Theory of consumer behavior

The Theory of Consumer Behavior

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The Theory of Consumer Behavior

The principle assumption upon which the theory of consumer behavior and demand is built is: a consumer attempts to allocate his/her limited money income among available goods and services so as to maximize his/her utility (satisfaction).

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UTILITY

• Utility - amount of satisfaction derived from the consumption of a commodity

• It is the power or capacity of a commodity to satisfy human wants.

• measurement units utils• Useful for understanding the demand side of the

market.

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Utility Concepts:◦ The Cardinal Utility Theory (Utility analysis approach)

Utility is measurable in a cardinal sense Cardinal utility - assumes that we can assign values

for utility, E.g., derive 100 utils from eating a slice of pizza

◦ The Ordinal Utility Theory (Indifference curve approach) Utility is not measurable in an ordinal sense Ordinal utility approach - does not assign values,

instead works with the order of preference of consumers for the goods.

It indicates consumers preference or choice for one commodity over another.

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The Cardinal ApproachTotal utility (TU) – The overall level of satisfaction derived from consuming a good or service. It

may be defined as the sum of the utility derived from each unit consumed of the commodity.

If consumer consumes four units of a commodity derives U1, U2, U3, U4 utils from the successive units consumed, then

TU = U1 + U2 + U3 + U4Marginal utility (MU) - Additional satisfaction that an individual derives from consuming an additional

unit of a good or service. It is the addition to TU derived from the consumption of additional unity of a

commodity. Formula :

MU = Change in total utility Change in quantity

= ∆ TU ∆ Q

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The Cardinal ApproachLaw of Diminishing Marginal Utility  =  As more

and more units of a commodity are consumed, marginal utility derived from each successive unit goes on falling.

Assumptions of the law-1.The units of the goods must be standard e.g. a cup

of tea or a bottle of coke, not sip of tea and coke.2.Consumers taste and preference remains

unchanged.3.There must be continuity in consumption.4.The mental condition of consumers remains

normal during consumption.

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Number Purchased Total Utility Marginal Utility

0 0 0

1 4 4

2 7 3

3 8 1

4 8 0

5 7 -1

Example

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Continue….

When TU is rising, MU is falling but it is greater than zero (+ve).

When TU is maximum, MU is zero.

And when TU starts declining, MU becomes negative.

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Consumer Equilibrium: Cardinal utility approach

definitionIt means a situation under which consumer spends his

given income on purchase of a commodity in such a way that gives him maximum utility (satisfaction) and he feels no urge to change.

It is a position of rest because he does not want consume less or more than that.

A consumer attains his equilibrium when he maximizes his TU given his income, consumption expenditure and price of the commodity he consumes.

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Assumptions

• Rationality- He satisfies his wants in the order of their utility.

• Limited money income• Maximization of satisfaction• Diminishing MU• Constant MU of money  explanation  from book

• Favourite 

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Consumer Equilibrium: A single commodity case

• Consumer equilibrium in purchase of a single good is attained when:

MU in terms of money = price of the commodity i.e., MU of a product / MU of a rupee = price of a

product.• A consumer while purchasing a good will compare its

price (cost) with is expected utility(benefits).• He will buy the good if the benefit derived in form of

utility is greater than or at least equal to its price.• It is difficult to compare MU of good (utils) with its

price (Rs.), therefore MU of good is converted in terms of money by dividing MU of good by MU of rupee.DIAGRAM WITH EXPLANATION FROM BOOK.

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Continue..• MU of one rupee is defined as the additional utility

when an additional rupee is spent on purchase of commodity. Example : Let MU of a Rupee is 2 utils.

• Consumer will consume 4 units of oranges to attain equilibrium.

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Units of orange consumed

MU of orange (utils)

MU in terms of money

Price of orange

1 10 10/2=5 1

2 8 4 1

3 5 2.5 1

4 2 1 15 1 0.5 1

6 0 0 1

Consumer Equilibrium: In case of two commodities

• A rational consumer consumes commodities in the order of their utilities.

• He picks up the commodity which yield the highest utility and next the one which yields second highest utility and so on…

• He switches his expenditure from one commodity to another in accordance with their MU.

• He continues to switch till MU of each commodity per unit of money expenditure is the same. This is called the law of equi-MU.

