Consumer Behavior

Key Concepts

Utility:

Utility is the satisfaction or pleasure derived by a consumer from consuming a good or service. It
forms the foundation of consumer behavior analysis in economics.

Total Utility (TU):

 TU is the aggregate satisfaction obtained from consuming a specific quantity of goods or

services.
 It increases as the quantity consumed rises, but at a decreasing rate due to the Law of
Diminishing Marginal Utility.

Marginal Utility (MU):

 MU is the additional utility or satisfaction gained from consuming one more unit of a
good or service.
 Mathematically: MU=ΔTU/ΔQ Where ΔTU is the change in total utility, and ΔQ is the
change in the quantity consumed.

Distinction Between Total Utility and Marginal Utility

Aspect Total Utility (TU) Marginal Utility (MU)

Total satisfaction from all units Additional satisfaction from one more
Definition
consumed. unit.
Increases initially, then plateaus or Decreases and can become zero or
Trend
decreases. negative.
Derivative (rate of change) of total
Relation Summation of marginal utilities.
utility.
At Maximum
TU is at its peak when MU = 0. MU = 0 when TU is at its maximum.
TU

Explanation: Maximum TU When MU = 0

1. Increasing Phase: When MU > 0, consuming additional units increases TU.

2. Peak Point: When MU = 0, no additional utility is gained, and TU reaches its maximum.
3. Declining Phase: If MU < 0, consuming more units reduces TU.
Example: Consuming glasses of orange juice:

Glass Total Utility (TU) Marginal Utility (MU)

1 10 10
2 18 8
3 24 6
4 27 3
5 27 0
6 24 -3

At the 5th glass, TU is at its peak (27), and MU = 0. Beyond this point, MU becomes negative,
and TU decreases.

Graphical Illustration

1. Total Utility (TU) Curve:

o Starts from the origin.
o Increases at a decreasing rate.
o Peaks when MU = 0.
2. Marginal Utility (MU) Curve:
o Starts high.
o Declines and intersects the x-axis where MU = 0.
o Becomes negative beyond that point.

I will now create a graphical illustration of TU and MU curves.

The graph above illustrates the relationship between Total Utility (TU) and Marginal Utility
(MU):

1. Total Utility (TU) Curve (Blue):

o Increases initially with additional consumption.
o Reaches a maximum at the 5th unit (27).
o Declines if consumption continues beyond the 5th unit.
2. Marginal Utility (MU) Curve (Green):
o Starts high, decreases as consumption increases.
o Becomes zero at the point where TU is maximized.
o Turns negative when additional consumption reduces overall satisfaction.

This visualization supports the concept that Total Utility is maximized when Marginal Utility
equals zero.
Example: Consuming Pizza Slices

Imagine you are eating slices of pizza. Each slice gives you satisfaction (utility), but the
additional satisfaction decreases as you eat more.

Pizza Slice Total Utility (TU) Marginal Utility (MU)

1st 15 15
2nd 28 13
3rd 36 8
4th 40 4
5th 40 0
6th 38 -2

Analysis:

1. 1st Slice: You enjoy it a lot, gaining 15 utility points.

2. 2nd Slice: You're still satisfied, but slightly less than the first (13 points).
3. 3rd Slice: Satisfaction continues to decrease to 8 points.
4. 4th Slice: Satisfaction is minimal (4 points).
5. 5th Slice: You’re full. Eating the 5th slice adds no extra satisfaction (MU = 0), and TU
stops increasing (TU = 40).
6. 6th Slice: Eating more makes you uncomfortable, leading to negative satisfaction (MU =
-2), and TU decreases to 38.
Conclusion: Total Utility reaches its maximum (40) at the 5th slice, where Marginal Utility
becomes zero. Beyond this point, consuming more leads to negative satisfaction.

The graph above represents the relationship between Total Utility (TU) and Marginal Utility
(MU) for pizza consumption:

1. Total Utility (Blue Line):

o Increases as more slices are consumed, peaking at the 5th slice (40).
o Declines after the 5th slice when overconsumption occurs.
2. Marginal Utility (Orange Line):
o Starts high and decreases as more slices are eaten.
o Reaches zero at the 5th slice, indicating maximum satisfaction (TU peak).
o Becomes negative after the 5th slice, reflecting discomfort or dissatisfaction.

