Unit 2

Demand Analysis - I

Objectives:

After going through this unit, you will be able to explain:

The concept and application of utility and utility maximization in comprehending

consumer behavior.

Indifference curve analysis for figuring out consumer choices and allocation of

budget between two commodities.

Revealed preference theory and its applications in consumer decisions

Foundations of demand and consumer demand behavior

Structure:

1.1 Introduction

1.2 Concept of Utility

1.3 Total Utility and Marginal Utility

1.4 Consumer Utility analysis

1.5 Law of Diminishing Marginal Utility

1.6 Utility maximization and consumer equilibrium

1.7 Indifference Curve analysis

1.8. Assumptions of Indifference Curve analysis

1.9 Concept of indifference curves

1.10 Indifference Map

1.11 Properties of indifference curves

1.12 Budget Line

1.13 Consumer’s equilibrium using indifference curves approach

1.14 Revealed Preference Theory

1.15 Summary

1.16 Key words

1.17 Self-assessment questions

1.1 Introduction

In the earlier units we have established that the focus of economics and managerial

economics is to understand the problems of Scarcity and Choice - the problems of

fulfilling the unlimited and constantly recurring wants of human beings and business with

limited resources which have alternative uses. Because of scarcity, economies and

business should allocate their resources efficiently and effectively. This leads us to

concept of utility, which explicates how individuals, businesses, and economies acquire

optimal satisfaction while dealing with scarcity.

1.2 Utility

In simple words, Utility can be understood as the want satisfying power of a commodity.

When a consuming commodities – goods or services- the goal of the consumer is to

maximize the satisfaction. Before dwelling into analyzing consumer behavior based on

the economic concept of utility it is important to outline definitions of the concepts

associated with consumer’s utility.

a) Utility: A measure of the relative satisfaction gained from consuming different

goods and services.

b) Utility Measurement: A quantification of the satisfaction of wants and needs

achieved through the consumption of goods and services. In principle, utility

measurement can take one of two forms: Cardinal and Ordinal

(i) Cardinal utility is the measurement of satisfaction using numerical values (1,

2, 3, etc.) that are comparable and based on a benchmark or scale.

(ii) Ordinal utility is the ranking of preferences (first, second, third, etc.) that are

only comparable on a relative basis.

While the hypothetical instructional analysis of utility relies on cardinal utility,

ordinal utility is a more realistic way to measure satisfaction.

c) Utility Analysis: A part of consumer demand theory that analyses consumer

behavior and market demand using the concepts of total utility and marginal

utility. The key principle of utility analysis is the law of diminishing marginal

utility, which offers an explanation for the law of demand and the negative slope

of the demand curve.

d) Utility Maximization: The progression or ambition of obtaining the maximum

level of gratification from the consumption of goods or services. The goal of

maximizing utility is a basic postulation underlying consumer behavior studied in

consumer demand theory. It is assumed that consumers make preferences among

available alternatives in such a way that they obtain the highest possible level of

satisfaction.

1.3 Total Utility and Marginal Utility

Two concepts which are relevant to Utility analysis for an insight into consumer behavior

are Total and Marginal Utility.

a) Total Utility : Total utility is a measure of the total satisfaction of wants and needs

obtained from the consumption or use of a good or service.

b) Marginal Utility: Marginal utility is the additional utility, or extra satisfaction of

wants and needs, obtained from the consumption or use of an additional unit of a

good or service. Marginal utility is, in other words, the extra satisfaction gained

from an extra unit of good. Marginal utility can be expressed as,

Marginal utility = change in total utility

change in quantity

1.4 Consumer Utility Analysis:

The primary focus of utility analysis is on the satisfaction of wants and needs obtained by

the consumption of goods. The utility generated from consumption affects the decision to

purchase and consume a commodity. The specific economic use of the term utility in the

study of consumer behavior means the satisfaction of wants and needs obtained from the

consumption of a commodity. The good consumed need not be “useful” in the everyday

sense of the term. It only needs to provide satisfaction. In other words, a frivolous good

that has little or no practical use, can provide as much utility as a more useful good.

Consumers will take into consideration

a) How much satisfaction they get from buying and then consuming an extra unit of

a good or service 

b) The price that they have to pay to make this purchase

c) The satisfaction derived from consuming alternative products 

d) The prices of alternatives goods and services

Consider the following table which describes the Total and Marginal Utility derived from

consuming successive units of a commodity.