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Example• Suppose consumer has Rs. 5 income to be

spent on two goods, each costing Re.1 per unit. How he will attain equilibrium.

• So he will consume 3 units of oranges and 2 units of apples to get maximum satisfaction. 

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Rupees spent MU of oranges (utils)

MU of apples (utils)

1 10 (1) 9 (2)

2 8 (3) 6 (4)

3 6(5) 4

4 4 2

5 2 1

The Law of Equi-MU• Let us suppose that a consumer consumes

only two commodities X and Y, their prices given as Px and Py respectively. Following the equilibrium rule of single commodity case, the consumer distributes his income between commodities X and Y such that

•                                                                                     

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Continue..• Alternatively consumer is in equilibrium,

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Continue…

Since MU of money is constant

Hence a utility maximizing consumer consumes till MU of each commodity per unit of money expenditure is the same. 

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The Ordinal Approach•Economists  following  the  lead  of  Hicks, Slutsky  and  Pareto  believe  that  utility  is measurable  in  an  ordinal  sense--the  utility derived  from  consuming  a  good,  is  a function  of  the  quantities  of  X  and  Y consumed by a consumer.   U = f ( X, Y )

•only reflects an order•but the difference between the numbers

assigned is meaningless

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Assumptions Underlying Ordinal Approach

• Rationality: The consumer is assumed to be rational. He aims at maximizing his benefits from consumption, given income and prices.

• Ordinality: The consumer is capable of ranking all conceivable combinations of goods according to the satisfaction they yield. Thus if he is given various combinations say A, B, C, D, E he can rank them as first preference, second preference and soon.

• Diminishing marginal rate of substitution: 19

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• Consistency: It means if good X is preferred over good Y inn one time, then consumer will not prefer Y over X in another time period.

• Transitivity of choice: If the consumer prefers combination A to B, and B to C, then he must prefer combination A to C. In other words, his choices are characterised by the property of transitivity.

• Non-satiation: If combination A has more commodities than combination B, then A must be preferred to B.

INDIFFERENCE CURVE (IC)

• An indifference curve is the set of all combinations of commodities X and Y that yield the same level of total utility or satisfaction.

• It is a curve representing different baskets of goods giving the same utility to an individual.

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INDIFFERENCE CURVE (IC)

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INDIFFERENCE MAP• Indifference Map: A set of indifference curves

is called indifference map.• An indifference map depicts complete picture of consumer's tastes and preferences. 

• In an figure indifference map of a consumer is shown  which  consists  of  three  indifference curves.

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INDIFFERENCE MAPGood Y

Good X0

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U=10U=20

U=30

PROPERTIES OF INDIFFERENCE CURVE(i) Indifference curves slope downward to the

right: This property implies that when the amount of one good in combination is increased, the amount of the other good is reduced. This is essential if the level of satisfaction is to remain the same on an indifference curve.

(ii) Indifference curves are always convex to the origin: It has been observed that as more and more of one commodity (X) is substituted for another (Y), the consumer is willing to part with less and less of the commodity being substituted (i.e. Y). This is called diminishing marginal rate of substitution.

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PROPERTIES OF INDIFFERENCE CURVE

• (iii) Indifference curves can never intersect each other:

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A

BC

PROPERTIES OF INDIFFERENCE CURVE

• (iv) A higher indifference curve represents a higher level of satisfaction than the lower indifference curve: This is because combinations lying on a higher indifference curve  contain  mere  of  either  one  or  both goods and more goods are preferred to less of them.

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Marginal Rate of Substitution

Def.: the marginal rate of substitution, X for Y, (written MRSXY) indicates the number of units of Y that must be given up to acquire one additional unit of X while satisfying the condition of constant total utility.

MRSXY is defined as the slope of the indifference curve at a certain point.

When the MRSXY diminishes along the indifference curve, the indifference curve is convex.

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X

Y

MUYMRS

X MU

BUDGET LINEA  higher  indifference  curve  shows  a  higher  level  of satisfaction than a lower one. 

Therefore,  a  consumer  in  his  attempt  to  maximise satisfaction  will  try  to  reach  the  highest  possible indifference curve. 

But  in  his  pursuit  of  buying  more  and  more  goods and thus obtaining more and more satisfaction he has to work under two constraints : firstly, he has to pay the  prices  for  the  goods  and,  secondly,  he  has  a limited  money  income  with  which  to  purchase  the goods.