This graphical representation aligns with the principle that Total Utility is maximized when
Marginal Utility equals zero

Cardinal Utility Approach and the Law of Diminishing Marginal Utility

Cardinal Utility Approach

The Cardinal Utility Approach assumes that:

1. Utility can be measured in absolute terms, such as "utils."

 2. The satisfaction derived from consuming goods can be expressed numerically.

Key principles of the Cardinal Utility Approach include:

1. Marginal Utility: The utility gained from consuming an additional unit.

2. Law of Diminishing Marginal Utility: As a person consumes more units of a good, the
additional utility derived from each subsequent unit decreases.

Law of Diminishing Marginal Utility

Definition

The Law of Diminishing Marginal Utility states that as a person consumes more units of a
specific good or service, the marginal utility obtained from each additional unit decreases,
eventually reaching zero or becoming negative.

Mathematical Representation

If MU is Marginal Utility and Q is the quantity consumed, the law implies:

MUn<MUn−1

Where MUnMU_n is the marginal utility of the nth unit, and MUn−1MU_{n-1} is the marginal
utility of the previous unit.

Assumptions of the Law

1. Rationality: Consumers aim to maximize satisfaction.

2. Homogeneity: The units consumed are identical in quality and size.
3. Continuity: Consumption occurs without significant time gaps.
4. Constant Utility of Money: The value of money remains constant throughout.
5. Single-Use: The good is consumed for a single purpose.

Graphical Illustration of the Law

 The Total Utility (TU) curve rises at a decreasing rate, peaking when Marginal Utility
(MU) becomes zero.
 The Marginal Utility (MU) curve slopes downward and can turn negative.
The graph above demonstrates the Law of Diminishing Marginal Utility:

1. Total Utility (Blue Line):

o Increases initially but at a decreasing rate.
o Reaches a maximum (30 utils at the 6th unit).
o Declines after the 6th unit when overconsumption leads to dissatisfaction.
2. Marginal Utility (Red Line):
o Starts high but decreases with additional consumption.
o Becomes zero at the 6th unit, where Total Utility is maximized.
o Turns negative when consuming beyond the optimal quantity reduces overall
satisfaction.

Exceptions to the Law

1. Addiction: Marginal utility may increase with more consumption (e.g., drug use).
2. Hobbies: Passionate engagement (e.g., collecting rare items) may not follow diminishing
utility.
3. Knowledge Acquisition: Learning can lead to increasing satisfaction over time.

Importance of the Law

 1. Consumer Behavior Analysis: Explains how individuals allocate their budget across
goods.
2. Pricing Strategy: Helps firms determine optimal pricing for goods.
3. Economic Policies: Provides a basis for progressive taxation, as the marginal utility of
income decreases.
4. Marketing: Encourages innovation and variety to combat declining satisfaction.

This principle is fundamental in understanding consumption patterns and utility maximization.

Cardinal Utility Approach and the Law of Diminishing Marginal Utility

Cardinal Utility Approach

The Cardinal Utility Approach assumes that:

1. Utility can be measured in absolute terms, such as "utils."

2. The satisfaction derived from consuming goods can be expressed numerically.

Ordinal Utility Approach

The Ordinal Utility Approach states that utility cannot be measured in absolute terms (utils) but
can be ranked or ordered based on consumer preferences. For example, a person may prefer a
cup of coffee to tea but cannot quantify the exact utility difference.

Key Features of Ordinal Utility Approach:

1. Ranking of Preferences: Consumers rank combinations of goods based on satisfaction.

2. Indifference Curve Analysis: Graphical representation of consumer preferences.
3. No Cardinal Measurement: Assumes relative, not numerical, satisfaction.
4. Focus on Choice: Concentrates on choosing the best bundle within a budget.

Indifference Curves (ICs)

An Indifference Curve represents combinations of two goods that give the consumer the same
level of satisfaction.

Properties of Indifference Curves:

1. Downward Sloping: A consumer must give up some units of one good to gain more of another
while maintaining the same utility.
 2. Convex to the Origin: Indicates diminishing Marginal Rate of Substitution (MRS).
3. Do Not Intersect: Each curve represents a different level of utility.
4. Higher IC = Higher Utility: ICs farther from the origin represent higher satisfaction levels.

Budget Line

The Budget Line represents all possible combinations of two goods that a consumer can afford
with a given income and prices.

Equation:

Where:

 PX and PY are prices of goods X and Y.

 X and Y are quantities of the goods.
 M is the consumer's income.

