Theory of Consumer Behavior Questions and Answers [With PDF]

Why do you buy a second cup of tea but feel less keen about the fifth? How do you decide how to split your pocket money between food and books? The theory of consumer behavior explains how people choose what to buy to get the most satisfaction from limited income. Here are 30 important questions with clear answers, tables and worked examples whose figures are checked.

This is Chapter 4 of our Economics course. It follows Concepts of Mathematical Economics and leads into Basic Elements of Demand.

Utility and Its Measurement

Q1. What is utility?

In economics, utility is the power of a good or service to satisfy a human want. It is the satisfaction a consumer gets from using it. Food, clothing, education and housing all have utility.

Q2. What are the characteristics of utility?

• It is psychological: it is a feeling and cannot be measured exactly in money.
• It differs between people: the same good may give different satisfaction to different consumers.
• It depends on time and place: a warm coat is useful in winter but not in summer.
• It depends on taste, habit and income.
• It changes for the same person: as a want is satisfied, the utility of more units falls.

Q3. Why is it important to measure utility?

It helps us understand how consumers decide what to buy, and therefore how demand in the market is formed.

Q4. What are the two approaches to utility?

• Cardinal utility approach (Marshall)
• Ordinal utility approach (Hicks and Allen, indifference curves)

The Cardinal Utility Approach

Q5. What is the cardinal utility approach?

It assumes that utility can be measured in definite numbers, called utils, such as 1, 2, 3. Because the numbers are exact, utilities can be added and subtracted.

Q6. What are the assumptions of the cardinal approach?

• The consumer is rational and wants to maximize satisfaction from his income.
• Utility can be measured in numbers.
• The utility from one good does not depend on the quantity of other goods.
• The marginal utility of money stays constant.
• Marginal utility of a good falls as more units are consumed.

Q7. What are the limitations of the cardinal approach?

• Utility is a feeling, so it cannot really be measured in exact numbers.
• Goods cannot always be bought in very small units.
• Many goods are related as substitutes or complements, so their utilities are not independent.
• The marginal utility of money does not stay constant. It changes as a person’s money stock changes.
• Consumers cannot work out the marginal utility of every good.

Q8. What are the three basic concepts of utility?

• Total utility (TU)
• Average utility (AU)
• Marginal utility (MU)

Q9. What is total utility?

Total utility is the sum of the utilities a consumer gets from all the units of a good consumed. Example: a buyer eats four apples and gets 8, 6, 4 and 3 utils from the first to the fourth. Total utility = 8 + 6 + 4 + 3 = 21 utils.

Q10. What is average utility?

Average utility is total utility divided by the number of units consumed: AU = TU / N. For four apples, AU = 21 / 4 = 5.25 utils per apple.

Q11. What is marginal utility?

Marginal utility is the change in total utility caused by consuming one more unit of a good: MU = change in TU / change in quantity. In the apple example, the MU of the third apple is 4 utils.

Q12. What are positive, zero and negative marginal utility?

• Positive MU: an extra unit raises total utility.
• Zero MU: an extra unit leaves total utility unchanged. This is the point of maximum total utility.
• Negative MU: an extra unit reduces total utility.

Q13. What is the relationship between total and marginal utility?

• Marginal utility is the extra utility from the last unit. Total utility is the sum of all marginal utilities.
• While MU is positive, TU rises, but at a falling rate.
• When MU is zero, TU is at its maximum.
• When MU becomes negative, TU falls.

Q14. Can you show TU, MU and AU in a table?

Notice that TU is highest (21) when MU is zero, at the fifth apple, and falls when MU turns negative at the sixth.

Q15. What are the laws of cardinal utility analysis?

• Law of diminishing marginal utility
• Law of equi-marginal utility

Law of Diminishing Marginal Utility

Q16. What is the law of diminishing marginal utility?

As a consumer consumes more and more units of a good, the marginal utility of each additional unit falls, other things remaining the same. The idea was first stated by Hermann Heinrich Gossen (Gossen’s first law), and Alfred Marshall explained it fully in 1890. It is also called Gossen’s first law.

Q17. What are the assumptions of this law?

• Utility can be measured in numbers.
• Tastes, preferences and income stay constant.
• The marginal utility of money is constant.
• Consumption takes place within a fixed period of time, without long gaps.
• Units of the good are identical and of a suitable size.
• The utility of one good does not depend on other goods.
• The consumer behaves normally and rationally.

Q18. What are the applications of this law?

