Eco 102 Introductory Economics

Lead Lecturer:
Joseph A. Kuzilwa
CONSUMER BEHAVIOUR
CONSUMER BEHAVIOUR

Objectives
After going through this session you
should be able to;
Define the concept of utility
Distinguish between cardinal utility and ordinal utility
Define and explain the properties of an indifference
curve
Differentiate between an indifference curve and an
indifference map
Define the concept of consumer equilibrium
Motivation
Consumer behaviour provides the basis for the law of
demand for commodities.

A consumer is of the central microeconomic unit in any

economy. In Tanzania and many other African countries,
individuals or households spend more than 70% of their
incomes on consumer goods. In some cases such high
per cent of income is spent only in a few basic goods
such as food and clothes.

Understanding of consumers’ behaviour is, therefore,

critical to those who produce and the policy makers.
Approach
The analysis will be simplified and
limited to two goods, X1 and X2.

Let us make X1 rice and X2 other foods.

To generalize we could make X1 one
good and X2 represent all other goods a
consumer can choose from
Building Blocks of Consumer Behaviour
A consumer behaviour analysis is built
on three key concepts that we need to
define them first. These concepts are:
 rationality,
 preference
 utility
Rationality
Rationality is to behave in such a way
as to maximize one’s objective. In the
case of consumer behaviour the
objective of consuming a particular
bundle from spending a given budget is
to get satisfaction / utility

The objective of a rational consumer is

to maximise this satisfaction or level of
utility.
Preference
The concept of preference means that if there
are given different bundles available to the
consumer, he/she can rank them according to
a particular order.

There are three possible ordering sets;

 strict preference,
 weak preference
 indifference.
Strict preference
Strict preference means that when given
two bundles bundle x; (x1,x2) and bundle
w, (w1,w2), a consumer will strictly prefer
the x bundle if (x1,x2)>(w1,w2).

In behavioural terms we would observe

the consumer to always choose the x
bundle rather the w bundle when such
bundles are available to him.
Weak preference
Weak preference is situation where
given two bundles, x = (x1,x2) and
w=(w1,w2), a consumer weakly prefers
the x bundle over w bundle if
(x1,x2)(w1,w2).

This means that bundle x, although

preferred, is at least as good as bundle
w.
Indifference
This means that given two bundles

x=(x1,x2), w=(w1,w2)
a consumer prefers them equally well.

We could use the following notation,

(x1,x2)(w1,w2).
He/she ranks them the same and is, therefore,
indifferent as to which one to choose.
Axioms of Preference
In order to build the theory of
consumer behaviour with
consistency, three key assumptions
(axioms) are normally made.
Axiom of Completeness
States that all possible bundles a
consumers has to choose from are
complete and that the bundles are actually
comparable.

The comparability assumption is necessary

for a consumer to be able to rank the
bundles.
Axiom of Transitivity
States that if there are three bundles, X
(x1x2), W (w1,w2) and Z(z1,z2), and if
bundle W is strictly preferred to bundle
Z and bundle X is strictly preferred to
bundle W, then bundle X must be
strictly preferred to bundle Z. This is
seen as logical and normal behaviour.
If
 (x1,x2)>(w1,w2),
and

 (w1,w2)>(z1,z2),
then

 (x1,x2)>(z1,z2)
Example:
We would expect a student who prefers
studying mathematics and economics to
literature and history, and prefers
literature and history to drama and music,
to also prefer mathematics and
economics to drama and music.
Axiom of Non-Satiation
States that a consumer always prefers more to
less. This prevents having a situation where too
much of something is harmful.
The Concept of Utility

Utility is what a consumer attains from

consuming a given market bundle.

There are two theories developed over

time to analyse the consumer
behaviour:
 Cardinal Utility Theory
 Ordinal Utility Theory
Cardinal Utility Theory
Is based on the premise that that utility is
measurable in a cardinal sense and can be
differentiated numerically.

For example, if you drank one bottle of cocacola, you

will be able to measure the amount of satisfaction
obtained, say 10 units. If you drank the second bottle
you should be able to tell whether you are two or
three times more satisfied.
Cardinal Utility Theory
Total utility is assumed to increase
with consumption, but that after some
stage the increase in utility will be at a
diminishing rate, with a possibility of
declining after some maximum number
is reached.
 TU

Total Utility

Quantity of good
consumed

Marginal
Utility
Quantity of Good
Ordinal Utility Theory
States that utility is measurable in an ordinal
sense, in that a consumer can rank market
bundles in terms of preference.