Properties of the Budget Line:

1. Downward Sloping: Indicates trade-offs due to limited income.

2. Straight Line: Reflects constant prices for both goods.
3. Shifts with Income Changes: An increase in income shifts the line outward; a decrease shifts it
inward.
a) Properties of Indifference Curves with Rationalization

1. Downward Slope:
o Reflects the trade-off between goods.
o Rational: A consumer cannot increase the quantity of one good without reducing the
other to maintain the same utility.

2. Convex Shape:
o Marginal Rate of Substitution (MRS) decreases as more of one good is substituted for
another.
o Rational: As a consumer acquires more of one good, they are willing to trade less of the
other.

3. Non-Intersecting:
o Two ICs cannot intersect as it would imply inconsistent preferences.
o Rational: A point common to two curves would indicate two different utility levels for
the same combination of goods.

4. Higher Curve, Higher Utility:

o Rational: More goods generally lead to higher satisfaction.

b) Law of Equi-Marginal Utility and IC-Budget Line Tangency

The Law of Equi-Marginal Utility states that utility is maximized when the consumer allocates
expenditure so that the Marginal Utility per unit of expenditure is equal for all goods:
Derivation from IC and Budget Line:

1. The optimal consumption bundle occurs at the tangency point of the budget line and an
indifference curve.
2. At this point:

This shows utility is maximized when the ratios of marginal utilities to prices are equal
for all goods.

Law of Demand and Supply with Analysis and Graphical Illustrations

Law of Demand
The law of demand states that, ceteris paribus (all other factors being equal), the quantity demanded of
a good decreases as its price increases, and vice versa. This inverse relationship forms the foundation of
the demand curve, which is downward-sloping from left to right. For example, as the price of apples
increases, consumers tend to buy fewer apples.

Law of Supply
The law of supply states that, ceteris paribus, the quantity supplied of a good increases as its price
increases, and vice versa. This direct relationship between price and quantity supplied forms the
upward-sloping supply curve. For instance, if the price of wheat rises, farmers are incentivized to
produce and supply more wheat.

Demand and Supply Equilibrium

The equilibrium price and quantity are determined at the intersection of the demand and supply curves.
At this point, the quantity demanded equals the quantity supplied, creating market stability. If the price
is above equilibrium, surplus occurs, and if it is below, there is a shortage.

Graphical Illustration: Law of Demand and Supply is shown below.

Distinction Between Extension/Contraction of Demand and Rise/Fall in
Demand

Extension and Contraction of Demand

Extension and contraction refer to movements along the demand curve caused by price changes. For
example, when the price of a good decreases, the quantity demanded increases (extension). Conversely,
if the price increases, the quantity demanded decreases (contraction).

Rise and Fall in Demand

Rise and fall in demand refer to shifts of the entire demand curve due to changes in non-price factors
such as income, tastes, or the prices of related goods. A rise in demand shifts the curve to the right,
while a fall shifts it to the left. For example, an increase in consumer income may shift the demand for
luxury cars to the right.

Graphical Illustration: Movements along and shifts of the demand curve are depicted below.

Determinants of Demand
Several factors determine demand:
1. Price of the good: The price directly affects the quantity demanded (law of demand).
2. Consumer income: Higher income typically increases demand for normal goods and reduces demand
for inferior goods.
3. Prices of related goods: Substitutes and complements significantly impact demand.
4. Consumer preferences: Trends and advertisements influence preferences.
5. Expectations: Anticipation of future price or income changes can shift demand.
6. Demographics: Changes in population size or structure alter market demand.
Distinction Between Extension/Contraction and Rise/Fall in Demand
The concepts of extension and contraction, and rise and fall in demand, explain the dynamics of how
demand changes due to price and non-price factors. Extension and contraction occur along the same
demand curve, while rise and fall represent shifts of the entire curve.

Extension and Contraction of Demand

Extension and contraction of demand refer to movements along the demand curve due to changes in
the price of the good, assuming ceteris paribus (all other factors remain constant).

Example:

If the price of oranges decreases from $5 to $3 per kg, the quantity demanded increases from 10 to 15
kg (extension). Conversely, if the price rises to $7 per kg, the quantity demanded decreases to 5 kg
(contraction).

Graphical Illustration:

Rise and Fall in Demand

Rise and fall in demand refer to shifts of the entire demand curve caused by non-price factors such as
income, preferences, and prices of related goods, assuming ceteris paribus.

Example:

If consumers' income increases, they may demand more of a normal good like branded clothes, shifting
the demand curve to the right (rise in demand). If consumer preferences change unfavorably, demand
shifts left (fall in demand).

