Theory of Consumer

Behaviour
TOPIC: 3
Topic Outline
 Introduction of Consumer Behavior Theory
 Principal assumption of the theory
 Importance of the theory
 Meaning of Utility
 Consumer Behavior Theories
 Cardinal Utility Approach
 Ordinal Utility Approach
Theory of Consumer Behaviour
 The principle assumption upon which the theory of
consumer behaviour and demand is built is:
 a consumer attempts to allocate his/her limited money
income among available goods and services so as to
maximize his/her utility.
 Recall Our assumption in the law of demand:
 Consumer always wish to maximize satisfaction.
Importance of the Theory
 The Covered Law of demand does not give answers
to the question of;
 How doe a consumer decide to consume at a given price
of a commodity?
 Thus by learning on how a consumer behaves at
consumption we will be able to understand the
demand side of the market in detail.
 Why a consumer exchange their money income for a
given particular quantity of a good at a certain price.
Meaning of Utility
 Utility;
 amount of satisfaction derived from the consumption
of a commodity.
 Therefore in abstract sense, Utility is the power of
the commodity to satisfy human needs.
 For example;
 Why do you drink water?
 Why do you pay tuition fee?
 Why do you buy a car?
 Why do you buy a cell phone?
Understanding Utility
 Utility is a relative in nature and not absolute.
 That is utility of a commodity depends on the need of
the commodity to a consumer.
 Therefore the greater the need of a commodity the
greater is the utility of that commodity to a consumer.
 Utility of a commodity depends on the availability
of complement goods.
 Example: electrical gadgets yield utility where there is
electricity.
Understanding Utility
 Utility is ethically neutral
 Neutrally ranges from something being bad or good.
 For-instance, some drugs are bad and harmful to
consume but they yield utility to addicts.
 OR Vegetarians regard eating meat as immoral, but if
they do it satisfies their hunger.
Measurement of Utility
 Question:
 Can we measure the utility we get from goods we
consume.
 Answer:
 A number of theories have developed by economists in
order to aid measurement of utility obtained from
consuming a commodity.
Consumer Behaviour Theories
 The Cardinal Utility Theory
 Utility is measurable in a cardinal sense
 cardinal utility - assumes that we can assign values for
utility, E.g. derive 10 utils from drinking a glass of
water.
 The Ordinal Utility Theory
 Utility is measurable in an ordinal sense
 ordinal utility approach - does not assign values,
instead works with a ranking of preferences.
Cardinal Utility Theory
 Nineteenth century economists, such as Jevons,
Menger and Walras, assumed that utility was
measurable in a cardinal sense, which means that
utility can be measured quantitatively.
 They used the term “util” meaning units of utility,
just like kilograms as a unit of weight.
Utility Concepts as per Cardinalist
• Total utility (TU): the overall level of satisfaction
derived from consuming a good or service

• Marginal utility (MU): additional satisfaction that

an individual derives from consuming an additional
unit of a good or service.
Formula :
MU = Change in total utility
Change in quantity
= ∆ TU
∆Q
Utility Concepts as per Cardinalist
 Law of Diminishing Marginal Utility: As more and
more of a good is consumed, the process of
consumption will (at some point) yield smaller and
smaller additions to utility.
 Example: Imagine your thirsty and offered a glass of
water, what happens to the successive glasses offered.
 Therefore, as total utility increases marginal utility
decreases.
 When the total utility maximum, marginal utility = 0
 When the total utility begins to decrease, the
marginal utility = negative (-ve)
Example
Number Total
Marginal Utility
Purchased Utility
0 0 0
1 4 4
2 7 3
3 8 1
4 8 0
5 7 -1
From the Table
 TU, in general, increases with Q
 At some point, TU can start falling with Q (see Q = 5)
 If TU is increasing, MU > 0
 From Q = 1 onwards, MU is declining
 Principle of diminishing marginal utility
 As more and more of a good are consumed, the process
of consumption will (at some point) yield smaller and
smaller additions to utility
Graphical Illustration
9
Total Utility / Marginal Utility Curves
8 8 8

