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48 views23 pagesChapter 6 - Consumer Behaviour
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/ 23
Consumer
Behaviour
| rere eS a= leltag
|
Meaning of Consumer Income
Consumer Equilibrium Budget Line Consumption}
Behaviour (Maximum Utility) Curve
| on Cardinal l |
| When individuals | + Substitution effect | + Change in + Nomat: Upward
are faced witha | + Income effect income sloping from left
choice of + The higher the + Change in to right
feasible price of goods, the price + Inferior:
alternatives lower the quantity Backward curve
+ Necessity |
Vertical
Law of
Diminishing
Marginal Utility
Indifference Consumer
Curve Surplus
I |
+ Negative gradient Total amount
+ Situated on the right, consumers are
ite, represents a higher willing to pay
level of satisfaction minus market price
+ Cannot intersect for the product EARNING OUTCOMES
¢ the end of this chapter, students should be able to understand:
Moaringof consumer behaviour 9 Marginal rate of substitution
2. Cardinalutty approach 40 Budget line
3. Total ily and marginal tity 41 Consumer equim (maximum uty) on
i 4 Lawofdiminishing marginal utility ordinal (IC & BL)
5 Consumer equlibrium (maximum uti) on 12 Derivedindividual demand curve on ordinal
cardinal 43. Engel curve (income effect and substtuton
6 Derivedindividualdemtandcurveon cardinal effect)
7 Ordinal uty approach 14 Consumer surplus and producer surplus
8 Indifference curve
Cardinal Total Utility Derived Marginal
sity and Marginal Individual Rate of !
Approach utility Demand Curve | | | Substitution
on Cardinal} |“
‘Consumer Price
Equilibrium ‘Consumption
(Maximum Usiity)
on Ordinal
Ordinal Utility
Approach
|
* Consumers cannot be
measured in quantitative
form, but can be compar
in lenis of comparso
i tion oF P22 ] MICROECONOMICS FOR BEGINNERS
$209 INTRODUCTION
This chapter outlines the basics of houschold utility theory. The theory of consump
choice behaviour studies the actions of a rational consumer in the allocation o¢
income to buy goods and services so as to maximise satisfaction or utility. It takes
into account the preferences of consumers and assumes consumers will try
ang
fulfil their satisfaction in the most efficient way.
(28) MEANING OF CONSUMER BEHAVIOUR
Economists assume that when individuals are faced with a choice of feasible
alternatives, they will always select the alternative that provides the highest level
of utility. Utility is defined as the level of happiness or satisfaction associated
with alternative choices. According to the theory of utility, consumers use
satisfaction level as the basis to make consumption choices and evaluate goods
based on satisfaction. Basically, there are two approaches ofutility theory analysis
namely, the cardinal approach and the ordinal approach.
(223) CARDINAL UTILITY APPROACH
1 This approach states that the individual can measure quantitatively the
intensity ofa preference for one basket of goods over another. The higher the
satisfaction, the higher the utility index will be.
2 ‘The cardinal utility theory says that utility is measurable by placinga number
of alternatives so that the utility can be added. The index used tomeasure
utility is called utils.
3 For example, if you get 10 utils when consuming bundle A and 20 utils for
consuming bundle B, then we can say that bundle B gives you twice the
satisfaction as compared to bundle A. In this case we measure the utility the
same as we measure weight ortemperature,
QE TOTAL UTILITY AND MARGINAL UTILITY
‘There are two basic concepts of utility, namely total utility and marginal utility.
Total Utility
1. Total utility is a measure of the total satisfaction of wants and needs obtained
from the consumption or use of all goods or services over a particular time
period.
|
|
i
}
j |
Hic exemple, Naim Syuksi spends a day consuming bread and then records |
mount of total utility achieved at the end of each consumption, as shown |
ble 4.1 |
ion Table 4.1 Total utlity achieved from bread consumption
» takes! abd Emule
¥ and 0 i 0
1 14
2 20
3 Hery
4 32
5 35,
& ee Heap eee
7 zi 34
a 32 i
(a) Naim’ utility increases for the first 6 consumptions, reaching a high of
36 utils, before declining to 32 utils for the 8th consumption.
(©) Presumably Naim’s utility continues to decline after the 8th consumption.
(f) Naim obtains the highest total utility from 6consumptions.
