TLC Economics
Section outline
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Students mustMark as done
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Students mustMark as done
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Students mustMark as done
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Students mustMark as done
Theory of Consumer Behaviour
The theory of consumer behaviour related with the decision making behaviour of the consumer.
The consumer is rational in the sense that always tries to maximise the satisfaction for each unit of money spent on commodities given his resources and market conditions.
The Neo-Classical economists assumed utility is cardinally measurable and the Modern Economists have instead assumed ordinal measurement.
Accordingly there are two approaches
1. Cardinal School of thought, called Neo-classical approach and
2. The Ordinal School of thought also known as indifference curve approach.
Cardinal and Ordinal Utility
Summary: Cardinal utility gives a value of utility to different options. Ordinal utility just ranks in terms of preference.
Meaning of Utility
Utility is the power or property of a commodity to satisfy human want.
Cardinal Utility is the idea that economic welfare can be directly observable and be given a value.For example, people may be able to express the utility that consumption gives for certain goods. For example, if a Nissan car gives 5,000 units of utility, a BMW car would give 8,000 units. This is important for welfare economics which tries to put values on consumption. For example, allocative efficiency is said to occur when Marginal cost = Marginal Utility.One way to try and put values on goods utility is to see what price they are willing to pay for a good.If we are willing to pay £5,000 for a second-hand Nissan Car, we can infer we must get 5,000 utils. In other words, the value of cardinal utility is related to the price we are willing to pay.The idea of cardinal utility is important to rational choice theory. The idea consumers make optimal choices to maximise their utility.Demand curve showing cardinal utility
Cardinal utility is an important concept in utilitarianism and neo-classical economics. Jeremy Bentham talked about utility as maximising pleasure and minimising pain.
William Stanley Jevons, Léon Walras, and Alfred Marshall all developed concepts of utility, usually linked to market prices. However, proving exact measurement of utility proved elusive.
Ordinal Utility
In ordinal utility, the consumer only ranks choices in terms of preference but we do not give exact numerical figures for utility.
For example, we prefer a BMW car to a Nissan car, but we don’t say by how much.
It is argued this is more relevant in the real world. When deciding where to go for lunch, we may just decide I prefer an Italian restaurant to Chinese. We don’t calculate the exact levels of utility.
Carl Menger, an Austrian economist, developed concepts of utility which rested on ranked preferences.
In 1906 Vilfredo Pareto in 1906 concentrated on an indifference curve map. This placed preferences on bundles of goods but did not attempt to say how much.
John Hicks and Roy Allen in 1934 first produced a paper which mentioned ordinal utility.
Behavioural economics and utility
Recent developments in utility theory have tended to downplay the role of cardinal utility. The ability of consumers to make exact evaluations of utility is not clear.
Also, the idea of heuristics is that consumers don’t have the ability to make perfectly rational choices but make rough rules of thumbs and quick judgements.
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Indifference Curves
Indifference curves are graphs that represent various combinations of two commodities which an individual considers equally valuable. The axes of those graphs represent one commodity each (e.g., good A and good B). Indifference curves are widely used in microeconomics to analyze consumer preferences, the effects of subsidies and taxes, and a few other concepts. Although they come in many shapes and sizes, most of them share a few important properties. Thus, we will look at the four most important properties of indifference curves in more detail below.
Properties of Indifference Curves
1. Indifference Curves are Downward Sloping
Virtually all indifference curves have a negative slope. That is, they slope downward from left to right. The slope of the curve shows the rate of substitution between two goods, i.e. the rate at which an individual is willing to give up some quantity of good A to get more of good B. If we assume that the individual likes both goods, the quantity of good B has to increase as the quantity of good A decreases, to keep the overall level of satisfaction the same. Because both axes each represent one of the two goods, this relationship results in a downward sloping curve. This becomes pretty obvious if we look at the indifference map below.
2. Higher Indifference Curves Are Preferred to Lower Ones
Consumers will always prefer a higher indifference curve to a lower one. This is due to the basic economic assumption that “more is always better“. Think about it if someone were to ask you if you wanted a free slice of pizza or an entire pizza for free, what would you say? Who says no to free pizza, right? Now, of course, it’s not always that simple, but in basic economic theory, we can assume that consumers have a preference for larger quantities. This is reflected graphically in the indifference map. The higher the indifference curves are, the larger the quantities of both goods. And thus, the more preferable the curve becomes.
