Revealed Preference Theory

Both the Marshalian cardinal utility theory of demand and Hicks-Allen indifference curve analysis provide psychological explanation of consumer’s demand. They derive laws about the consumer’s demand from the consumers reaction psychologically to contain hypothetical changes in price and income but the revealed preference theory which has been put forward by Prof Samuelson seeks to explain consumers demand from his actual behavior in the market at various prices and income situation.

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Substitution, Income and Price Effect

The Substitution Effect 

The substitution effect takes place when the income of the consumer remains constant and the relative prices of the tow commodities changes. Suppose the price of one commodity rises and the other decreases now the consumer is neither better off nor worse off than before. However he will rearrange this purchase to compensate the loss. It means the consumer substitutes relatively cheaper goods for the relatively costlier ones.

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Consumer’s Equilibrium Through Indifference Curve

The consumer spends all his income to maximise his satisfaction it is called consumer equilibrium. It s not possible to know the consumer equilibrium by indifference curve only. For this we must know the income of the consumer and price of the goods. Therefore we should consider both indifference map and price line. If we incorporate the price line into indifference map we can get consumer equilibrium.

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Marginal Rate of Substitution

The concept is the basis of indifference curve and the modern theory of consumer demand. If the consumer exchanges additional unit of one commodity for another commodity it called marginal rate of substation (MRS). In this MRS the consumer reduces the consumption of one commodity and increase the consumption of another commodity if he wants to get same amount of satisfaction.

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Properties of Indifference Curve

1. IC slopes downwards from left to right:

The IC curve always slopes downwards from left to right, then only we can show the consumer is purchasing one commodity more and the other one less. In our ex the consumer purchases more apples and fewer oranges.

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Indifference Curve Analysis

The utility analysis lost its popularity because of its assumptions like utility can be measured, marginal utility of money remain constant. To replace these old concepts the modern economists have introduced an indifference curve analysis. This technique was originally developed by F.Y Edgeworth in 1881. Later picked up by Irving Fisher, who tried to give a concrete shape to it in 1892.It was further developed by Pereto. In 1931, I.R Hicks and Allen gave a scientific treatment to this new analysis, Indifference curve analysis is now being used in the analysis of many economic problems.

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Importance of the Concept of Consumer Surplus

The concept of consumer’s surplus does emphasize the amenities that we enjoy in a modern society. Much of the consumer’s surplus, we enjoy depends on our surroundings and the opportunities of consumption available to us, example, amenities of life in America as compared to Central Africa. It thus clarifies conjectural importance. The concept enables us to compare the advantages of environment and opportunities or conjectural benefits. The larger the consumer’s surplus, the better off is the people. The concept, thus, serves as an index of economic betterment.

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Assumptions and Criticisms of Consumer Surplus

Assumptions: 

This concept is based on the following assumptions. 

• Cardinal measurement of utility. 

• Constant marginal utility of money. 

• The commodity in question does not have substitutes. 

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Consumer Surplus

Dupuit originated the concept of consumer’s surplus. But, it was Marshall who popularized it by presenting it in a most refined way. Marshall viewed that when a consumer buys a commodity, his satisfaction derived from derived from it may be in excess of the dissatisfaction he has experienced in parting with money for paying its price. This excess of satisfaction is called” consumer’s surplus”.

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Limitations of the Law of Equi-Marginal Utility

The law has been subject to certain criticisms or limitations. They are as follows: 

• The law is based on unrealistic assumption, being, an extension of the law of diminishing marginal utility, it involves all the unrealistic assumptions and conditions such as homogeneity, continuity, constancy etc. 

• The proportionality rule presumes cardinal measurement of utility, but, it is not an unrealistic phenomenon. 

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Assumption and Importance of the Law of Equi-Marginal Utility

Assumption of the Law:

The law of equi-marginal utility is based on the following assumptions;

• The consumer is a rational economic man who seeks to maximize his total satisfaction.

• Utility is measurable in cardinal terms. 

• The consumer has a given scale of preference for the goods in consideration. He has perfect knowledge of utility derived. 

• Prices of goods are unchanged. 

• Income of the consumer is fixed. 

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Relationship between the Law of Diminishing Marginal Utility and the Law of Equi-Marginal Utility

The law of equi-marginal utility is an extension of the law of diminishing marginal utility. It considers the satisfaction derived from the number of commodities at a time. the law of diminishing marginal utility is applicable only to a single commodity whereas the law of equi-marginal utility is applicable to several commodities at a time, therefore, it has greater practical value. 

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The Law of Equi-Marginal Utility

The law of equi-marginal utility is an extension of the law of diminishing marginal utility. This law is called the law of substitution or the law of maximum satisfaction. It is obvious that the law of diminishing marginal utility is applicable only to a single want with one commodity in use. But, in reality there may be a number of wants to be satisfied at a time, and, these various wants are to be satisfied with several goods. To analyse, such a situation, one has to extend the law of diminishing marginal utility and such an extended form is called the law of equi-marginal utility.

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Total Utility and Marginal Utility

The concepts of total utility and the marginal utility are the basic concepts used in the cardinal measurement of utility. 

According to Prof. Meir, "Total utility is the amount of satisfaction derived from one unit of that commodity". 

According to Prof. Boulding, "Marginal utility of any quantity of commodity is the increase in the total utility, which results from a unit increase in consumption". 

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Measurement of Utility

Utility being an introspective phenomenon cannot be directly measured in a precise manner. Economist however adopted an indirect measurement of utility in terms of ’price’ a consumer is willing to pay for a given commodity. When a consumer is willing to pay a high price for a commodity, it means there is high utility estimated by him for that commodity and vice versa. But, this is just a rough indication it suggests no precise and proportionate measurement of utility.

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Utility and Satisfaction

The term utility is, however, distinct from satisfaction. Utility implies potentiality of satisfaction in a commodity. It serves as a basis to induce the consumer to buy the commodity. But, the real satisfaction is the end result of the consumption of a given commodity.

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Utility and its Meaning

Consumer has a pivotal role in the economic activity. He consumes goods and services for the satisfaction of his wants. Satisfaction of wants is the beginning and end of all economic activity. Thus micro economics analysis always begins with the understanding of the consumer’s behaviour by investigating into fundamental basis of demand.

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Exceptions to the Law of Diminishing Marginal Utility

Under the assumptions of homogeneity, continuity, reasonability, constancy and rationality, the law is deemed to be universal. In certain cases, however, it has been observed that a consumer tends to attain increasing marginal utility with an increase in the stock of a commodity consumed or acquired. Such cases are treated as exception to the law of diminishing marginal utility.

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Importance of the Law of Diminishing Marginal Utility

The law of diminishing marginal utility has great economic significance, theoretical as well as practical. From the theoretical point of view the law is important because, 

• The law explains the behaviour and the equilibrium condition of a rational consumer with respect to a single want and commodity. 

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Criticism of the Law of Diminishing Marginal Utility

Though the law expresses a universal tendency of consumer’s introspective behaviour, its traditional exposition has been criticized on various counts. 

• The traditional or Marshallian explanation of the law presumes the cardinal measurement of utility. The law assumes that utility can be numerically measured added or subtracted. This is rather not convincing because utility being a subjective or introspective phenomena cannot be measured numerically. It is a feeling experienced by the consumer. We cannot therefore have a objective measure of a subjective feeling. 

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