4 The motivation that guides Naim’s bread consumption is to maximize utility,
that is, to consume the quantity of goods that generates the highest level of
utility. In this example, utility is maximized at 6 consumptions, as shown in
Figure 4.1.
ustty
+ +
of
2}
Total utility
bere
Figure 4.1. Maximum utility Marginal Utility
1 Marginal urility is a measure of the additional utility that is received when
one of more units of the same goods or services is consumed
2 Table 4.2 illustrates the relationship that exists between the total ang
marginal utility associated with Naim Syukei’s consumption of bread in 4
given time petiod.
r
|
Table 4.2. Relationship between total utility and marginal utility
I
|
|
|
i
3 As Table 4.2 indicates, the marginal utility associated with an additionalslice —?
of bread is the change in the level of total utility that occurs when one more
slice of breadis consumed, Note, forexample, that the marginal utility of the
third slice of bread is 7 since total utility increases by 7 units (from 20 to 27)
when the thitd slice of bread is consumed.
4 ‘The formula for marginal utility is as follows:
5 ‘The marginal utility curve is depicted in Figure 4.2.
Change in total utility
Minginal uti = eee an
Marginal uty
Number of slices
Figure 4.2 Marginal utility curve 4. The principle of diminishing marginal utility is the increment in utility shat
Q accompanies an increment in the consumption of the goods. The increment |
becomes smaller and smaller as more of the goods is consumed.
Since marginal utility diminishes as consumption increases, there comes a
point where the consumer is unwilling to spend any more money on the
particular goods.
‘The law of diminishing marginal utility states that marginal utility declines
as more of a particular goods is consumed ia a given time period, ceteris
paribus. Even though marginal utility declines, total utility still increases as
long as marginal utility is positive, Total utility will decline only if marginal
utility is negative, as shown in Table 4.2.
The relationship between total utility aad marginal utility is illustrated in @)
Figure 4.3.
‘Total Utility (TU) i
100 + :
40 12 Quantity
Marginal Usity (4U)
A ae
4 | 40 12 Guentity
GE My
Figure 4.3 Relationship between total utlity and marginal uility 4 Based on Figure 4.3, cherelationship between total utility and marginal utiiy
can be described as follows: :
@ TU mex, MU=0
(b) TU T, MU ¥ (stil positive)
(© TUL, MU = negative
§2EB CONSUMER EQUILIBRIUM (MAXIMUM
UTILITY) ON CARDINAL
In maximising utility ot satisfaction, consumers are restricted by limited income
and price of goods. Consumer equilibrium is known as the Law of Equi-Marginal
Utility (EMU) which states that other things being equal, a consumer gets maximum
satisfaction when he allocates his limited income to the purchase of differen
goods, where the marginal utility derived from the last unic of money spent on
each item of expenditure tends to be equal. The different scenarios for consumes
i equilibrium are tabulated in Table 4.3 and will be discussed in the following section,
| Table 4.3 Different scenarios for consumer equilibrium
eo
‘Scenario of three or more
goods’
‘Scenario of income. changes,
‘Scenario of price char
i
|
i
|
Scenario of One Goods
1 Table 4.4 shows the total utility, marginal utility and price of goods X, where |
P= RMS and MU,.= Py, From the table, consumers achieved equilibrium at |
the fourth unit, thatis, when matginal utility is equivalent to price, Thus, the
consumer will choose to buy 4 units of goods X since MU, = P, at RMS,
Table 4.4 Scenario of one goods
eect’
bonds
a Gonstimer Bahia
2 Whar if you can obtain the particular goods free of charge? When goods aze
free of charge, there are no more budget constraints and you ate not restricted
by the willingness to pay. Therefore, you will use the goods until total utility is
maximised atthe sixth unit. The seventh unit will not be considered becavee
it decreases the total uly, If you purchase the seventh unit, you will feel
uncomfortable or reluctant due to excessive consumption,
3 Marginal utility becomes the sum of money w
villing t0 be paid to obtain
one additional unit of goods, Here, when consumption only involves one
type of goods, consumers will maximise satisfaction from the consumption
of the goods when marginal utility is equivalent 0 ptice, Satisfaction is
maximised when ptice is equivalent to marginal utility because marginal
usllty indicates the willingness to pay. ‘Therefore, if marginal utility obtained
from the consumption of an additional unit is much higher than the price
that needs to be paid, consumers will still be able to increase satisfaction ith
additional purchases,
Scenario of Two Goods with the Same Price
g 1 Wehave seen the behaviour of consumers when they deal with the problem
* ofconsuming one ‘goods. Now, let us look at consumers who have to divide
‘Certain amount of expenditure between two or more goods,
Assume that you have a sum of income (1) to be divided for the purchase of
food @X) and textbooks (¥). As a rational consumer, you vill spend all the
money t0 choose 4 combination where marginal uilty per ringgit for both
Boods are the same, that is MU, = MU, and Py =P, = RMI, Based on Table
45, the consumer will choose to buy 5 units of goods X and 1 unit of goods
Y since MU, = MUy.