No. of units of

a commodity consumed

Total Utility Marginal Utility

0 0 0

1 70 70

2 80 10

3 85 05

4 88 03

5 87 -1

In the above table shows the total and marginal utility derived by a consumer from

consuming successive units of commodity show the following trends,

a) As the consumer consumes more and more units of a commodity total utility or

the total satisfaction derived may initially increase but the rate of increase

declines with every next unit consumed.

b) As the consumer consumes more and more units of a commodity the marginal

utility or additional satisfaction derived from consuming every next unit of the

commodity declines.

c) When total utility increases at a diminishing rate, marginal utility declines, and

when total utility declines marginal utility becomes negative.

In conclusion, the amount of a person’s total utility corresponds to the person’s level of

consumption. This leads us to the well recognized Law of Diminishing Marginal Utility.

1.5 Law of Diminishing Marginal utility

Marginal Utility, as defined earlier is the change in total utility or satisfaction resulting

from the consumption of one more unit of a good. The premise of diminishing marginal

utility states that the utility or additional satisfaction derived from consuming successive

units of a commodity declines as more and more units of the commodity are consumed.

In other words, marginal utility diminishes as more units of a commodity are consumed.

Consider the following example,

Example - A consumer enjoys successive glasses of his favorite juice. The total and

marginal utility gained from each extra glass of juice is shown in the table below. Total

utility is maximized when marginal utility = zero. Consuming the seventh glass would

create negative utility as total utility falls (marginal utility becomes negative).

Glasses of Juice Total Utility

(TU)

Marginal Utility

(MU)

0 0 -

1 10 10

2 18 8

3 24 6

4 28 4

5 30 2

6 30 0

7 29 -1

Consider the following diagram,

The above diagram presents The Law of Diminishing Marginal Utility diagrammatically.

1.6 Utility Maximization and Consumer’s equilibrium

a) With one commodity purchase:

It is only logical to think that people are generally motivated to do what is best for them,

to purchase the most satisfying goods, to make the decisions that do more good than

harm, to improve their overall living standards and well-being. In economic terms we

would say that in general all people tend to maximize their utility. Utility maximization

then becomes the guiding notion underlying consumer choices.

So how much of a commodity does the consumer purchase? The consumer equates the

satisfaction derived from a commodity with its price. He goes on consuming more and

Utility

Quantity of a commodity

TU

MU

more units of a commodity as long as the additional satisfaction or MU is more than the

price that he pays for the commodity and stops at a point where MU is equal to the price.

Beyond this point of equality, because MU continues to diminish as a result of the law of

diminishing MU, MU becomes less than the unit price of the commodity. Hence,

consumer equilibrium occurs at the point where MU is just equal to the price. This point

can be expressed as the point at which,

Px = MUx,

Where, Px is the per unit price of commodity ‘X’ and MUx is the marginal utility derived

from consuming the commodity ‘X’.

b) With two commodity purchase :

Owing to the multiplicity of wants and scarcity of means, wants become competitive.

Consumers constantly weigh in their minds whether to buy a little more one or a little less

of another commodity. They have to make a choice between how much to spend on

buying what quantities of various commodities. The concept of utility helps in

understanding consumer’s equilibrium in such a situation.

Suppose the consumer is buying two commodities X and Y. For arriving at consumer’s

equilibrium, i.e., the point of maximum satisfaction, the consumer takes into

consideration two factors, given the total money that he plans to spend on the two

commodities,

a) MU of the two commodities

b) Their Prices

The equilibrium position will be at a point where,

MUx = MUy

Px Py

Where,

MUx – Marginal Utility of commodity X

MUy – Marginal Utility of commodity Y

Px – Price of commodity X

Py – Price of commodity Y

1.7 Indifference Curves Analysis

A more advanced form of consumer demand theory involves the analysis of indifference

curves. This model is used to analyze the choices that consumers make in spending their

limited incomes on the various goods and services available. Indifference curve analysis

has widespread applicability in many other areas, such as the choices employees make

between work and leisure and the choices investors make among alternative investments

with different risks and returns.

