MICROECONOMIC

S
UNIT- II
By: Ms. Saima

This Photo by Unknown Author is licensed under CC BY

Theory of Consumer
Behaviour
 Consumer Behavior
• The consumer is a central entity in the business economics and
environment.
• A consumer is an influential stakeholder who spends part of
his/her limited income on goods and services to satisfy his/her
needs.

• Consumer behavior is best understood in three distinct steps:

1. Consumer preferences

2. Budget constraints

3. Consumer choices
• 1. Consumer Preferences: The first step is to find a practical way to describe the
reasons people might prefer one good to another. We will see how a consumer’s
preferences for various goods can be described graphically and algebraically.
• 2. Budget Constraints: Of course, consumers also consider prices. In Step 2,
therefore, we take into account the fact that consumers have limited incomes
which restrict the quantities of goods they can buy. What does a consumer do in
this situation? We find the answer to this question by putting consumer
preferences and budget constraints together in the third step.
• 3. Consumer Choices: Given their preferences and limited incomes, consumers
choose to buy combinations of goods that maximize their satisfaction. These
combinations will depend on the prices of various goods. Thus, understanding
consumer choice will help us understand demand—i.e., how the quantity of a
good that consumers choose to purchase depends on its price.
 CONSUMER PREFERENCES
Market Basket or Bundle
● List with specific quantities of one or more goods.

TABLE Alternative Market Baskets

Market Basket Units of Food Units of Clothing

A 20 30
B 10 50
D 40 20
E 30 40
G 10 20

H 10 40

To explain the theory of consumer behavior,

we will ask whether consumers prefer one
market basket to another.
 CONSUMER PREFERENCES
Some Basic Assumptions about Preferences
1.Completeness: Preferences are
assumed to be complete. In other
words, consumers can compare and
rank all possible baskets. Thus, for
any two market baskets A and B, a
consumer will prefer A to B, will prefer
B to A, or will be indifferent between
the two.

Note that these preferences ignore

costs. A consumer might prefer steak
to hamburger but buy hamburger
because it is cheaper.
Some Basic Assumptions about Preferences

2.Transitivity: Preferences are transitive. Transitivity means

that if a consumer prefers basket A to basket B and basket B
to basket C, then the consumer also prefers A to C.
Transitivity is normally regarded as necessary for consumer
consistency.
 Some Basic Assumptions about Preferences

3.More is better than less

(Non-satiety): Goods are
assumed to be desirable—
i.e., to be good.
Consequently, consumers
always prefer more of any
good to less. In addition,
consumers are never
satisfied or satiated; more is
always better, even if just a
little better.
THEORIES OF CONSUMER
BEHAVIOUR
■ Theory of consumer behavior explains how consumers allocate their
income among different goods and services to maximize their well-being.
■ In practice, there are two theories that explain consumer behavior. These
include
1. The cardinal utility theory
2. The ordinal utility theory
 The cardinal utility theory

⮚ Utility simply refers to amount of satisfaction a

consumer obtains from consumption /possession/use of
a good or a service.
⮚ Alfred Marshal believed that utility is cardinally
measured. It implies that utility can be assigned a
cardinal number like 1,2,3
⮚ It was further assumed that one util (measure of
satisfaction) equals one unit of money.
THE ORDINAL APPROACH (I.C)

⮚ This approach abandons the assumption that utility is

measurable in numerical terms.
⮚ Instead, the consumer is faced with a number of baskets
(goods) from which he/ she can express preference by way
of ranking.
⮚ The basic tool of analysis is an “indifference curve”. An
indifference curve refers to a locus of points showing
different combinations of two commodities that yield the
same level of satisfaction to a consumer.
 Utility
• The value a consumer places
on a unit of a good or service
depends on the pleasure or
satisfaction he or she expects
to derive form having or
consuming it at the point of
making a consumption
(consumer) choice.

• In economics the satisfaction

or pleasure consumers derive
from the consumption of
consumer goods is called
“utility”. It is the “want
satisfying power” of the
commodity.
 Utility
• Consumers, however, cannot have every
thing they wish to have. Consumers’
choices are constrained by their incomes.

