CHAPTER ONE

THEORY OF CONSUMER BEHAVIOUR

❖ The theory of consumer behaviour deals with the way in which scarcities encroach
upon the individual consumer & hence the way such individual makes a choice.

❖Consumers buy goods/services to obtain satisfaction from possession.

❖Consumer Behaviour can be best understood in three steps.

1) First, we must take into account that consumers face budget constraints.

2) Second, examining consumer‘s preference to describe how people prefer one

good to another.

3) Third, put consumer preference and budget constraint together to determine

consumer choice.
 ➢ Budget constraint
• Budget is the level of income an individual consumer has acting as a constraint to the quantities
of goods the consumer can buy.

✓Example; suppose a consumer with money income “M” buys only two goods, say good X
and good Y, then the budget constraint is written as follow;
Px.X+Py.Y < M

• Budget line; shows a combination of the two goods (X & Y) for which total expenditure equals
income, i.e. Px.X+Py.Y =M

• We have three possible areas in which our preference points are located. These are inside and
outside of the BL and points on the BL.
➢Consumer preferences
❖ A consumer makes choices by comparing bundle of goods.
❖ Given any two consumption bundles, the consumer either decides that one of the
consumption bundles is strictly better than the other, or decides that he/she is
indifferent between the two bundles.

❖Given income constraint, all combination of goods /services has no equal importance for
an individual consumer.

✓Example; see the following graph

✓Consumers preference can be strict, weak or indifference.

➢Axioms of consumers preference
✓Consumers preference ordering is based on the following assumptions;
✓Completeness; A consumer is able to compare and rank all possible

combination or has a complete information about the good he /she can buy.
✓Consistency

✓Transitivity and

✓No satiation/More is better assumption.

➢The concept of utility
❖Utility is the level of expected satisfaction that a person gets from consuming a good or
undertaking an activity.

❖In other words, utility is the power of the product to satisfy human wants.

❖Utility is different from Usefulness.

For example: Paintings by Picasso may be useless functionally but offer great utility to art lovers.
❖Utility is subjective concept
➢ Approaches of measuring utility
✓Two major approaches: cardinal and ordinal approaches.
❖The Cardinalist school postulated that utility can be measured objectively.
❖For Ordinalists, utility is not measurable in cardinal numbers rather the consumer can
rank or order the utility he derives from different goods and services.
A. Cardinal Utility Analysis
✓Assumptions
▪ Utility is additive
▪ Consumers are rational
▪ Cardinal measurement of utility
▪ Constant MU of money
▪ Diminishing MU
➢Total and marginal utility
✓ Total Utility (TU); is the total satisfaction a consumer gets from consuming some specific
quantities of a commodity at a particular time.

✓Marginal Utility (MU); is the extra satisfaction a consumer realizes from an additional unit
of the product.

❖ Relation between Total and marginal utility

✓Marginal utility of a good is the change in total utility that results from the consumption of
one more unit of a product. It measures the slope of total utility curve.
∆𝑻𝑼
𝑴𝑼 =
∆𝑸
✓Total utility of a good measures the sum total of marginal utilities obtained from the
consumption of successive unit of the good.
Example: Lets consider a hypothetical example given in Table below.
Table: Total and marginal utility
Quantity Total Utility(TU) Marginal Utility(MU)

0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2
❖ Graphically, the relationship can be depicted as follows.

Figure. Total and Marginal Utility curves

❖ From the graph of TU and MU, the relationship can be summarized as;
✓ When TU is increasing, MU is positive.
✓ When TU is maximized, MU is zero.
✓ When TU is decreasing, MU is negative.
➢ Principle of the Law of diminishing marginal utility (LDMU)
✓ The principle holds that for a given time period, the greater the level of consumption of a
particular commodity, the lower the marginal utility.
➢ Equilibrium of the consumer under the Cardinalist Approach
✓ One commodity case and N-commodity case
➢ Weakness of the Cardinalist approach
✓ The assumption of cardinal (measurable) utility is doubtful.
✓ The assumption of constant marginal utility of money is also unrealistic.
❖ Derivation of Cardinalist demand curve (Class Work)
➢ The ordinal utility theory
❖ According to this approach utility is not measurable cardinally
(quantitatively) but can be ranked as 1st ,2nd ,3rd ,….
✓ It is possible to express utility in relative terms.
❖ The consumer need not know in specific units the utility of various
commodities to make his choice.
✓ It suffices for him to be able to rank the various baskets of goods
according to the satisfaction that each bundle gives him.
➢ It is also called the indifference curve approach
➢ Assumptions of ordinal utility theory
❖ Consumers are rational
❖ Utility is ordinal
❖ Diminishing marginal rate of substitution; It is the rate at which a
consumer is willing to substitute one commodity for another
commodity keeping his total satisfaction remains the same.
❖ Total utility of a consumer is measured by the amount (quantities)
of all items he/she consumes from his/her consumption basket.
❖ Consumer’s preferences are consistent and
❖ Transitivity axiom holds true
➢ Indifference set, curve and map
✓ Indifference curve (IC) – is a curve or a locus of points which represent various
combinations of two goods which give the same level of satisfaction so the
consumer is indifferent between any two bundles on the curve.
✓ Indifference set
✓ Indifference map

