BCom 1st Year Theory of Consumer Behaviour Notes Study Material
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BCom 1st Year Theory of Consumer Behaviour Notes Study Material
The theory of consumer behaviour is concerned with the manner in which the consumer decides to purchase goods and services, given his income, prices of these goods and services and tastes. Milton Friedman says that these decisions “can be regarded as (1) purely random and haphazard or (2) in strict conformity with some customary, purely habitual mode of behaviour or (3) as a deliberate act of choice. On the whole, economists reject (1) and (2) and accept (3), partly, one supposes, because even casual observation suggests more consistency and order in choices than would be expected from (1) and more variation than would be expected from (2); and partly, because only (3) satisfies our desire for an explanation.”
Accordingly, we analyse consumer behaviour on the assumption that consumer decides to purchase in a way so as to maximize a single end, that is, to maximize utility. Utility is a common characteristic found in different goods.
Origin of the Classical Theory of Consumer Demand
The classical theory of consumer behaviour originated in the simultaneous but independent work of three economists, William Stanley Jevons (1835-1882 of England, Karl Menger (1840-1921) of Austria and Leon Walras (1834-1910) of France. In the early 1870s, these three economists introduced the concept of utility maximization as the basic motivating force of consumer behaviour.
But it was Alfred Marshall who in his Principles of Economics presented a complete systematic treatment of this theory. Though amended, refined and sophisticated considerably during the last hundred years, yet “the fundamental proposition that the rational individual consumer will attempt to maximize the total satisfaction or utility that he derives from the purchase of any bundle of goods remains central to the theory of demand.”
1. Law of Diminishing Marginal Utility
Utility analysis of consumer demand, also known as the Marshallian analysis, has at its basis the law of diminishing marginal utility. This law is also known as the First Law of Gossen. It is based on the familiar and fundamental tendency of human nature which Marshall has put as under:
“There is an endless variety of wants, but there is a limit to each separate want.”
This limit on each separate want is stated in the law of satiable wants or of diminishing utility thus:
“The total utility of a thing to anyone (that is, the total pleasure or other benefit it yields him) increases with every increase in his stock of it, but not as fast as his stock increases……….. In other words, 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.”
To put it simply, the law states that, after some point, successive equal increments in the quantity of a good yield smaller and smaller increases in utility, that is, marginal utility diminishes. Marginal utility is the increase in total utility from consumption of a good which results from increasing the quantity of the good consumed by one unit.
The marginal utility of a good varies with the quantity possessed. A child with only one ice-cream has a high marginal utility for it. When he acquires a second ice-cream, its marginal utility falls, and after a third, marginal utility falls again. With each additional ice-cream he obtains, the marginal utility of such ice-creams for him successively declines.
Eventually a time will arrive when the marginal utility of the ice-cream will be so low that an additional unit will have no utility at all for him. This will be the point of satiety. The Law of Diminishing Marginal Utility is a general law of life. In fact, it applies to everything. Table 10.1 explains this law more clearly:
It can be seen in the table that each unit of tea consists of 100 g. Marginal utility of the successive units of tea goes on declining. The first unit of tea gives marginal utility of 20, while the marginal utility of the second unit with 18 is less than the first.
Marginal utility of the third unit is 15 which is less than that of the second. Marginal utility of the seventh unit is zero and at this level the total utility is the maximum at 75. This is the point of maximum satisfaction, the point of satiety. Further addition of the units of tea, say the eighth unit, yields negative utility, as a result of which total utility falls to 73.
Fig. (A) depicts total utility, while Fig. (B) presents marginal utility as continuous curves. As consumption rises, total utility increases at a decreasing rate and so marginal utility is positive but declining.
The law of diminishing marginal utility operates under the following assumptions:
(i) Utility is quantifiable: It is assumed that utility is measurable in cardinal numbers. Human desires are measurable, not directly but indirectly, by the amount of money which a person is prepared to pay for a unit of a good rather than go without it.
(ii) Consumer is rational: It means that the consumer tries to maximise satisfaction from consumption and that he clearly knows the utilities of various units of a good he wants to buy. This assumption rules out the influence of habit, tradition or impulse or haphazard behaviour on the part of the consumer.
(iii) Normal units: It means that the units of the commodity that are purchased are all normal units-neither too small nor too large. Tea in 100 g pack is a normal unit.
(iv) Homogeneous units: All units are homogeneous, that is, of the same quantity and quality. So all units are perfect substitutes of one another.