Table 4.5 Scenario of two goods with the same price
_ —_ ICONOMICS FOR BEGINNERS
Scenario of Two Goods with Different Prices
1 For the scenario of owo goods with different prices, assume that income (Y)
1
= RMI9, Px = RM3,Pr= RM2 and MUs = MUy 95 shown in Table 46.
OP '
Table 4.6 Scenario of two goods with different prices
2 Table 4.7 shows the possible combination of goods based on an income of
RMI9 and goods X and ¥ priced at RM3 and RM2 respectively.
|
3X and 5Y 3(RM8) + 6(RM2) = RMS
4X and6Y ——4(RM3) + 6(RM2) = RM24
‘ a at
3 Based on Table 4.7, the consumer will choose to buy 3 units of goods X and 5
1
units of goods Y since MUx= “ and total expenditure for X + ¥ =RML9.
Px Y ario of Three or More Goods
For the scenario of theee goods with different prices, assume that income (¥)
MU, _ MU, _ MU,
|
RM37, Px = RM5,P,= RMI, P,= RM4 and AX: , as shown in
Table 4.8.
RM37 and goods P,Q and R priced at RM5, RM1 and RM4respectively.
fable 4.9 Possible combinations of three goods with different prices
2X, 4Y and 1Z 2(RMS) + 4(RM1) +
4(RM4) = RM18 i
4(RMB) + BRIM) +
(RMA) = = RM37
3 Based on Table 4.9, the consumer will choose to buy 4 units of goods X, 5 units I
of goods Y and 3 units of goods Z since MU = MUy MU. and total
expenditure of K + Y + Z = RM37. Pr Py By
Scenario of Income Changes
‘The scenario of income changes is explained with reference to the scenatio of }
two goods with different prices. Based on eatlier Table 4.6 and Table 4.7, it was
cwfiéluded that the consumer will choose to buy 3 units of goods X and 5 units
Uy snd total expendivare of X + ¥ = RMI9, Howevet,
Py Py
+ 0 income change (cither increase ot decrease) will give tise to the following
two situations. i
Situation 7 (income Decreases)
Supposing that the consumer's income decreases from RM19 to RM14, the new
utility would be obtained by maximizing the combination of goods X and goods
Y. Thus, combination 1, ie. 2 units of X and 4 units of Y, will be selected. This
means that the consumer will choose to buy 2 units of goods X and 4 units of
goods Y since MU, My ad total expenditure of X + Y = RMI4,
Py Py
Situation 2 (Income Increases)
Supposing that the consumer’s income increases from RM19 to RM24, the new
utility would be obtained by maximizing the combination of goods X and goods
Y. Thus, combination 3, ie. 4 units of X and 6 units of Y, will be selected. This
means that the consumer will choose to buy 4 units of goods X and 6 units of
MU, MU and total expenditure of X + ¥ = RM.
PU, PU,
goods Y since
Scenario of Price Changes
As consumption increases, marginal utility will dectease. ‘The quantity demanded
will be dependent on the price level, and the consumer reaches equilibrium at
MU,
PUx
Situation 1 (Price Decreases)
When the price of goods X falls while the price of goods Y remains, the MU per
price obtained becomes higher for goods X compared to goods Y. In order to make
the MUx = MUy soain, the consumer has to reduce consumption of goods ¥ and
PU, PU,
inctease consumption of goods X. In shost, when MU,/Py > MUy/Py, increase the
quantity of goods X.
Situation 2 (Price Increases)
When the price of goods X increases while the price of goods Y remains, the MU
pet price obtained becomes smaller for goods X compated to goods Y.In order
MU, _ MU,
PU, PUy
goods Y and reduce consumption of goods X. In short, when MUy/Py < MUy/Py,
seduce the quantity of goods X.
vo make the again, the consumer has to increase consumption of
DERIVED INDIVIDUAL DEMAND CURVE ON
CARDINAL
1 Utility analysis also explains the law of demand. Consumers purchase goods
that satisfy wants to generate utility, Marginal utility can be used to illustrate
che nll she law of demand which claims that the price and quanti
inversely related, cereris paribus.
| golf 2. A fall in the price of goods A will cause MU,/P,to be greater than MU,/P,.
od. Ty ‘Asa result, the consumer will purchase more of goods A to testore herself to
@ eqailibrium |
3 Arise in the price of goods A will cause MU,/P, to be smaller than MU,/P,,
‘Asa result, the consumer will purchase less of goods A to restore herself to
equilibrium
4 Table 4.10 shows that at a price of RM10, the quantity demanded is 1 and the
marginal utility is 50. When the price falls to RM8, the quantity demanded
| increases to 2 but the marginal utility is at 40. This means that the lower the
vd. Thg prise, the higher the quantity demanded but the lower the matginal utility
due to an increase in consumption.
