2. Theory of Consumer Behavior

 Introduction

Consumer: A consumer is a person who purchases goods and services for the satisfaction of wants.

Aim of the consumer: To obtain maximum satisfaction of wants from spending limited money income on various goods and services.

Consumer Behavior: Method or technique of obtaining maximum satisfaction by optimum utilization of limited money income.

Theory of Consumer Behavior: Analytical and scientific study of consumer behavior (consumption behavior of the consumers).

Two approaches to the study of consumer behavior are as follows:

•        Cardinal utility approach (or marginal utility analysis)

•        Ordinal utility approach (or indifference curve analysis)

Concept of Utility

Utility is an elusive and controversial topic in microeconomics. The controversial part comes in the application and measurement of utility. When we speak of maximizing utility, then, we are speaking of the maximization of something we cannot measure.

"Utility is the pleasure, happiness, or satisfaction obtained from consuming a good or service". - C.R. McConnell, S.L. Brue and S.M. Flynn

"Utility can mean want-satisfying power….. Utility resides in the mind of the consumer. The consumer knows it by introspection.  - D. S. Watson and M. Getz

For providing utility to a consumer, it is not necessary that a commodity be useful or beneficial. On this reasoning, for example, the satisfaction derived by an individual by drinking a cup of apple juice and smoking a cigarette is utility although smoking is harmful to human health.

Generally speaking, utility refers to the degree of removed discomfort or perceived satisfaction that an individual receives from an economic act. It is the satisfaction, actual or expected, derived from the consumption of a commodity. It is the subjective entity and can vary from person to person, time to time and place to place.

Utility is the basis of consumer demand (intensity of want). A consumer thinks about his demand for a commodity on the basis of utility derived from the commodity. In modern time, utility has been called as 'expected satisfaction'. Expected satisfaction may be less or equal to or more than the real satisfaction.

Characteristics of Utility

1. Utility Has No Ethical or Moral Significance:

A commodity which satisfies any type of want, whether moral or immoral, socially desirable or undesirable, has utility, i.e., a knife has utility as a household appliance to a housewife, but it has also a utility to a killer for stabbing somebody.

2. Utility is Psychological:

Utility of a commodity depends on a consumer’s mental attitude and assessment regarding its power to satisfy his particular want. Thus, utility of a commodity may differ from person to person. Psychologically, every consumer has his likes and dislikes and everyone determines his own level of satisfaction.

3. Utility is Abstract:

It is abstract in a sense as it cannot be seen or touched or felt. For example, teaching of a teacher, advice of a lawyer can neither be seen nor touched.

4. Utility is Always Individual and Relative:

Utility of a commodity varies in different situations in relation to time and place. Even the same consumer may derive a higher or lower utility for the same commodity at different times and different places. For example—a person may find more utility in woolen clothes during the winter than in summer or at Mustang than at Nepalgunj.

5. Utility is Not Necessarily Equated With Usefulness:

A health injurious commodity like cigarette or liquor may have utility but it may not be useful to the consumer (user).

6. Utility Cannot be Measured Objectively:

Utility being a subjective phenomenon or feeling of a consumer cannot be expressed in numerical terms or cannot be measured directly in a precise manner. Professor Marshall has however, unrealistically assumed cardinal measurement of utility in his analysis of demand.

7. Utility Depends on the Intensity of Want:

Utility is the function of intensity of want (tendency of diminishing utility).

            - Unsatisfied and greatly intense want → high utility

            - Satisfied in the process of consumption→ lesser utility

8. Utility is Different From Pleasure:

A commodity like medicine or injection may have utility but its consumption may not give any pleasure to the consumer (patient).

Cardinal Utility Analysis

The concept of cardinal utility analysis was initially developed by H.H. Gossen and popularized by famous neoclassical economist Alfred Marshall. According to Marshall, utility is a objective phenomenon and it can be quantitatively measured by means of money as a measuring rod. It is based on the following assumptions:

Assumption of Cardinal Utility Analysis

1. Rational Consumer:

The consumer is assumed to be a rational being who acquire all relevant information required to maximize utility given his limited income. He, thus, makes consistent choice and avoids irrational behavior while trying to maximize utility. The consumer makes the choice (in the order of the preference) that will result in the greatest possible amount of the utility.

