CHAPTER 2C LOGIC OF BUYING & CONSUMPTION

1. Introduction In explaining consumer behavior, economics relies on the fundamental premise that people choose those goods and services they value most highly. To describe the way consumers choose among different consumption possibilities, the notion of utility was developed. Utility denotes satisfaction. It refers to how consumers rank different goods and services. Utility can be thought of as the subjective pleasure or usefulness that a person desires from consuming a good or service. Utility is not a psychological function or feeling but rather a scientific construct that economists use to understand how rational consumers divide their limited resources among the commodities that provide them with satisfaction. People maximize their utility i.e. they choose the bundle of consumption goods they most prefer. 2. Marginal Utility & the Law of Diminishing Marginal Utility: The concept of marginal utility can be explained with the help of the following example. Let us say that when you consume the first unit of ice cream, it gives you a certain level of satisfaction or utility. Now you consume a second unit of ice cream. Your total utility goes up as the second unit of ice-cream gives you same additional utility. When you eat a third and fourth unit of the same, the total utility further goes up. Eventually if you eat enough ice-cream, instead of adding to your satisfaction or utility, it makes you sick. This brings us to the concept of marginal utility. Marginal utility denotes the additional utility you get from the consumption of an additional unit of commodity. The law of diminishing marginal utility states that as you consume more and more of a good, the marginal utility declines. In other words, the growth in total utility will become slower and slower. The diminishing marginal utility results from the fact that your enjoyment of the good drops off as more of it is consumed. The law of diminishing marginal utility states that, as the amount of a good consumed increases, the marginal utility of the goods tends to diminish. This can be illustrated with the help of the following examples.

Quantity of a good Consumed (Q) 0 1 2 3 4 5

Total utility (U) 0 4 7 9 10 10

Marginal utility (MU) 4 3 2 1 0

The above data can be represented graphically as under.

U U

From the above we can observe that total utility is the sum of all the marginal utilities that were added from the beginning. Ordinal utility: Economists today generally reject the notion of a cardinal (measurable) utility that people feel or experience when consuming goods and services. What is recognized is ordinal utility. Under this approach consumers needs to determine only their preference ranking of bundles of commodity. Ordinal utility asks Is bundle A preferred to Bundle B *do I prefer a sandwich or an ice cream]. Using such ordinal preference rankings the general properties of market demand curves can be established.

3. Equi-Marginal Principle: Let us take an example: you want to buy goods A or B. A costs twice as much as good B. you will buy good A only, when its marginal utility is at least twice as great as good Bs marginal utility. This means that you should arrange your consumption so that the last rupee spent on each good brings you the same marginal utility. In such a situation you will attain maximum satisfaction or utility from your purchases.

The fundamental condition of maximum satisfaction or utility is the equi-marginal principle. It states that a consumer having a fixed income and facing given market prices of goods will achieve maximum satisfaction or utility when the marginal utility of the last rupee spent on each good is exactly the same as the marginal utility of the last rupee spent on any other good. The principle can be explained as under: If any one good gives you more marginal utility per rupee, you would increase your utility by taking money away from other goods and spending more on that good, until the law of diminishing marginal utility drives its marginal utility per rupee down to the level of marginal utility of other goods. When a stage is reached where the marginal utility of all goods is same, it is called the consumer equilibrium stage. The fundamental condition of consumer equilibrium can be written in terms of marginal utilities (MUs) and prices (Ps) of the different goods in the following term. MU1/P1 = MU2/P2 = MU3/P3 = MU per unit of income The above principle can be used to explain why demand curves slope downward. Suppose P1 goes up, then MU1/P1 will be below the marginal utility per rupee of all other goods. The consumer will, therefore, have to readjust the consumption of good 1. The consumer will do this by lowering the consumption of good 1, thereby raising the marginal utility of good 1 so that the MU1/P1 is again equal to the MU/P of other goods. In other words a higher price for a good reduces the consumers desired consumption of that commodity; this is the reason why demand curve slopes downwards.