The difference in utility between two bundles

cannot, however, be measured in numbers.

According to this theory it is just enough to rank

your bundles as 1st, 2nd, 3rd, or A,B,C. The
Difference between the bundles is not important.
Ordinal Utility Theory
According to the ordinal utility theory,
utility describes preferences.

This is elaborated well using

indifference curves, which we are
going to develop in the next section.
Indifference curves
Indifference curves is a graphic way of
presenting preferences based on ordinal
utility theory and the axioms of
preference.

An indifference curve is a locus of

points connecting all bundles for which
a consumer is indifferent.
Linking IC to Utility
Utility gained from consuming any of the
bundles in a given indifferent curve is the
same.
Bundles in higher indifferent curves have
higher utility. In terms of our notation,
(x1,x2) > (w1,w2)
U(x1,x2) > U(w1,w2)
and
(x1,x2)  (w1,w2)
U(x1,x2) = U(w1,w2)
The many indifference curves
connecting indifference preference is
called an indifference map.
Market Bundle X1 (kilogram) X2 ( weight unit) Rank

A 2 5 3rd
B 2 7 1st
C 3 4 3rd
D 3 5 2nd
E 4 3 3rd
F 4 4 2nd
G 5 2 3rd
H 5 3 2nd
I 6 1 3rd
J 6 2 2nd
K 7 2 1st
Bundles C, E, G, and I, lie on the same
indifference curve. A consumer is indifferent
about these combinations.

Bundles D, F, H also lie in the same

indifference curve, but all combinations are
strictly more preferred than those in the
previous indifference curve.

Bundles B and K lie on the highest

indifference curve.
Properties of IC
1: An indifference curve slope downward
from left to right.

This property follows from the assumption

that a consumer is willing to trade off one
commodity for the other, amongst the
possible commodities available, in order to
remain on the same level of preference.
2: Indifference curves cannot intersect.

Since indifference curves represent bundles

that are equally preferred, an intersection of
two indifference curves would be a
contradiction.

EXPLAIN THE CONTRADITION

3: Indifference curve is convex to the origin.
The convexity assumption is made to get what are considered as
well behaved indifference curves, which are the ones we have so far
been drawing.

The slope of the indifference curve gets continuously smaller as one

moves from left to right along any particular curve. What this
implies is that since commodities in the different bundles
are not perfect substitutes, a consumer would be indifferent
if he/she gives up less and less of one good for more and
more of the other.

We will see below that this property will not hold true in the case of
perfect substitutes or in the case of a good and bad.
Indifference Curves for Perfect Substitutes
Perfect substitutes are goods that can be consumed
in place of others without a consumer noting the
difference. For example, to some consumers a Coca-
Cola and Pepsi-Cola are perfect substitutes.

For such kinds of goods which satisfy the same want,

when they are put against each other for choice
purposes, a consumer would like have the same total
of both goods, irrespective of combinations, to get
indifference preference.
Thus five bottles of Coca-Cola and five of
Pepsi-Cola would be equally preferred to six
of Pepsi and Four of Coca-Cola, or any other
combination adding up to ten.

Such an indifference curve will be linear, with

a trade off of one to one
Indifference Curves for Perfect
Compliments
Perfect complements are goods that have to be
consumed together in certain fixed proportion.
Examples of perfect compliments:
• Sand and cement in the case of consumption in
building cement block structures;\
• right and left foot shoes;
• ink and pens.
For such cases, increasing the amount of one good
without the other and in required proportion does not
alter the preference level.

For example, one right shoe and one left shoe will be
equally preferred to one right shoe and ten left
shoes, with the remaining nine left shoe not having
any additional preference. Preference level increase
only by increasing the goods in required proportions.

