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12 views97 pages

Week 2

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aace97629
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© © All Rights Reserved
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The Theory of Consumer

Behavior
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).

Useful for understanding the demand side of the market.

Utility - amount of satisfaction derived from the consumption of a


commodity ….measurement units  utils
Theories of Consumer Choice
Utility Concepts:

• The Cardinal Utility Theory (TUC)


• 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 bread

• The Ordinal Utility Theory (TUO)

• Utility is measurable in an ordinal sense


• ordinal utility approach - does not assign values, instead
works with a ranking of preferences.
The Cardinal Approach
Nineteenth century economists, such as Jevons, Menger and Walras,
assumed that utility was measurable in a cardinal sense, which means
that the difference between two measurement is itself numerically
significant.

UX = f (X), UY = f (Y), …..

Utility is maximized when:


MUX / MUY = PX / PY
The Cardinal Approach
• Total utility (TU) - the overall level of satisfaction derived from consuming a
good or service

• Marginal utility (MU) additional satisfaction that an individual derives from


consuming an additional unit of a good or service.
Formula :
MU = Change in total utility
Change in quantity
= ∆ TU
∆Q
The Cardinal Approach

• Law of Diminishing Marginal Utility (Return) = As more and


more of a good are consumed, the process of consumption
will (at some point) yield smaller and smaller additions to
utility

• When the total utility maximum, marginal utility = 0

• When the total utility begins to decrease, the


marginal utility = negative (-ve)
EXAMPLE

Number Total Marginal


Purchased Utility Utility

0 0 0

1 4 4

2 7 3

3 8 1

4 8 0

5 7 -1
The Cardinal Approach
• TU, in general, increases with Q

• At some point, TU can start falling with


Q (see Q = 5)

• If TU is increasing, MU > 0

• From Q = 1 onwards, MU is declining


 principle of diminishing marginal
utility  As more and more of a good
are consumed, the process of
consumption will (at some point) yield
smaller and smaller additions to utility
Consumer Equilibrium
• So far, we have assumed that any amount of goods and services are
always available for consumption

• In reality, consumers face constraints (income and prices):


• Limited consumers income or budget
• Goods can be obtained at a price

• Consumer’s objective: to maximize his/her utility subject to income


constraint
• 2 goods (X, Y)
• Prices Px, Py are fixed
• Consumer’s income (I) is given
Consumer Equilibrium
• Optimizing condition:

MU X MU Y

• If
PX PY

MU X MU Y

PX PY

 spend more on good X and less of Y


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, such as X, is a function of


the quantities of X and Y consumed by a consumer.
U = f ( X, Y )

Ordinal Utility Theory (TUO)


–Can be measured in qualitative, not quantitative, but only lists
the main options (indifference curves & budget line).

Rational human beings will choose to maximize the utility by


selecting the highest utility

Different consumers, difference utilities.


INDIFFERENCE CURVE (IC)

• Curve where the points represent a combination of items when


the consumer at indifference situation (satisfaction).

• Axes: both axes refer to the quantity of goods

• For the combination that produces a higher level of satisfaction,


the curves shift to the right (IC2) from the first curve (IC1)

• In contrast, the curves shift to the left (IC-1)


INDIFFERENCE CURVE

goods Y
M

S
A

B
C
T D IC2
IC1

IC-1

O
4 7 11
goods X
PROPERTIES OF INDIFFERENCE CURVE

• Downward sloping from left to right: This shows an increase in quantity of


certain good.
• Convex to the origin: the marginal rate of substitution (MRS) decreased
• MRS = quantity of goods Y willing to substitute to obtain one unit of
goods X & this substitution is to maintain its position at the same level of
satisfaction
• Do not cross (intersect): consumer preferences transitive
• Eg : Quantities X and Y for the combination of A> a combination of B;
 utility A> B *
When cross = C, so the utility A = C & B = C;  utility A = B = C. This
is not transitive as above *

• Different ICs show different level of satisfaction. Far from the origin, the higher
the satisfaction.
Necessities and Luxuries

Necessities typically have an income elasticity


between O and 1

Luxuries typically have an income elasticity


greater than 1

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