Bab5 theory of consumer behavior

Theory of consumer behaviour

• IntroductionIn previous chapter, we studied the concept of individual demand and market demand. We also looked at the various determinants of

demand, which will affect the quantity demanded of particular goods. In this chapter , we will look at how a consumer chooses to spend his/her limited income to purchase available goods in the market so as to achieve maximum utility. We will also l ook at two approaches- the cardinal approach and the

ordinal approach.

• Definition of Consumer Behaviour

Consumer behaviour refers to the study of a consumer while he/she is engaged in the process of consumption. This will tell us how a consumer with his limited resources (income) purchases various goods and services, and we will compare the price and utilities of different alternatives

Utility ApproachThe term ‘utility’ means the satisfaction obtained from consuming a commodity. Or in other words, ‘Utility is the ability or the power of goods or services to satisfy the wants of a consumer.’There are two type of measurement or approach to explain the condition of maximizing utility or satis faction

• Cardinal ApproachThe cardinal utility theory says that utility is measurable and by placing a number of altrnatives where the utility can be added. The index used to measure utility is called utils. For example an apple equals 5 utils or an orange gives 8 utils.

• Ordinal ApproachThe ordinal utility says that utility is not measurable

but it can be compared. The ordinal approach uses the ranking of alternatives as first, second, third and so on. For example, an apple is preferred to a durian. This only means that an apple has higher utility than a durian, but it cannot say by how much an apple has greater utility than a durian.

Cardinal ApproachTotal Utility The total satisfaction that a person derives from the consumption of certain goods and services. As quantity increases, total utility increase. For example, two apples give more utility than one apple, three apples give more utility than two apples and so onMarginal UtilityThe additional total utility derived from consuming one more unit of the same kind of goods or services. The more we consume of a goods and services, the lesser satisfactio. Marginal utility can be expressed mathmetically in terms of the following formula :

Marginal Utility (MU) = Change in total Utility Change in Total Quantity

Law of Diminishing Marginal Utility

One of the most important propositions of the marginal utility approach to demand is the Law of Diminishing Utility . The first to explain the Law was a German economist, Gossen.

‘The additional benefit which a person derives from a given increase of a stock of a thing diminishes, other thing being equal, with every increase sin the stock that he already has.’Or in other words, as consumption increases marginal utility derived become less.An increase in consumption to satisfy needs result in intensity of the want becoming lesser. We should all have experienced the Law of Diminshing Marginal Utility at some point in our lives. The total will increase until it reach certain maximum level after which it will decline.

For example, Zain is hungry and wants to consume aples. In this situation, if he getan apple, the first apple will have high utility. After the first apple he we be less hungry, so the second apple will have lesser utility. The more apple he eats, the lower total utility Zain derives.

Unit of Apple

Total Utility Marginal Utility

1 20 20

2 35 15

3 45 10

4 50 5

5 55 5

6 60 5

7 60 0

8 55 -5

Table 5.1

From the table, it is clear that total utility increases with the consumption of the first apple. At the seventh apple, it reaches a saturation point. After the 7th apple, total utility decrease. Marginal utility will decrease and become zero at the 7th apple and further consumption of apple will not satisfy the consumer as the marginal utility show negative results. If a person given for the 8th apple to consume, he may no longer derive any satisfaction. Therefore, the marginal utility for the 8th or more apples will show negative results. The total utility and marginal utility can be ilustrated by figure

Figure 5.1 illustrates the general relationship between total utility and marginal utility. The total utility curve show how total utility increases, reaches a maximum and the decrese. The Marginal Utility curve show that marginal utility derease, reache zero and then become negative.

Utility

Quantity

Total Utility Marginal Utility

Relationship between Total Utility (TU) and Marginal Utility (MU)– When TU is increasing, Mu will be positive– When TU is at maximum, MU will be zero– When TU is decreasing, MU will be negative

AssumptionsThis Law states that on other things remain equal, total utility and marginal utility will decrease after reaching a maximum level. The main assumptionsw of the law follow as follws :1. Homogenous unit2. Consumption ini time frame3. No change in taste4. No change in price5. Suitable quantity of consumption

Law of Equi-Marginal Utility(EMU)• In cardinal utility analysis, the consumer equilibrium is

explained by the way of the utility. This pricnciple states that to get maximum utility from expenditure of a consumer’s limited income, the consumer purchases such amount of each commodity that the last ringgit spent on each gives the same marginal utility.

