ECN 1100
Lecture 5
Purpose
The purpose of this presentation is to give an
introduction to the theory of consumer behaviour.
Learning Objectives
At the completion of this presentation you should be
able to have an understanding of:
• Utility and Budget Constraint.
• Indifference Curves.
• Producer and Consumer Surplus.
Theory of Consumer Behaviour
Last lecture, the law of demand was explained with
reference to consumer behavior. Within this lecture ,
diminishing marginal utility theory will be addressed
since this theory is key in explaining how consumers
allocate their income among many good and services
available to them.
Theory of Consumer Behaviour
Last lecture, the law of demand was explained with
reference to consumer behavior. Within this lecture ,
diminishing marginal utility theory will be addressed
since this theory is key in explaining how consumers
allocate their income among many good and services
available to them.
Consumer Choice and Budget
Constraint
A typical consumer exhibits certain attributes such as:
1) Rational Behaviour- The average consumer if a
rational person, that is he or she will try to dispose of
their income in such a way which derives the greatest
amount of satisfaction or utility from it. They want to
receive the most for their money or they want to
maximize total utility.
Consumer Choice and Budget
Constraint Cont’d
A typical consumer exhibits certain attributes such as:
2) Preferences- The average consumer has a
predisposition for various goods and services available
to them in the market. They have a good idea of how
much marginal utility they will get from successive
units of various products they might choose to
purchase.
Consumer Choice and Budget
Constraint Cont’d
A typical consumer exhibits certain attributes such as:
3) Budget Constraint- The average consumer is constrained
by the amount of money income available to them.
4) Prices- Goods and services available to consumers have
price tags on them because they are scarce in relation to the
demand for them. That is, their production entails the use of
scarce resources. Similarly, the consumer is constrained by
their income and as such can only buy a limited amount of
goods and services. Thus the concept of scarcity for the
consumer is embodied within the fact after the consumer
exhausts their limited money income and can no longer buy
anything else.
Theory of Utility
Utility or Utils is defined as the level of satisfaction or
happiness associated with the consumption of a good or
service.
Implied in the first characteristic is the fact that utility is
subjective. The utility of a specific product may vary
widely from person to person. A “jacked-up” truck may
have great utility to someone who drives off-roading but
little utility to someone too old to climb into the rig.
Eyeglasses have tremendous utility to someone who has
poor eyesight but no utility at all to persons like with
20/20 vision.
Theory of Utility
Total Utility- is the total amount of satisfaction or
pleasure a person derives from consuming some specific
quantity.
Marginal Utility- is the additional satisfaction a
consumer derives from consuming an additional unit of a
product. Alternatively, we can say that marginal utility is
the change in total utility that results from the
consumption of 1 more unit of a product.
Calculating Marginal Utility
Mu= change in Tu / change in quantity
Where;
Mu= Marginal Utility
Tu= Total Utility
Calculating Marginal Utility
Theories of Utility
Cardinal Approach- Quantify the Utility
1) Diminishing Marginal Utility
2) Equi marginal Utility
Ordinal Approach- Ranked in order of Preference (Non
Quantification)
1) Indifference Curve Analysis
The Law of Diminishing Marginal
Utility
For any good or service, the marginal utility of that good
or service decreases as the quantity of the good increases.
The law of diminishing marginal utility states that the
additional satisfaction derived from consuming a
particular good declines as more and more of the good is
consumed in a given time period ceteris paribus.
The Law of Diminishing Marginal
Utility
Starting at the origin (from the graph or table), we observe that each
of the first 5 units increases total utility (TU) but by a diminishing
amount. Total utility reaches a maximum with the addition of the
sixth unit and then decline. So in the graph and table above we find
that marginal utility (MU) remains positive but diminishes through
the first 5 units (while total utility increases but at a decreasing
rate).
Marginal utility is zero for the sixth unit (because that unit doesn’t
changes total utility). Marginal utility then becomes negative with
the seventh unit and beyond (because total utility is falling).
The Law of Diminishing Marginal
Utility
Total Utility
35
30
25
20 Total Utility
15
10
5
0
1 2 3 4 5 6 7 8
Marginal Utility
12
10
8
6 Marginal Utility
4
2
0
1 2 3 4 5 6 7
-2
-4
Utility Maximization Rule
To maximize satisfaction, the consumer should allocate
his or her money income so that the last dollar spent on
each product yield the same amount of extra (marginal)
utility. We call this the utility maximizing rule. When the
consumer has balanced his or her margins using the rule,
there is no incentive to alter the expenditure pattern.