(v) Continuous consumption: It means that the consumption of the different units of a commodity takes place without break, that is, it is a continuous process in time. If a child eats one ice-cream in the morning and another at mid-day, we cannot say that second unit yields less satisfaction. It is possible that due to the heat of the noon, the child may get more utility from the second ice-cream.
(vi) No change in taste, temperament during consumption: It is also assumed that during the period of consumption, no change occurs in the taste and temperament of the consumer.
(vii) No change in income: The consumer has a fixed income at any given time.
Limitations or Exceptions
It is pointed that the law of diminishing marginal utility does not always hold. The following are said to be its exceptions:
(i) Sweet music: The more we hear melodious songs, the more we like to listen to them. It might be true. But will it hold if we hear a song repeatedly without break?
(ii) Rare collections: It is also said that the law does not apply in the case of rare collections. A second rare collection does not give less satisfaction, probably more. But are both the collections homogeneous units to which the law applies?
(iii) Marginal utility of money: It is often said that the law of diminishing marginal utility does not apply in the case of money. The more the money that we get the greater is the desire for money. It is true that law does not apply to money. But what about money? Is it a homogeneous commodity?
Money is not a final consumption good, rather it is a medium of exchange, a command over many heterogeneous commodities. So money is not an exception of the law of diminishing marginal utility which applies to the homogeneous units of a final good.
(iv) Dissimilar and small units: The law does not apply in the case of dissimilar and small units of a commodity. But it is no exception because it is an infringement of its assumption.
(v) Abnormal Persons: Abnormal persons like misers or drunkards or those of unbalanced mind are not subject to this law. It is again no exception of the law because the law is propounded in the case of normal, rational persons only.
(vi) Change in Income, Tastes and Temperaments: Such changes may lead to the non-operation of the law. But it is again a violation of its assumption.
As a broad proposition, this law has some plausibility. But the most serious objection raised against it by economists is that utility is not measurable in cardinal numbers. Secondly, there is no objective yardstick with which to measure utility. Money measure is very defective because its marginal utility is not constant.
This law is the basis for analysing consumer behaviour and derivation of demand curve. But in order to analyse consumer equilibrium and to derive a downward falling demand curve, there is no need to measure utility. It means that we can do without this law.
2. Law of Equi-marginal Utility
The law of diminishing marginal utility provides a tool with the aid of which it is possible to analyse consumer behaviour. The theory of consumer behaviour explains how a consumer allocates his given money income among many goods and services which are available to him in the market at given prices.
The theory of consumer behaviour is explained under the following assumptions:
(i) The consumer is rational. He attempts to dispose of his money income in such a way as to derive the greatest amount of satisfaction or utility from it. In other words, maximisation of utility is his aim. Whether the aim is realised or not is a different thing.
(ii) The consumer has clear-cut preferences for various goods and services available in the market. It means that he knows how much marginal utility he will get from successive units of the goods and services which he might choose to purchase.
(iii) The consumer has a given or fixed money income, that is, he is under a budget constraint.
(iv) The goods and services available in market have price tags on them. In other words, they are scarce in relation to demand and so they cannot be acquired free.
It is quite obvious that a consumer with a limited money income can purchase only a limited amount of goods which have price tags on them. In the problem before him is like this:
“Of all the collections of goods and services which a consumer can obtain within the limits of his budget, which specific collection will yield him the greatest utility or satisfaction.”
Maximum satisfaction is obtained when the consumer allocates his money income in such a way that the last rupee spent on each good purchased yields him the same amount of marginal utility. This will be his equilibrium position because he will have no incentive to alter his expenditure. Any change will lead him to a position where total utility is not maximum and so he is worse off.
If each unit of the commodities he intends to purchase is available at the same price, the utility maximisation rule is the one in which the marginal utility of each commodity purchased is equal. It is known as the principle of equi-marginal utility.
This theory of consumer behaviour or equilibrium is subject to a number of criticisms.
The first and the most serious criticism is that there is no yardstick to measure utility. Utility is essentially a psychological concept which cannot be measured directly in absolute units. If utility is not quantifiable, then the law of diminishing marginal utility and the principle of equi-marginal utility based on it have no tenability.
Secondly, it is extremely difficult to incorporate large and indivisible products like houses, automobiles, higher education, etc. in this principle.
Thirdly, critics point out that utility maximisation is not a proper assumption of the theory. In his revealed preference theory, Samuelson does not base his analysis on this assumption.
However, it cannot be denied that the theory presents an accurate description of the basic rationale underlying the theory of consumer behaviour. So despite its limitations, the principle of equi-marginal utility is a meaningful general statement of consumer behaviour.