chapter 05 - 1 CHAPTER FIVE CONSUMER THEORY The consumer is one of the main economic decision-making units in an economy Consumer theory is an attempt

chapter 05 - 1 CHAPTER FIVE CONSUMER THEORY The consumer is...

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CHAPTER FIVE CONSUMER THEORY The consumer is one of the main economic decision-making units in an economy. Consumer theory is an attempt to give an explanation of consumer’s behaviour when faced with the problem of choice, i.e. it is an explanation as to why the consumer chooses to spend his income as he does 1 . This chapter among other things will rationalise the downward sloping demand curve. Two theories have been advanced in an attempt to explain consumer’s behaviour; Cardinalist or Marginal Utility Approach Ordinal or Indifference Curve Approach A more recent theory is the theory of revealed preference None of these theories presents a complete picture of consumer’s behaviour. Definitions Utility : this is the satisfaction derived by a consumer from the consumption of a commodity 2 . Marginal Utility : this is that extra or additional utility derived from the consumption of one more unit of a commodity (the consumption of all other commodities held constant) Cardinalist (Marginal utility) approach This approach is based on the following assumptions Rationality The consumer 3 is assumed to be rational, i.e. he aims at maximising utility subject to his income and commodity prices. 4 Utility is measurable The utility from each commodity is measurable cardinally, i.e. using cardinal numbers. The unit of measurement can be in subjective units known as utils 5 or in monetary units, which 1 Blue print of consumers’ behaviour 2 Utility is subjective and thus different from usefulness. E.g. Drugs give the user some satisfaction but are harmful. 3 It is assumed also that the consumer has complete knowledge of all the relevant information to make decisions. I.e. he has complete knowledge of all commodities available, their prices and his income. 4 In reality subject also to other things, morals, legislation etc. rationality means use of reason. 5 Subjective because others in this case cannot verify this measurement unlike meters, Celsius etc 1
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are more convenient i.e., the amount of money the consumer is willing to sacrifice for another unit of the commodity 6 Constant marginal utility of money The marginal utility of money 7 is assumed to be constant, and this is necessary if the monetary unit is used as a measure of utility. The essential feature of a standard unit of measure is that it be constant. Total utility Total utility of a basket (or combination) of goods depends on the quantities of individual commodities consumed. If there are n commodities in the basket with quantities q 1 , q 2 … q n the total utility is U = f (q 1 , q 2 …q n ) 8 Diminishing marginal utility Central to the Cardinalist theory is the axiom or hypothesis of diminishing marginal utility. To illustrate this hypothesis consider an individuals’ consumption of commodity X over a given period of time. The table below shows what happens to the consumer’s total utility and marginal utility (both measured in utils) as he consumes more and more units of the commodity during the week.
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