Summary
Highlights
The theory of consumer behavior analyzes how consumers react to goods and services, aiming to achieve the highest satisfaction at the lowest price. This theory is also known as utility theory, where utility (satisfaction) must be greater than the price of an item.
The cardinal utility approach, developed in the 20th century by economists like Alfred Marshall, posits that consumer satisfaction can be numerically measured in 'utiles'. Consumer equilibrium under this theory is achieved when marginal utility (MU) equals the price (P) for a single product, or when the ratio of marginal utility to price is equal across all consumed products (MUx/Px = MUy/Py).
There is a positive relationship between the law of demand and the law of diminishing marginal utility. As a consumer buys more of an item, satisfaction initially increases but then decreases. When marginal utility falls, demand typically falls, leading to a decrease in price. A rational consumer aims for marginal utility to be greater than price to increase demand.
The ordinal utility approach, pioneered by Eugen Slutsky, argues that utility cannot be numerically measured but can be ranked. This theory uses indifference curves and budget lines to determine consumer equilibrium. An indifference curve represents combinations of two goods that yield the same level of satisfaction, always having a negative slope.
Indifference curves are negatively sloped, showing an inverse relationship between two commodities, but maintaining the same satisfaction level. Higher indifference curves represent higher satisfaction. The budget line represents the combination of two items a consumer can afford. Consumer equilibrium is reached when the indifference curve is tangential to the budget line, signifying the point of consumer optimality where MUx/MUy = Px/Py.