Unit 1

Theory of Consumer Behaviour

Unit Introduction
A consumer is a decision making unit (an individual or a household) who uses or
consumes a commodity or service. The theory of consumer behavior is concerned
with how a consumer decides on the basket of goods and services he/she consumes in
order to maximize his/her satisfaction. In this unit, we will discuss how the consumer
decides to spend his/ her income on different goods.
The theory of consumer behavior, set out with the following important assumptions;

yy The consumer has a limited income.

yy The consumer is assumed to be rational. Given the consumer’s income and
the market prices of the commodities, he/she spends the income on goods
and services that give the highest possible satisfaction or utility.
The consumer has relevant information to make a decision, is aware of his or her
income, and is aware of the commodities available and their prices.

Unit Objectives

After completing this unit, students will be able to:

66 Explain cardinal utility

66 Discuss the law of diminishing marginal utility
66 Illustrate the consumer optimum under the cardinal approaches
66 Mentions the assumptions of ordinal utility theory
Main Contents
1.1. The concept of utility
1.2. The cardinal utility theory
1.3. The consumer maximization problem
1.4. Introduction to the ordinal utility theory

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 1.1 The Concept of Utility
At the end of this section, students will be able to:
66 Define the term utility
66 Discuss relativity of utility
👉ź Key Concepts
Commodity, Satisfaction, Utility

✍Ǧ Startup Activity
1. Why do you buy goods and services?
In our everyday lives, we buy different goods and services for consumption. Utility is
the level of satisfaction or pleasure derived from the consumption of a good or service.
Thus, utility is the power of a commodity to satisfy human wants. For example, bread
has the power to satisfy hunger, while water quenches our thirst.

In defining utility, it is important to bear in mind the following points:

yy Relativity of Utility: The utility of a commodity is subjective to a person’s

needs. It is not absolute (objectively determined).The same commodity provides
different utilities to different consumers. For example, non-smokers do not
derive any utility from cigarettes.
yy The utility of a product can be different at different places and times. For
example, the utility that we get from wearing jackets during the cold season is
not the same as during the hot season. For the same consumer, utility varies from
unit to unit, from time to time, and from place to place. For example, the utility
we get from drinking tea early in the morning may be different from the utility
we get during lunch time.
yy ‘Utility’ and ‘usefulness’ are not synonymous: usefulness is the concern of a
product whereas utility is the concern of the consumer.
Approaches to measuring Utility:Since utility is a qualitative concept, it is difficult
to measure quantitatively, but economists try to quantify it in two different ways:
cardinal utility and ordinal utility.
ĂĂ Activity 1.1
1. Define utility
2. Why is the level of utility obtained by consuming the same product by
different individuals different?

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 1.2. The Cardinal Utility Theory
At the end of this section, students will be able to:

66 Discuss the cardinal utility and its key assumptions

66 Compute total utility
66 Calculate marginal utility
66 State law of diminishing marginal utility
66 Derive consumer optimum
👉ź Key Concepts
utils, cardinal utility

✍Ǧ Startup Activity
1. How do you measure the satisfaction level (utility) that you get from goods
and services?
To get a higher level of satisfaction, the consumer must be able to compare the utility of
the various baskets of goods that can be bought with the available income. According
to Cardinal Utility theory, utility is measurable like weight, height, and temperature,
and they suggested a unit of measurement of satisfaction called ‘utils’. The Cardinal
School postulated that utility can be measured in monetary units (i.e., by the amount
of money that the consumer is willing to pay for another unit of a commodity) or by
subjective units called ‘utils’. Thus, the school assumes that the level of utility can be
expressed in numbers.

1.2.1. Assumptions of Cardinal Utility Theory

I . The consumer is Rational: The main objective of the consumer is to maximize
his/her satisfaction given his/her limited budget or income. Thus, in order to
maximize his/her satisfaction, the consumer has to be rational.
II . Cardinal Utility: Utility is a cardinal concept, which means the utility of each
commodity is measurable, with the most convenient measure being money.
III . Constant Marginal Utility of money: the utility that one derives from each
successive unit of money income remains constant.
IV . Diminishing Marginal Utility: The utility gained from the successive units of
a commodity diminishes. In other words, the marginal utility of a commodity
diminishes as the consumer consumes larger quantities of it. This is the law of
diminishing marginal utility.
V . The total utility of a basket of goods depends on the quantities of the individual
commodities. If there are n commodities in the bundle with quantities X 1 , X 2

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 ,...X n , the total utility is given by TU = f ( X1 , X 2; ……X n).