2. Cardinal Measurement:

The core hypothesis of cardinal approach is that utility form the consumption of a good or service is measurable in absolute number. It can be measured in terms of money, which the consumer is ready to pay for it. For e.g., the total utility derived by consuming a commodity can be expressed in terms of cardinal numbers as 20, 30, 40 utils.

3. Diminishing Marginal Utility of Commodity:

This analysis assumes that as more of a commodity is consumed, the utility derived from successive units of it goes on diminishing.It means total utility increases at a decreasing rate.

4. Constant Marginal Utility of Money (MU_M):

Since the cardinal utility analysis used monetary unit as the measuring rod of utility, MU_M is assumed to be constant and it implies that the utility of money does not diminish with its use. Daniel Bernoulli first of all introduced this assumption but later Marshall adopted this in his famous book 'Principles of Economics'. In symbol, it is written as, MU_M = K (where K is constant)

5. Utilities are Independent:

It means utility obtained from commodity X is not dependent on utility obtained from commodity Y. Thus, if the consumer has consumed n-commodities with quantities x₁, x₂, x₃, …, x_n, then total utility (U) is a function of all goods and is expressed as: U = f (x₁, x₂, x₃, …, x_n)

6. Utility is Additive:

According to author economist A. Koutsoyiannis in the early version of the cardinal approach to consumer behavior it was assumed that total utility is additive,

            U = U₁ (x₁) + U₂ (x₂)+… + U_n (x_n)

However in the later versions of the cardinal utility theory, the assumption of additivity was dropped.

7. Introspection:

“Introspection is the ability of the observer to reconstruct events which go on in the mind of another person with the help of self-observation. This form of comprehension may be just guesswork or intuition or the result of long lasting experience.” We conclude from it that other individuals' mind will work in a similar fashion, that is, marginal utility to them of a good will diminish as they have more units of it.

Ordinal Utility Analysis

The Ordinal Utility approach is based on the fact that the utility of a commodity cannot be measured in absolute quantity, but however, it will be possible for a consumer to tell subjectively whether the commodity derives more or less or equal satisfaction when compared to another. In this ordinal approach a good with a higher utility is preferred to one with lower utility but the size of the difference has no meaning.

"Ordinal utility means that the consumer is assumed to order, or rank, the subjective utilities of goods. That is all. There is no need to assume that he consumer knows quantities of utilities". – D.S. Watson & M. Getz

"Under ordinal utility approach consumers need to determine only their preference ranking of bundles of commodities". – P. A. Samuelson and W.D. Nordhaus

Cardinal and Ordinal Approaches to Utility Analysis

Basis for Comparison	Cardinal Utility	Ordinal Utility
Meaning	The satisfaction derived by the consumers from the consumption of good or service can be expressed numerically.	The satisfaction which a consumer derives from the consumption of good or service cannot be expressed numerical units.
Approach	Quantitative i.e. 1, 2, 3, and so on	Qualitative i.e. 1st, 2nd, 3rd or more than, less than
Realistic	Less	More
Measurement	Utils based on WTP (objective)	Ranks based on satisfaction (subjective)
Basis for Comparison	Cardinal Utility	Ordinal Utility
Analysis	Marginal Utility Analysis	Indifference Curve Analysis
Curve	Demand curve	Indifference Curve
Example	The value of cardinal utility is related to the price we are willing to pay. If we are willing to pay £5,000 for a second-hand Nissan Car, we can infer we must get 5,000 utils. Similarly, if we are willing to pay £8,000 for a BMW car, we can infer we must get 8,000 utils	We prefer a BMW car to a Nissan car, but we don’t say by how much.
Promoted by	Classical and Neo-classical Economists Alfred Marshall, Leon Walrus, and Carl Meneger	Modern Economists J.R. Hicks, R.G.D. Allen, Edgeworth, and Pareto

Concept of Total Utility, Average Utility & Marginal Utility

Total Utility (TU)

In cardinal utility approach, the utility gained by consuming the given units of the commodity in a given time period can be expressed in terms of cardinal number which is called total utility (TU).

TU = f (x_i)

Where x is the quantity consumed of a commodity

TU = MU₁ + MU₂ + ………+ MU_n

TU = 𝛴MU

Units of Commodity	Marginal  Utility (MU)	Total Utility (TU)
1st	10	10
2nd	8	18
3rd	6	24
4th	4	28
5th	2	30

TU increases at decreasing rate because of MU.