Table 4.10 Relationship between price, quantity and marginal utility
Quantity Cred
omakg (a) Margins! uty
ease i
Mu
+ duantry
s ord gy
* Quantity
Figure 4.4(a) & (b) Relationship between marginal
go utility and individual demand :
ist Fignee 44 (a) shows that at quanscy 0Q, marginal utility is high: OU.
‘Therefore, consumer is willing to buy at a higher price. At quantity 0Q,
i marginal utility is low: OU. Therefore, consumer is willing to buy with a low
price. When joining the points A and B, the demand curve will be derived
i Figure 4.4 (b) explains the relationship between price and quantity
i 1 demanded. The quantity in Figure 4.4 (a) is similar to Figure 4.4 (b). Points
‘AQB,C,D” and F? are depicted from point A, B, C, D and E in figure (@)
{ DD curve derived from joining all points A’, B’, CD’ and FE’ indicating
I demand curve is a negative slope. At point A’, a consumer is willing to
buy at a high price to get a high marginal utility. On the other had, a |
consumer with a lower marginal utilty has to pay a.lower price, Marginal
utility curve and demand curve ate the same curve. Therefore, demand
curve is detived from the marginal utility curve.
ORDINAL UTILITY APPROACH
|
1 According to the ordinal utility theory, the benefit or satisfaction gained by |
consumers cannotbe measured in quantitative form, butitcanbecompared |
in terms of comparison to the consumption of other goods. |
2 “This approach states that udlity cannotbe measured in quantitative form but |
as a ranking of one basket of goods over another. This appronch also j
stresses on compezison with consumption of other goods to determine the |
level of satisfaction. |
3 For example if bundle B gives mose satisfaction than bundle A, we assign a
higher value of utility to bundle B. We can assign 20 utils to bundle B and 10
utils to bundle A, but it does not mean that bundle B is twice as good as
bundle A. In fact we can assign 6 utils to bundle B and 5 utils to bundle A
just to show that B is more preferred than. A.
4. Ordinal approach uses the ranking of alternatives as first, second, third and
30 on,
(ZEB INDIFFERENCE CURVE
1. Consumer behaviour in maximizing satisfaction is depicted by the indifference |
curve. An indifference curve shows a combination of two types of goods
ies, that give the same level of satisfaction to a consuther. Any two points on an
indifference curve provides the same level of utility.
2 ‘The diageam below contains an indifference curve for two goods, X and Y.
When choice involves only two goods, ie. goods X and goods Y, the indifference
i curve will show various combinations of goods X and goods Y that can give
| equal satisfaction to the consumer. 5 Lerus assume that a consumer purchases two types of goods: burger (X)
and soft drink (¥)
Table 4.11 shows all the combinations which will give an equal
level of
satisfaction,
Table 4.11 Combination of goods x and goods Y ;
eum eed Goods ¥
A 2
Indifarence
| curve
° pp
23 6
Figure 4.5 Indifference curve for goods X and goods
4 Based on Figure 4.5, the consumer will choose combinations A, C and D
that can give equal satisfaction, In combination A, although th
X is the same as in combination B, combination A has more of
combination C, even thou,
A, quantity X is larger,
5 When you are able to identify all the combinations that can provide an
equal level of satisfaction and connect those combinations together, then
we will obtain an indifference curve,
© quantity of
f goods Y. In
igh the quantity of Y is less compared to combination
~, Characteristics of an Indifference Curve
[he following characteristics desctibe the indifference curve:
ative Gradient
_ the indifference curve has a negative gradient whereby the cutve always slopes
downwards from left to right because you must obtain more of goods X if you
five up a part of goods Y to ensure that satisfaction remains unchanged. For
Semple, suppose there are two groups of goods, X and Y, If the quantity of goods
Mereases, the quantity of goods Y will decrease within that group of goods so that both goods can contribute equal levels of utility and lie along the same
' indifference curve. If we increase X, we have to decrease Y to obtain the same
level of satisfaction based on the concept of marginal rate of substitution.