• Within the limits of their incomes,

consumers make their consumption
choices by evaluating and comparing the
available consumer goods with regard to
their “utilities.”
How to Measure Utility
Measuring utility in “utils” (Cardinal):
• Jack derives 10 utils from having one slice of pizza
• but only 5 utils from having a burger.

Measuring utility by comparison (Ordinal):

• Joy prefers a burger to a slice of pizza and a slice of pizza to a hotdog.

Often consumers are able to be more precise in expressing their preferences.
For example, we could say:

• Joy is willing to trade a burger for four hotdogs but he will give up only two hotdogs for a slice of pizza.

• We can infer that to Joy, a burger has twice as much utility as a slice of pizza, and a slice of pizza has twice as much
utility as a hotdog.
 Utility and Money
• Because we use money (rather than hotdogs!) in just about
all of our trade transactions, we might as well use it as our
comparative measure of utility.
(Note: This way of measuring utility is not much different
from measuring utility in utils)
• Joy could say: I am willing to pay $4 for a burger, $2 for a
slice of pizza and $1 for a hotdog.
Note: Even though Joy obviously values a burger more (four
times as much) than a hot dog, he may still choose to buy a
hotdog, even if he has enough money to buy a burger, or a
slice of pizza, for that matter.
 Total Utility Vs Marginal Utility
• Marginal utility is the utility a consumer
derives from the last unit of a consumer
good she or he consumes (during a given
consumption period), ceteris paribus.

• Total utility is the total utility a consumer

derives from the consumption of all of the
units of a good or a combination of goods
over a given consumption period, ceteris
paribus.
Total utility = Sum of marginal utilities
The Law of Diminishing Marginal Utility

• Over a given consumption period, the

more of a good a consumer has, or has
consumed, the less marginal utility an
additional unit contributes to his or her
overall satisfaction (total utility).

• Alternatively, we could say: over a given

consumption period, as more and more
of a good is consumed by a consumer,
beyond a certain point, the marginal
utility of additional units begins to fall.
TU and MU
1. TU increases so long as MU is
more than zero
2. TU is at maximum when MU is
zero
3. TU starts declining when MU
becomes negative
CONSUMER EQUILIBRIUM THROUGH UTILITY
ANALYSIS
Consumer equilibrium through utility analysis is based on following set of assumptions:
1. Rationality: The consumer is rational. He aims at the maximization of his utility subject to
the constraint imposed by his given income. He measures, compares and chooses the
best option in order to maximise his utility.
2. Cardinal measurement of utility: Utility can be measured in quantifiable terms.
3. Marginal utility of money is constant: It is assumed that utility is measured in terms of
money and utility of money does not change. This assumption is necessary if the
monetary unit is used as the measure of utility. The essential feature of a standard unit of
measurement is that it be constant.
4. Fixed income and prices: It is assumed that income of the consumer and prices of goods
remain constant.
5. Constant tastes and preferences: It is assumed that taste and preferences of the
consumer remain same.
1) Consumer equilibrium-One commodity
case
• A consumer, when consuming a single commodity (say x) will be at equilibrium
when: Marginal Utility (MUx) is equal to Price (Px) paid for the commodity.
MUx = Px
• If MUx > Px, then the consumer will not be at equilibrium and he continues to
purchase the commodity as the benefit gained from the consumption is more
than the cost of the commodity. As the consumer buys more, Marginal Utility
falls because of the Law of DMU, and when it becomes equal to the price, the
consumer gets maximum satisfaction and is said to be in equilibrium.
• Similarly, if MUx < Px, then also the consumer will not be at equilibrium and he
will have to reduce the consumption of the commodity in order to increase the
satisfaction level, till MU becomes equal to the price.
For example:
Let’s assume, a consumer wants to buy a good (say x), of price ₹10 per unit and the marginal
utility derived from each successive unit (in utils and in ₹) is as follows (let’s assume that 1
util/MU = ₹1):
M
Marginal
Price (Px) Marginal Utility
Units of x Utility MUx – Px Remarks
( ₹) in ₹ (MUx)
(Utils)
1 util = ₹1
1 10 30 30/1 = 30 20 Here, MUx > Px,
so the
consumer
2 10 20 20/1 = 20 10 will increase the
consumption
Consumer’s
3 10 10 10/1 = 10 0 Equilibrium
MUx = Px