 Average Utility (AU)

It is per unit utility, which is calculated by dividing total utility by the number of commodity consumed.

AU = TU/Q

Units of Commodity	Total Utility (TU)	Average Utility (AU)
1	10	10
2	18	9
3	24	8
4	28	7
5	30	6

AU decreases slower in comparison with MU and after saturation point TU also declines.

Marginal Utility (MU)

The extra utility obtained by consuming one additional unit of a commodity is known as marginal utility (MU).

In other words, change in total utility due to one unit change in the commodity consumed is known as marginal utility.

And this marginal utility diminishes when more and more units of a good are consumed.

MU =🛆TU / 🛆Q 

        =  (TU_n  - TU_n-1) / (Q_n - Q_n-1)

        =  (TU_n  - TU_n-1) / 1

∴ MU  =  TU_n  - TU_n-1

Units of Commodity	Total  Utility (TU)	Marginal Utility (MU)
1	10	10
2	18	8
3	24	6
4	28	4
5	30	2

MU continuously decreases to every successive unit of consumption.

Derivation or Nature of TU, MU & AU

Units of Commodity (Q)	Total Utility (TU)	Marginal Utility (MU)	Average Utility (AU)
1	10	10	10
2	18	8	9
3	24	6	8
4	28	4	7
5	30	2	6
6	30	0	5
7	28	- 2	4

Law of Diminishing Marginal Utility

Introduction

The law of diminishing marginal utility was first developed by German Economist Herman Henrich Gossen in 1854 A.D. It is also known as the first law of Gossen. Later, this law was popularized by Alfred Marshall.

This law states that, "MU derived from the consumption of every additional unit (successive units) of the commodity goes on diminishing, other things remaining the same".

It means that additional satisfaction of a commodity diminishes at the consumer gets larger quantities of it. In other words, when a consumer consumes one after another commodity, he or she will derive less and less utility form the consumption at a particular point of time.

According to Watson & Getz, "the thing which we have enough is suppose to be less important to us. And the thing which we don't have would become very important to us".

This law is based on the two important facts:

1. Though human wants are unlimited, each single want is satiable.
2. Commodities are not perfect substitute for each other.

Assumptions

1. Rational Consumer:

The consumer is assumed to be a rational being who acquire all relevant information for measurement, calculation and comparison of utilities of different commodities and aims at maximizing total satisfaction (utility) with given limited income. He, thus, makes consistent choice and avoids irrational behavior while trying to maximize utility. The consumer makes the choice (in the order of the preference) that will result in the greatest possible amount of the utility.

2. Cardinal Measurement:

The core assumption of law of DMU is that utility form the consumption of a good or service is measurable in absolute (quantitative) number. It can be measured in terms of money, which the consumer is ready to pay for it. For e.g., the total utility derived by consuming a commodity can be expressed in terms of cardinal numbers as 20, 30, 40 utils.

3. Constant Marginal Utility of Money (MU_M):

As a consumer spends money on the commodity, he is left with lesser money to spend on other commodities. In this process, the remaining money becomes dearer to the consumer and it increases MU of money for the consumer. But, such an increase in MU of money is ignored.

Thus, as monetary unit is the measuring rod of utility of a commodity, MU_M is assumed to be constant and it implies that the utility of money does not diminish with its use. If the marginal utility of money changes as income increases (or decreases) the measuring-rod for utility becomes like an elastic ruler, unsuitable for measurement. Symbolically, MU_M = K (where K is constant)

4. Consumption of Reasonable Quantity ( Proper Unit):

It is assumed that a reasonable quantity of the commodity is consumed. For example, we should compare MU of glassfuls of water and not of spoonful’s. If a thirsty person is given water in a spoon, then every additional spoon will yield him more utility. So, to hold the law true, suitable and proper quantity of the commodity should be consumed.

5. Continuous Consumption:

It is assumed that consumption is a continuous process or there is no time gap during consumption. For example, if one ice-cream is consumed in the morning and another in the evening, then the second ice-cream may provide equal or higher satisfaction as compared to the first one.

6. No Change in Quality:

Quality of the commodity consumed is assumed to be uniform. For example: A second cup of ice-cream with peanut (badam) and cashew nut (kaju) may give more satisfaction than the first one, if the first ice-cream was without any nuts.