1.2.2. Measurement of Utility (Total and Marginal Utility)

Total Utility (TU): refers to the total amount of satisfaction a consumer gets from
consuming or possessing some specific quantities of a commodity (X) at a particular
time. As the consumer consumes more of a good (X) per time period, his/her total
utility increases. However, there is a saturation point for that commodity after which
the consumer will not be capable of enjoying any greater satisfaction from it. Therefore,
TUn refers to the total utility derived from consuming n units of a commodity X.
Marginal Utility(MU): refers to the additional utility obtained from consuming an
additional unit of a commodity. In other words, marginal utility is the change in total
utility resulting from the consumption of one more unit of a product per unit of time.
Mathematically, the formula for marginal utility is:
TU
MU  Where, TU is the change in total utility, and,
Q
Q is change in the amount of product consumed.
Suppose Beka gets 10 utils of total utility by consuming 2 quantities of orange, and
his total utility increases to 12 utils as he consumes 3 quantities of orange. Thus,
consumption of the 3rd quantity of orange has caused total utility to increase by 2 utils
(12 utils minus 10 utils). Therefore, themarginal utility of the 3rd orange is 2 utils.
TU 12utils  10utils
Thus, MU    2 utils
Q 3 2

👉ź Activity 1.2
Find the missed value of total utility (TU) and marginal utility (MU) in the
following table.
Table 1.1 Numerical Values of marginal and total utility derived from consumption
of hypothetical commodity (X).

Quantity consumed (Qb) 0 1 2 3 4 5 6 7 8 9 10

Total Utility (TU) 0 8 15 20 24 24 22 19 5
Marginal Utility (MU) 0 7 5 3 1 0 -3 -6 -8

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Example: Given Table 1.2 Numerical Values of marginal and total utility derived from
consumption of hypothetical commodity (banana).
Quantity consumed (Qb) 0 1 2 3 4 5 6 7 8 9 10
Total Utility (TU) 0 12 22 29 34 36 37 37 36 34 30
Marginal Utility (MU) - 12 10 7 5 2 1 0 -1 -2 -4

Table 1.2 As a consumer consumes only one quantity of banana, both the marginal
utility and total utility are equal, which is 12 utils. When a consumer consumes 2
quantities of banana, he/she gets 10 additional utils (marginal utility). The total utility
from 2 quantities of banana is 22 utils (12 fromthe first quantity of banana and 10
from the second quantity of banana). Finally, at 7 unit of quantity, the saturation point
of total utility, marginal utility becomes zero. After this maximum point of total utility,
if he/she consumes more quantity of banana, his/her total utility decreases, which
leads to dissatisfaction. Figure 1.1 is the graphical representation of table 1.2, and it
shows the relationship between total utility and marginal utility.

Figure 1.1: Relationship between total utility and marginalutility

Fig.1.1 shows that total utility initially increases, and reaches ‘its pick (saturation)
point’. This saturation point indicates that by consuming 7 quantities of banana, the

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consumer attains its highest satisfaction level of 37 utils. However, consumption
beyond this point results in dissatisfaction, because consuming the 8th and more
quantities of banana brings negative additional utility.
On the other hand, the marginal utility continuously diminished and became zero
when the total utility reached maximum, and then became negative as consumption
increased beyond the saturation point of the total utility.
ĂĂ Activity 1.3
1. Given: Table 1.3 hypothetical table showing TU of consuming commodity Y,

Quantity(Y) consumed 0 1 2 3 4 5 6
TUY 0 10 16 20 22 22 20

From the given table (1.3)

a. Find marginal utility (MUY)
b. Draw total utility (TUY) and marginal utility (MUY) curve.
2. What does it mean that marginal utility of a commodity is diminishing?
3. Explain the main assumptions of the cardinal utility theory.

1.2.3 The Law of Diminishing Marginal Utility (LDMU)

Do you get the same utility from drinking the first glass of water and the second glass
of water? The utility that a consumer gets by consuming a commodity for the first time
is not the same as the consumption of the good for the second, third, fourth, etc.
LDMU is central to the cardinalutility analysis of consumer behavior. This law states
that as the quantity consume do facommodity increases over a unit of time,the utility
derived by the consumer from the successive units goes on decreasing, provided
the consumption of all other goods remains constant. The above(table 1.2) shows
a numerical illustration of the law of diminishing marginal (LDMU). Here, TU
increases with a nincrease inconsumption of banana, but at a decreasing rate.It means
that MU decreases witha n increase in consumption.