4 10 0 0/1 = 0 -10 Here, MUx < Px,

so the
consumer
5 10 -10 -10/1 = -10 -20 will decrease
the
• With the help of the above schedule, it can be said that the consumer will be at
equilibrium at point E, when he consumes 3 units of commodity x because at that
point MUx = Px.
• The consumer will not consume 4 units of the commodity x because the MU of
₹0 is less than the price paid for x; i.e., ₹10. Similarly, he will not consume 2 units
of the commodity x because the MU of ₹20 is more than the price paid for x; i.e.,
₹10.
• Hence, in conclusion, it can be said that a consumer consuming a single
commodity (say x) will be at equilibrium when the Marginal Utility from the
commodity (MUx) is equal to the price paid for the commodity (Px).

MU in terms of money=Price
(i.e., MU of a product/MU of a rupee=Price)
• If price of a mango is ₹1 per piece, how many mangoes will a
consumer buy to attain the level of equilibrium? Suppose MU of a
rupee is 2 utils.
Units consumed MU
0 -
1 10
2 8
3 5
4 2
5 1
6 0
2) Consumer
equilibrium in
Multi-
commodity
case:
 To reach the equilibrium, consumer should
purchase that combination of both the goods,
when:
a) MU of last rupee spent on each commodity
is same; and
b) MU falls as consumption increases.

Suppose, total money income of a consumer is 5 which he wants to spend on two goods ‘x’ and ‘y’. Both
these commodities are priced at Re. 1 per unit.
Equilibrium happens when consumer buys 3 units of ‘x’ and 2 units of ‘y’ because:
a) MU from last rupee (i.e. 5th rupee) spent on commodity y gives the same satisfaction of 8 utils as given
by last rupee (i.e. 4th rupee) spent on commodity x; and
b) MU of each commodity falls as consumption increases.

The total satisfaction of 47 utils will be obtained when consumer buys 3 units of ‘x’ and 2 units of ‘y’. It
reflects the state of consumer’s equilibrium. If the consumer spends his income in any other order, total
satisfaction will be less than 47 utils.
Ordinal Utility Analysis
• Cardinal utility analysis is simple to understand, but suffers from a
major drawback in the form of quantification of utility in numbers. In
real life, we never express utility in the form of numbers.
• At the most, we can rank various alternative combinations in terms of
having more or less utility.
• In other words, the consumer does not measure utility in numbers,
though she often ranks various consumption bundles. This forms the
starting point of this topic – Ordinal Utility Analysis.
 Preferences:
What the Consumer Wants
A consumer’s preference among
consumption bundles may be illustrated
with indifference curves.

An indifference curve shows bundles of goods that make the

consumer equally happy. An indifference curve is a curve
that represents all the combinations of goods that give the
same satisfaction to the consumer.
Since all the combinations give the same amount of
satisfaction, the consumer prefers them equally. Hence the
name indifference curve.
Indifference Schedule
A table or a schedule that shows
different combinations of two goods
giving the same level of satisfaction to
the consumer is known as an
Indifference Schedule. An indifference
schedule is used to plot the different
combinations of two goods on a graph
for the formation of an indifference
curve.

Peter has 1 unit of food and 12 units of

clothing. Now, we ask Peter how many
units of clothing is he willing to give up
in exchange for an additional unit of
food so that his level of satisfaction
remains unchanged.
Any combination lying on this curve gives the
same level of consumer satisfaction. Another
name for it is Iso-Utility Curve.

The consumer is indifferent, or equally happy,

with the combinations shown at points A, B, and C
because they are all on the same curve.

Note: the good that is sacrificed is taken on y-axis

and the good that is gained is taken on x-axis
while drawing the indifference curve.
Indifference Map
An Indifference Map is a set of Indifference
Curves.
We know that a consumer is indifferent
among the combinations lying on the same
indifference curve. However, it is important
to note that he prefers the combinations on
the higher indifference curves to those on
the lower ones.
This is because a higher indifference curve
implies a higher level of satisfaction.
Therefore, all combinations on IC1 offer the
same satisfaction, but all combinations on
IC2 give greater satisfaction than those on
IC1.
The Marginal Rate of Substitution