Indifference Curve Situated on the Right Represents a Higher
1 Level of Satisfaction
‘The positions of different indifference curves reflect the different levels of
satisfaction. The higher the indifference curve is from the otigin, the higher
the level of satisfaction will be. An indifference map consists of a series or group
of indifference curves showing various levels of consumer satisfaction. An
indifference cutve that lies above and to the tight of another indifference curve
shows a higher level of satisfaction. For example, curve Uy in Figure 4.6 gives «
higher level of satisfaction compared to curves U,and Uj. Also the satisfaction
gained for curve U, is much higher than curve U, but lower than cutve Us,
i
4 i
{
o x
i :
i Figure 4.6 Indifference curves representing various {
i levels of consumer satisfaction
i
1 Indifference Curves Cannot Intersect
| Indifference curves are non-crossing. It is not possible for an indifference curve
| to intersect because if it does, it contravenes the assumption that consumers aze
rational, Points A and B in Figure 4.7 represent two combinations which must
give an individual equal satisfaction since they are on the same, albeit different,
indifference, U, Similarly, points A and C represent combinations that give the
| same satisfaction since they are on the same indifference carve, U,, If combinations
‘| Aand B and C gives the same levels of satisfaction; logically combinations A and
i C must also give the same level of satisfaction. However, it is not possible, as
i shown in Figure 4.7, that point C gives the consumers higher satisfaction and must |
| give greater satisfaction than the combination at point B. Therefore, indifference
i
curves cannot intersect. Su,
Li,
L
Figure 4.7 Indifference curves cannot intersect
Indifference Curves are Convex vis-a-vis the Origin
Indifference curves are convex vis-a-vis the origin because of the diminishing
| marginal rate of substitution, As we increase X, we have to decsease the consumption @
“of Y in order to obtain the same level of satisfaction. Lesser amounts of Y are
| substituted for one more unit of X,
: y
yx 5
Figure 4.8 Convex shape of indifference curves
MARGINAL RATE OF SUBSTITUTION l
1 Marginal ste of substitution (MRS) is equal to the rat
_ of the two goods being consumed. It can be defin
substitution between the two goods without changi
‘These changes will occue on the same indifferenc,
slope of the indifference curve, as given in the fol
MU,
MS =
_ 2 As the consumer has less of goods Y, more of goods X is required to maintain
utility when a unit of goods Y is taken away. If an additional unit of the goods
is consumed while the level of the other goods is held fixed, the additional
init will cause the utility to increase, and the amount by which that utility
increases is called the matginal utility,
itio of the marginal utilities :
red as the marginal rate of :
ing the level of satisfaction.
curves. ‘The MRS, is the
lowing formula; Figure 4.9 Marginal rate of substitution
3 Diminishing marginal rate of substitution is related to the law of diminishing
marginal utility that we discussed earlier, which states that individuals will
obtain diminishing satisfaction from every addition of consumption units
4. When we move downward along the indifference cutve, consumption of X
increases while consumption of Y decreases. Hence, marginal utility of X
decreases and marginal utility of Y increases. Willingness to give up Y for
every additional unit of X becomes lesser and MRS,q-will decrease further.
5 In short, MRS depends on the consumption level of consumers; the lower the
rate of goods consumption, the hasderit is to be substituted with other goods
BUDGET LINE
“The indifference curve shows consumess’ priotity while the budget line indicates
budget constraints or the ability to purchase, In other words, the budget linc
is a cutve that shows the combination of two goods that can be purchased by
consumers using a cettain amount of income and based on the market ptice of
the goods. Assume that you have an allocation of RM10 to be spent on goods X
and goods Y, where the price of X (P,) is RMI and the price of ¥ (Py) isRM2. Table
4.12 shows the budget of goods X and Y and Figure 4.1 illustrates the budget line
Table 4.12 Budget of goods X and Y poe 8
A
° sa yx
Figure 4.10 Budget line
{you spend all the money to purchase Y, you will obtain 5 units of Y, and you
pin {0 units of X if you decide to spend all the money on X. You can also
X + PLY, that is, g
of Change in Income
ion 1 (income Increases) i
=
y
‘any of the combinations that satisfies the rule 1 =
@) is equivalent to total expenditure (PX + PyY)
6
ao
x
- ro
Figure 4.11 Budget line shift when income increases,
ome from RM10 to RM20 while prices remain unchanged will
hase the maximum amount of 10 units for Y and 20 units for X.