Theory of Consumer Behavior

Utility

• Utility is the benefits consumers obtain from the goods and

services they consume.
• Consumer preferences can be represented as a utility
function. A utility function shows an individual’s perception of
the level of utility that would be attained from consuming
each conceivable bundle or combination of goods and
services. A simple form of a utility function for a person who
consumes only two goods, X and Y, might be
U = f (X, Y)
• Ex: U = f (20,30) > U = f (15,32)
 Cardinal vs. Ordinal Utility
• There are two different schools of thought regarding the
measurability of utility. Some argue that utility can be cardinally
measured and others disagree, who rather advocate ordinal utility.
William Stanley Jevons, Léon Walras and Alfred Marshall were the
principal proponents of cardinal theory of utility. Although
outdated, cardinal measure of utility builds the basis of the law of
demand. Downward sloping demand curve underlies the law of
diminishing marginal utility- which is one of the prime provisos of
cardinal utility theory.
• Among others, John Hicks and Roy Allen were the leading
contributors in the field of ordinal theory of utility. Ordinalists
believe that utility can’t be measured, can only be compared. For
example, an individual can say that his utility from the consumption
of an apple is greater than utility from an orange. Cardinalists, on
the other hand, opine that individual knows for certain- how much
utility is obtained from the consumption of an apple or an orange.
 Total Utility and Marginal Utility

• Amount of satisfaction obtained from the consumption of a

certain quantity of a good or a service is called total utility
(TU). Unit of measurement of total utility is util.
• Change in total utility due to one unit change in consumption
is called marginal utility (MU).
• Suppose total utility, U = f(q), where q stands for quantity of
consumption ;
• Marginal utility, MU = Slope of Total utility = dU/dq
 Total Utility and Marginal Utility

Unit Total Utility Marginal Utility

1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2
 Law of Diminishing Marginal Utility

• Law of diminishing marginal utility states that marginal utility

decreases with successive increase in consumption. Total
utility, in the beginning, increases with consumption and once
it falls but marginal utility always falls. Total utility curve is
therefore inverse ‘U’-shaped and marginal utility curve slopes
downward.
Law of Diminishing Marginal Utility
 Consumer Surplus

• Consumer surplus is the amount a buyer is willing to pay for a

good minus the amount the buyer actually pays for it.
 Producer Surplus

• Producer surplus is the amount a seller is paid for a good

minus the seller’s cost of providing it.
Consumer and Producer Surplus in Market
Equilibrium
 Indifference curve

• A fundamental tool for analyzing consumer behavior is an

indifference curve, which is a set of points representing
different combinations of goods and services, each of which
provides an individual with the same level of utility. Therefore,
the consumer is indifferent among all combinations of goods
shown on an indifference curve
 Indifference curve: Properties

• A fundamental tool for analyzing consumer behavior is an

indifference curve, which is a set of points representing
different combinations of goods and services, each of which
provides an individual with the same level of utility. Therefore,
the consumer is indifferent among all combinations of goods
shown on an indifference curve. Properties of Indiffernece
curves are:
1. Indifference curve slopes downward to the right.
2. Indifference curve is convex to the origin.
3. Indifference curves do not intersect each other.
4. Higher indifference curve represents higher utility.
Indifference curve
Indifference Maps
 Marginal rate of Substitution (MRS)

• The marginal rate of substitution (MRS) measures the

number of units of Y that must be given up per unit of X
added so as to maintain a constant level of utility.
• The consumer is indifferent between combinations A (10X and
60Y) and B (20X and 40Y). Thus, the rate at which the
consumer is willing to substitute is
∆Y/∆X =( 60-40)/(10-20) = -2
MRS = -∆Y/∆X = MUx/MUy = 2
• The marginal rate of substitution is 2, meaning that the
consumer is willing to give up two units of Y for each unit of X
added.
Marginal rate of Substitution (MRS)
Different Shape of Indifference Curves
 Budget Line

• Budget line is the line showing all bundles of goods that can
be purchased at given prices if the entire income is spent.
• The relation between income (M) and the amount of goods X
and Y that can be purchased can be expressed as
M = PxX + PyY
• Ex: $5X + $10Y = $1,000
Budget Line
Shifting the Budget Line
 Consumer’s Equilibrium: Utility Maximization

• A consumer achieves equilibrium if it can maximize utility by

spending a given amount of money income.
• Consumer’s equilibrium under indifference curve theory
requires two conditions to be fulfilled.
1. Budget line is tangent to indifference curve. This implies,
slope of indifference curve = slope of budget line
2. At the point of tangency indifference curve should be convex
to the origin. Convexity of indifference curve underlies
diminishing MRS. Therefore diminishing MRS is termed as the
sufficient condition of consumer’s equilibrium.
Consumer’s Equilibrium: Utility Maximization
Price Effect: Shift in Equilibrium
Income and Substitution Effect
Income and Substitution Effect
Decomposition of Income and Substitution Effect
 Exercises

• Ex-1: Assume the utility function, U = 100q – q2. Find

marginal utility and draw the marginal utility function.
• Ex-2: A consumer consumes only two goods X and Y, and has a
utility function given by U(X,Y)=2XY. Find the marginal utility
function of X and Y. Find the marginal rate of substitution
(MRS).
• Ex-3: If Px=2 and Py=4 and the consumer's income is 16. Draw
the budget line.
 Warning!

• Never use these slides as a substitute of your Managerial

Economics text books.
• These slides should help to keep you on track, as a guiding
assistance of reading text books that has come to you along
with these slides.
• Please use the relevant sections of the following text books in
reading the slides.
• Microeconomics- N. Gregory Mankiw
• Microeconomics-Michael Parkin
• Managerial Economics- Christopher R. Thomas & S. Charles
Maurice.