The Theory of Consumer

Behavior

The Theory of Consumer

Behavior

Consumers play an important role in determining the demand for a firm’s products. They are quality conscious and price sensitive. The success of a product is dependent on the consumers’ acceptance of the product. Price sensitive customers like to buy products in small quantities at affordable prices. For example, Motorola had initially launched seven models of cellular phones at high prices but none of them were successful. On the other hand, Nokia launched a simple cellphone at an affordable price, which captured the market. Therefore, firms must try to offer products that are of high quality, at affordable prices. Consumer behavior is an important determinant of the type of product a firm should produce. Before launching a product a firm has to take into consideration its target customers tastes and preferences. For example, when Dabur Foods launched Real orange juice, consumers rejected it because it tasted bitter. Research revealed that Indian consumers wanted juices to be sweeter. Dabur then modified Real’s taste by sweetening the orange juice. Consumer behavior assumes that every individual tries to maximize his satisfaction by consuming products and service with the limited income available to him at a particular time. This limited income can also be referred to as the budget constraint.

Choice & utility

consumer behavior theory explains the relationship between changes in price and consumer demand. Variations in price determine whether a particular product is in demand or not. If the demand for a product is low in spite of the price being less, it can be said that consumers are not accepting that product. On the other hand, if the demand for a particular product is high, then the price of the product would increase. Hence, the manufacturer can determine and fix prices of their products according to the consumer demand. Thus, consumer behavior plays an important role for manufacturers decision making.

It is important to understand the difference between preference and choice. The consumers may have preference when they have a range of products to choose from. Preferences depend upon the consumers’ likes and dislikes but the final decision is dependent on budget constraints. In order to maximize satisfaction, consumers have to choose the alternatives for which the net benefit is more. Net benefit is calculated as the difference between benefits and cost. Here, we assume that the consumers have unlimited wants or preferences and numerous choices to satisfy them. But the resources with the consumers to satisfy all these wants are limited. This resource limitation is the income constraint or budget constraint referred earlier. Thus, the income constraint limits the consumer from satisfying all his preferences and forces him to make choices.

CHOICE AND UTILITY THEORY

Utility in economics means the extent of satisfaction obtained from the consumption of products and services by consumers. The concept of utility was developed by economists to explain the basic principles of consumer choice and behavior. Given the available resources, the level of income and market prices of various products, it is assumed that the rational consumer allocates his spending in such a way that the preferred combination gives him the highest utility.

The concept of utility is purely subjective i.e. there is no way of measuring the amount of utility that a consumer might be able to derive by consuming a particular product. In other words, utility is the psychological satisfaction that a customer derives by using a particular product. Hence, utility is not measurable but can be compared. It helps to understand how consumers make better choices. 

CHOICE AND UTILITY THEORY

Utility can be measured using the cardinal approach and ordinal approaches. The cardinal approach is based on the Marshallian school of thought, while the ordinal approach was proposed by the economists J.R. Hicks and P.G.D Allen.

Cardinal utility approach According to Marshall, utility can be measured and quantified.

This approach is based upon certain assumptions like: Utility can be measured: This approach assumes that utility

can be measured in terms of units called as ‘utils,’ which are measurable and quantifiable. It reveals how much money a consumer is willing to pay for a given unit of product. In ‘util’ terms, the consumer can compare the utility of two products say mineral water and soft drinks. Thus by comparing, one can say that one bottle of mineral water provides him utility equal to 5 utils, and one bottle of soft drink gives him utility equal to 3 utils. 

Measurement of Utility

The proponents of the ordinal approach opine that utility cannot be measured, but can only be ranked in order of preferences. In other words, instead of measuring the utility obtained from products, they rank them in the order of preferences to match consumers’ choice. Thus, it explains that the customer is able to compare different levels of satisfaction. Hence, if a customer prefers commodity x to commodity y, he will not be in a position to compare the ‘quantitative difference’ between the two-satisfaction levels, but he can do qualitative comparisons. This approach can be explained with the help of indifference curve

Ordinal utility approach

In a given period of time, the amount of utility a person derives from the consumption of a particular product is called total utility. In the initial stages of consumption, the total utility increases. After consuming certain number of units the total utility becomes constant and beyond that it starts reducing.  This means that the consumption of a particular product gives satisfaction to a person initially but after some time, utility starts diminishing.

Total Utility

According to Prof. Boulding, “The marginal utility of any quantity of a commodity is the increase in total utility which results from a unit increase in consumption.” In other words, marginal utility of a commodity is the additional utility derived by a consumer, by consuming one more unit of that commodity. From the below table, it is clear that every increase in the consumption of a product reduces its marginal utility. Let us analyze the relationship between total utility and marginal utility. Marginal utility starts diminishing as the consumer starts consuming more units of a product. When marginal utility reaches zero, total utility reaches its maximum and remains constant. When marginal utility becomes negative it implies that the total utility has started diminishing. 