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 1.3. The Consumer Maximization Problem
At the end of this section, students will be able to:

66 Drive consumers’ budget equations

66 Compute the optimum for the consumer
👉ź Key Concepts
Consumer income/budget, Consumer equilibrium

✍Ǧ Startup Activity
1. Discuss in pairs how you spend your money. How should a consumer spend
his/her income on different commodities?
A consumer that maximizes utility reaches his/her equilibrium position when the
allocation of his/her expenditure is such that the last birr spent on each commodity
yields the same utility.
Assumptions: Economists have developed the concept of consumer equilibrium
based on the following assumptions.
yy The consumer is rational. She/he aims at the maximisation of her/his utility or
satisfaction,
yy Cardinal measurement of utility is possible,
yy If utility is measured in terms of money, the marginal utility of money remains
constant,
yy The law of diminishing marginal utility operates,
yy The Consumer income is given and remains constant,
yy Commodity prices given and remain constant.
I . Consumer Equilibrium:The Case of one commodity
Let’s assume that the consumer consumes a single commodity, X. The consumer can
either buy x or retain his money income Y. Under these conditions, the consumer is in
equilibrium when the marginal utility of X is equated to its market price (px).
Symbolically,

MUx= Px

yy If MUx>Px, the consumer can increase his/her welfare by purchasing more units
of X, and
yy If the MUx<Px, welfare can be increased by reducing the consumption of X.

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 Figure 1.2: Consumer equilibrium and derivation of demand curve
At Q*xthe marginal utility is MU*x which is equal to P*x. Hence, at P*x consumer
demands Q*x and this forms the demand curve for commodity X. The demand curve
is simply the graphical representation of the relationship between price and quantity
demanded.Thus, the expenditure on a single commodity X is: PX QX =Income/budget
of the consumer, which is called consumers’ budget equation.
II . Consumer Equilibrium:thecase of more than one commodity
In the case where there are more commodities, the condition for the optimality of the
consumer is the equality of the ratios of MU of the individual commodities to their
prices, i.e. the utility derived from spending an additional unit of money must be the
same for all commodities. For example, if the consumer consumes a bundle of N
commodities, i.e A, B, C,… N, he/she would be in equilibrium or utility is maximized
if and only if:

Where, MUM =marginal utility of money

MUA= Marginal utility of commodity A;
MUB= Marginal utility of commodity B;
MUN= Marginal utility of commodity N,
PA= Price of commodity A
PB = Price of commodity B
Thus, the consumer’s budget equation will be:
Consumer’s Income=Expenditure on A + Expenditure on B + Expenditure on C... +
Expenditure on N.

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Mathematically:
Consumer’s Income= APA+BPB+CPC +--------+NPN
PN = Price of commodity N.
Therefore, in the situation of a consumer’s equilibrium, the utility derived from
spending an additional unit of money must be the same for all commodities. If the
consumer derives greater utility from any one commodity, he/she can increase his/
her satisfaction by spending more on that commodity and less on the others. It will
continue till the above equilibrium condition is reached.
Suppose a single commodity (bread) and its price (p) is equal to Birr 2 per unit and
consumer equilibrium is computed as in table 1.4 below.
Table1.4. Utility schedule for a single commodity (bread)
Marginal Marginal
Quantity of Total utility Marginal
utility per Birr utility of
bread (TU) utility (MU)
(price=2 birr) money
0 0 - - 1
1 4 4 2 1
2 6 2 1 1
3 7 1 0.5 1
4 7 0 0 1
5 6 -1 -0.5 1

For consumption levels of less than 2 quantities of bread, since the marginal utility of
bread is higher than the price, the consumer can increase his/her utility by consuming
more quantities of bread. On the other hand, for quantities greater than 2, since the
marginal utility of bread is less than the price, the consumer can increase his/her utility
by reducing their consumption of bread.

i.e MU bread 2
MU bread  pbread  2 or   1  MU Money
Pbread 2
Thus, the consumer will be at equilibrium when he/she consumes 2 quantities of bread
at a price where the marginal utility of bread (MUbread) is equal to the Price of bread
(pbread).
Suppose that an individual, whose income is Birr 22 consumes two types of goods,
bread (X) and injera (Y), whose prices are Px = Birr 2 and Py =Birr 4, spend all his/
her income on these goods. By using the above information and the utility table for the
two goods, determine the following questions.