The slope at any point on an indifference curve is the marginal rate of

substitution.
It is the rate at which a consumer is willing to substitute one good for
another so that total satisfaction of the consumer remains the same.
MRS of A for B will be number of units of B that a consumer is willing to
sacrifice for an additional unit of A so as to maintain the same level of
satisfaction.
MRSA,B = Units of B willing to sacrifice
Units of A willing to gain
For example, a consumer must choose between clothing and food. To
determine the marginal rate of substitution, the consumer is asked what
combinations of clothing and food provide the same level of satisfaction.
In this example, Peter initially gives up 6 units of clothing to
get an extra unit of food. Hence, the MRS is 6. Similarly, for
subsequent exchanges, the MRS is 2 and 1 respectively.
Therefore, the MRS of X for Y is the amount of Y whose loss
can be compensated by a unit gain of X, keeping the
satisfaction the same.

Interestingly, as Peter accumulates more units of food, the

MRS starts falling – meaning he is prepared to give up
fewer units of clothing for food.

• As Peter gets more units of food, his intensity of desire

for additional units of food decreases.
• Most of the goods are imperfect substitutes for one
another. If they could substitute one another perfectly,
then MRS would remain constant.
An indifference curve exhibits a
diminishing marginal rate of
substitution:

1. The more of good x you have, the more

you are willing to give up to get a little
of good y.

2. The indifference curves

• Get flatter as we move out along the
horizontal axis
• Get steeper as we move up along
the vertical axis.

39
Properties of Indifference Curves

✔Higher indifference curves are preferred to lower ones.

✔ Indifference curves are downward sloping.

✔ Indifference curves do not cross.

✔ Indifference curves are Convex to the Origin.

 Property 1: Higher indifference curves are
preferred to lower ones.

●Consumers usually prefer

more of something to less of
it.

●Higher indifference curves

represent larger quantities of
goods than do lower
indifference curves.
Property 2: Indifference curves are downward sloping.

●A consumer is willing to give up one good only if he or she

gets more of the other good in order to remain equally
happy.

●If the quantity of one good is reduced, the quantity of the

other good must increase.

●For this reason, most indifference curves slope

downward.
 Property 3: Indifference curves do not cross.

As two indifference curves

cannot represent same level of
satisfaction, they cannot intersect
each other.

At IC1, A=B
At IC2, A=C
Therefore B should be equal to C
which is not possible.
Property 4: Indifference curves are bowed inward.
● People are more willing to
Quantit
yof
trade away goods that they
Pepsi
14
have in abundance and less
willing to trade away goods of
MRS = which they have little.
6
8 A
1

4 MRS = 1 B
3 Indifferenc
1
e curv
e
0 2 3 6 7 Quantit
yof
Pizza
Perfect Substitutes

Pepsi

I1 I2 I3
0 1 2 3 Coke
Perfect Complements

Lef
Shoe
t
s

I2
7
5 I1

0 5 7 Right Shoes
 The Budget Line
●The budget line depicts the consumption “bundles” that
a consumer can afford.

●It is the graphical presentation of all the bundles of 2 goods

which a consumer can actually buy with his entire income at
the prevailing market prices.
●People consume less than they desire because their spending is
constrained, or limited, by their income.

●Equation:
All the combinations in the positive quadrant,
which lie on or below the budget line are called
a budget set.
The Consumer’s Budget Line
● The slope of the budget line equals the relative price of the two goods,
that is, the price of one good compared to the price of the other.
● It measures the rate at which the consumer will trade one good for the
other.

Gain
Sacrifice
Properties of budget line

• Budget line is downward sloping:

It slopes downwards as more of one good can be bought by decreasing
some units of the other good
• Budget line is a straight line:
Slope of budget line is represented by the price ratio. As price ratio is
constant throughout. the budget line is a straight line.
A shift in Budget Line

• Shift due to change in price: The amount of the product either increases or
decreases from time to time. For instance, if the price and income of product A
remains constant and the price of product B decreases, then the buying potential
of product B automatically increases. Similarly, if the price of B increases and the
other factors remain steady, the demand for product B automatically decreases.