7 7 7

4 4

3 3

1 1

0 0 0

0 1 2 3 4 5
-1 -1

-2
Total Utility Marginal Utility
Exception of Law of Diminishing Marginal Utility
 The law of diminishing marginal utility does not hold
in account of the following scenarios;
 Accumulation of Money.
 Collection of items, like stamps, books, and
paintings.
 In these situations and others of similar nature, a
person marginal utility increase as he/she increases
consumption, although it will decrease eventually.
Consumer Equilibrium
 So far, we have assumed that any amount of goods
and services are always available for consumption.
 In reality, consumers face constraints (income and
prices):
 Limited consumers income or budget
 Goods can be obtained at a price
Some simplifications
 Consumer’s objective: to maximize his/her utility
subject to income constraint
 2 goods (X, Y)
 Prices Px, Py are fixed
 Consumer’s income (I) is given
 Marginal utility of money (Mum) is constant
Consumer Equilibrium
 The law of equi-marginal utility
 This is the law which govern how a consumer comes to an
equilibrium
 The law states that:
 Consumer will distribute his money income between the
goods in such a way that the utility derived from the
last shilling spent on each good is equal.
Consumer Equilibrium
•
Consumer Equilibrium
•
Numerical Illustration:
Qx TUX MUX MUx QY TUY MUY MUy • Suppose: X = Cake
Px Py Y = Pepsi
1 30 30   1 50 50  
• Assume: PX = 2
2 39 9   2 105 55   PY = 10

3 45 6   3 148 43   • Income : 60

4 50 5   4 178 30  

5 54 4   5 198 20  

6 56 2   6 213 15  
Numerical Illustration: Calculated Values
Qx TUX MUX MUx QY TUY MUY MUy
Px Py

1 30 30 15 1 50 50 5

2 39 9 4.5 2 105 55 5.5

3 45 6 3 3 148 43 4.3

4 50 5 2.5 4 178 30 3

5 54 4 2 5 198 20 2

6 56 2 1 6 213 15 1.5
Numerical Illustration: Equilibrium Points.
Qx TUX MUX MUx QY TUY MUY MUy
Px Py

1 30 30 15 1 50 50 5

2 39 9 4.5 2 105 55 5.5

3 45 6 3 3 148 43 4.3

4 50 5 2.5 4 178 30 3

5 54 4 2 5 198 20 2

6 56 2 1 6 213 15 1.5
Equilibrium Points
 2 potential optimum positions
 Combination A:  X = 3 and Y = 4
 TU = TUX + TUY = 45 + 178 = 223

 Combination B:  X = 5 and Y = 5
 TU = TUX + TUY = 54 + 198 = 252
 With two possible preferences, the choice will
depend on the income of the consumer at present.
Equilibrium points: Income & Budget
 To determine the affordable preference a
consumer has to make a budget since his/her money
income is fixed.
 Consumer Budget per combination is give by:
 Total expenditure = PX X + PY Y
 Total Expenditure per combination in our illustration:
 Combination A: 3(2) + 4(10) = 46
 Combination B: 5(2) + 5(10) = 60
Cont.
 Therefore:

 If consumer’s income = 46, then the optimum is given by

combination A. ……………Combination B is not affordable

 If the consumer’s income = 60, then the optimum is

given by Combination B….….Combination A is affordable
but it yields a lower level of utility
Derivation of Demand Curve
•
 MUm

Q1 Q2 Q3 Quantity

D
Q Q2 Q3
Quantity
QUIZ
 Suppose the MU of good X is 20, its price is Tsh. 4, and the
MU of good Y is 50 and its price is Tsh. 5. The individual
whom this information applies is spending Tsh. 20 on each
good. Is he or she maximizing satisfaction? Why or why not?

 Explain the law of equi-marginal utility? How does it

explain consumers equilibrium?

 State and the law of diminishing marginal utility? How is

law of demand related to it?
ORDINAL UTILITY THEORY
Ordinal utility Approach
 Economists following the lead of Hicks, Slutsky and Pareto
believe that utility is measurable in an ordinal sense.
 Utility is measured in qualitative, not quantitative,
by listing the main options/preferences.
 Rational human beings choose to maximize the utility by
selecting the commodity which offer high utility.
 Utility derived from consuming a good, such as X, is a function of
the quantities of X and Y consumed by a consumer.
 U = f ( X, Y )
Utility Concept by Ordinalists
 Utility -- is a psychological feeling is not quantifiable.
 Given different commodities, Ordinalists assume a
consumer is capable of comparing different levels of
satisfaction.
 Example:
 A consumer is presented with two bundles (A,B) of commodities;
 Bundle A with given quantity of X and quantity of Y
 Bundle B with given quantity of X and quantity of Y
 In this case a consumer is capable of judging whether bundle A
gives higher satisfaction than bundle B or the vice-versa.
Preference and Indifference
 Given different bundles of goods a consumer is capable of
ranking them.
 The rank is the scale of preference to this consumer.
 Example;
 If a consumer has different bundles A, B, C, and D.
 He / She can indicated she prefers A to B or B to C. In this
case bundle A yield higher utility than bundle B or bundle B
yield higher utility than bundle C.
 Given preferences a consumer can prefer bundle A to B or
bundle B to A.
 In this case a consumer is indifferent between bundle A and B.
 What can explain such a situation?
Preferences, Indifference, and Transitivity
 Given preferences a consumer can prefer bundle A to B,
and bundle B to C, then he also prefer bundle A to C.
 In this case the order of preferences is transitive.
 A > B and B > C; then A > C.