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 1. Indicate how much of X & Y, should the individual purchase to maximize
utility.
2. Show that the condition for utility maximization is achieved.
3. Determine how much total utility the individual receives when he /she
maximizes utility.
Table 1.5 Utility schedules for two commodities (bread and injera)

Quantity (X) TU MU MU/Px Quantity (Y) TU MU MU/Py

0 0 - - 0 0 - -
1 6 6 3 1 12 12 3
2 10 4 2 2 19 7 1.75
3 12 2 1 3 24 5 1.5
4 12 0 0 4 28 4 1
5 11 -1 -0.5 5 23 0 0
6 9 -3 -1.5 6 20 -2 -0.5

Solution:
1. As we have discussed, a consumer maximizes his/her total utility when the
marginal utility of one commodity divided by its market price is equal to the
marginal utility of the other commodity divided by its market price, i.e.
MU1 MU 2

P1 P2
Thus, the consumer will be in equilibrium when he consumes 3 quantities of
commodity X (bread) and 4 quantities of commodity Y (injera) , because:
MU X MUY 2 4
   1
PX PY 2 4
2. At the equilibrium of the consumer, Expenditure on X (bread) + Expenditure on
Y(injera)= Consumer’s Income (I).
Thus, PxX + PyY = I
ÖÖ 2(3) + 4(4) = 22
ÖÖ 22 = 22
3. Maximum total utility obtained from consumption of these commodities is;

TU = ∑MUs = ∑MUx + ∑MUy

ÖÖTU = (6+4+2)x + (12+7 +5+ 4 )y
ÖÖTU = (12)x + ( 28)y
ÖÖTU = 40 utils

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 ĂĂ Activity 1.4
Table 1.6 Utility schedule for two commodities (X and Y)

Qx MUx Qy MUy
1 10 4 5
2 6 5 4
3 4 6 3
4 2 7 2
5 0 8 1

Assume that an individual, whose income is birr 10, consumes two types of goods, X
and Y, whose prices are Px = 2 and Py = 1, and that the consumer spends all his/her
income on these goods. Usethe information in table 1.6 to determine the following
things/ answer the following questions.
1. Indicate how much of X & Y the individual should purchase to maximize utility.
2. Show that the condition for constrained utility maximization is achieved.
3. Determine how much total utility the individual receives when he /she maximizes
utility.

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 1.4. Introduction to the Ordinal Utility Theory
At the end of this section, students will be able to:

66 Explain ordinal utility

66 State the assumptions of ordinal utility theory
👉ź Key Concepts
Ordinal utility

✍Ǧ Startup Activity
1. Suppose you have just eaten an orange and a banana. Can you tell how much
you are satisfied with each of these items?
You can probably tell which item you liked more. But, it is very difficult to express
“how much” you liked one over the other. In the ordinal utility approach, utility cannot
be measured absolutely, but different consumption bundles are ranked according to
preferences. The concept is based on the fact that it may not be possible for consumers
to express the utility of various commodities they consume in absolute terms, like, 1
util, 2 util, or 3 util, but it is always possible for consumers to express the utility in
relative terms. It is practically possible for the consumers to rank commodities in the
order of their preference, as 1st, 2nd, 3rd, and so on.
That is, to make his/her choice, the consumer needs not know the utility of various
commoditiesin a specific unit, but be able to rank the various baskets of goods (order
of preference) according to the satisfaction that each bundle gives.
Assumptions

yy Rationality: The consumer is assumed to be rational. The main objective of

rational consumer is to maximize his/her satisfaction or utility given his/her
income and market prices.
yy Utility is ordinal: utility is not absolutely (cardinally) measurable. The consumer
can rank his/her preference (order the various baskets of goods) according to the
satisfaction of each basket.
yy The Diminishing marginal rate of substitution (DMRS): The marginal rate of
substitution is the rate at which a consumer is willing to substitute one commodity
for another commodity so that his/her total satisfaction remains the same. The
rate at which one good can be substituted for another in a consumer‘s basket of
goods diminishes as the consumer consumes more and more of the good. This
means that as the consumer substitutes more and more of one commodity (say

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 Y) for another commodity (say X), he/she will be prepared to give up fewer units
of the latter (X) for each additional unit of the former (Y).
yy The total utility of the consumer depends on the quantityof the commodity
consumed: The total utility of a consumer is measured by the amount (quantities)
of all items he/she consumes from his/her consumption basket.
yy Consistency and transitivity of choices: is assumed that the consumer is consistent
in his/her choice, that is, if he/she chooses bundle A over B in one period, he/she
will not use B over A in another period if both bundles are available to him/her,
under exactly the same conditions.
The consistency assumption may be symbolically written as follows:
═> If bundle A>B, then B is not greater than A
Similarly, it is assumed that consumers’ choices are characterized by transitivity: if
bundle A is preferred to B and B is preferred to C, then bundle A is preferred to C.
Symbolically, we may write the transitivity assumption as follows:
═> If bundle A >B and B>C, then A>C.

