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Week 5

Consumer Behavior

Theory of Consumer Behavior

• In our previous lectures, we looked at the concept of a market, we saw

that a market comprises mainly of the consumer and the producer.

• A consumer was represented by a demand curve while a producer by a

supply curve.

• This chapter we shall concentrate on the consumer by looking at the

behavior of a consumer in exclusion from both other consumers and
producers.

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Cont.…

• We recall that a consumer is one who uses goods and services to satisfy
her wants.

• She is assumed to be rational meaning that he aims at utility

maximization; given her income and commodity prices.

• There are several theories that have been developed to try and explain
the behavior of a consumer. However, they can be categorized into two
distinct theories

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Cont…

1. Cardinal Utility Theory; Which argues that a consumer has the

capacity to measure the level of satisfaction that she derives from
consumption of a given quantity of a commodity

2. Ordinal Utility Theory; Which argues that a consumer can not

measure satisfaction numerically or subjectively. Instead she can rank
the different baskets or bundles so as to choose the best basket

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1. Cardinal Utility Theory

• The basic concept in this approach is utility, which refers to the satisfying
power that a good or service consumed possesses.

• In this approach it is assumed that a consumer assigns a cardinal measure

which can be counted.

• This means that a consumer can tell exactly how much satisfaction she can
derive from the consumption of a certain good

• The theory assumes a cardinal measures in units called Utils i.e. that utility
can be measured subjectively in units called Utils using an instrument
called a Utilometer.
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Assumptions to the Cardinal Utility Theory

• Rationality; By the term rationality in consumption, we mean that a

consumer aims at maximizing her utility given her income and prices
of the commodities purchased by her. The consumer will always
exhaust the income if she is to maximize her satisfaction

• Utility is subjective; This means that the consumer is capable of

measuring numerically and exactly the level of satisfaction that she
gets from the consumption of a good.

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Cont.…
• Total utility of a basket of goods depends on different quantities of the individual
commodities by her U=U(Xi); i=1,2…,n are the different quantities of the good.
This means that the consumer derives satisfaction from all the different units of
goods consumed by her alone.

• Consumer derives utility from the consumption of every commodity consumed by

her. The consumer’s utility function is therefore independent of the utility
functions of other consumers. This also means that, whether the consumer decides
to buy or not, depends entirely on personal preferences. So the consumer is
assumed not be under influence of other consumers.
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Cont.…
• The theory assumes the consumption of only one commodity
• All commodities available to the consumer are perfectly are perfectly
divisible into smaller units
• When more of a single commodity is consumed, total utility increases,
reaches maximum then falls.
• The theory assumes diminishing marginal (addition) satisfaction or
utility as more of a single commodity is consumed.
• In other words, it is based on the law of diminishing marginal utility
which states that, “As more and more of a single commodity is consumed,
each additional unit consumed provides the consumer with less and less
additional satisfaction than the preceding unit

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Total Utility (TU)

• This refers to total satisfaction derived by an individual from the
consumption of a good or service.

• In other words, it refers to the sum of individual utilities derived from

the different units of a particular commodity consumed.

• Graphically, the Total Utility curve rises from zero up to a point

referred to as the point of satiety then it falls

• The curve behaves in accordance with the law diminishing marginal

utility.

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Figure 1.1 Total Utility Curve

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Marginal Utility (MU)

• This refers to the additional utility derived from consumption of an extra
unit of a commodity.
• It can be defined as the change in total utility divided by a change in
quantity if a commodity consumed, that is
!(#$)
• MU=
!&
• In other words MU is the slope or gradient of the utility function.
• This implies that when the total utility function(TU) is rising, marginal
utility (MU) is positive, and when TU reaches maximum MU is zero and
when the TU function is falling MU is negative
• This can be illustrated using the figure 1.2 below

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Figure 1.2 Marginal Utility Curve

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Diminishing Marginal Utility

• The shape of the MU curve is in accordance with the law of diminishing

marginal utility, which states that “as more and more of a given
commodity is consumed, additional utility (MU) will keep on failing.”

• This law is illustrated using the following hypothetical table

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A hypothetical Example

Quantity of X Utility MU
0 0
1 12 12
2 22 10
3 30 8
4 35 5
5 35 0
6 34 -1
7 30 -4
8 25 -5

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Equilibrium of a Consumer under the Cardinal Utility

Approach

• A consumer is said to be in equilibrium when she equates her marginal

utility with the price of the commodity.
• This implies that the consumer can measure the satisfaction in money
terms.
• If the consumer’s marginal utility exceeds the price of a commodity, the
consumer should purchase more units of the commodity
• But as she consumes more of the same commodity, the marginal utility
will start falling up to a point when MU equals to the price of a
commodity
• At that point a consumer is said to be in equilibrium

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Cont.…

• On the other hand when the price of a commodity exceeds marginal

utility, the consumer should purchase less and less units of the
commodity.

• As less and less units are consumed marginal utility will start rising up to
the point when it is equal to the price of the commodity.