1.8. Assumptions of indifference curves analysis

This analysis is based on the following assumptions about consumer behavior and

preferences,

a) The consumer’s preferences are complete. For any two markets baskets, A and B,

the consumer can provide an ordinal ranking of these market baskets, indicating

one of the following: A is preferred to B (written A>B), B is preferred to A

(A<B), or the consumer is indifferent between A and B (A=B). If A>B, this is

interpreted to mean that the consumer gets greater utility or satisfaction from

market basket A than from market basket B. If A=B, this means the two market

baskets provide the same utility or satisfaction.

b) The consumer’s preferences are transitive. Given three market baskets A, B and

C, if the consumer prefers A to B and also prefers B to C, then the consumer must

prefer A to C. If the consumer is indifferent between A and B and also between B

and C, then the consumer must be indifferent between A and C.

c) The consumer’s wants are insatiable. The consumer always prefers more of a

good to less of it, given the quantities of other goods.

d) The consumer’s marginal rate of substitution of one good for other goods

diminishes as the consumer gets more of that good. That is, the amount of other

goods a consumer is willing to give up to get one more unit of good X is lower the

more X she already has. An equivalent statement is that the marginal benefit

from good declines as the consumer gets more of that good.

e) The goal of the consumer is to maximize utility or satisfaction.

Based on these assumptions the indifference curve analysis analyses how a rational

consumer chooses between two goods. While doing so it combines two concepts;

indifference curves and budget lines.

1.9. Concept of indifference curves

An indifference curve is a line or a locus of all those points that show all possible

combinations of two goods between which a person is indifferent. In other words, it is a

line that shows the consumption of different combinations of two goods that will give the

same utility (satisfaction) to the person.

The following figure shows an indifference curve when a person is making a choice

between how many hours of work and how many hours of leisure.

In the above diagram the person would receive the same utility (satisfaction) from

consuming 4 hours of work and 6 hours of leisure, as they would if they consumed 7

hours of work and 3 hours of leisure.

1.10. Indifference Map

A consumer’s preferences can be completely described by an infinite number of

indifference curves in two-dimensional space, each indifference curve representing a

different level of utility. Each point in the two-dimensional space represents a particular

combination of good X and spending on other goods, and there will other points that

represent other combinations that provide that same utility level. Hence, every point in

the two-dimensional space lies on an indifference curve. An indifference map is

illustrated in the following figure,

1.11. Properties of indifference curves

Given the assumptions about consumer behavior stated above, indifference curves have

certain properties, as discussed below.

a) Indifference curves are negatively sloped.

b) Indifference curves are convex to the origin.

c) Indifference curves are non-intersecting.

d) Higher indifference curves represent higher levels of satisfaction.

1.12. Budget Line

The budget line is an important component when analyzing consumer behavior. The

budget line illustrates combinations of two goods that can be purchased at given prices,

for a given consumer budget. The amount of a commodity that a person can buy will

depend upon their income and the price of the good. The following figure shows a budget

line.

The above budget line is constructed for a given budget of Rs.60, Rs.2 per unit of x and

Rs.1 per unit of y. With a limited budget the consumer can only consume a limited

combination of x and y, the maximum combinations of the two commodities are the end

points of the budget line.

1.13. Consumer’s Equilibrium using the Indifference Curve approach

A rational, maximizing consumer would prefer to be on the highest possible indifference

curve given their budget constraint. This point occurs where the indifference curve

touches (is tangential to) the budget line. This point of optimum consumption point is

illustrated in the following figure,

In the above figure, the optimum consumption point occurs at point A on indifference

curve I3. It cannot lie below point A, for on all such points consumer does not maximize

satisfaction. The equilibrium cannot be beyond point A, for all such points are outside the

budget line, and hence not attainable. Consumer, hence, maximizes satisfaction at point

A.

1.14. Revealed preference Approach

This theory is associated with the name of Prof. Samuelson. Also called as behaviorist

ordinal-utility theory, it is based on the proposition that the consumer is supposed to

reveal his preferences. The theory makes the following assumptions,

a) The consumer is rational seeking to maximize satisfaction from the available

resources.

b) The consumer’s choices are consistent.

c) The consumer’s demand for commodities should have a positive relationship with

income, i.e., his demand for goods and services should increase with increases in

income.

d) The consumer exhibits “strong ordering”. Strong ordering indicates that the

consumer is very clear about the relative order of his preferences between various

commodities, i.e., he clearly specifies his relative preference between

commodities. Strong ordering is distinguished from ‘weak ordering’ in which the

consumer may not be able to specify preferences between some commodities.

The theory postulates if a person chooses a certain bundle of goods (For e.g. 2 apples, 3

bananas) while another bundle of goods is affordable (For e.g. 3 apples, 2 bananas), then

we say that the first bundle is revealed preferred to the second. It then follows that the

first bundle of goods is always preferred to the second. Therefore if the consumer ever

purchases the second bundle of goods then it must be the case that the first bundle is

unaffordable. Further theory states that preferences are transitive. In other words if we

have bundles A, B, C, ...., Z, and A is revealed preferred to B which is revealed preferred

to C and so on then it can be concluded that A is revealed preferred to C through Z.