 Given preferences a consumer can be indifferent between

A and B, and between B and C, then he is also indifferent
between A and C.
 In this case the order of preferences is transitive.
 A = B, and B = C; then A = C
Indifference Curve
 Presented with different preferences a consumer might
be indifferent between those preferences.
 All of those indifferent option they offer the same level of
satisfaction.
 Thus an indifference curve is a curve which is drawn to
represent different preferences which yield the same
level of satisfaction.
Example: Table representation

Combination Good X Good Y

A 25 5
B 15 7
C 10 12
D 6 20
E 4 30
F 25 5
Example: Graphical representation

Good Y

25 A

20 B
15 C
10 D
6 E
F
5

5 7 12 15 20 25 Good X
The Indifference Map
 Indifference Map: A collection of indifference curves.
 A higher indifference curve represents a higher level of
satisfaction
Good Y

IC3
IC2
IC1

Good X
Marginal rate of Substitution
 Given a number of bundles a consumer can substitute one
bundle for another given they yield the same level of
satisfaction.
 This involves a substitution of quantities of X for Y being
consumed.
 Therefore, the quantity of Y given up for additional quantity of
X is the marginal rate of substituting X for Y.
Combination Good X Good Y MRSxy
 Example:
A 1 12 4
B 2 8
3
C 3 5
D 4 3 2
MRS and Indifference Curve.
•
Marginal Rate of Substitution and MU.
•
MRS and MU
 Recall: An Indifference Curve
 Is a curve which indicate preferences to a consumer that
yield same level of utility to a consumer.
 In this regard given two commodities consumers total
utility will be the same as he substitute one commodity for
the other.
 Thus a change in total utility of commodity X will offset a
change in total utility of commodity Y.
Principle of Diminishing MRS
•
Why MRS decreases..
 Question: Why is it that consumer is willing to give up less
and less of Y for a given increment in X as he slides down
on the curve?
 Answer:
 Wants for a particular good is satiable.
 That is as consumer has more and more of a particular
good the intensity of his want for that good goes on
decreasing.
 The goods are imperfect substitute.
Properties of Indifference Curve
 Downward sloping  from left to right: This shows an
increase in quantity of certain good.
 Convex to the origin: the marginal rate
of substitution (MRS) decreased
 MRS = quantity of goods Y willing to substitute  to
obtain one unit of goods X & this substitution is to maintain
its position at the same level of satisfaction
 Do not cross (intersect): consumer preferences transitive
 Eg : Quantities X and Y for the combination of A> a
combination of B;   utility A> B *
 When cross = C, so the utility A = C & B = C;   utility A
= B = C. This is not transitive as above *
Properties of Indifference Curve
 Different ICs show different level of satisfaction.
 Far from the origin, the higher the satisfaction.
 Recall: the Indifference Map.
Good Y

IC3
IC2
IC1

Good X
Properties of Indifference Curve
 Indifference curve do not intersect, if they do there is a
violation of a transitivity rule of preferences.
Good Y
From the Graph Bundle A is
Common to both indifference
curves, thus;
A = B; and A = C.
A By transitivity principle
B IC1
B = C.
However, from the graph;
C B>C
IC2 This is a violation of
transitivity principle.
Because they are on
Good X
different indifference
curves.
Budget Constraint
•
Budget Line (BL)
 Budget Line….
Good Y Budget Line
Line showing all combinations
of items can be
purchased for a
Budget Line particular level of income (M)
.

Good X
Slope of the Budget Line
•
Factors Shifting the Budget Line
 Changes in prices of goods X or good Y
 When  price of good X increases, the quantity of good X is
reduced (by maintaining the quantity of Y) & vice vers
 Points on the X axis shifted to the left (a decrease
in quantity of X)

 When the price of Y increases, the quantity Y is reduced (by

maintaining the quantity of X) & vice versa
 Point on Y axis move to the bottom ( a decrease in  quantity
of Y)
Shift of Budget line due to change in price of X
Good Y

Good X
Shift of budget line due to change in price of Y
Good Y

Good X
Factors Shifting the Budget Line
 Changes in income
 When income increases, QX and QY can be bought even
more, because consumer’s purchasing power increases.
 For the sake that they are normal goods.