ĂĂ Activity 1.5
1. What is ordinal utility?
2. What are the assumptions of ordinal utility theory?

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 Unit Summary
The theory of consumer behavior is concerned with how consumers decide on the
basket of goods and services they consume in order to maximize their satisfaction/
utility. Utility is the power of a commodity to satisfy human wants. There are two
approaches for the measurement of utility: the Cardinal Utility and Ordinal utility
approaches.
The cardinal utility approach argues that utility is measurable and quantifiable with
a unit of measurement of ‘utils’ while the ordinal utility approach argues that utility
has only ordinal value and could only be ordered and ranked. The law of diminishing
marginal utility states that as the amount consumed of a commodity increase, the
utility derived by the consumer from the additional units (marginal utility) goes on
decreasing.
Under the cardinal utility approach, the consumer reaches equilibrium when the
marginal utility of the commodity is equal to its price in the case of one commodity
(MUx = Px), and when the ratio of the marginal utilities of the commodities to their
prices is equal for all commodities.
In the ordinal utility approach, utility cannot be measured absolutely, but different
consumption bundles are ranked according to preferences. The concept is based on
the fact that it may not be possible for consumers to express the utility of various
commodities they consume in absolute terms, like, 1 util, 2 util, or 3 util, but it is
always possible for consumers to express the utility in relative terms. It is practically
possible for the consumers to rank commodities in the order of their preference, as 1st,
2nd, 3rd, and so on.

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 Unit Review Exercises
Part I: Write ‘True’ if the statement is correct or ‘False’ if the statement is
incorrect.
1. Total utility is the sum of all marginal utilities.
2. Total utility increases as long as marginal utility is postive.
3. The law of diminishing marginal utility is an assumption of ordinal utility theory.
4. As ordinal utility, the level of satisfaction (utility) obtained from commodities is
be measurable in monetary units.
5. Consistency and transitivity can be applied to a single commodity case.
6. An ordinal utility attaches figures to utility measurement, but a cardinal utility
ranks market baskets.
Part II: Multiple-choice items.
Direction: Read the following questions and choose the correct answer from the given
alternatives.
1. Which of the following is false about utility?
A . The utility of a product can be different at different places and time.
B . Utility means usefulness.
C . Utility is pleasure derived from the consumption of a good or service.
D . The same commodity gives different utilities to different consumers.
2. When we rank the utility gained from the consumption of different commodities
as 1st , 2nd and 3rd, etc, we are measuring utility:
A . Cardinally
B . Ordinally
C . both Cardinally and Ordinally
D . Using Traditional theory
3. Which of the following assumptions is common in Cardinal and Ordinal
approaches?
A . Constant marginal utility
B . Diminishing marginal utility
C . Considering the consumer as rational
D . Measuring the utility of each commodity in number.
4. Which one is true if total utility is increasing at a decreasing rate?
A . Marginal utility is increasing.
B . Marginal utilityiszero.
C . Marginal utility is decreasing.
D . MU will benegative.

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 5. Which of the following is true?
A . The consumer is in equilibrium when the TUX =PX .
B . If the MUX>PX
C . If the MUX<PX, the consumer can increase his/her utility by purchasing
more units of good.
D . When the total utility curve reaches its maximum point, marginal utility
becomes zero.
Part III: Write detail answers to the following.
1. Mention at least one assumption that is common for both the cardinal and ordinal
utility approaches.
2. What is meant by the marginal rate of substitution? Discuss with examples the
principles of the diminishing marginal rate of substitution.
3. Explain why a consumer’s equilibrium is attained when the marginal utility of a
product is equal to its price?

QX TUX QY TUY MUx MUy

0 0 0 0
1 10 1 24
2 19 2 45
3 27 3 63
4 34 4 78
5 40 5 87
6 44 6 90
7 41 7 91
8 41 8 91
9 40 9 90

4. Assume a hypothetical consumer consumes good X and good Y. The price of

good X is 1 and price of good Y is 3 and the consumer budget is birr 10 for the
two goods. Where: QX is quantity of good X, QY is quantity of good Y and TUX
and TUY is total utility from consuming good X and good Y respectively, MUx
and MUyare marginal utilities for good X and good Y respectively.Based on the
given information (from theabove table), answer the following questions.
a . Calculate the marginal utility of the two goods
b . Determine the quantities of the two goods that the consumer should buy in
order to maximize his total utility.

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