Marginal Utility

Qty. consumed Total Utility Marginal Utility

0 0 0

1 5 5

2 8 3

3 10 2

4 10 0

5 9 -1

6 7 -2

Total utility & marginal utility

The law of diminishing marginal utility states that if a consumer goes on consuming more units of a particular product at a given point of time, his total utility increases but only at a diminishing rate. The law says that more a consumer consumes a product, the less is the utility he derives from the consumption of the same product. In other words, the desire of that product goes on decreasing as he consumes more and more units of that product.

According to Alfred Marshall, the law of diminishing marginal utility is, “The additional benefit which a person derives from a given increase of his stock diminishes with every increase in the stock that he already has.”

Marginal utility reveals how much a consumer is ready to sacrifice for a particular product. Usually, the consumer pays high price for the first unit of a product, since his desire to get that product is very high. As he goes on consuming more units of the same product, his utility level goes down and he pays less for the same commodity.

LAW OF DIMINISHING MARGINAL UTILITY

Explains value paradox The law of diminishing marginal utility explains the factors

that determine the value of a product. Adam Smith in his book “The Wealth of Nations” (1776) formulated a theory to explain why different products have different market values. In an attempt to explain this theory, he introduced the ‘diamond-water’ paradox. He said that an essential commodity like water is priced lower, when compared to a less essential product like diamond. He explained this through two concepts: value in use and value paradox. Though diamond has a low value in use but a high value in exchange while water has high value in use but low value in exchange. Hence, ‘diamond-water’ paradox explains that the more quantity of a product we have, the marginal utility starts diminishing. If the availability of a product is less, marginal utility would be high. 

Application and Uses of Diminishing Marginal Utility

Explains the derivation of Law of demand

Diminishing marginal utility helps to derive the law of demand and explain the downward sloping of the demand curve. It also helps to analyze why prices fall. It also explains consumer surplus, and how it is derived. 

According to Marshall, the law of equi-marginal utility says: “If a person has a product which can be put to several uses, he will distribute it among these uses in such a way that it has the same marginal utility. If the product has a greater marginal utility in one use than in another, the person would gain by taking away some of the product from the second use and applying it to the first.”  In other words, the law states that the consumer will spend his money income on different products in such a way that the marginal utility of each product is proportional to its price. Hence, the consumer will have the same level of satisfaction while consuming the two products. 

LEMU

Indifference Curves

What is the indifference curve? An indifference curve shows all the possible combinations of two products that will yield the same level of satisfaction to the consumer.

Combination Quantity X Quantity Y

A 2 8

B 4 6

C 6 4

D 10 2

Characteristics of Indifference curves

Indifference curve will be downward sloping

An indifference curve is convex to the origin

Two indifference curves cannot intersect each other

A higher indifference curve gives a higher level of satisfaction

Slopes downwards

Convex to the origin

Never intersect

Indifference map

Degree of substitutability Normal Goods: The indifference curve for

ordinary goods is convex and downward sloping. Example: Apple and Mango

Perfect Substitutes: The indifference curve for perfect substitutes is a downward sloping straight line. Example, Reynolds pens at the university bookshop and Reynolds pens at the local supermarkets.

Perfect compliments: The indifference curve for perfect complements is a right angle straight line. Example: Monitor and keyboard.

Budget line

A budget line shows different combinations of two products that can be bought with a given money income. Like indifference curve, budget line also slopes down because if we want to consume more of one product, we have to consume less of another product. If Y is the income of the consumer and Px and Py are the prices of X and Y per unit of Qx and Qy, then budget equation of the consumer is given by             Y = Px. Qx + Py. Qy

Let the income of the consumer be Rs.12 and the prices of A and B are Rs.1.50 and Re. 1 respectively. The budget line shows different combinations of A and B that can be purchased with the given income of Rs.12. If the consumer spends his total income only on A, he can buy 8 units (i.e. income/price of A = 12/1.50) of A. Conversely, if he spends all his income on B, he can buy 12 units (i.e. 12/1) of B. Budget line is drawn using these two extremes. The slope of the budget line measures the ratio of the price of B to the price of A.

Slope = (8 – 0)/(12 – 0) = (Income/PA) x (PB/Income) = PB/PA = 1/1.5 = 2/3 = 0.667

Budget line

Consumer equilibrium

The consumer is in equilibrium when he attains the highest satisfaction, given his income and the market prices of the products.

By definition, the budget line of the consumer shows different combinations of products A and B that he can buy, given his income and the prices of A and B. Of these attainable combinations, the consumer will prefer that combination which gives him the maximum level of satisfaction. In the example, consumer attains the greatest satisfaction at point X, where the budget line is tangent to I3. Why not point A or C? The reason is that points Y and Z are on the indifference curves I2 and I1, which are lower than I3.  Thus, a consumer attains the greatest satisfaction at a point where the budget line is tangent to indifference curve. Note that although he gets higher level of satisfaction at point w, he cannot the reach that point with his given income