The Theory of Consumer
Behavior
The Theory of Consumer Behavior
The principle assumption upon which the theory of consumer behavior 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 (satisfaction).
Useful for understanding the demand side of the market.
Utility - amount of satisfaction derived from the consumption of a
commodity ….measurement units utils
Theories of Consumer Choice
Utility Concepts:
• The Cardinal Utility Theory (TUC)
• Utility is measurable in a cardinal sense
• cardinal utility - assumes that we can assign values for utility.
E.g., derive 100 utils from eating a slice of bread
• The Ordinal Utility Theory (TUO)
• Utility is measurable in an ordinal sense
• ordinal utility approach - does not assign values, instead
works with a ranking of preferences.
The Cardinal Approach
Nineteenth century economists, such as Jevons, Menger and Walras,
assumed that utility was measurable in a cardinal sense, which means
that the difference between two measurement is itself numerically
significant.
UX = f (X), UY = f (Y), …..
Utility is maximized when:
MUX / MUY = PX / PY
The Cardinal Approach
• 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
The Cardinal Approach
• Law of Diminishing Marginal Utility (Return) = As more and
more of a good are consumed, the process of consumption
will (at some point) yield smaller and smaller additions to
utility
• When the total utility maximum, marginal utility = 0
• When the total utility begins to decrease, the
marginal utility = negative (-ve)
EXAMPLE
Number Total Marginal
Purchased Utility Utility
0 0 0
1 4 4
2 7 3
3 8 1
4 8 0
5 7 -1
The Cardinal Approach
• 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
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
• 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
Consumer Equilibrium
• Optimizing condition:
MU X MU Y
• If
PX PY
MU X MU Y
PX PY
spend more on good X and less of Y
The Ordinal Approach
Economists following the lead of Hicks, Slutsky and Pareto believe
that utility is measurable in an ordinal sense—
the 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 )
Ordinal Utility Theory (TUO)
–Can be measured in qualitative, not quantitative, but only lists
the main options (indifference curves & budget line).
Rational human beings will choose to maximize the utility by
selecting the highest utility
Different consumers, difference utilities.
INDIFFERENCE CURVE (IC)
• Curve where the points represent a combination of items when
the consumer at indifference situation (satisfaction).
• Axes: both axes refer to the quantity of goods
• For the combination that produces a higher level of satisfaction,
the curves shift to the right (IC2) from the first curve (IC1)
• In contrast, the curves shift to the left (IC-1)
INDIFFERENCE CURVE
goods Y
M
S
A
B
C
T D IC2
IC1
IC-1
O
4 7 11
goods X
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 *
• Different ICs show different level of satisfaction. Far from the origin, the higher
the satisfaction.
Necessities and Luxuries
Necessities typically have an income elasticity
between O and 1
Luxuries typically have an income elasticity
greater than 1