1.15. Summary

It has been established in the earlier unit that because of scarcity, economies and business

should allocate their resources efficiently and effectively. This leads us to various

theories that help us understand consumer’s behavior in this unit. An attempt is made to

explain consumer behavior using Utility analysis, Indifference Curves approach and the

theory of Revealed Preference. The key principle of utility analysis is the law of

diminishing marginal utility, which offers an explanation for the law of demand and the

negative slope of the demand curve. A more advanced form of consumer demand theory

involves the analysis of indifference curves. This model is used to analyze the choices

that consumers make in spending their limited incomes on the various goods and services

available. The Revealed Preference theory, also called as behaviorist ordinal-utility

theory, is based on the proposition that the consumer is supposed to reveal his

preferences.

1.16 Key words

a) Utility: A measure of the relative satisfaction gained from consuming different

goods and services.

b) Utility Measurement: A quantification of the satisfaction of wants and needs

achieved through the consumption of goods and services.

c) Cardinal utility: A measurement of satisfaction using numerical values (1, 2, 3,

etc.) that are comparable and based on a benchmark or scale.

d) Ordinal utility : The ranking of preferences (first, second, third, etc.) that are only

comparable on a relative basis.

e) Utility Analysis: A part of consumer demand theory that analyses consumer

behavior and market demand using the concepts of total utility and marginal

utility.

f) Utility Maximization: The progression or ambition of obtaining the maximum

level of gratification from the consumption of goods or services.

g) Total Utility : Total utility is a measure of the total satisfaction of wants and needs

obtained from the consumption or use of a good or service.

h) Marginal Utility: Marginal utility is the additional utility, or extra satisfaction of

wants and needs, obtained from the consumption or use of an additional unit of a

good or service.

i) Diminishing marginal utility: Utility or additional satisfaction derived from

consuming successive units of a commodity declines as more and more units of

the commodity are consumed.

j) Indifference curves: Locus of points that show different combinations of two

goods that will give the same utility (satisfaction) to the person.

k) Indifference Map: A two-dimensional space that describes a consumer’s

preferences by an infinite number of indifference curves.

e) Budget line : Illustrates the combinations of two goods that can be purchased at

given prices, for a given consumer budget.

1.17 Self-assessment questions

1. Explain the concept of utility. Discuss utility maximization for explaining

consumer behavior.

2. Explain the Law of diminishing marginal utility

3. What is an indifference curve? List its properties.

4. Explain consumer’s equilibrium using indifference curves analysis.

5. Write a brief note on the theory of revealed preference.

6. Utility can be understood as the

a) Want satisfying power of a commodity

b) Want dissatisfying power of a commodity

c) Want revealing power of a commodity

d) None of the above

7. Cardinal utility is the measurement of satisfaction using,

a) Factual information

b) Diagrams

c) Ordinal comparisons

d) Numerical values

8. The goal of maximizing utility is a basic postulation underlying consumer

behavior studied in consumer demand theory.

a) True

b) False

c) Both true and false

d) Neither true nor false

9. Which law in economics explains that as the consumer consumes more and more

units of a commodity the additional satisfaction derived from consuming every

next unit of the commodity declines?

a) Law of increasing satisfaction

b) Law of increasing pace

c) Law of neutrality

d) Law of Diminishing Marginal Utility

10. Consumers constantly weigh in their minds whether to buy,

a) A little more one or a little less of few commodities

b) A little more one or a little less of all commodities

c) A little more one or a little less of another commodity

d) None of the above

11. An indifference curve is a line or a locus of all those points that show all possible

combinations of two goods between which a person is

a) Different

b) Indifferent

c) Both different and indifferent

d) Can’t say

12. Fill in the blanks:

(i) A consumer’s preferences can be completely described by an

______________number of indifference curves in two-dimensional space.

(ii)

(iii) Indifference curves are ______________sloped.

(iv) Indifference curves are ______________to the origin.

(v) Higher indifference curves represent ______________levels of

satisfaction

(vi) The amount of a commodity that a person can buy will depend upon their

______________and the ______________of the good.

(vii) A rational, maximizing consumer would prefer to be on the

______________possible indifference curve given their ______________

constraint.

(viii) Also called as ______________theory, revealed preference theory is

based on the proposition that the consumer is supposed to reveal his

preferences.