 A point on the X axis shifted to the right & a point on

the Y axis move to the right as well; & vice
versa when income decreases.
Shift of budget line due to change in Income
Good Y

Good X
Consumer Equilibrium
 A consumer is at equilibrium when he is buying such a
combination of goods as leaves him with no tendency to
rearrange his purchase of goods.

 With income (M) consumer choose combination of goods

that gives the highest satisfaction.
 This imply a consumer is a rational being.

 Therefore;
 Consumer choice influenced by income; and
 Price of the two goods prevailing in the market
Simplifications of Ordinal Utility Theory.
 Consumer is rational being.
 Consumer has indifference map showing his scale of
preferences.
 There is transitivity and consistency of choices.
 Consumer prefer large quantity of both goods
(Nonsatiety).
 There is diminishing marginal rate of substitution.
 Price of commodities are given and constant.
 Consumer has a fixed amount of money to spend on the
two goods.
Consumer Equilibrium.
 Give the conditions a consumer is at equilibrium when the
budget line and indifference curves are tangent.
Good Y

Equilibrium point
A A consumer cannot
rearrange the two
goods.
Qy E
IC2 Slopes
IC2 Slope of budget line
B equal that of
IC1
Indifference curve
Qx Good X
Consumer Equilibrium
 At point A and point B the slopes of indifference curve
and slope of the budget line they are equal but a
consumer is not at equilibrium. Why???
 Because both A and B they are on lower indifference curve,
which indicates a lower level of satisfaction.
 Furthermore, a consumer is capable of attaining a higher
level of satisfaction at point E because he can afford.
 NOTE:
 A consumer to be at equilibrium, the tangency of budget
line and indifference curve must be on the highest
indifference curve a consumer can afford.
Effect of Change in Income on equilibrium
 A change in income
 Result to a change in consumers purchasing power of the
goods.
 Suppose Income of consumer increases.
Good Y Income Consumption Curve
Is the curve that traces
equilibrium points of a
ICC
E2
consumer due to an
Qy3 increase in consumers
Qy2 IC3
income.
E2
Qy E1 ICC – also it is known as an
IC2
IC1 Engle Curve.

Q Qx2 Q Good X
Effect of Change in Income on equilibrium
 Recall: A change in income can result to;
 Quantity to increase – incase a good is normal
 Quantity to decrease – in case a good is an inferior

 Nature of Income consumption curve:

 For the case of normal good the Income consumption curve
will be positively sloped.
 For the case of infer goods the income consumption curve
will be negatively sloped.
Income Consumption Curve – Inferior Good
Good Y ICC
Qx4

Qx4

Qx3

Qx2

Qx1

Good X
Reading Task
 Recall: A change in income can result to;
 Quantity to increase – incase a good is normal
 Quantity to decrease – in case a good is an inferior
 Furthermore, a normal good can either be;
 A luxury – if the quantity purchased increase more than
proportionately to the increase in consumers income.
 A necessity – if the quantity purchased increases less than
proportionately to the increase in consumers income.
 Therefore; On your time go and find out the nature of
income consumption curves of a luxury and a necessity
goods.
Effect of Change in price on equilibrium
 When price change we have a tilt of a budget line, in a direction of
price change.
 This will result to a change in equilibrium of a consumer.
 Suppose price of good X decreases.
Good Y
Price Consumption Curve
Is the curve that traces
equilibrium points of a
consumer as a result of
Qy E change in price of one of
E the commodity.
Qy2
Qy3 E
PCC
IC1 IC2 IC3
Qx2
Good X
Q Qx3
Derivation of Demand Curve
Good Y

Qy E

Qy2 E
Qy3 IC1 E
IC2 IC3 PCC
Qx Qx2 Qx3 Good X
Px

Px E1

P E2
x

P E3
x
D
Qx Qx2 Qx3 Qx
Application and Use of Indifference Curve
 The concept is used to in understanding the
following;
 Substitutability and Complementarity of goods
 Several principles of welfare economics
 Burden of direct and indirect tax
 Effect of administration of in-kind – subsidy and Lump-
sum cash subsidy
 Effect of rationing on consumers welfare.
 Supply curve of labor of an individual.
 Gains from International Trade.
 THE END

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