Theory of consumer behavior

Introduction
 In our day –to- day life, we buy different goods
and services for consumption. As consumer, we act to
derive satisfaction by using goods and services.
 Consumer theory is based on the premise that we
can infer what people like from the choices they
make.
Introduction…
 Consumer behavior can be best understood in three
steps.
 First, by examining consumer‘s preference, we need
a practical way to describe how people prefer one
good to another.
 Second, we must take into account that consumers
face budget constraints – they have limited incomes
that restrict the quantities of goods they can buy.
 Third, we will put consumer preference and budget
constraint together to determine consumer choice.
3.1 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 she is
indifferent between the two bundles.
 In order to tell whether one bundle is preferred to
another, we see how the consumer behaves in choice
situations involving two bundles.
 3.1 Consumer preferences…
 If she always chooses X when Y is available, then it is
natural to say that this consumer prefers X to Y.
 We use the symbol ≻ to mean that one bundle is strictly
preferred to another,
 so that X ≻Y should be interpreted as the consumer strictly
prefers X to Y.
 If the consumer is indifferent between two bundles of
goods, we use the symbol ∼ and write X~Y.
 Indifference means that the consumer would be just as
satisfied, according to her own preferences, consuming the
bundle X as she would be consuming bundle Y.
 3.1 Consumer preferences…

 If the consumer prefers or is indifferent between the two

bundles we say that she weakly prefers X to Y and write
X ⪰ Y.
 The relations of strict preference, weak preference, and
indifference are not independent concepts; the relations
are themselves related. For example, if X ⪰ Y and Y ⪰ X,
we can conclude that X ~Y.
3.2 The concept of utility
 Utility to describe the satisfaction or pleasure derived
from the consumption of a good or service.
 In other words, utility is the power of the product to
satisfy human wants.
 Given any two consumption bundles X and Y, the
consumer definitely wants the X-bundle than the Y-
bundle if and only if the utility of X is better than the
utility of Y.
 Do you think that utility and usefulness are
synonymous?

 Do two individuals always derive equal satisfaction

from consuming the same level of a product?
In defining utility
 ‘Utility’ and ‘Usefulness’ are not synonymous. For
example, paintings by Picasso may be useless
functionally but offer great utility to art lovers.
Hence, usefulness is product centric whereas utility is
consumer centric.
 Utility is subjective. The utility of a product will vary
from person to person e.g. non-smokers.
 Utility can be different at different places and time.
E.g. the utility get drinking coffee at morning is differ
from at lunch time.
3.3 Approaches of measuring utility

 How do you measure or compare the level of satisfaction

(utility) that you obtain from goods and services?
 There are two major approaches to measure or
compare consumer‘s utility: cardinal and ordinal
approaches.
 The cardinalist school postulated that utility can be
measured objectively.
 The ordinalist school, utility is not measurable in
cardinal numbers rather the consumer can rank or order
the utility he derives from different goods and services.
3.3.1 The cardinal utility theory
 utility is measurable by arbitrary unit of
measurement called utils in the form of 1, 2, 3 etc
 For example, we may say that consumption of an
orange gives Bilen 10 utils and a banana gives her
8 utils, and so on.
 From this, Bilen gets more satisfaction from orange
than from banana.
3.3.1.1 Assumptions of cardinal utility
theory
1. Rationality of consumers. The main objective of
the consumer is to maximize his/her satisfaction
given his/her limited budget or income.
2. Utility is cardinally measurable.
3. Constant marginal utility of money. A given unit
of money deserves the same value at any time or
place it is to be spent.
4. Diminishing marginal utility (DMU).
5. The total utility of a basket of goods depends on
the quantities of the individual commodities.
3.3.1.2 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.
 As the consumer consumes more of a good per time
period, his/her total utility increases.
 Marginal Utility (MU) is the extra satisfaction a consumer
realizes from an additional unit of the product. In other
words, marginal utility is the change in total utility that
results from the consumption of one more unit of a
product. Graphically, it is the slope of total utility.
Relationship between TU and MU
Total and marginal utility…

 The total utility first increases, reaches the

maximum (when the consumer consumes 6 units) and
then declines as the quantity consumed increases.

 On the other hand, the marginal utility continuously

declines (even becomes zero or negative) a quantity
consumed increases.
3.3.1.3 Law of diminishing marginal utility (LDMU)

 The law of diminishing marginal utility states that as

the quantity consumed of a commodity increases per
unit of time, the utility derived from each successive
unit decreases, consumption of all other commodities
remaining constant.
 The extra satisfaction that a consumer derives
declines as he/she consumes more and more of the
product in a given period of time.
Assumption of LDMU
 The law of diminishing marginal utility is based on the
following assumptions.
 The consumer is rational
 The consumer consumes identical or homogenous
product.
 The commodity to be consumed should have similar
quality, color, design, etc.
 There is no time gap in consumption of the good
 The consumer taste/preferences remain unchanged
3.3.1.4 Equilibrium of a consumer
 The objective of a rational consumer is to maximize
total utility.
 As long as the additional unit consumed brings a
positive marginal utility, the consumer wants to
consume more of the product because total utility
increases.
 However, given his limited income and the price level
of goods and services, what combination of goods
and services should he consume so as to get the
maximum total utility?
 A) The case of one commodity
 The equilibrium condition of a consumer that consumes
a single good X occurs when the marginal utility of X
is equal to its market price.
A) The case of one commodity…
A) The case of one commodity…