• Shift due to change in income: Change in income makes a huge difference that
leads to a change in the budget line. High income means high purchasing
possibility and low income means low purchasing potential, making the budget
line to shift.
• Change in price of both the commodities
Consumer’s equilibrium through indifference curve analysis
• In the above graph, IC1, IC2, and IC3 are three
indifference curves, and AB is the budget line.
The highest indifference curve that a consumer
can reach with the budget line’s constraint is
IC2. The budget line AB is tangent to the
indifference curve IC2 at point E. This point is
the point of equilibrium, where the consumer
buys OM quantity of Good X and ON quantity
of Good Y.
• The other points, i.e., F and G to the left or right
of point E lie on the lower indifference curve
IC1, indicating a lower level of satisfaction.
Also, as the budget line can be tangent to only
one indifference curve, the consumer maximises
his level of satisfaction at point E when he
meets both conditions of the consumer’s
equilibrium.
How Changes in Income Affect the
Consumer’s Choices

● An increase in income shifts the budget line outward.

● The consumer is able to choose a better combination of
goods on a higher indifference curve.
An Increase in Income...
Quantit
New budget line
yof
Pepsi
1. An increase in income shifts
the budget line outward…

New
optimum
3. …and Pepsi Initial
consumption. optimum
I2
Initial
budget line
I1
0 Quantit
2. …raising pizza consumption… yof
 How Changes in Prices Affect
Consumer Choices
A fall in the price of any good rotates
the budget constraint outward and
changes the slope of the budget line.
 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt,
Inc.

A Change in Price...
Quantity
of Pepsi
1,000 New budget
constraint

New 1. A fall in the price of Pepsi

optimum rotates the budget constraint
500 outward…
3. …and
raising Pepsi
consumption. I2

Initial budget I1
constraint
0 100 Quantity of
Pizza
2. …reducing pizza consumption…
• Price effect: price effect can be defined as the change in quantity demanded of a commodity
as a result of a change in its price. This change in quantity demanded takes place through the
substitution effect and income effect simultaneously.

• Substitution effect: as the price of a commodity falls, it becomes cheaper in comparison to

other commodities. Therefore, consumers will buy more of the commodity as it is relatively
cheaper compared to other goods that are expensive. This increase in quantity demanded
due to a change in relative price is called the substitution effect. The substitution effect is
always positive, but, its magnitude depends on the nature and type of commodity.

• Income effect: with a fall in the price of a commodity, purchasing power of the consumer
increases. He or she can buy the same quantity of commodity with less income spent. In the
case of normal goods, the income effect is positive as the quantity demanded of commodity
increases with an increase in income. However, the income effect is negative for inferior
goods because consumers prefer to buy other goods as their real income rises.

Price effect = substitution effect + income effect

Price Effect

• The price effect is a concept that looks at the effect of market prices on consumer demand. In
general, when prices rise, buyers will typically buy less and vice versa when prices fall. This is
demonstrated by a standard price to demand curve.
• Price-consumption curve is a graph that shows how a consumer's consumption choices
change when price of one of the goods changes. The price-consumption curve (PCC) indicates
the various amounts of a commodity bought by a consumer when its price changes.
Downward sloping price
consumption curve for good
X means that as the price of
good X falls, the consumer
purchases a larger quantity
of good X and a smaller
quantity of good Y.
• Upward-sloping price
consumption curve for X
means that when the price
of good X falls, the
quantity demanded of
both goods X and Y rises.
• Price consumption curve
for a good can take
horizontal shape too. It
means that when the price
of the good X declines, its
quantity purchased rises
proportionately but
quantity purchased of Y
remains the same.
• When good X is giffen good
and Y is normal good.
• Backward-sloping price
consumption curve for good
X indicates that when price of
X falls, after a point smaller
quantity of it is demanded.
This is true in case of
exceptional type of goods
called Giffen Goods.
• But it is rarely found that price
consumption curve slopes downward
throughout or slopes upward
throughout or slopes backward
throughout. More generally, price
consump­tion curve has different slopes
at different price ranges. At higher price
levels it generally slopes downward, and
it may then have a horizontal shape for
some price ranges but ultimately it will
be sloping upward.
 INCOME AND SUBSTITUTION EFFECTS

A fall in the price of a good has two implications:

1. Consumers will tend to buy more of the good that has

become cheaper and less of those goods that are now
relatively more expensive.