Utility Maximization Rule
The consumer is in equilibrium and would be worse off if there
were any alteration in the bundle of goods purchased, providing
there is no change in taste, income, products or prices.
Utility Maximizing Rule:
Mux= Muy = Mun
Px P y P n
MU of product x/ price of x = MU of product y/ Price of y…MU
of product n/ Price of n
Utility Maximization:
Cardinalist Approach
The cardinalist states that the utility wherein the satisfaction derived by the
consumers from the consumption of good or service can be measured numerically.
Which gives the equation for utility maximization:
Mux= Muy = Mun
Px Py Pn
MU of product x/ price of x = MU of product y/ Price of
y…MU of product n/ Price of n
Utility Maximization:
Cardinalist Approach
Amy has an income of $10 and
she can consume two goods, A
and B. A has a price of $1 and B
has a price of $2. Given marginal
utility for the two goods, as
reflected in the table below, what
combinations of the two goods
would maximize Amy’s total
utility?
I = PA(A) + PB(B)
Utility Maximization:
Cardinalist Approach
Cardinalist Approach ( good A = $1, good B = $2)
Utility Maximization:
Cardinalist Approach
Cardinalist Approach ( good A = $1, good B = $2)
Total to spend =$10
Utility Maximization:
Cardinalist Approach
From the table above, the utility maximizing combination of
goods attainable by John is 2 units of A and 4 units of B
Note that the marginal utility per dollar for both products is
equal to 8. By summing the marginal utility information
from column 2 and column 4, we find that John is obtaining
18 (10+8 =18) utils of satisfaction from 2 units of product A
and 78 (24+20+18+16=78) utils of satisfaction form the 4
units of B. His 10 dollars optimally spent (1*2 + 2*4 =
10), yielding 96 utils of satisfaction (18+78 =96).
Utility Maximization:
Cardinalist Approach
To maximize utility using the cardinalist approach you must
look to see where the marginal utility per dollar ratio is equal
for the both goods.(in this case both Good A and Good B)
MUA/PA = MUB /PB
Where these ratios are equal, look at the first column to see
what units corresponds.
You may see that there are a number of places where the
marginal utility to price ratio are the same but you must be
careful what you choose.
Utility Maximization:
Cardinalist Approach
Places where we have the same utility price ratio are as
follows:
MUA/PA = 10 MUB/PB=10
MUA/PA = 8 MUB/PB = 8
MUA/PA = 6 MUB/PB = 6
MUA/PA = 3 MUB/PB =3
But what pair should we choose?
Utility Maximization:
Cardinalist Approach
We should choose the pair which has the unit combination that will
allow us to spend all of our income.
Income Constraint Identity
I= PA(A) + PB(B)
I = Pricea (quantiy of good A) + Priceb (quantiy of good B)
Given the income function I = $1(A) + $2(B) >>> Our income is
$10. So whatever units we choose must be substituted to give us $10.
Utility Maximization:
Cardinalist Approach
I= PA(A) + PB(B)
MUA/PA = 10 MUB/PB=10 >>>> $1(1) + $2(2) = $5
MUA/PA = 8 MUB/PB = 8 >>>> $1(2) + $2(4) = $10
MUA/PA = 6 MUB/PB = 6 >>>> $1 (4) + $2 (5) = $14
MUA/PA = 3 MUB/PB =3 >>>> $1 (7) + $2 (6) = $19
Therefore the consumer will maximize utility once he/she
consumes 2 units of good A and 4 units of good B.
Utility Maximization
Ordinalist Approach
The ordinalist states that the satisfaction which a
consumer derives from the consumption of product or
service cannot be measured numerically. Preferences are
ranked in order of the satisfaction derived from the
consumption of a good or service. For example paying
rent vs buying a dress.
Utility Maximization
Ordinalist Approach
The ordinalist states that the satisfaction which a
consumer derives from the consumption of product or
service cannot be measured numerically. Preferences are
ranked in order of the satisfaction derived from the
consumption of a good or service. For example paying
rent vs buying a dress.
Indifference Curves Analysis
A market basket is a collection of one or more commodities.
One market basket may be preferred over another market
basket containing a different combination of goods.
Three Basic Assumptions
1) Preferences are complete.
2) Preferences are transitive.
3) Consumers always prefer more of a good to less.
