Theory of Consumer Behaviour – SS2 Economics Lesson Note (First Term)

The theory of consumer behaviour is also known as the theory of household behaviour. It is primarily concerned with how the consumer or household tries to satisfy his/her wants by dividing his/her limited amount of income between the various commodities that give him/her an equal amount of satisfaction.

Behavioural objectives

By the end of the lesson, students should be able to:

• define utility and explain why it is relative to each consumer;
• state the assumptions of the cardinal approach;
• explain total, average and marginal utility and calculate them from a utility schedule;
• describe the relationship between total utility and marginal utility;
• state the law of diminishing marginal utility;
• state the conditions for utility maximisation and define consumer surplus.

What is utility?

Utility can be defined as the satisfaction derived from the consumption of a given commodity. Hence, when a consumer derives satisfaction from the consumption of a commodity, it can be said that the commodity or service possesses utility.

Utility, therefore, is relative to a consumer, depending on the time, place, form, etc. A commodity that can satisfy a consumer’s wants at a particular point in time and place may not satisfy the wants of other consumers.

What are the schools of thought in the analysis of utility?

There are two schools of thought in the analysis of utility:

1. Cardinal school of thought
2. Ordinal school of thought

Cardinal school of thought

This approach emphasises that utility is measurable. That is, after consuming a given quantity of a commodity, the consumer can simply evaluate his satisfaction through the use of figures which range from zero to infinity.

Assumptions of the cardinal approach

1. Utility is measurable.
2. The consumer is rational.
3. There is diminishing marginal utility.
4. Total utility (TU) depends on the quantity consumed.
5. Money income of the consumer is held constant.

What are total, average and marginal utility?

Total utility

Total utility is the total amount of satisfaction a consumer derives from the consumption of a particular commodity at a point in time. Utility increases as the quantity consumed increases, but not at an equal rate, because consumers have a saturation point in the consumption of a particular commodity at a given time.

Average utility

Average utility is derived by dividing total utility by the units of the commodity consumed. That is, it is the satisfaction that a consumer derives per unit of a commodity consumed.

AU = TU/Q

Marginal utility

Marginal utility is the additional satisfaction a consumer derives from the consumption of additional units of a particular commodity. It is the change in total utility as a result of the consumption of additional units of a commodity.

MU = ∆TU/∆Q

Utility schedule

What is the relationship between total utility and marginal utility?

• MU begins to fall right after the first unit of the commodity has been consumed. It continues to diminish until it reaches zero on the x-axis, and then goes below it.
• At the point where MU reaches zero on the x-axis, TU reaches its maximum point.
• When MU cuts the x-axis, TU begins to fall from its peak.
• When MU descends below the x-axis and becomes negative, the TU curve slopes downward.

What is the law of diminishing marginal utility?

The law of diminishing marginal utility states that, other things being equal, the marginal utility of a commodity to an individual decreases with each extra unit of that commodity he consumes. In other words, if a consumer goes on consuming successive equal increments of a commodity, the increase in total utility becomes smaller and smaller. That is, satisfaction per extra unit starts falling.

For instance, a beer drinker may derive maximum satisfaction from the first three bottles, after which satisfaction decreases as more and more bottles are consumed, until he may be unable to consume any more.

What is utility maximisation?

Utility maximisation is also known as the equilibrium of the consumer. It is the point where a consumer derives maximum satisfaction, which is when his marginal utility equals the price of the commodity consumed. That is, the additional utility derived from consuming additional units of the commodity is equal to its price.

The case of one commodity

A consumer maximises his satisfaction from a particular commodity when the MU of that commodity equals its price, for example MU_x = P_x.

The case of two or more commodities

A consumer is in equilibrium, or maximises his utility, when the ratio of the MU of the last unit of each commodity consumed to its price is the same for all the commodities. Put another way, utility is maximised when the MU per amount spent on a product is equal to the MU per amount spent on any other product:

MU_x/P_x = MU_y/P_y = MU_z/P_z

where:

• MU_x = MU of commodity X
• P_x = price of commodity X
• MU_y = MU of commodity Y
• P_y = price of commodity Y
• MU_z = MU of commodity Z
• P_z = price of commodity Z

What is consumer surplus?

Consumer surplus is the difference between the amount a consumer was prepared to pay for a commodity, based on the anticipated level of satisfaction, and the amount he actually paid for it.

For example, when a consumer consumed the first unit, he was willing to pay as much as ₦50, but the commodity price was ₦30. Thus, he saved ₦20. Any amount he was willing to pay above the market price of ₦30 represents the consumer surplus.

Evaluation

1. Define utility.
2. Write the formulae for average utility and marginal utility.
3. State the law of diminishing marginal utility.
4. Using the utility schedule above, what is the marginal utility of the third unit consumed?
5. Define consumer surplus.

Assignment

1. Which one of these assumptions do economists always make about consumers?
   
   (a) That they are all wage earners (b) That they make rational decisions in the market (c) That they cannot spend more than their incomes (d) That they can measure utility derived from consumption
2. The aim of the consumer in allocating his income is
   
   (a) to maximise his marginal utility (b) to buy the goods he wants most whatever the price (c) to maximise his total utility (d) to buy those goods which have fallen in price.
3. …………………… takes place when the ratio of the MU of a commodity consumed is equal to the ratio of its price.
   
   (a) consumer surplus (b) law of diminishing marginal utility (c) consumer behaviour (d) utility maximisation
4. Total utility (TU) attains its peak when the marginal utility (MU) is …..
   
   (a) zero on the x-axis (b) above the x-axis (c) close to the x-axis (d) under the x-axis
5. The difference between the amount of money a consumer planned to pay for a commodity and the actual amount of money he paid is ……….
   
   (a) commodity price (b) consumer surplus (c) marginal cost (d) producer surplus