Chapter Three

Theory of Consumer Behavior

3.1 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. But, have ever thought of how your
mother or any other person whom you know decides to buy those consumption goods and
services? Consumer theory is based on what people like, so it begins with something that we
can‘t directly measure, but must infer. That is, consumer theory is based on the premise that we
can infer what people like from the choices they make.

Consumer behaviour 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.

Chapter objectives

After successful completion of this chapter, you will be able to:

 explain consumer preferences and utility

 differentiate between cardinal and ordinal utility approach

 define indifference curve and discuss its properties

 derive and explain the budget line

 describe the equilibrium condition of a consumer

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. 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 saying that the consumer strictly prefers X to Y, in
the sense that she definitely wants the X-bundle rather than
the Y-bundle. 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. 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. That is, if the consumer thinks that X is at least as good as Y and that Y
isat least as good as X, then she must be indifferent between the two bundles of goods. Similarly,
if X ⪰ Y but we know that it is not the case that X~ Y, we can conclude that X≻Y. This just says
that if the consumer thinks that X is at least as good as Y, and she is not indifferent between the
two bundles, then she thinks that X is strictly better than Y.

3.2 The concept of utility

Economists use the term 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, it is important to bear in mind the following points.

 ‗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. That means,
the utility that two individuals derive from consuming the same level of a product may
not be the same. For example, non-smokers do not derive any utility from cigarettes.

 Utility can be different at different places and time. For example, the utility that we get
from drinking coffee early in the morning may be different from the utility we get during
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.
According to 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

According to 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, we can assert that
Bilen gets more satisfaction from orange than from banana.

3.3.1.1 Assumptions of cardinal utility theory

The cardinal approach is based on the following major assumptions.
1. Rationality of consumers. The main objective of the consumer is to maximize his/her
satisfaction given his/her limited budget or income. Thus, in order to maximize his/her
satisfaction, the consumer has to be rational.

2. Utility is cardinally measurable. According to the cardinal approach, the utility or

satisfaction of each commodity is measurable. Utility is measured in subjective units
called utils.

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. A person at the start of the month where he has received
monthly salary gives equal value to 1 birr with what he may give it after three weeks or so.

4. Diminishing marginal utility (DMU). The utility derived from each successive units of a
commodity diminishes. In other words, the marginal utility of a commodity diminishes as
the consumer acquires larger quantities of it.

5. The total utility of a basket of goods depends on the quantities of the individual
commodities. If there are n commodities in the bundle with quantities X 1 , X 2 ,...X n , the

total utility is given by TU = f ( X 1 , X 2 ......X n ).

 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. However, there is a saturation point for that
commodity beyond which the consumer will not be capable of enjoying any greater satisfaction
from it.

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.

Mathematically, marginal utility is:

TU
MU 
Q
where, TU is the change in total utility, and Q is the change in the amount of product
consumed.

To explain the relationship between TU and MU, let us consider the following hypothetical
example.

Table 3.1: Total and marginal utility

Quantity Total utility (TU) Marginal utility (MU)
0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2

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) as quantity consumed increases.
Graphically, the above data can be depicted as follows.

TU

30

TU

18

0 2 6 Quantity Consumed

MU

Quantity Consumed
0 2 6

Figure 3.1: Total and marginal utility curves

As it can be observed from the above figure,

 When TU is increasing, MU is positive.
 When TU is maximized, MU is zero.
 When TU is decreasing, MU is negative.

3.3.1.3 Law of diminishing marginal utility (LDMU)

Is the utility you get from consumption of the first orange the same as the second or the third
orange?

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. In other words, the extra satisfaction that a
consumer derives declines as he/she consumes more and more of the product in a given period
of time. This gives sense in that the first banana a person consumes gives him more marginal
utility than the second and the second banana also gives him higher marginal utility than the
third and so on (see figure 3.1).
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 consumer 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.
MU X  PX

Proof
Given the utility function
U  f (X )

If the consumer buys commodity X, then his expenditure will be . The consumer
maximizes the difference between his utility and expenditure.
Max(U  QX PX )

The necessary condition for maximization is equating the derivative of a function to zero.
Thus,
dU d (Q X PX )
 0
dQ X dQ X
dU
 PX  0  MU X  PX
dQ X
 MUX
A


PX C



 B

MUX
QX

Figure 3.2: Equilibrium condition of consumer with only 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. That is,

PxX + PyY = M
where, M is the income of the consumer.

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.

Table 3.2: Utility schedule for two commodities

Income = 7 Birr, Price of banana = 1 Birr, Price of bread = 4 Birr
Banana Bread
Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 6 1 12 12 3
2 11 5 5 2 20 8 2
3 14 3 3 3 26 6 1.5
4 16 2 2 4 29 3 0.75
5 16 0 0 5 31 2 0.5
6 14 -2 -2 6 32 1 0.25
 Recall that utility is maximized when the condition of marginal utility of one commodity
divided by its market price is equal to the marginal utility of the other commodity divided by
its market price.
MU 1 MU 2

P1 P2
In table 3.2, there are two different combinations of the two goods where the MU of the last
birr spent on each commodity is equal. However, only one of the two combinations is
consistent with the prices of the goods and her income. Saron will be at equilibrium when she
consumes 3 units of banana and 1 loaf of bread. At this equilibrium,

i) MU1/P1 = MU2/P2
MU banana MU b rea d 3 12
   3
Pbanana Pbread 1 4

ii) P1.Q1+ P2.Q2= M

(1*3) + (4*1) = 7

The total utility that Saron derives from this combination can be given by:
TU= TU1 + TU2
TU= 14 + 12
TU= 26

Given her fixed income and the price level of the two goods, no combination of the two goods
will give her higher TU than this level of utility.