Consumer Choice and Budget
Constraint Cont’d
Consumer Choice and Budget
Constraint Cont’d
Properties of Indifference Curves
1) Its always downward or negatively sloped because more of one
product means less of the other if total utility is to remain
unchanged.
2) Indifference curves are convex to the origin
3) Indifference curves never intersect
4) A higher indifference curve represents a higher level of total
utility.
5) The slope of the indifference curve is called the Marginal
Rate of Technical Substitution (MRS) of good x for good y.
That is, exchanging one good for the other.
Indifference Map
Each indifference curve in the map shows the market
baskets among which the person is indifferent.
Market basket A
is preferred to B.
Market basket B is
preferred to D.
Indifference Curves
Marginal rate of Technical
Substitution
The marginal rate of substitution (MRS) quantifies the
amount of one good a consumer will give up to obtain
more of another good.
It is measured by the slope of the indifference curve.
Along an indifference curve there is a diminishing
marginal rate of substitution.
MRS= Mux / Muy
Marginal rate of Technical
Substitution
MRS= Mux / Muy
Extreme Examples of Indifference
Curves
Perfect Substitutes and Perfect Complements
Two goods are perfect substitutes when the marginal rate
of substitution of one good for the other is constant. For
example bottles used in packaging.
Two goods are perfect complements when the indifference
curves for the goods are shaped as right angles. Laptops
and chargers.
Extreme Examples of Indifference
Curves
The Budget Constraint
Preferences do not explain all of consumer behavior.
Budget constraints also limit an individual’s ability to
consume in light of the prices they must pay for various
goods and services.
The Budget Line: indicates all combinations of two
commodities for which total money spent equals total
income. Combinations below or on the budget line are
affordable.
The budget lie is downward sloping.
The slope of the budget line is called the relative price
ratio that is, the price of one commodity in terms of
another.
The Budget Constraint
Let F equal the amount of food purchased, and C is the
amount of clothing.
If the price of food = Pf and price of clothing = Pc,
then Pf x F is the amount of money spent on food, and Pc
x C is the amount of money spent on clothing.
P FF P C C I
The Budget Constraint
P FF P C C I
The Slope of the Budget Constraint
The Budget Line
As consumption moves along a budget line from the
intercept, the consumer spends less on one item and more
on the other.
The slope of the line measures the relative cost X2 and X1
= the negative of the ratio of the prices of the two goods.
That is Income over price Y=I/ Px
The slope indicates the rate at which the two goods can be
substituted without changing the amount of money spent.
The Slope of the Budget Line
UTILITY MAXIMISATION
Ordinalist Approach
PF
Clothing
(units per MRS
week)
40
At market basket A
the budget line and the
indifference curve are
PC
tangent and no higher
level of satisfaction
can be attained.
30 The ordinalist states
that the satisfaction
A which a consumer
20 At A:
MRS =Pf/Pc = .5 derives from the
consumption of
U2
product or service
Budget Line
cannot be measured
numerically.
0 20 40 80 Food (units per week)
Changes in Prices and the Budget
line
When price changes the budget line does not shift it
pivots.
Changes in Prices and the Budget
line
Price Price
increase decrease
of good of good Y
Y
Price
Price
decrease
increase of
of good x
good x
Changes in Income and the Budget
line
When income changes the budget line shift either inwards
or outwards.
Derivation of an Individual Demand
Curve
Consumer Surplus
Producer Surplus
Consumer and Producer Surplus
Calculating Consumer and Producer
Surplus
Class Exercise
Clarisse spends her income of $24 on two goods, W and
V. W sells for $3 and V sells for $2.
Draw the budget constraint to show how Clarisse can
spend her money on the two goods.
Calculate the slope of the budget line.
If the price of V reduces by $1 what will happen to the
budget line?
If the price of W increases by $1 what will happen to the
budget line?
Class Exercise
Formula: Quantity on any axis = Income/Price
W = $24/$3 = 8 units
V = $24/$2 = 12 units
Good V
12
8 Good W
Class Exercise
The slope of the line can be derived using two methods:
1. Quantities = change in good V(rise) / change in good W
(run)
= -12/8
= - 3/2
2. Prices = -Pw /Pv
= -3/2
Class Exercise
Since the price of V changed from $2 to $1, we still
have to recalculate the units which can be consumed
before we show the effect on the budget line.
V = $24/$1
Good V= 24 units
24
12
8 Good W
END