7. Independent Utilities:

It is assumed that all the commodities consumed by a consumer are independent. It means, MU of one commodity (MU_X) has no relation with MU of another commodity (MU_Y). Further, it is also assumed that one person’s utility is not affected by the utility of any other person.

8. Fixed Income and Prices:

It is assumed that income of the consumer and prices of the goods which the consumer wishes to purchase remain constant during the consumption period.

9. Homogeneous and Divisible Product:

It means commodity must be similar in character with appropriate divisible quantity.

10. No Change in Fashion:

Suppose, if there is a fashion of lifted shirts (t-shirt), then consumer may not receive utility from open shirts (with button).

Explanation with Schedule and Diagram

We assume that a man is very thirsty. He takes the glasses of water successively. The marginal utility of the successive glasses of water decreases, ultimately, he reaches the point of satiety. After this point the marginal utility becomes negative, if he is forced further to take a glass of water. The behavior of the consumer is indicated in the following schedule:

Combination Point	Units of Commodity (Q)	Marginal Utility (MU)	Total Utility (TU)
A	1st	10	10
B	2nd	8	18
C	3rd	6	24
D	4th	4	28
E	5th	2	30
F	6th	0	30
G	7th	-2	28

On taking the 1^st glass of water, the consumer gets 10 units of utility, because he is very thirsty. When he takes 2^nd glass of water, his marginal utility goes down to 8 utils because his thirst has been partly satisfied. This process continues until the marginal utility drops down to zero which is the saturation point. By taking the seventh glass of water, the marginal utility becomes negative because the thirst of the consumer has already been fully satisfied.

In the given figure, the MU of different glasses of water is measured on the y-axis and the units (glasses of water) on X-axis. With the help of the schedule, the points A, B, C, D, E, F and G are derived by the different combinations of units of the commodity (glasses of water) and the MU gained by different units of commodity. By joining these points, we get the MU curve. The MU curve has the downward (negative) slope. It intersects the X-axis at the point of 6th unit of the commodity. At this point "F" the MU becomes zero. When the MU curve goes beyond this point, the MU becomes negative. So there is an inverse functional relationship between the units of a commodity and the MU of that commodity. The consumer is in equilibrium when he maximizes his total satisfaction given his income and market prices of the goods consumed. In this model "The consumer should purchase that much quantity of a commodity where marginal utility of the commodity in terms of money becomes equal to the price of the commodity". 

Condition for Equilibrium

MU_M  = MU_X / P_X 

or, P_X =MU_X / MU_M 

∴ P_X =MU_XM

Where, MU_M  = Marginal utility of money

P_X = Price of X-commodity

MU_X = Marginal utility of X-commodity

MU_XM = Marginal utility of X-commodity in terms of money

Exceptions or Limitations or Critical Evaluation of Law of DMU

When any of the assumption of this law is violated, this law does not hold true. The conditions in which the law is not applicable are known as exceptions or limitations. As this law assumes too much and explains too little, it suffers from the following limitations:

1. DMU is Not Valid for Various Types of Rare Good Collection:

The law does not hold well in the hobby of rare collections of different varieties of ancient coins, stamps, artistic objects, scarce goods, precious goods, old music etc. As one gets more and more of it, s/he will be interested in getting still more. Thus, a collector of stamp or coins is interested in collection of stamps or coins of different variety not the same variety. If he collects the stamps of same variety then from every additional unit he will derive less and less of satisfaction.

2. The law is Not Fully Applicable to Money:

The marginal utility of money declines with richness but never falls to zero. Not only money, love, hobbies, knowledge, art, innovations, fashionable dress, demonstration condition, person with fond of beauty and decoration, good music, novel and stories are exceptions of the law.

3. Irrational Consumer or Abnormal Persons:

Law does not operate if consumer behaves in irrational manner. For example, in case of misery (unhappiness, distress), drunkard is said to enjoy (happy) each successive peg more than the previous one.

4. Cardinal Measurability of Utility is Unrealistic:

In reality, utility is a comparable subjective concept not the objective like a matter in the laboratory. It is a sort of psychic feeling and introspection. How can we measure feeling by giving number (quantitative terms). This appears to be impossible.