Graphical Illustration:
Factors Causing Changes in Demand
Demand changes due to several factors:
1. Consumer Income: Higher income increases demand for normal goods and reduces demand for
inferior goods.
2. Prices of Related Goods: A rise in the price of substitutes increases demand, while a rise in the price of
complements decreases demand.
3. Preferences and Trends: Positive changes shift demand right, while negative changes shift it left.
4. Expectations: Anticipation of future price or income changes can alter current demand.

Income and Substitution Effects of a Price Change

The income effect and substitution effect are two fundamental concepts in economics used to
explain how changes in the price of a good or service affect consumer behavior.

1. Substitution Effect

The substitution effect refers to the change in the quantity demanded of a good that results from
a change in its price relative to other goods. When the price of a good falls, it becomes cheaper
relative to other goods, leading consumers to substitute it for more expensive alternatives.
Conversely, if the price of a good rises, consumers will substitute it with other cheaper goods.

 If the price of a good decreases, consumers may buy more of it because it has become
relatively cheaper than other goods.
 If the price of a good increases, consumers will buy less of it and may switch to
substitutes that are now relatively cheaper.

The substitution effect is always in the opposite direction of the price change (i.e., a price
decrease leads to an increase in quantity demanded, and a price increase leads to a decrease in
quantity demanded), assuming the good is a normal good.
2. Income Effect

The income effect refers to the change in the quantity demanded of a good due to a change in the
consumer's real income or purchasing power as a result of the price change. When the price of a
good falls, the consumer's real income increases because they can now buy more with the same
amount of money. Similarly, when the price of a good rises, the consumer's real income
decreases, reducing their purchasing power.

 If the price of a good decreases, the consumer feels "richer" and may buy more of that
good as well as other goods.
 If the price of a good increases, the consumer feels "poorer" and may reduce their
overall consumption.

For a normal good, the income effect and substitution effect work in the same direction (i.e., both
will lead to an increase in the quantity demanded when the price of the good falls and a decrease
when the price increases).

Hicksian Method (Hicks Substitution and Income Effects)

The Hicksian method of decomposing the total effect of a price change into the substitution and
income effects is one of the most common techniques used in consumer theory. The total change
in the demand for a good resulting from a price change can be split into two parts:

1. The substitution effect, which holds utility constant by adjusting the consumer's income
so that they can still afford the original bundle of goods.
2. The income effect, which reflects the change in quantity demanded when the consumer is
allowed to adjust their income in response to the price change.

Graphical Illustration of Hicksian Decomposition

Consider the demand curve for a normal good. Let’s say the price of this good decreases from P1
to P2, and we want to decompose the total effect of this price change into the substitution and
income effects.

Step-by-Step Graph Construction

1. Indifference Curves and Budget Line:

o Initially, the consumer is at point AA, where the budget line B1 (representing the
original price P1) is tangent to the indifference curve IC.
o After the price of the good falls to P2, the consumer's budget line shifts outward
to B2 , reflecting an increase in real income, as the consumer can now afford
more goods.
2. Substitution Effect:
 oTo isolate the substitution effect, we adjust the consumer's income to maintain
the original level of utility, i.e., the utility level at point A. The new budget line,
B3B_3, is drawn parallel to the new budget line B2, but it touches the original
indifference curve IC (this reflects that the consumer can still achieve the same
level of utility with less income).
o The consumer moves from point AA to point BB on the new indifference curve
IC2 due to the substitution effect. The movement from A to B represents the
change in quantity demanded purely due to the relative price change, keeping
utility constant.
3. Income Effect:
o The income effect occurs when the consumer’s income is adjusted to reflect the
increase in purchasing power after the price drop. The consumer moves from
point BB (on the new indifference curve IC2) to point C, which represents a
higher level of utility (because real income has increased).
o The movement from BB to C reflects the increase in quantity demanded due to
the increase in real income or purchasing power.

Total Effect:

The total effect of the price change is the movement from point A (on the original indifference
curve IC to point C (on the higher indifference curve IC2). This total effect is the sum of the
substitution effect (from A to B) and the income effect (from B to C).
Conclusion

In summary, the substitution effect occurs when a price change alters the relative attractiveness
of goods, causing consumers to substitute one good for another. The income effect results from
the change in real income or purchasing power, which influences overall consumption. Using the
Hicksian method, we can graphically decompose the total effect of a price change into these
two components, providing a clearer understanding of consumer behavior in response to price
changes.