Indifference curves for such perfect compliment

would be L-shaped,
Marginal Rate of Substitution (MRS)
This is the rate at which a consumer is willing
to trade off one good for the other and
remain indifferent

Shown by movement from A to B to C in the

diagram
Let us consider the indifference curve
containing bundles C, E, and G, in Table. The
Marginal rate of substitution (MRS) of moving
from A to C is
 X1 over X2.
 = X1/X2 = +1/-1 = -1
The Budget Constraint
A consumer will like to be as high as possible in his / her
indifference map. How far up the consumer can be in the
indifference map will depend on the consumer’s
purchasing power.

This purchasing power depends on two things:

 the consumer’s money income (or
endowment)
 market prices.
Market prices are determined by forces of supply and
demand and are, therefore, exogenous variables to the
consumer.
The intercept in each axis, R/P1 and R/P2,
assumes that the consumer spends all his/her
income in that good at the existing prices.

The slope of the budget line is the ratio of the

prices of the two commodities, -P1/P2. The
price ratio or relative price, is the trade-off
that the market is willing to make for the two
commodities.
Budget Line
Let us assume that the consumer’s fixed nominal income is R. The
prices of out two goods, X1 and X2, as determined in the market are P1
and P2. The consumer can at most spend his/her income. This can be
presented as:

 P1X1 + P2X2 = R

This can be transformed into a linear equation in terms of X1 or X2 as

follows:

 X1 = R/P1 - (P2/P1)X2
Or
 X2 = R/P2 - (P1/P2)X1
Let us remind ourselves that the slope of the
indifference curve is the trade-off that a
consumer is willing to make between the two
commodities according to tastes and
preference.
Budget Line and Changes in Money
Income
Change in consumer’s money income is something that
happens in practice due to exogenous influences.

It is of interest to see the effect on the consumer

behaviour

For example:
 A government may announce an increase in salaries of civil
servants.
 A consumer may secure a better paying job.
 An investor’s investments may be maturing and yielding good
returns.
 The Higher Education Students’ Loans Board may increase
students’ Meals Allowance
Budget Line and Change in Consumer’s
Money Income
An increase in consumer’s income with constant
commodity prices, implies an increase in consumer’s
purchasing power. This is represented by a parallel
shift of the budget line to the right (Refer diagram
(a)). The opposite is true if money income falls.

In terms of the budget line equation, this is

represented by change in the intercept of the budget
line in both axes with the slope of the budget line
remaining constant.
Budget line and changes in income
Thus if you have a new income R1>R0, then the new
budget equations are:

X1 = R1/P1 - (P2/P1)X2
Or
X2 = R1/P2 - (P1/P2)X1
Also
R1/P1 > R0/P1
and
R1/P2 > R0/P2
Budget Line and Changes in
commodity Prices
 Just like changes in money incomes, commodity
prices can also change as result of exogenous
factors. An increase in commodity price without
change in consumer’s income leads to a reduction in
the purchasing power and vice versa.

 The price of one commodity or both commodities

may change at the same time.
Budget Line and Changes in commodity
Prices cont.
This will tilt the budget line, inwardly (in case
of price increase Refer Diagram (b)) or
outwardly (in case of a price decrease), away
from the intercept in the axis whose
commodity has changed.

For example, an increase in the price of X1

leaving X2 and money income constant, will
tilt the budget line inwardly along the X1 axis,
while anchored in axis X2
Budget Line and Changes in commodity
Prices cont.
Suppose the price of X1 increases, so that we
have:

 P1 >P 1.
0
1

The new budget line in terms of X1 will be

X = R/P11 - (P2/P11)X2
1

See diagram (b)

Consumer’s Objective
The consumer’s income depends on his/current
earnings as well as his/her savings.

In the short run a consumer’s income is fixed.

A rational consumer, therefore, tries to maximise

utility (highest indifference curve) subject to
the budgetary constraint.
Consumer’s objective cont.
We, therefore, have to search for a point in the
highest indifference curve such that the rate
at which the consumer is willing to trade of one
good for the other (which is marginal rate of
substitution, MRSxy), will be the same as the
rate at which the market is willing to do the
same (Px/Py)

MRSxy = Px/Py
Consumer’s objective cont.
Graphically, the highest indifference curve
that satisfies the budget constraint is the one
that is tangential to the budget line, as
shown by point B.
Exercise
Why can’t indifference curves intersect?

Bundle (A) in the diagramme above is

within the consumer’s budget. Why
doesn’t the consumer choose this
bundle?