➢ Characteristics of indifference curves

✓ ICs slope downward from left to right
✓ ICs are convex to the origin
✓ ICs can never intersect each other
✓ The higher the IC from the origin represents high level of satisfaction
➢ Marginal Rate of Substitution (MRS)
❖ It is a rate at which one commodity can be substituted for another,
keeping the level of satisfaction constant.
❖ It measures the slope of an IC.
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒐𝒇 𝒀 𝒈𝒊𝒗𝒆𝒏 𝒖𝒑 ∆𝒀
𝑴𝑹𝑺𝑿𝒀 = =
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒐𝒇 𝑿 𝒈𝒂𝒊𝒏𝒆𝒅 ∆𝑿
❑ Derivation of MRS
✓ Conceptual derivation and
✓ Mathematical derivation
❖ The law of Diminishing MRS; It is reflected by the convex shape of the
indifference curve
➢ The Budget Line Analysis
❖ It is the set of the commodity bundles that can be purchased if the entire
income is spent.
❖ It is a graph which shows the various combinations of two goods that a
consumer can purchase given his/her limited income and the prices of
the two goods.
❖ The slope of a budget line is explained by the price ratio of the two goods.
✓ Slope (m) = Px/Py
❖ Budget set (BS) -a set of bundles that are affordable by the consumer at a
given price and income.
❖ Effects of change in price and income on the budget line;
✓ Shifting factors and
✓ Pivoting factors
➢ Examples of utility functions
✓ perfect substitutes
✓ perfect complements
✓ Quasilinear preferences
✓ Cobb-Douglas preferences
➢ Consumer equilibrium: Ordinal utility approach
✓ A consumer attains his equilibrium position when he maximizes his total
utility given his income and price of the commodities.
✓ Technically, the conditions that make the consumer in equilibrium are:
i. First order condition (Necessary condition); Slope of IC=Slope of BL
ii. Second order condition (Sufficient condition); Highest IC
✓ The highest IC must be tangent to the budget line
✓ Therefore, at the equilibrium point;
MRSx,y = Px/Py
❖ In figure, the equilibrium of the consumer is at point E, where the budget
line is tangent to the highest attainable indifference curve (IC2).
❖ Mathematically, To determine consumer’s optimum determined we can use;

1. The marginal (short-cut) approach and

2. The Lagrangian approach
➢ The marginal (short-cut) approach
✓ In this approach we use the marginal equilibrium analysis,
✓ Optimal values will be determined at the point where;
𝑴𝑼𝑿 𝑴𝑼𝒚
=
𝑷𝒙 𝑷𝒀

➢ The Lagrangian approach

✓ Given U=f(X,Y), income M and Px, Py as price of good X and Y, respectively;
❖ Equilibrium of the consumer will be determined based on the following steps; note that,
PxX+PyY=M is the budget equation.

i. Rewrite the budget equation as, PxX+PyY-M=0

ii. Multiply left-hand side of the above equation by the Lagrangian multiplier ( λ ),

iii. Subtract the above rewritten constraint from the utility function and construct the composite
function,

iv. Then maximize the composite function and find the optimal values of X, Y and λ

Use the FOC and SOC.

✓Interpretation of λ: λ is interpreted as the marginal utility of income (MUI), or the extra

satisfaction derived from having one more birr which is amounted to λ.
➢ Example:
✓ Consider a Cobb-Douglas utility function of the consumer having a given income of 120
birr and consuming only two commodities X&Y is given as; 𝑈𝑓(𝑋, 𝑌)=𝑋1/4 𝑌 3/4 , assuming
further that prices of X&Y are 3 birr and 5 birr respectively,
Then determine:
i. The consumer’s optimal bundles
ii. The marginal utility of income and interpret
iii. The portion of income that he spends on the consumption of the optimal bundles X&Y
respectively.
➢ Solution
✓ X=10units, Y=18units,
✓ λ =0.129units
✓ 30 and 90, respectively
➢ Effects of change in Income and price on consumer optimum point
✓ Effects of change in Income on Consumption
❖ ICC/IEP/IOC; a curve which is a locus of various consumer equilibrium points resulting
from changes in income, citrus paribus.
❖ Engle curve; a curve depicting the relationship between equilibrium quantity purchased
of a commodity and the level of income.
A. ICC and/or Engle curve for normal good B. ICC and/or Engle curve for inferior good

❖ Exercise: Derive and explain Engle curve for inferior goods.

➢ Effects of change in Income and price on consumer optimum point
✓ Effects of change in Price on Consumption
❖ PCC/PEP/POC; is a locus of equilibrium points on Indifference curves resulting from
changes in the price of a commodity.
❖ Demand curve; a curve depicting the relationship between equilibrium quantity
purchased of a commodity with a given price level.
A. PCC and/or Demand curve for normal goods B. PCC and/or Demand curve for Giffen goods
➢ Elasticity

✓ Measure of responsiveness of the dependent variable with a unit change in the independent
variable.
❑ Elasticity of Demand
A. Price elasticity of demand (𝑬𝒅 )
i. Point price elasticity of demand
ii. Arc price elasticity of demand
B. Income elasticity of demand (𝑬𝑰 )
i. Point income elasticity of demand
ii. Arc income elasticity of demand
C. Cross price elasticity of demand (𝑬𝒙𝒚 )
❑ Elasticity of supply
➢ Price elasticity of supply (𝑬𝒔 )
i. Point price elasticity of supply
ii. Arc price elasticity of supply