Theory of Consumer Behaviour – UGC NET Commerce Notes

The Theory of Consumer Behaviour is a core concept in microeconomics that examines how consumers allocate their limited income to maximize satisfaction or utility. It focuses on understanding consumer preferences, decision-making processes, and the factors influencing demand. Key approaches include the cardinal utility theory, emphasizing measurable satisfaction, and the ordinal utility theory, which relies on ranking preferences. Important concepts such as the law of diminishing marginal utility, indifference curves, and consumer equilibrium form the foundation of this theory. For UGC NET Commerce, mastering these principles is essential to answer questions on demand analysis, market behavior, and economic decision-making effectively.

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Key Concepts in the Theory of Consumer Behaviour

1. Utility

It refers to the satisfaction or benefit a consumer derives from consuming goods and services. Two main approaches to utility:

• Cardinal Utility:
  • Assumes utility can be measured in numerical units.
  • Utility is quantifiable and expressed in specific units.
  • Total Utility (TU): The total satisfaction from consuming a given quantity of a good.
  • Marginal Utility (MU): The additional satisfaction gained from consuming one more unit of a good.

MU=ΔTU/ΔQ

• Ordinal Utility (Ranking Preferences)
  • It assumes consumers can rank their preferences without assigning numerical values.
  • Consumers rank combinations of goods in order of preference.
  • Focuses on the relative satisfaction rather than precise measurement.
  • Basis for Indifference Curve Analysis.

2. Law of Diminishing Marginal Utility

• Law of Diminishing Marginal Utility states that as more units of a good are consumed, the additional satisfaction (MU) decreases.
• Example: Eating slices of pizza—initial slices give high satisfaction, but the utility decreases with each additional slice.
• Real Illustration:
  • Scenario: A person drinks glasses of water when thirsty.
  • First glass: High satisfaction (high MU).
  • Second glass: Moderate satisfaction (lower MU).
  • Third glass: Low satisfaction (MU further decreases).
• Diagrammatic Representation – Graph of TU and MU:
  • X-axis: Quantity of the good consumed.
  • Y-axis: Total Utility (TU) and Marginal Utility (MU).
  • TU curve rises initially but flattens as utility diminishes.
  • MU curve slopes downward, eventually reaching zero or negative.

Consumer Equilibrium

What is Consumer Equilibrium?

• It refers to the point at which a consumer allocates their income in such a way that maximizes their total utility.
• It represents the optimal combination of goods and services that a consumer can purchase with their available budget.
• At equilibrium, the consumer has no incentive to change their consumption pattern, as they are achieving the highest possible satisfaction given their budget.

Different Approaches for Consumer Equilibrium

1. Cardinal Utility Approach (MU/P = MU of money):
   • According to the Cardinal Utility Theory, consumer equilibrium is achieved when the ratio of the marginal utility of a good (MU_x) to its price (P_x) is equal for all goods purchased: MU_x/P_x = MU_y/P_y
   • This implies that the consumer should allocate their budget in a way that the marginal utility per unit of currency is equal for all goods consumed.
   • Example: If the marginal utility per rupee spent on apples is higher than that spent on oranges, the consumer will buy more apples until the marginal utility per rupee spent on both is equal.
2. Ordinal Utility Approach (Indifference Curve Analysis)
   • It assumes that consumers can rank their preferences but cannot measure the exact level of satisfaction.
   • Consumer equilibrium is reached where the budget line (representing the consumer’s income and prices) is tangent to an indifference curve (representing the consumer’s preference).
   • At this point, the Marginal Rate of Substitution (MRS) between two goods is equal to the ratio of their prices: MRS = P_x/P_y

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Budget Constraint and Its Role

• The budget constraint represents the combination of goods a consumer can afford given their income and the prices of the goods.
• It is a straight line that shows all possible combinations of two goods the consumer can purchase.
• The budget constraint limits the consumer’s choices, but equilibrium is achieved when they maximize their utility within this constraint.