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

In the ordinal utility approach, it is not possible for consumers to express the utility of various
commodities they consume in absolute terms, like 1 util, 2 utils, or 3 utils but it is possible to
express the utility in relative terms. 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
The ordinal approach is based on the following assumptions.
 Consumers are rational - they maximize their satisfaction or utility given their income
and market prices.
]

 Utility is ordinal - utility is not absolutely (cardinally) measurable. Consumers are

required only to order or rank their preference for various bundles of commodities.
 Diminishing marginal rate of substitution: The marginal rate of substitution is the rate
at which a consumer is willing to substitute one commodity for another commodity so
that his total satisfaction remains the same. The rate at which one good can be substituted
for another in consumer‘s basket of goods diminishes as the consumer consumes more
and more of the good.
 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.

The ordinal utility approach is explained with the help of indifference curves. Therefore, the
ordinal utility theory is also known as the indifference curve approach.

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.

Consider a consumer who consumes two goods X and Y (table 3.3).

Table 3.3: Indifference schedule

Bundle (Combination) A B C D
Orange 1 2 4 7
Banana 10 6 3 1

In table 3.3 above, each combination of good X and Y gives the consumer equal level of total
utility. Thus, the individual is indifferent whether he consumes combination A, B, C or D.

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.
 10 A

Banana
Banana

6 B

C
3 IC3
D IC2
1
IC1
Orange
1 2 4 7 Orange

i) Indifference curve ii) Indifference map

Figure 3.3: Indifference curve and indifference map

3.3.2.3 Properties of indifference curves

1. Indifference curves have negative slope (downward sloping to the right). Indifference
curves are negatively sloped because the consumption level of one commodity can be
increased only by reducing the consumption level of the other commodity. In other words, in
order to keep the utility of the consumer constant, as the quantity of one commodity is
increased the quantity of the other must be decreased.

2. Indifference curves are convex to the origin. This implies that the slope of an indifference
curve decreases (in absolute terms) as we move along the curve from the left downwards to
the right. The convexity of indifference curves is the reflection of the diminishing marginal
rate of substitution. This assumption implies that the commodities can substitute one another
at any point on an indifference curve but are not perfect substitutes.

3. A higher indifference curve is always preferred to a lower one. The further away from the
origin an indifferent curve lies, the higher the level of utility it denotes. Baskets of goods on a
higher indifference curve are preferred by the rational consumer because they contain more
of the two commodities than the lower ones.

4. Indifference curves never cross each other (cannot intersect). The assumptions of
consistency and transitivity will rule out the intersection of indifference curves. Figure 3.4
shows the violations of the assumptions of preferences due to the intersection of indifference
curves.
 Good Y
A
B
IC2
C
IC1

Good X
Figure 3.4: Intersection of indifference curves

In the above figure, the consumer prefers bundle B to bundle C. On the other hand, following
indifference curve 1 (IC1), the consumer is indifferent between bundle A and C, and along
indifference curve 2 (IC2) the consumer is indifferent between bundle A and B. According to
the principle of transitivity, this implies that the consumer is indifferent between bundle B and
C which is contradictory or inconsistent with the initial statement where the consumer prefers
bundle B to C. Therefore, indifference curves never cross each other.
22

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. Since one of the goods is scarified to obtain more of the other
good, the MRS is negative. Hence, usually we take the absolute value of the slope.
Number of units of Y given up Y
MRS  
X ,Y
Number of units of X gained X

To understand the concept, consider the following indifference curve.

Good Y

30 A

20 B

12 C
8 D
IC

5 10 15 20 Good X

Figure 3.5: Indifference curve for two products X and Y

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. That is, for the same increase in the
consumption of good X, the amount of good Y the consumer is willing to scarify diminishes.
This principle of marginal rate of substitution is reflected by the convex shape of the
indifference curve and is called diminishing marginal rate of substitution.

It is also possible to derive MRS using the concept of marginal utility. MRS X ,Y is related to

MUX and MUY as follows.

MU X
MRS X ,Y 
MU Y
Proof: Suppose the utility function for two commodities X and Y is defined as:
U  f ( X ,Y )

Since utility is constant along an indifference curve, the total differential of the utility
function will be zero.
U U
dU  dX  dY  0
X Y

MU X dX  MU Y dY  0

MU X dY MU Y dX
  MRS X ,Y Similarly,   MRS Y , X
MU Y dX MU X dY

Example: Suppose a consumer‘s utility function is given by U ( X ,Y )  X 4Y 2 . Find MRSX,Y

MU X
Solution: MRS 
X ,Y
MU Y
3 2
U U MU X 4X Y 2Y
MU   4X Y 3 2
and MU   2X Y
4
Hence, MRS   
X Y
X Y X ,Y
MU Y 2 X 4Y X

3.3.2.5 The budget line or the price line

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?