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BUDGET LINE• These  constraints  are  explained  by budget line or price line. 

• In  simple words  a    budget  line  shows  all those  combinations  of  two  goods  which the consumer can buy spending his given money income on the two goods at their given prices. 

• All  those  combinations  which  are  within the reach of the consumer (assuming that he  spends  all  his  money  income)  will  lie on the budget line.

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BUDGET LINELine showing

all combinations of items can be purchased for a particular level of income (M) ;M =PxQx + PyQy

Slope of budget line is Px / Py.

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FACTORS SHIFT THE  BUDGET LINE

• Changes in prices of goods X              Y

            Px                Px        X

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EFFECTS OF PRICE CHANGES ON THE BUDGET LINE

When  price  of  good  X increases, the quantity of  good  X is  reduced (by maintaining the quantity of Y) & vice versa. Points on  the X axis shifted to the  left (a small quantity of X)

When  the price  of Y increases, the quantity Y is  reduced (by  maintaining the quantity of X) & vice versa  Point  on Y axis move  to  the bottom (small quantity in Y)

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FACTORS SHIFT THE  BUDGET LINE

• Changes in the price of goods Y                Y                            Py 

                                                     Py         X                                    

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FACTORS SHIFT THE BUDGET LINE

Changes in income                                                   Y

          I         

                                                                 I

                                                                                                                       X

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EFFECTS OF INCOME CHANGES ON THE BUDGET LINE

• When M increases, QX and QY can  be bought even  more, a  point  on  the X axis shifted to  the  right & a  point  on the Y axis move on; & vice versa when M decreases.

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CONSUMER EQUILIBRIUM• A consumer is in equilibrium when he is

deriving maximum possible satisfaction from the goods and is in no position to rearrange his purchases of goods. We assume that :

• (i)the consumer has a given indifference map which shows his scale of preferences for various combinations of two goods X and Y.

• (ii)he has a fixed money income which he has to spend wholly on goods X and Y.

• (iii)prices of goods X and Y are given and are fixed for him.

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CONSUMER EQUILIBRIUM• To show which combination of two goods X and Y

the consumer will buy to be in equilibrium we bring his indifference map and budget line together.

• the indifference map depicts the consumer’s preference scale between various combinations of two goods and the budget line shows various combinations which he can afford to buy with his given money income and prices of the two goods.

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CONSUMER EQUILIBRIUM

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CONSUMER EQUILIBRIUM• IC1, IC2, IC3, IC4 and IC5 are shown together with

budget line PL for good X and good Y. Every combination on budget line PL costs the same. Thus combinations R, S, Q, T and H cost the same to the consumer.

• The consumer’s aim is to maximize his satisfaction and for this he will try to reach highest indifference curve.

• But since there is a budget constraint he will be forced to remain on the given budget line, that is he will have to choose any combinations from among only those which lie on the given price line. 

• Which combination will he choose?

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CONSUMER EQUILIBRIUMAt the tangency point Q, the slopes of the price line PL and

indifference curve IC3 are equal. The slope of the indifference curve shows the marginal rate of substitution of X for Y (MRSxy) which is equal to MUy / MUx while the slope of the price line indicates the ratio between the prices of two goods i.e., Px / Py

At equilibrium point Q, MRSxy = MUx / MUy = Px / Py Thus, we can say that the consumer is in equilibrium

position when price line is tangent to the indifference curve or when the marginal rate of substitution of goods X and Y is equal to the ratio between the prices of the two goods.

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Exceptions to the convex shape of indifference curve

• (1) X and Y are perfect substitutes: The two goods are perfect substitutes when the marginal rate of substitution of one good for another is a constant. The indifference curves are straight lines.

• (2)  X and Y are perfect complements: The two goods are perfect complements when the marginal rate of substitution of one good for another is infinite. The indifference curves are shaped as right angles.

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Continue…..

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An Income-Consumption Curve For Normal Good

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Explanation and meaning from bookCont…

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An Income-Consumption Curve

Income-consumption curve (ICC): for a good X is the set of optimal bundles traced on an indifference map as income varies (holding the prices of X and Y constant).

Engel curve: curve that plots the relationship between the quantity of X consumed and income.

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Cont….