2. Because one of the goods is now cheaper, consumers

enjoy an increase in real purchasing power.
 Income and Substitution Effects
●A price change has two effects on consumption.
●An income effect
●A substitution effect

● The income effect is the change in consumption that

results when a price change moves the consumer to a
higher or lower indifference curve.
● The substitution effect is the change in consumption
that results when a price change moves the consumer
along an indifference curve to a point with a different
marginal rate of substitution.
Income Effect

• The income effect can be defined as the change in consumption resulting from a
change in real income. This income change can come from one of two sources:
from external sources, or from income being freed up (or soaked up) by a
decrease (or increase) in the price of a good that money is being spent on.
• The effect of the former type of change in available income is depicted by the
income-consumption curve.
• The income–consumption curve is the set of tangency points of indifference
curves with the various budget constraint lines, with prices held constant, as
income increases shifting the budget constraint out.
• Income consumption curve traces out the income effect on the quantity
consumed of the goods. Income effect can either be positive or negative.
Income Consumption
Curve
Positively
sloped ICC
1. When X and Y are normal
goods
2. when X is necessity, Y is
luxury
3. when X is luxury, Y is
necessity
Case of inferior goods
Negatively
sloped ICC
1. When X is inferior Y is
normal
2. when X is normal Y is
inferior
Engel curve

• The Engel curve, named after the German statistician Ernst Engel (1821-96), is a
relation be­tween the demand for a good and the income of its buyers, the former
depending on the latter.
• The Engel curve of an individual consumer can be obtained from his ICC.
• Engel curve shows relationship between income and quantity demanded, other
influences on quantity purchased such as prices of goods, consumer preferences are
assumed to be held constant.
Engel curve for a normal good (positive slope)
Engel curve
for a luxury
good
(declining
slope)
 Engel curve
for an
inferior good
(backward
bending)
 Engel curve
for a neutral
good (vertical
straight line)
Substitution effect

Two different concepts of substitution effect have been developed; one by J.R. Hicks
and the other by E. Slutsky. These two concepts of substitution effect have been named
after their authors
The two concepts differ in regard to the magnitude of the change in money income
which should be effected so as to neutralise the change in real income of the consumer
which results from a change in the price.
• Hicks’ Method
According to Hicks, income level must be reduced in such a manner that the consumer returns
to the original level of utility. The budget line needs to be shifted leftwards in order to return
the consumer to the original indifference curve. The new budget line must be tangent to the
original indifference curve. Hence, the income effect is eliminated by reducing the income level
through a leftward shift in the budget line. As a result, the visible change in quantity demanded
is due to the substitution effect only.

• Slutsky’s Method
Slutsky suggested a different approach where income level must be reduced in such a manner
that the consumer is back to purchasing the original quantity of goods when there was no price
change. The resultant budget line passes through the original equilibrium point. On this new
budget line, the consumer is at equilibrium on an indifference curve that gives higher utility.
The quantity demanded of a commodity at this point represents the substitution effect because
the income effect has been eliminated.
Hicksian substitution effect

• In the Hicksian substitution effect price change is accompanied by a so much change in

money income that the consumer is neither better off nor worse off than before, that is, he is
brought to the original level of satisfaction. In other words, money income of the consumer is
changed by an amount which keeps the consumer on the same indifference curve on which
he was before the change in the price.
• Thus the Hicksian substitution effect takes place on the same indifference curve. The amount
by which the money income of the consumer is changed so that the consumer is neither
better off nor worse off than before is called compensating variation in income. In other
words, compensating variation in income is a change in the income of the consumer which is
just sufficient to compensate the consumer for a change in the price of a good.
• Thus, in the Hicksian type of substitution effect, income is changed by the magnitude of the
compensating variation in income.
Hicks Substitution Effect
Hicks Approach
For Inferior goods
Income Effect < Substitution Effect
Slutsky substitution effect

• Slutsky explained the income and substitution effects of the price effect by taking the
apparent real income of the consumer constant. With the fall in the price of X when the real
income of the consumer increases, it is adjusted in such a way that the consumer is in a
position to have the same amount of X as before if he likes so that his apparent real income
remains constant.
• This is because he moves on to a higher indifference curve when the substitution effect takes
place. It implies that the Slutsky effect corresponds with rotating budget lines about a point
where they intersect each other.
• Hicks call this the cost difference method in his A Revision of Demand Theory.
Slutsky Approach
For Giffen goods
Income Effect >Substitution Effect
For Inferior goods
Income Effect < Substitution Effect