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).

Assuming that the consumer spends all his/her income on the two goods (X and Y), we can
express the budget constraint as:
M  PX X  PY Y
By rearranging the above equation, we can derive the following general equation of a budget
line.

M PX
Y  X
PY PY

Graphically,

Good Y

M/PY

B


A




 Good X
 M/PX

 Figure 3.6: The budget line

Note that:
PX
 The slope of the budget line is given is by  (the ratio of the prices of the two goods).
PY
 Any combination of the two goods within the budget line (such as point A) or along the
budget line is attainable.
 Any combination of the two goods outside the budget line (such as point B) is
unattainable (unaffordable).
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.

Solution: The equation of the budget line can be derived as follows.

PX X  PY Y  M Y
3 X  5Y  100
5Y  100  3 X 20

100 3
Y   X
5 5
3
Y  20  X X
5
33.3

When the consumer spends all of her income on good Y, we get the Y- intercept (0,20).
Similarly, when the consumer spends all of her income on good X, we obtain the X- intercept
(33.3,0). Using these two points we can sketch the graph of the budget line.

Recall that a budget is drawn for given prices and fixed consumer‘s income. Hence, the
changes in prices or income will affect the budget line.

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 and decreases in income causes a downward/inward shift in the budget line that leads
the consumer to buy less quantity of the two goods. It is important to note that the slope of the
budget line (the ratio of the two prices) does not change when income rises or falls.

Good Y

M/Py

Good X
M/Px

Figure 3.7: Effects of increase (right) and decrease (left) in income on the budget line
Change in prices: An equal increase in the prices of the two goods shifts the budget line
inward. Since the 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, one the other hand, shifts
the budget line out ward. Since the two goods become cheaper, the consumer can purchase the
more amounts of the two goods.

Good Y

M/Py

Good X
M/Px
Figure 3.8: Effect of proportionate increase (inward) and decrease (out ward) in the prices
of both goods

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. For instance, if the price of good X
decreases while both the price of good Y and consumer‘s income remain unchanged, the
horizontal intercept moves outward and makes the budget line flatter. The reverse is true if the
price of good X increases. On the other hand, if the price of good Y decreases while both the
price of good X and consumer‘s income remain unchanged, the vertical intercept moves
upward and makes the budget line steeper. The reverse is true for an increase in the price of
good Y.

Good Y

Good X
Figure 3.9: Effect of decrease in the price of only good X on the budget line
 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 the point
where the indifference curve is tangent to the budget line so that the slope of the indifference
curve ( MRS XY ) is equal to the slope of the budget line (PX / PY ). In figure 3.10, the equilibrium
of the consumer is at point ‗E‘ where the budget line is tangent to the highest attainable
indifference curve (IC2).

Y* E
IC3

IC2
IC1

X
X*

Figure 3.10: Consumer equilibrium under indifference curve approach

Mathematically, consumer optimum (equilibrium) is attained at the point where:

Slope of indifference curve = Slope of the budget line
PX
MRS XY 
PY
MU X PX
 
MU Y PY

Example: A consumer consuming two commodities X and Y has the utility function
U ( X ,Y )  XY  2 X . The prices of the two commodities are 4 birr and 2 birr respectively. The
consumer has a total income of 60 birr to be spent on the two goods.

a) Find the utility maximizing quantities of good X and Y.

b) Find the MRS X ,Y at equilibrium.
 Solution
a) The budget constraint of the consumer is given by:
PX.X+ PY.Y = M
4X+2Y= 60 …………….…………. (i)

Moreover, at equilibrium
MU X P
 X
MU Y PY
Y 2 4

X 2
Y 2
2
X
Y  2 X  2 ………….………… (ii)

Substituting equation (ii) into (i), we obtain Y  14 and X  8.

b) MRS  MU X  Y 2  14 2  2

X ,Y
MU Y X 8

(At the equilibrium, MRS can also be calculated as the ratio of the prices of the two goods)
Chapter summary

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 he is indifferent between the two bundles. Economists use the term
utility to describe the satisfaction or pleasure derived from consumption of a good or service.
In other words, utility is the power of the product to satisfy human wants.

There are two approaches to measure or compare consumer‘s utility derived from consumption
of goods and services. These are cardinal and ordinal approaches. The cardinalist school
postulated that utility can be measured objectively. However, the assumption of cardinal utility
is doubtful because utility may not be quantified. Unlike the cardinal theory, the ordinal utility
theory says that utility cannot be measured in absolute terms but the consumer can rank or
order the utility he derives from different goods and goods.

The ordinal/indifference curve approach is based on the consumer‘s budget line and
indifference curves. An indifference curve shows all combinations of two goods which yield
the same total utility to a consumer and the budget line represents all combinations of two
products that the consumer can purchase, given product prices and his or her money income.
The consumer is in equilibrium (utility is maximized) at the point where the budget line is
tangent to the highest attainable indifference curve.