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THE IMPACT OF A PRICE CHANGE

• Economists often separate the impact of a price change into two components:– the substitution effect; and– the income effect.

• The substitution effect involves the substitution of good x1 for good x2 or vice-versa due to a change in relative prices of the two goods. 

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Cont…

• The income effect results from an increase or decrease in the consumer’s real income or purchasing power as a result of the price change.

• The sum of these two effects is called the price effect.

• The decomposition of the price effect into the income and substitution effect can be done in several ways: The Hicksian method.

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Y (units)

X (units)0PX = 4 PX = 2

PX = 1

XA=2 XB=10 XC=16

•• •

10Price consumption curve

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The price consumption curve for good x plots all the utility maximization points as the price of x changes. This reveals an individual’s demand curve for good x.

The Price Consumption Curve

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Individual Demand Curve for X

X

PX

XA=2 XB=10 XC=16

The points found on the price consumption curve produce the typically downward-sloping demand curve we are familiar with.

PX = 4

PX = 2

PX = 1

••

• U increasing

THE HICKSIAN METHOD• Sir John R.Hicks (1904-1989)• Awarded the Nobel Laureate in Economics (with Kenneth J. Arrrow) in 1972 for work on general equilibrium theory and welfare economics.

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THE HICKSIAN METHOD

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X2

X1

Ea

I1

xa

Optimal bundle is Ea, on indifference curve I1.

THE HICKSIAN METHOD

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X2

X1

I1

xa

Ea

A fall in the price of X1

The budget line pivots out from P P*

THE HICKSIAN METHOD

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X2

X1

Eb

I1

I2

xa xb

Ea

The new optimum is Eb on I2.

The Total Price Effect is xa to xb

THE HICKSIAN METHOD

• To isolate the substitution effect we ask….“what  would  the  consumer’s  optimal  bundle  be  if s/he  faced  the  new  lower  price  for  X1  but experienced no change in real income?”

• This  amounts  to  returning  the  consumer  to  the original indifference curve (I1)

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THE HICKSIAN METHOD

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X2

X1

Eb

I1

I2

xa xb

Ea

The new optimum is Eb on I2.

The Total Price Effect is xa to xb

THE HICKSIAN METHOD

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X2

X1

I1

I2

xa xb

EaEb

Draw a line parallel to the new budget line and tangent to the old indifference curve

THE HICKSIAN METHOD

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X2

X1

Ec I1

I2

xa xc xb

EaEb

The new optimum on I1 is at Ec. The movement from Ea to Ec (the

increase in quantity demanded from Xa to Xc) is solely in response to a

change in relative prices

THE HICKSIAN METHOD

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X2

X1

I1

I2

Substitution Effect

EaEb

Ec

This is the substitution effect.

Xa Xc

THE HICKSIAN METHOD

• To isolate the income effect …• Look at the remainder of the total price effect • This is due to a change in real income.

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THE HICKSIAN METHOD

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X2

X1

I1

I2

Income Effect

EaEb

Ec

The remainder of the total effect is due to a change in real income. The

increase in real income is evidenced by the movement from I1

to I2

XcXb

THE HICKSIAN METHOD

Final diagram....

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X2

X1

I1

I2

xa xc xb

Sub Effect

Income Effect

EaEb

Ec

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The individual’s demand curve can be seen as the individual’s willingness to pay curve.

On the other hand, the individual must only actually pay the market price for (all) the units consumed.

For example, you may be willing to pay $40 for a haircut, but upon arriving at the stylist, discover that the price is only $30

The difference between willingness to pay and the amount you pay is the Consumer Surplus

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Definition: The net economic benefit to the consumer due to a purchase (i.e. the willingness to pay of the consumer net of the actual expenditure on the good) is called consumer surplus.

The area under an ordinary demand curve and above the market price provides a measure of consumer surplus.

Note that a consumer will receive more surplus from the first good than from the last good.

Consumer Surplus

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D

Q*

P*EquilibriumOr marketPrice

Quantity

Price

ConsumerSurplus

Consumer Surplus: The difference between what a consumer is willing to pay and what they pay for each item

Efficiency of the Equilibrium Quantity

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D

10

$8This calculationOnly works forA linear demandcurve

Quantity

Price

ConsumerSurplus

Consumer Surplus = area of triangle=1/2bh=1/2(16-8)(10)=40

$16

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