 At any point above point C (like point A) where MUX > PX, it
pays the consumer to consume more.
 When MUX < PX (like point B), the consumer should consume
less of X.
 At point C where MUX = PX the consumer is at equilibrium.
 B) The case of two or more commodities

 For the case of two or more goods, the consumer‘s

equilibrium is achieved when the marginal utility per
money spent is equal for each good purchased and
his money income available for the purchase of the
goods is exhausted.
Example …

 Suppose Saron has 7 Birr to be spent on two goods:

banana and bread. The unit price of banana is 1
Birr and the unit price of a loaf of bread is 4 Birr.
The total utility she obtains from consumption of
each good is given below.
Saron will be at equilibrium when she consumes 3 units of
banana and 1 loaf of bread. At this equilibrium,

TU= TU1 + TU2

TU= 14 + 12
TU= 26
Limitation of the cardinal approach

1. The assumption of cardinal utility is doubtful

because utility may not be quantified. Utility cannot
be measured absolutely (objectively).
2. The assumption of constant MU of money is
unrealistic because as income increases, the
marginal utility of money changes.
 3.3.2 The ordinal utility theory
 The consumers can rank commodities in the order of
their preferences as 1st, 2nd, 3rd and so on.
 Therefore, 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.
3.3.2.1 Assumptions of ordinal utility theory

 Consumers are rational

 Utility is ordinal
 Diminishing marginal rate of substitution:
 The 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.
For example, if there are three goods in a given
consumer‘s basket, say, X, Y, Z and if he prefers X to Y
and Y to Z, then the consumer is expected to prefer X
to Z. This property is known as axioms of transitivity.
3.3.2.2 Indifference set, curve and map

 Indifference set/ schedule is a combination of goods

for which the consumer is indifferent.
 It shows the various combinations of goods from
which the consumer derives the same level of
satisfaction.
 Indifference curve: When the indifference
set/schedule is expressed graphically, it is called an
indifference curve.
 An indifference curve shows different combinations of
two goods which yield the same utility (level of
satisfaction) to the consumer.
 A set of indifference curves is called indifference
map.
Indifference curve and map
3.3.2.3 Properties of indifference curves

1. Indifference curves have negative slope

(downward sloping to the right).
2. Indifference curves are convex to the origin.
3. A higher indifference curve is always preferred to
a lower one
4. Indifference curves never cross each other (cannot
intersect).
 3.3.2.4 Marginal rate of substitution (MRS)

 Marginal rate of substitution is a rate at which consumers

are willing to substitute one commodity for another in such
a way that the consumer remains on the same indifference
curve.
 It shows a consumer‘s willingness to substitute one good for
another while he/she is indifferent between the bundles.
 Marginal rate of substitution of X for Y is defined as the
number of units of commodity Y that must be given up in
exchange for an extra unit of commodity X so that the
consumer maintains the same level of satisfaction
From the above graph, MRSX,Y associated with the movement from point
A to B, point B to C and point C to D is 2.0,1.6, and 0.8 respectively
 It is also possible to derive MRS using the concept of marginal
utility. X Y MRS , is related to MUX and MUY as follows.
Example
 Do you think that the indifference curve
discussed in the previous section tells us whether
a given combination of goods is affordable to
the consumer? If no, what are the major
constraints to the consumer in maximizing
his/her total utility?
3.3.2.5 The budget line or the price line

 Indifference curves only tell us about consumer

preferences for any two goods but they cannot show
which combinations of the two goods will be bought.
 In reality, the consumer is constrained by his/her income
and prices of the two commodities. This constraint is often
presented with the help of the budget line.
 The budget line is a 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.
 In order to draw a budget line facing a consumer, we
consider the following assumptions.
 There are only two goods bought in quantities, say, X
and Y.
 Each consumer is confronted with market determined
prices, PX and PY.
 The consumer has a known and fixed money income
(M).
 we can express the budget constraint as:
Budget line…
 we can derive the following general equation of a
budget line.
Budget line…
 Example:
 A consumer has $100 to spend on two goods X and Y
with prices $3 and $5 respectively. Derive the
equation of the budget line and sketch the graph.
Change in income
 If the income of the consumer changes (keeping the
prices of the commodities unchanged), the budget
line also shifts (changes).
 Increase in income causes an upward/outward shift
in the budget line that allows the consumer to buy
more goods and services.
 Decreases in income causes a downward/inward shift
in the budget line that leads the consumer to buy less
quantity of the two goods.
 The slope of the budget line (the ratio of the two
prices) does not change when income rises or falls.
Income change…
 Change in prices
 An equal increase in the prices of the two goods shifts
the budget line inward.
 Two goods become expensive, the consumer can
purchase the lesser amount of the two goods.
 An equal decrease in the prices of the two goods
shifts the budget line out ward.
 Two goods become cheaper, the consumer can
purchase the more amounts of the two goods.
Change in prices…
 An increase or decrease in the price of one of the
two goods, keeping the price of the other good and
income constant, changes the slope of the budget
line by affecting only the intercept of the
commodity that records the change in the price.
3.3.2.6 Equilibrium of the consumer
 The preferences of a consumer (what he/she wishes to
purchase) are indicated by the indifference curve.
 The budget line specifies different combinations of two
goods (say X and Y) the consumer can purchase with
the limited income.
 Therefore, a rational consumer tries to attain the highest
possible indifference curve, given the budget line.
 This occurs at a point where the indifference curve is
tangent to the budget line.
 The slope of indifference curve is equal to the slope of
budget line. i.e. MRSxy =Px/P y.
Equilibrium of the consumer…
Examples