5. Assumption of Ceteris Paribus is Not Realistic:

The law assumes that ‘other things’ like habits, taste, temperament and income of the consumer must remain constant for the operation of the law. If any of these things changes, the consumer will behave differently and the law will not operate.

6. Indivisible Goods:

The law is difficult to operate in case of indivisible goods (cannot be divided in small units) like automobiles, laptop, mobile, television sets and normally purchases only one of such commodity at a time.

7. Hypothesis of Independent Utilities is Wrong:

In actual life the utility or satisfaction derived from a good depends upon the availability (or existence) of some other complements or substitutes goods. For example, the utility derived from a pen depends upon whether ink is available or not. On the contrary, if you have only tea, then the utility derived from it would be greater but if along with tea you also have the coffee, then the utility of tea to you would be comparatively less.

8. Assumption of Constant MU_M is Not Valid:

In actual practice, constancy of MU_M is not correct because if a consumer spends his given money income on the goods, money income left with him declines. With the decline in money income of the consumer as a result of increase in his expenditure on goods, MU_M to him rises. Moreover, with the assumption of constant MU_M, Marshall ignored the income effect of the price change (PE = SE+IE).

P_X↓→Real Income↑ (Better off) → Q_X↑ with the initial income → Income Effect

P_X↓→ relatively cheaper than other goods→ induced to substitute →Q_X↑ → substitution effect

Importance / Use / Implications  of Law of DMU

This law is of great importance in economics. Some major importance of this law are as follows:

1. Basis of Economic Laws:

The Law of DMU is the basic law of consumption. The Law of Demand, elasticity of demand, the Law of Equi-marginal Utility, and the Concept of Consumer’s Surplus are based on it.

2. Diversification in Consumption and Production:

The changes in design, pattern and packing of commodities very often brought about by producers are in keeping with this law. We know that the use of the same good makes us feel bored; its utility diminishes in our estimation. We want variety in Smartphone, laptops, soaps, toothpastes, pens, etc. Thus, this law helps in bringing variety in consumption and production.

3. Value Theory:

The law helps to explain the phenomenon in value theory that the price of a commodity falls when its supply increases. It is because with the increase in the stock of a commodity, its marginal utility diminishes. In this way prices are determined.

4. Sales Promotion:

This law helps the producer in increasing sales. For the purpose of increase in sales, the producer reduces the price of the product to equalize with the marginal utility of the product.

5. Basis for Household Expenditure:

The law of DMU regulates our daily expenditure. We know that as we go on buying more of a commodity, its marginal utility falls.

6. Diamond-Water Paradox:

The famous “diamond-water paradox” of Smith can be explained with the help of this law. Because of their relative scarcity, diamonds possess high marginal utility and so a high price. Since water is relatively abundant, it possesses low marginal utility and hence low price even though its total utility is high. That is why water has low price as compared to a diamond though it is more useful than the latter.

7. Progressive Taxation:

The principle of progression in taxation is also based on this law. As a person’s income increases, the rate of tax rises because the marginal utility of money to him falls with the rise in his income. Thus, this law has a practical application, imposing a heavier burden on the rich people.

8. Basis of Equity (Socialism):

This law underlies the socialist plea (logic) for an equitable distribution of wealth. The marginal utility of money to the rich is low. It is, therefore, advisable that their surplus wealth be acquired by the state and distributed to the poor who possess high marginal utility for money.

Law of Substitution

Introduction

The law of substitution was also developed by German Economist Herman Henrich Gossen in 1854 A.D. It is also known as the law of equi-marginal utility, law of maximum satisfaction, the proportionate rule, law of indifference, or Gossen's second law.

A consumer is said to be in equilibrium when he maximizes total utility under the budget constraint. In cardinal utility analysis, consumer gets maximum satisfaction when the ratio of marginal utility and price of each commodity (MU/P) is equivalent to marginal utility of money(MU_M). It means consumer always tries to get equal MU by consuming a commodity which is equal to money spent on that commodity. According to this law, consumer attains equilibrium under the following conditions:

Conditions for consumer's equilibrium

1. MU_X / P_X = MU_Y / P_Y = MU_M 

2. P_X . Q_X + P_Y . Q_Y = M

Assumptions

1. Rational consumer

2. Cardinal Measurement

3. MU_M Remains Constant

4. Law of DMU Operates

5. Independent Utilities

6. P_X, P_Y and M are given

7. Consumer spent total M in both X and Y goods

Explanation with Schedule and Diagram

On the basis of these assumptions, we can explain consumer's equilibrium in two commodity model as follows. Suppose that there are two commodities X and Y.