Price, Income, and Substitution Effects

Price Effect

• The Price Effect refers to the change in the quantity demanded of a good due to a change in its price, keeping other factors constant.
• It combines both the Substitution Effect and the Income Effect.
• Example:
  • If the price of coffee decreases, consumers may buy more coffee, as it is now cheaper. This is due to the Price Effect, which reflects both a substitution and an income effect.

Income Effect

• The Income Effect occurs when a change in the price of a good affects the consumer’s real income (or purchasing power), influencing the quantity demanded.
• When the price of a good falls, real income rises, allowing consumers to purchase more of the good (and potentially other goods).
• When the price of a good rises, real income falls, leading to a decrease in quantity demanded.
• Example:
  • Gasoline becomes cheaper, allowing consumers to drive more or purchase other goods with the saved income, showing an increase in demand for gasoline.

Substitution Effect

• The Substitution Effect occurs when a price change causes consumers to substitute the good with other goods that are now relatively cheaper or more expensive.
• A price increase in one good leads to a decrease in demand as consumers switch to cheaper alternatives.
• Example:
  • If the price of apple juice decreases, consumers may substitute orange juice with the now cheaper apple juice, increasing the demand for apple juice.

Applications of the Theory of Consumer Behaviour

Theory of Consumer Behaviour has a very specific role in understanding demand analysis, market trends, and economic decision-making. Let’s explore it in detail.

1. Understanding Demand Curves

• Consumer Behavior and Demand Curve:
  • The Theory of Consumer Behaviour helps explain how changes in price and income affect the quantity demanded, forming the basis for the demand curve.
• Example:
  • If the price of a good falls, consumers tend to buy more of it, leading to a movement down along the demand curve (price decreases → quantity demanded increases).

2. Implications in Business Decision-Making

• Pricing Strategies:
  • Businesses use the Theory of Consumer Behaviour to set prices that maximize their profits.
  • By understanding how consumers react to changes in price (through the Price Effect, Income Effect, and Substitution Effect), businesses can make informed decisions on pricing.
• Product Positioning and Marketing:
  • Knowledge of consumer preferences (via Ordinal Utility and Indifference Curve Analysis) helps businesses design product offerings that appeal to consumer tastes.
  • Marketers can use insights from consumer behavior to position products effectively and target specific market segments.
• Example:
  • A company like Apple may adjust the price of its iPhone in response to competitors’ pricing (substitution effect) or consumers’ income levels (income effect), leading to changes in demand and revenue.

3. Relevance in Economic Policies

• Price Regulation:
  • Governments use the Theory of Consumer Behaviour to design policies that influence consumer demand, such as setting minimum or maximum prices on essential goods (e.g., food, medicine) to ensure affordability or limit inflation.
• Taxation Policies:
  • Taxes on goods (such as sin taxes on cigarettes or alcohol) are based on understanding how price changes affect demand.
  • A higher tax raises the price, which, according to the Price Effect, decreases demand for the taxed good.
• Subsidies and Welfare Programs:
  • Subsidies on basic goods (e.g., food, energy) are designed to lower prices, increasing the quantity demanded as a means of improving the welfare of lower-income consumers by boosting their purchasing power (Income Effect).
• Example:
  • GST (Goods and Services Tax) affects consumer behavior by altering the price of goods and services, potentially decreasing demand for high-tax items and shifting consumer spending to lower-taxed items.

Theory of Consumer Behaviour Conclusion

In conclusion, the Theory of Consumer Behaviour explains how individuals make consumption choices to maximize utility within their budget constraints. Key concepts like Utility, Cardinal and Ordinal Utility, and the Law of Diminishing Marginal Utility illustrate consumer preferences. The theory’s application in Price, Income, and Substitution Effects helps businesses in pricing and marketing, while informing economic policies on taxation, subsidies, and price controls. Understanding consumer equilibrium and demand curves is crucial for businesses and policymakers, making the theory vital for UGC NET Commerce candidates.

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