• This is also known as condition for maximum utility or satisfaction. In other words, a consumer will maximize his utility when the price of goods are equal to the marginal utility or value of the goods.

Condition 1

Marginal Utility of X = Marginal Utility of Y Price of X Price of Y

Condition 2- Total expenditure of all goods must be equal to the total budget allocated to maximize utility- P1Q1 + P2Q2 +… = Total Budget

For example: Arwin has income of RM 37 and the price of goods P,Q,R are RM 5, RM 1 and RM 4 respectively. The amount of total utility he would derive from consuming P,Q and R is Shown in Table 5.2 below.

Quantity Product P Product Q Product R

Total Utility

Mup/ Pp

Total Utility

MUq / Pq

Total Utility

MUr / Pr

1 21 7 16

2 41 13 30

3 59 18 42

4 74 22 50

5 85 25 55

6 91 27 58

7 91 28 60

Example (continued)Question : How many units of three products will Arwin purchases ?

Answer : First ConditionThere are two combination Combination 1 : 2P, 4Q and 1RCombination 2 : 4P,5Q and 3R

Second ConditionCombination 1 : 2(5) + 4(Q) + 1(R) = 18Combination 2 :

Example (continued)The total budget (income) is RM37, so combination 2 reflects consumer equilibrium because it fulfils both condition. So, Arwin will purchase 4 units of Product P, 5 unit of Product Q and 3 unit of Product R.

Assumption of the Law of Equi-marginal Utility1) The consumer is rational in his behavior and seeks maximum

satisfaction2) The consumer has a fixed income3) The prices of all goods are provided4) Taste, fashion, preferences and habits of consumer remain

unchanged.

• Ordinal ApproachWhat will happen if the utility cannot be

measured absolutely? How can we achieve consumer equilibrium? To answer these questions, the indifference curve and budget line analysis are used to explain the conditions of consumer equilibrium or maximum utility.

Indifference Curve

An indifference curve represents all the possible combinations of two goods which will give the same level of satisfaction. For all possible points on the indifference curve, the total satisfaction will be equal. Before we discuss how an indifference curve is formed using an indifference schedule. Let us look at the assimptions.

Assumption

1. Scale of preferances2. Consumer’s Preferences are termed

transitivity3. Rationality4. Diminishing marginal rate of substitution5. Concept of ordinal utility

• Indifference Shedule and curveAn indifference is a list of combinations of two goods that give equal satisfaction to the consumer. An indifference schedule may be defined as a scheduleof various combinations of goods that will satisfy the individual.

Combination Product Y Product X

A 12 2

B 6 4

C 4 6

D 3 8

E 2 12

Combination A show the consumer has 12 Y and 2 X, While combination B shows he has 6Y and 4X. The consumer is indifference to these combinations as they give him equal satisfaction.

• The above schedule can be shown as a diagram to obtain the in the indifference curve. An indifference curve represents all those combination of two goods, X and Y which yield the same levelof satisfaction to a consumer,

Good Y

Good X

Each indifference curve represent only one articular level of satisfaction. If there are a number of indifference curves showing different level of satisfaction, it is called an indifference map. The higher the indifference curve from the origin, the higher the utility.

Marginal Rate of Substitution

• The study of the indifference curve shows that as the consumer gets one more unit of X, he has to sacrifice some unit of Y to maintain his/her satisfaction level.

• Marginal rate of substitution refers to the rate at which goods are substituted for other goods

Combinations Y X Marginal Rate of Subsitution

A 12 1 -

B 8 2 4 Y : 1 X

C 5 3 3 Y : 1 X

D 3 4 2 Y : 1 X

E 1 5 1 Y : 1 X

• Characteristic of an Indifference Curve1) Indifference curve slope downward from left

to right2) Indifference curves are convex vis-à-vis the

origin3) Higher indiference curves represent a higher

level of satisfaction4) Indifference curves never intersect each other5) Indifference curves do not touch the Y axis or

X axis.