P_x = Rs. 2 and P_Y = Rs. 3 per unit

Consumer money income (M) = Rs. 24

MU_x and MU_Y with price ratio are given in the table below. In order to maximize satisfaction the consumer will not equalize MU_x with the MU_Y because prices of these two goods are different. He will equalize the MU_X obtained from the last rupee spend on X i.e. MU_X/P_x with the MU_Y obtained from the last rupee spend on Y i.e. MU_Y/P_Y. In the table 4^th and 5^th columns dividing marginal utilities (MU_x) by X Rs. 2 and marginal utilities (MU_Y) of Y by Rs. 3, we get the marginal utility and price ratio. In order to have maximum utility consumer will purchase 6 units of X and any 4 units of Y. because because it satisfies the following two conditions required for consumer's equilibrium.

Units (Q)	MUX	MUY	MUX/PX	MUY/PY
1st	20	24	10	8
2nd	18	21	9	7
3rd	16	18	8	6
4th	14	15	7	5
5th	12	12	6	4
6th	10	9	5	3

At 6 units of X = MU_X / P_X = 10 / 2 = 5 

At 4 units of Y = MU_Y / P_Y = 15 / 3 = 5 

Expenditure on X + expenditure on Y = Total income

⥤ P_X . Q_X + P_Y . Q_Y = M

⥤ 2×6 + 3×4 = 24

In the figure, marginal utilities of commodities with their price ratio are measured along the Y-axis and unit of consumption is measured along the X-axis.

When the consumer consumes 6 units of X-commodity and 4 units of Y-commodity, s/he gets the maximum utility i.e. (20+18+16+14+12+10) + (24+21+18+15) = 168. So this is the equilibrium condition of the consumer. No other combinations with this money expenditure will yield her/him greater utility then this point. 

Suppose, consumer increase X-commodity for 6 units to 7, STUV is the area of gain. Because of increase in X-commodity from 6 to 7 units, s/he must reduce Y-commodity from 4 to 3 units then ABCD will be the area of loss. Here area of loss is greater than area of gain. i.e. ABCD > STUV. So consumer's equilibrium is there, Where 

(1) MU_X / P_X = MU_Y / P_Y = MU_M  and 

(2) P_X . Q_X + P_Y . Q_Y = M

 Exceptions or Limitations or Critical Evaluation of Law of EMU

When any of the assumption of this law is violated, this law does not hold true. The conditions in which the law is not applicable are known as exceptions or limitations. As this law also assumes too much and explains too little, it suffers from the following limitations:

1. Ignorance:

Law does not operate if consumer behaves in irrational manner (carelessness). Sometimes purchased commodity do not obtain the maximum advantage by equating the MU in the uses.

2. Cardinal Measurability of Utility is Unrealistic:

In reality, utility is a comparable subjective concept not the objective like a matter in the laboratory. It is a sort of psychic feeling and introspection. How can we measure feeling by giving number (quantitative terms). This appears to be impossible.

3. Indivisible Goods:

The law is difficult to operate in case of indivisible goods (cannot be divided in small units) like automobiles, laptop, mobile, television sets and normally purchases only one of such commodity at a time. If we divide them in various parts to make comparison of utility they become valueless. 

4. Assumption of Ceteris Paribus is Not Realistic:

The law assumes that ‘other things’ like habits, taste, temperament and income of the consumer must remain constant for the operation of the law. If any of these things changes, the consumer will behave differently and the law will not operate.

5. Effect of Fashions and Customs:

Consumers sometimes cannot be discerning (rational) when it comes to the consumption of items associated with rituals, culture or fashion. In that case the consumer cannot replace the less useful thing with the more useful thing from the available expendable income.

6. Unlimited Resources:

There is no need to get maximum satisfaction by substituting these items with each other in terms of consumption of free goods which do not have exchange value provided by nature.

Importance / Use / Implications  of Law of EMU

This law is of great practical importance in economics. Some major importance of this law are as follows:

1. In Consumption:

The importance of this rule is to achieve efficiency in consumption by replacing less useful items with more useful items from a limited budget.

