982
10980
1194-4


Let us illustrate the law with the help of an example. Consider Table 6, in which we have presented the total utility and marginal utility derived by a person from the chocolate bars consumed. When one chocolate bar is consumed, the total utility derived by the person is 30 utils (unit of utility) and the marginal utility derived is also 30 utils. With the consumption of 2nd chocolate bar, the total utility rises to 50 but marginal utility falls to 20. We see that till the consumption of chocolate bars increases to 9, the marginal utility from the additional chocolate bars goes on diminishing (i.e., the total utility goes on increasing at a diminishing rate). The 10th chocolate bar adds no utility and therefore, the total utility remains the same at 98. However, when the chocolate bars consumed increases to 11, instead of giving positive marginal utility, the eleventh chocolate bar gives negative marginal utility or disutility as it may cause him discomfort

From Table 6, we can conclude the following important relationships between total utility and marginal utility
1. Total utility rises as long as MU is positive, but at a diminishing rate because MU is diminishing.
2. Marginal utility diminishes throughout.
3. When marginal utility is zero, total utility is maximum. It is a saturation point.
4. When marginal utility is negative, total utility is diminishing
5. MU is the rate of change of TU or the slope of TU.
6. MU can be positive ,zero or negative 

Graphically we can represent the relationship between total utility and marginal utility (fig. 11).
Consumer Behaviour & Marginal Utility CA Foundation Notes | EduRev
Fig. 11 : Marginal utility of chocolates consumed 
As will be seen from the gure, the marginal utility curve goes on declining throughout. The diminishing marginal utility curve applies to almost all commodities. A few exceptions however, have been pointed out by some economists. According to them, this law does not apply to money, music and hobbies. While this may be true in initial stages, beyond a certain limit these will also be subjected to diminishing utility.
The Law of diminishing marginal utility helps us to understand how a consumer reaches equilibrium in case of a single good. It states that as the quantity of a good with the consumer increases, marginal utility of the good decreases. In other words, the marginal utility curve is downward sloping. Now, a consumer will go on buying a good till the marginal utility of the good becomes equal to the market price. In other words, the consumer will be in equilibrium (will be deriving maximum satisfaction) in respect of the quantity of the good when marginal utility of the good is equal to its price. Here his satisfaction will be maximum.
What happens when there is a change in the price of the good? The equality between marginal utility and price is disturbed when the price of the good falls. The consumer will consume more of the good so as to restore the equality between the marginal utility and price. The marginal utility from the good will fall when he consumes more of the good. He will continue consuming more till the marginal utility becomes equal to the new lower price. On the other hand, when price of the good increases, he will buy less so as to equate the marginal utility to the higher price. We can say that the downward sloping demand curve is directly derived from the marginal utility curve.
In reality, a consumer spends his income on more than one good. In such cases, consumer equilibrium is explained with the law of Equi-Marginal utility. According to this, the consumer will be in equilibrium when he is spending his money on goods and services in such a way that the marginal utility of each good is proportional to its price and the last rupee spent on each commodity yields him equal marginal utility. The law states that the consumer is said to be at equilibrium, when the following condition is met:

(MUX/PX) = (MUY/PY)
or (MUx / MUY) = (Px /PY)

Limitations of the Law
The law of diminishing marginal utility is applicable only under certain assumptions.
(i) Homogenous units: The different units consumed should be identical in all respects. The habit, taste, temperament and income of the consumer also should remain unchanged. (ii) Standard units of Consumption: The different units consumed should consist of standard units. If a thirsty man is given water by successive spoonfuls, the utility of the second spoonful of water may conceivably be greater than the utility of the first.
(iii) Continuous Consumption: There should be no time gap or interval between the consumption of one unit and another unit i.e. there should be continuous consumption. (iv) The Law fails in the case of prestigious goods: The law may not apply to articles like gold, cash, diamonds etc. where a greater quantity may increase the utility rather than diminish it. It also fails to apply in the case of hobbies, alcohol, cigarettes, rare collections etc.
(v) Case of related goods: Utility is not in fact independent. The shape of the utility curve may be affected by the presence or absence of articles which are substitutes or complements. The utility obtained from tea may be seriously affected if no sugar is available and the utility of bottled soft drinks will be affected by the availability of fresh juice.
(vi) Based on unrealistic assumptions: The assumptions of cardinal measurability of utility, constancy of marginal utility of money, continuous consumption and consumer rationality are unrealistic.

Consumer’s Surplus
The concept of consumer’s surplus was propounded by Alfred Marshall. This concept occupies an important place not only in economic theory but also in economic policies of government and in decision-making of monopolists.
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. It has been seen that consumers generally are ready to pay more for certain goods than what they actually pay for them. This extra satisfaction which consumers get from their purchase of a good is called by Marshall as consumer’s surplus.
Marshall defined the concept of consumer’s 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 consumer’s surplus.” 
Thus consumer’s surplus = what a consumer is ready to pay - what he actually pays
The concept of consumer’s surplus is derived from the law of diminishing marginal utility. As we know from the law of diminishing marginal utility, the more of a thing we have, the lesser marginal utility it has. In other words, as we purchase more of a good, its marginal utility goes on diminishing. The consumer is in equilibrium when the marginal utility of a good is equal to its price i.e., he purchases that many number of units of a good at which marginal utility is equal to price (It is assumed that perfect competition prevails in the market). Since the price is the same for all units of the good he purchases, he gets extra utility for all units consumed by him except for the one at the margin. This extra utility or extra surplus for the consumer is called consumer’s surplus.
Consider Table 7 in which we have illustrated the measurement of consumer’s surplus in case of commodity X. The price of X is assumed to be ₹20.