• Therefore at equilibrium , 𝑀𝑢' = 𝑃'

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Cont.…
• However, it is not always the case that an individual will consume only one
commodity, for simplicity, if we consider a situation where a consumer purchases
two commodities, the consumer will be in equilibrium when she equates the
marginal utility derived from each commodity to its respective price, that is

• 𝑀𝑢! = 𝑃! ……………………..(1)

• 𝑀𝑢" = 𝑃" ……………………..(2)

• Dividing equation (1) by equation (2) we get

#$! %!
• = ………………………..(3)
#$" %"

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Cont.…

• The above expression states that a consumer is in equilibrium when she

equates the ratio of marginal utilities obtained from two commodities to
the ratio of their respective prices

• Re-arranging the above expression we get the following

()& ()'
• *&
= *'
…………………………(4)

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Cont.…

• Basing on the expression in equation (4), we cn now write the general

equilibrium condition of a consumer who consumes several commodities.

()( ()) ()
• *(
= *)
=……………………… * *
*

• The above expression means that the consumer is in equilibrium when

she gets equal additional satisfaction upon spending an extra unit of her
income on any of the commodities given the commodity prices

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Ordinal Utility Theory/Indifference Curve

Approach

• The ordinal utility theory of consumer behavior is also commonly known as the
indifference curve theory because its analysis is based on indifference curves.

• The major difference between the ordinal theory and cardinal utility theory is that
under the ordinal utility theory, the consumer can not measure numerically the level
of satisfaction derived from consumption of the commodity.

• But can instead arrange or rank the different baskets of commodities basing on the
quantities contained in each and their satisfying power with the assumption that the
goods are homogeneous

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Cont.…

• The basic concept under this approach is the indifference curve; that,
preferences are arranged in form of indifference curves. Indifference
curves are psychological levels of satisfaction hence are more hypothetical
than real

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Assumptions of Ordinal Utility Approach

• The ordinal utility approach to consumer behavior is built on the

following assumptions
a) Utility is ordinal meaning that, a consumer can arrange her preferences
according to the order of satisfaction that she derives from each basket.
• She does not need to know exactly the amount of satisfaction which she
derives from each basket instead what is necessary is to know the
satisfying power of each basket
• For instance a consumer can say precisely that basket A gives her more
satisfaction than B without requiring her to measure numerically the
amount of satisfaction

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Cont.…

b) A consumer is assumed to be rational this means that she aims at

maximizing satisfaction given her income and the commodity prices and
will always choose the basket that gives her the greatest level of
satisfaction

c) The theory assumes consumption of at least two commodities

d) Total utility of the consumer depends upon the different quantities

consumed by her, that is U=U(𝑋+, 𝑋,, … … . 𝑋- ) where 1, 2,…n are the n
commodities
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Cont.…

e) It assumes diminishing Marginal Rate of substitution. The slope of an

indifference curve is known as Marginal Rate of Substitution (MRS)
and it shows the rate at which the consumer is willing to substitute
commodity say X for another commodity say Y
f) It assumes consistency and Transitivity. By consistency we mean
that if the consumer prefers combination A to B in one situation then
she would not prefer B to A in another situation when A is still available
otherwise she would be inconsistent in her choice
In other words, if A>B, B>A
On the other hand, transitivity means that if the consumer prefers A to
B and yet she prefers B to C then it would imply that she prefers A to C.
I.e. if A>B and B>C……..A>C

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An Indifference Curve

• An indifference curve is a locus of two commodity combinations that give

rise to equal levels of satisfaction to a consumer.

• Therefore, along an indifference curve a consumer is indifferent between

the commodity combinations.

• This means that faced with a set of different combinations, the consumer
can choose any combination since each gives her equal satisfaction

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Figure 1.5 An indifference Curve

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Cont.…
• From figure 1.5, all points along the indifference curve (IC) such as A, B and
C give the consumer the same level of utility

• But of the three combinations, A contains the greatest amount of commodity

Y, and least amount of commodity X.

• While C contains the greatest amounts of commodity X, and least amount of

commodity Y

• Moving down the curve from A to C, the consumer reduces the quantity of
commodity Y, so as to acquire more units of commodity X, if she is to remain
on the same indifference curve

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Cont.…
• Since along the same indifference curve, quantity of one commodity is
reduced while that of another is increased, it means that an indifference
curve has a negative slope.
• Also the reduction in commodity Y and increase in commodity X are not
in equal proportions, instead down the curve, the successive reduction in
the quantity of commodity Y declines progressively in exchange for an
extra unit of commodity X.
• This means that an indifference curve is convex to the origin, which
implies that
i. It has a negative slope and
ii. Its slope decreases in absolute terms down the curve

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An Indifference Map

• An indifference map is a set of indifference curves that are parallel to

each other since they represent different utility levels.

• Given an indifference map, the higher the indifference curve the

greater the level of satisfaction and vice versa

• Since a consumer is assumed to be rational, meaning that she prefers

more to less, then she will prefer a commodity combination that lies on
the highest possible indifference curve to one that lies on a lower
indifference curve
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Figure 1.6 An indifference map

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Cont.…

• From figure 1.6, above, Since 𝑈. lies on the highest indifference curve, it
means that it gives the consumer the greatest level of satisfaction as
compared to 𝑈, & 𝑈+

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END
Wemesa Richard, PhD 0772504537 /
0752695456

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