2. In Production:

This law is also important for achieving efficiency in production by replacing the means of production on the basis of different marginal productivity from limited resources.For the optimum level of production given condition must need to satisfied and this concept is derived from law of diminishing marginal utility. 

(1) MP_L / W = MP_K / I = MU_M  and 

(2) W . L + I . K = M

3. In Exchange:

When we sell a commodity, say sugar, we get money. With this money, we buy another commodity, say wheat. Therefore, we have really substituted sugar for wheat. In this way, the consumer continues to substitute one factor for the other till their marginal returns from all the goods are equalized.

4. In Distribution:

In distribution, we are concerned with the determination of the rewards of the various factors of production, i.e, determination of rent, wages, interest, and profit. These shares are determined according to the principle of marginal productivity of other factor. The law of substitution helps to equalize their marginal productivity.

5. Public Finance:

It is also applicable in the field of public finance. Taxes are levied in such a manner that the marginal sacrifice of each tax payer is equal. The government should try to maximize the welfare of the community. For this, the government should cut down all wasteful expenditures where the return is not proportionate and instead divert the resources on more productive sectors.

6. Price Determination:

The principle of substitution is also applicable in the determination of prices when a commodity becomes scarce and its price becomes high. In order to bring its price down, we should substitute it with the commodity in abundance so that its scarcity will end.

Consumer Surplus

Introduction

Consumer surplus is one of the most important concept in economics. It was first introduced by French Economist A. J. Dupit (Arsene Jules) and later on it was developed by Alfred Marshall in his famous book, "Principle of Economics". A consumer get surplus when the price he actually pays is lower than the price he is willing to pay. Therefore, consumers surplus is the difference between what one is prepared to pay and what he actually pays. It can be expressed as; 

Consumer's Surplus = Total Utility – Total Amount Spent

In the words of Alfred Marshall, "The excess of the price which consumer would be willing to pay rather than go without the thing over that which he actually does pay is the economic measure of this surplus satisfaction. It may be called consumer's surplus. 

This can be explained with an example, Let's think a consumer is prepared to pay Rs. 50,000 for a set of Laptop. When he goes to market, he found that the actual price of his desired Laptop is Rs. 40,000. Hence, consumer's surplus in this case is Rs. 10,000 (i.e. 50,000 – 40,000 = 10,000).

It is calculated by finding difference between what consumer was ready to pay and what he actually pays.

Assumptions

1. Rational consumer

2. Cardinal Measurement

3. MU_M Remains Constant

4. Law of DMU Operates

5. Expected price should be more than actual price

6. Homogeneous Goods

7. Constant Price

Explanation with Schedule and Diagram

Consumer surplus is derived when a consumer gets more benefit (in terms of monetary value) from a good. It is derived by the difference of his/her willingness to pay and actual payment made for it. We can illustrate the concept consumer's surplus with the help of table below.

Units (Q)	Marginal Utility (Willingness to Pay)	Actual Payment (Paid Price)	Consumer's Surplus
1st	200	50	150
2nd	180	50	130
3rd	150	50	100
4th	110	50	60
5th	50	50	0
	TU = 690	TE = 250	CS = 440

In the table, consumer is ready to pay Rs. 200 for the first unit of the goods. But, he actually pays Rs. 50. In such a case, he gets Rs. 150 as surplus. In the same way, the consumer is ready to pay Rs. 180, Rs. 150, Rs. 110 and 50 for second, third, fourth and fifth unit respectively. He actually pays Rs. 50 to each unit and he gets surplus equal to Rs. 130, Rs. 100, Rs. 60 and zero at last.

Therefore,

Consumer Surplus = Total Utility – Total amount Spent

CS = TU – TE

Or, CS = 690 – 250

⸫ CS = 440

 According to the above table, graphical representation is as follows: 

For further explanation using figure, we can use following figure. 

In the figure, units of commodity is shown along X-axis and Price and MU (in terms of price) is shown along Y-axis. MU curve itself a demand curve. P is the price line which intersects demand line at point E. This point E is the equilibrium point which gives equilibrium price OP and equilibrium quantity OQ. If OP is the price, OQ units of commodities are purchased and the price paid is OP × OQ which is equal to the area OQEP. But the total amount of money s/he is willing to pay (total utility) for OQ unit is OQEFG.