4. Indifference Curves: A century ago, the economist Vilfredo Pareto discovered that all the important elements of a demand theory could be analyzed without the utility concept. He discovered indifferences curves and his theory has come to be known as the modern theory of Indifference analysis Assume that you are a consumer who buys different combinations of two commodities say, food and clothing at a given set of prices. For each combination of goods you may prefer one to the other or are indifferent between the two pairs. Assume that you are indifferent to pairs of 1 unit of food and 6 units of clothing and 2 units of food & 3 units of clothing. If these are plotted on a graph. the points (representing one combination of units of clothing and food) when joined together become an indifference curve.

Clothing

E o o Food d The points on the curve (A, B, C, D) represent consumption bundles among which the consumer is indifferent; all are equally desirable. Indifference curves are drawn as bowl shaped or convex to the origin, hence, as you move downward and to the right along the curve- a movement that implies increasing the quantity of the food and reducing the units of clothing, the curve becomes flatter. This shape of the curve illustrates the property of law of substitution. Law of substitution states that the scarcer the good, the greater its substitution value; its marginal utility rises relative to the marginal utility of the good that has become plentiful. Thus, in going from A to B, you would swap 3 of 6 clothing units for 1 extra food unit, but from B to C, you would sacrifice only one unit of clothing to obtain an extra food unit a 1 to 1 swap for a fourth unit of a food, you would sacrifice only 1/2 unit of clothing . These swap ratios (3, 1, 1/2) are the substitution ratios (also called the marginal rates of substitution) between the two goods. The slope of the indifference curve is the measure of the goods relative marginal utilities or of the substitution terms on which the consumers would be willing to exchange a little less of one good in return for a little more of the other. An indifference curve that is convex conforms to the law of substitution. As the income of the consumer increases, the indifference curve will successively shift to the right (reaching higher and higher level of satisfaction).

A o o B d o C o o d o d

D 1

Clothing u4 u3 u2 u1 Food

5. Budget Line: Let us assume that a consumer has only Rs 60 to spend and he has two choices spend on food or clothing. Prices of food and clothing are fixed. A unit of food costs Rs 15 and a unit of clothing costs Rs 10. He can spend the money on the variety of alternative combinations of food and clothing Food Clothing Choice A 4 0 Choice B 3 1 Choice C 2 3 Choice D 1 4 Choice E 0 6 If the above are plotted on a graph, it would be a straight line as shown under.

E D Clothing C B A Food Any other combination will also lie on the same straight line The above line AE is called the consumers budget line or budget constraint. The slope of the line is the ratio of the food price to the clothing price, in the instant case it is3/2. This means that every time consumer gives up to 3 clothing units, he can gain 2 units of food,

6. Equilibrium Position of Tangency: On a given budget line, what will the consumer choose? Obviously he will choose that point which yields the greatest satisfaction. The greatest satisfaction he will receive at the point where the budget line touches the indifference curve. Geometrically the consumer is at equilibrium where the slope of the budget line is exactly equal to the slope of the indifference curve. This is attained at the point where budget line is tangent to the highest indifference curve.

u3 u2 u1 f

The slope of the budget line is the substitution ratio whereas the slope of the indifference curve is the ratio of marginal utilities of the two goods. Thus PF/FC = substitution ratio = MUF/MUC Where PF is the price of 1 unit of food PC is the price of 1 unit of clothing MUF is the marginal utility of one additional unit of food MUC is the marginal utility of one additional unit of clothing

7. Application of Indifference Curves: Two important applications of indifference curves are frequently used to consider the effects of o A change in money income and o A change in the price of one of the two goods. a. Income change: Let us assume that the daily income of the consumers is halved from Rs 60 to Rs 30, based on the prices per unit of food and clothing the new budget line can be drawn as under: C E

B E

B f A A

The consumer is now free to move along this line new line (AE). To maximize satisfaction he will move to the highest attainable indifference curve or to point B.

b. Single price change: Assume that the consumers income remains same at Rs 60 per day but assume that the price of food rises from 15 to 30, while the price of clothing is unchanged. Draw the new budget line. F E B B f A A

The budget line is new AE The new equilibrium point will be at B It means that the higher food price, has reduced the food consumption but the clothing consumption may move in either direction.