• It is the foundation of the law of demand: lower prices induce buying more because the extra units give lower utility.
• It explains consumer surplus.
• It explains the difference between value in use and value in exchange (the diamond-water paradox).
• It supports progressive taxation: a rich person loses less utility from a rupee of tax than a poor person does.

Q19. What are the limitations or exceptions to this law?

• Wrong unit size: one teaspoon of water to a very thirsty person may increase thirst rather than reduce it.
• Changing tastes and habits: the more music a music lover hears, the stronger the taste may become.
• Time gaps: if there is a long gap between two consumptions, the utility of the second unit may not fall.
• Hobby goods: collectors of stamps or old coins want more as the collection grows.
• Related goods: the utility of a good depends on the price and availability of its substitutes and complements.
• Unusually scarce or rare goods: the desire for more may increase.
• Quality changes: if the good improves in quality, utility may rise.
• Irrational consumers: the law applies to normal, rational behaviour.

Law of Equi-Marginal Utility

Q20. What is the law of equi-marginal utility?

A rational consumer spends a limited income so that the marginal utility of the last unit of money spent on each good is equal. In symbols, the consumer is in equilibrium when MUx / Px = MUy / Py = MU of money. It is also called Gossen’s second law or the law of maximum satisfaction.

Q21. What are the assumptions of this law?

• The consumer’s income is fixed.
• Each good obeys the law of diminishing marginal utility, and the MU schedule is known.
• Prices of goods stay constant.
• Goods can be bought in small units.
• Tastes and preferences stay the same.

Q22. Can you show an example?

A consumer has an income of 5 and buys goods X and Y, each priced at 1 per unit. Marginal utilities are:

Each unit of money should go to the item that gives the highest marginal utility. The five best values are 12 (X), 10 (X), 10 (Y), 8 (X) and 8 (Y). So the consumer buys 3 units of X and 2 units of Y. At this point MUx = 8 and MUy = 8, which are equal, and total utility = 12 + 10 + 8 + 10 + 8 = 48 utils. No other split of 5 units gives more.

Q23. What is consumer equilibrium?

Consumer equilibrium is the position in which a consumer gets the maximum possible satisfaction from his income and has no reason to change what he buys.

The Ordinal Approach: Indifference Curves

Q24. What is the ordinal utility approach?

It assumes that utility cannot be measured in numbers, but a consumer can rank bundles of goods as better than, worse than or equal to each other. It is also called indifference curve analysis, and it removes the problems of the cardinal approach.

Q25. What is the difference between the cardinal and ordinal approaches?

Q26. What is an indifference curve?

A curve that shows all the combinations of two goods that give the consumer the same level of satisfaction, so the consumer is indifferent between them.

Q27. What is the marginal rate of substitution (MRS)?

The MRS of X for Y is the amount of Y that a consumer is willing to give up for one more unit of X, while staying at the same level of satisfaction. MRSxy = change in Y / change in X = MUx / MUy. It falls as the consumer moves down along the curve, which is why indifference curves are convex to the origin.

Q28. What are the assumptions of indifference curve analysis?

• The consumer is rational.
• The consumer can rank bundles by preference. He does not need to state exact utility.
• More of a good is preferred to less.
• MRS diminishes: as he gets more of one good, he is willing to give up less and less of the other.
• His choices are consistent. If he prefers A to B once, he will not prefer B to A later.
• Tastes, income and prices stay constant.

Q29. What are the characteristics of indifference curves?

• They slope downward from left to right.
• They are convex to the origin.
• A higher indifference curve shows a higher level of satisfaction.
• Two indifference curves never intersect.

Q30. What is the budget line?

The budget line shows all the combinations of two goods that a consumer can buy by spending all his income at given prices. Its equation is Px.X + Py.Y = M, and its slope is -Px / Py.

Example: Income M = 100, price of X is 10 and price of Y is 5. If everything is spent on X, the consumer buys 100 / 10 = 10 units. If everything is spent on Y, he buys 100 / 5 = 20 units. The budget line joins these two points, and its slope is -10 / 5 = -2. Any bundle on or below the line is affordable.

Quick Revision Points

• MU = change in TU from one more unit. TU is maximum when MU = 0.
• Law of diminishing MU: each extra unit gives less utility.
• Equi-marginal law: MUx / Px = MUy / Py.
• Indifference curves slope downward, are convex to the origin and never intersect.
• Ordinal equilibrium: budget line tangent to the highest indifference curve (MRS = Px / Py).

Test yourself with the chapter quiz below, then continue to Basic Elements of Demand.