Table 7: Measurement of Consumer’s Surplus

No. of unitsMarginal Utility (worth ₹)Price (₹)Consumer’s Surplus
1302010
228208
326206
424204
522202
620200
71820-

We see from the above table that when consumer’s consumption increases from 1 to 2 units, his marginal utility falls from ₹30 to ₹ 28. His marginal utility goes on diminishing as he increases his consumption of good X. Since marginal utility for a unit of good indicates the price the consumer is willing to pay for that unit, and since price is assumed to be fixed at ₹ 20, the consumer enjoys a surplus on every unit of purchase till the 6th unit. Thus, when the consumer is purchasing 1 unit of X, the marginal utility is worth ₹ 30 and price fixed is ₹ 20, thus he is deriving a surplus of ₹ 10. Similarly, when he purchases 2 units of X, he enjoys a surplus of ₹ 8 [₹ 28 – ₹20]. This continues and he enjoys consumer’s surplus equal to ₹ 6, 4, 2 respectively from 3rd, 4th and 5th unit. When he buys 6 units, he is in equilibrium because his marginal utility is equal to the market price or he is willing to pay a sum equal to the actual market price and therefore, he enjoys no surplus. Thus, given the price of  ₹ 20 per unit, the total surplus which the consumer will get, is ₹ 10 + 8 + 6 + 4 + 2 + 0 = 30.

The concept of consumer’s surplus can also be illustrated graphically. Consider figure 12. On the X-axis we measure the amount of the commodity and on the Y-axis the marginal utility and the price of the commodity. MU is the marginal utility curve which slopes downwards, indicating that as the consumer buys more units of the commodity, its marginal utility falls. Marginal utility shows the price which a person is willing to pay for the different units rather than go without them. If OP is the price that prevails in the market, then the consumer will be in equilibrium when he buys OQ units of the commodity, since at OQ units, marginal utility is equal to the given price OP. The last unit, i.e., Qth unit does not yield any consumer’s surplus because here price paid is equal to the marginal utility of the Qth unit. But for units before Q

Consumer Behaviour & Marginal Utility CA Foundation Notes | EduRev

Fig. 12 : Marshall’s Measure of Consumer’s Surplus

In Figure 12, the total utility is equal to the area under the marginal utility curve up to point Q i.e. ODRQ. But, given the price equal to OP, the consumer actually pays OPRQ. The consumer derives extra utility equal to DPR which is nothing but consumer’s surplus.
Limitations: It is often argued that this concept is hypothetical and illusory. The surplus satisfaction cannot be measured precisely.
(1) Consumer’s surplus cannot be measured precisely - because it is dificult to measure the marginal utilities of different units of a commodity consumed by a person.
(2) In the case of necessaries, the marginal utilities of the earlier units are infinitely large. In such case the consumer’s surplus is always infinite.
(3) The consumer’s surplus derived from a commodity is affected by the availability of substitutes.
(4) There is no simple rule for deriving the utility scale of articles which are used for their prestige value (e.g., diamonds).
(5) Consumer’s surplus cannot be measured in terms of money because the marginal utility of money changes as purchases are made and the consumer’s stock of money diminishes. (Marshall assumed that the marginal utility of money remains constant. But this assumption is unrealistic).
(6) The concept can be accepted only if it is assumed that utility can be measured in terms of money or otherwise. Many modern economists believe that this cannot be done.

The concept of consumer surplus has important practical applications. Few such applications are listed below:

  • Consumer surplus is a measure of the welfare that people gain from consuming goods and services. It is very important to a business firm to reflect on the amount of consumer surplus enjoyed by different segments of their customers because consumers who perceive large surplus are more likely to repeat their purchases.
  • Understanding the nature and extent of surplus can help business managers make better decisions about setting prices. If a business can identify groups of consumers with different elasticity of demand within their market and the market segments which are willing and able to pay higher prices for the same products, then firms can profitably use price discrimination.
  • Large scale investment decisions involve cost benefit analysis which takes into account the extent of consumer surplus which the projects may fetch.
  • Knowledge of consumer surplus is also important when a firm considers raising its product prices Customers who enjoyed only a small amount of surplus may no longer be willing to buy products at higher prices. Firms making such decisions should expect to make fewer sales if they increase prices.
  • Consumer surplus usually acts as a guide to finance ministers when they decide on the products on which taxes have to be imposed and the extent to which a commodity tax has to be raised. It is always desirable to impose taxes or increase the rates of taxes on commodities yielding high consumer’s surplus because the loss of welfare to citizens will be minimal.

Complete Syllabus of CA Foundation

Dynamic Test

Content Category

Related Searches

Important questions

,

Free

,

ppt

,

Consumer Behaviour & Marginal Utility CA Foundation Notes | EduRev

,

past year papers

,

video lectures

,

Objective type Questions

,

study material

,

Semester Notes

,

Exam

,

Consumer Behaviour & Marginal Utility CA Foundation Notes | EduRev

,

practice quizzes

,

Previous Year Questions with Solutions

,

Viva Questions

,

Summary

,

mock tests for examination

,

Consumer Behaviour & Marginal Utility CA Foundation Notes | EduRev

,

Extra Questions

,

Sample Paper

,

MCQs

,

shortcuts and tricks

,

pdf

;