3. Indifference Curves Cannot Intersect
Two indifference curves can’t cross each other, all combinations of good A and good B that lie on the same indifference curve make the consumer equally happy. Therefore, if two indifference curves were to cross, they would both have to provide the consumer with the same level of total satisfaction, because the exact point where they intersect (i.e., point A) is on both curves. Thus, all other combinations on both curves would have to provide the same level of satisfaction as well. However, if we compare point B and point C, we can see that point C offers more of good A and good B (90 and 140) as compared to point B (80 and 130). As we already learned above, consumers always prefer larger quantities. Therefore both curves can’t provide the same level of satisfaction, which means they can never intersect.
4. Indifference Curves are convex
In most cases, indifference curves are bowed inward. This has to do with the marginal rate of substitution (MRS). We know that the marginal utility of consuming a good decreases as its supply increases Therefore consumers are willing to give up more of this good to get another good of which they have little. Let’s look at the graph below to illustrate this. If a consumer has a lot of good B, the MRS is 3 units of good B per unit of good A. If she has more of good A, the MRS is 0.5 units of good B per unit of good A. In other words, if they have a lot of good B, they are more willing to trade some of it in to get an additional unit of good A and vice versa. Because of this relationship, the indifference curve is bowed inward (i.e., convex).
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Economic Utility Definition
Economic utility refers to the usefulness or value that consumers experience from a product or service and can be judged based on the form, time, place and possession, these factors help in assessing the purchase decisions and the drivers behind those decisions.
Explained with Example
The economic utility is a term used by economists to relate to the satisfaction received after utilization of an item. Upon measuring the economic utility of an item one can understand if it is accepted or not by the user, hence its impact on demand in the market. This term is more frequently used by companies to understand the market performance of their products.
The thirsty individual looks for a glass of water to quench his thirst. This thirst can be quenched by consumption of any other liquid like soda, juice or maybe a shake. However, upon consumption, the rate of utility for each product will differ. So, assuming the classical approach of measuring economic utility in units, the individual may rate each product by adding units to them – say a glass each of:
- a) water – 10 units;
- b) soda – 8 units;
- c) juice – 7 units and
- d) shake – 6 units.
Hence, it is seen that each product may have a different utility measure, which may also vary on an individual basis. Based on this type of measurement, companies may try to analyze and understand which product may be more acceptable based on customer requirements.Economic Utility gives a relative measure of satisfaction for a product. Based on the requirement of the customer, the product may be assigned its utility. It relies completely on the need and preferences of a customer.
- In the above economic utility example, the individual will consume any or all of the above products only when he is thirsty. He may not even try any of them if his preference is any particular product. Hence it is important to understand the requirement in markets.
- For a product that is unknown and yet to be launched, the utility can be “created”. For example, a robot, which may be an invention by a company, but there is no demand for this product as it is not introduced yet. In such cases, a utility can be created by creating a need for such products amongst customers. The company can make the customers realize about changes in today’s lifestyle and how the robot can ease out their day to day work (or other features of the robot based on consumer requirements).
- The Economic utility does not always exist with a particular measured unit even for a particular individual. For example, an individual is happy with a glass of water and gives it 10 units. However, upon being offered a second glass of water, since he is already almost satisfied, he may assign it 8 units, and keep on reducing its utility with every glass of water. This is because utility works on requirements and satisfaction levels. Once a particular product brings satisfaction, it may be possible that the customer may try to find a substitute the next time.
- Economic Utility is not the same as usefulness. For example, the individual who is thirsty may consume soda instead of juice or shake based on availability and may assign it a higher utility based on his requirement, however, its usefulness is based on how beneficial it is to the body.
The economic utility of a product refers to the requirements and expectations of consumers as well, and the loopholes (if any) in its features.
A downward movement in the utility of a particular product in markets may also indicate new technology or upgraded versions being introduced. This acts as an eye-opener to existing companies.
Final Thoughts
Companies should keep a keen eye on the economic utility of their products. The utility may not be a direct indicator of progress or downfall, and may even act like a very slow indicator which is fruitful only with other parameters being perfectly applied, yet it gives an overall picture of acceptance (or rejection) to products in an economy. The latest technology and new inventions are required in every economy to be introduced which depends largely upon the utility of that particular product. In other words, the economic utility is a silent indicator of the growth of the country’s economy.
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