Therefore,

CS       = TU – TE

            = OQEFG – OQEP

            = PEFG

Shaded area PEFG shows consumer's surplus area.

Exceptions or Limitations or Critical Evaluation

When any of the assumption of this law is violated, this law does not hold true. The conditions in which the law is not applicable are known as exceptions or limitations. As this law also assumes too much and explains too little, it suffers from the following limitations:

1. Ignorance:

Law does not operate if consumer behaves in irrational manner (carelessness). Sometimes marginal utility is less than actual payment if the consumer behaves irrationally.

2. Cardinal Measurability of Utility is Unrealistic:

In reality, utility is a comparable subjective concept not the objective like a matter in the laboratory. It is a sort of psychic feeling and introspection. How can we measure feeling by giving number (quantitative terms). This appears to be impossible.

3. Assumption of Constant MU_M is Not Valid:

In actual practice, constancy of MU_M is not correct because if a consumer spends his given money income on the goods, money income left with him declines. With the decline in money income of the consumer as a result of increase in his expenditure on goods, MU_M to him rises.

4. Indivisible Goods:

The law is difficult to operate in case of indivisible goods (cannot be divided in small units) like automobiles, laptop, mobile, television sets and normally purchases only one of such commodity at a time. If we divide them in various parts, they become valueless. 

5. Assumption of Ceteris Paribus is Not Realistic:

The law assumes that ‘other things’ like habits, taste, temperament and income of the consumer must remain constant for the operation of the law.

If any of these things changes, the consumer will behave differently and the law will not operate.

6. Not Applicable to Necessaries:

The price of necessary good is comparatively very low whereas utility derived from them is very high. Therefore, consumer's surplus from them is infinite when a person is dying of thirst, s/he may be prepared to pay any amount of money for a glass of water. 

7. Hypothesis of Independent Utilities is Wrong:

In actual life the utility and CS derived from a good depends upon the availability (or existence) of some other complements or substitutes goods. For example, the utility derived from a pen depends upon whether ink is available or not. On the contrary, if you have only tea, then the utility derived from it would be greater but if along with tea you also have the coffee, then the utility of tea to you would be comparatively less.

Importance / Use / Implications

This law is of great practical importance in economics. Some major importance of this law are as follows:

1. To Determine Price:

On the basis of consumer's willingness to pay, businessman (monopolist) can determine the price of the commodity for maximum profit.

WTP↑→  Price ↑→ Profit↑

2. Distinction between Value in Use & Value in Exchange:

Value in use means utility and value in exchange means the price of a commodity.

Water-Diamond Paradox

Commodity	Value in Use	Value in Exchange	Consumer Surplus
Salt, Match Box, Newspaper	High	Low	High
Jewelry	Low	High	No

3. Measuring Benefits from International Trade:

Comparative analysis of willingness to pay and actual payment permits to measure benefits from international trade.

Commodity	WTP	Actual Payment	Consumer Surplus	International Trade
Laptop	50,000	40,000	10,000	Yes
Electric Scooter	2,50,000	3,00,000	No	No

4. To Make Cost Benefit Analysis:

Project viability can be analyzed by using willingness to pay (benefit) and actual payment (cost).

Benefit > Cost → Project Accepted

Benefit < Cost → Project Rejected

So, concept of consumer surplus provide the basis for cost benefit analysis of project.

5. Guide to Formulate Tax Policy:

The best tax policy is that which maximize the public revenue with least sacrifice from tax on those commodities in which the consumer's enjoy much surplus.

High CS→ Tax↑→ Govt. Rev.↑

Producer's Surplus

Introduction

Producer's surplus is the difference between income received by producer and cost of production. In other words, producer's surplus is the difference between the prices of goods and services producer willing and able to supply and the price they actually receive in the market. 

A producer get surplus when the price he actually received is higher than the price he is willing to sell. I can be expressed as:

Producer's Surplus = Actual price received - Willingness to sell = Actual price received - Cost of production

Explanation

In the figure E is equilibrium point where demand curve DD and supply curve SS are intersect with each other at market price Po with quantity Qo. 

Producer's Surplus = Actual price received - Willingness to sale

PS = 0PoEQo - OSEQo 

      = SPoE