Chapter I

The Theory of Consumer Behavior

The theory of consumer behavior is the concern of how consumers decide on the basket of goods
and services they consume in order to maximize their satisfaction. The theory of demand starts
with the examination of the behavior of the consumer, since the market demand is assumed to be
the summation of the demand of the individual consumers.
In explaining the consumer behavior which is the basis for the theory of demand we assume that:
1. The consumer is rational: - given his/her income and the market price of the
commodities, he/she plans the spending of his/her income so as to attain the highest
possible satisfaction or utility. This is the axiom of utility maximization.
2. The consumer has complete knowledge of all the information relevant to his/her decision.
S/he has
 Complete knowledge of all the available commodities,
 Complete knowledge of the price of the commodities,
 Complete knowledge of his/her income.
Some Basic Concepts
Consumer: A decision making unit -an individual or a household who uses or consumes a
commodity or service.
Utility: The power of a commodity to satisfy human wants. It is the satisfaction or subjective
pleasure that one gets from consuming a good or service.
Relativity of Utility: The utility of a commodity is subjective to a person’s need. It is not
absolute or objectively determined.
Utility and Moral Values: - Utility is free from moral values. For example, eating a food item
which may be immoral in a society yields utility as long as it satisfies hunger. It is also the case
that utility is ethically neutral between good and bad, and harmful and useful. For example: drug
yields utility to the drug-takers.

In order to maximize utility, the consumer must be able to compare the utility of the various
baskets of goods which she can buy with her income.
There are two approaches to the problem of comparison or measurability of utility:

1
 Approaches of Measuring Utility
1.1. The Cardinal Utility Approach
The cardinal school postulated that utility can be measured in monetary units (i.e., by the amount
of money that the consumer is willing to sacrifice for another unit of a commodity) or by
subjective unit called “utils”.
Assumptions
1. Rationality:- the consumer is assumed to be rational in a since that he/she aims at the
maximization of his/her utility subject to the constraints imposed by his/her income.
2. Cardinal utility: - the utility of each commodity is measurable, with the most
convenient measure being money.
3. Constant marginal utility of money:- the utility that one derives from each
successive unit of money income remains constant.
4. Diminishing marginal utility (DMU):- the MU of a commodity diminishes as the
consumer acquires more and more of it.
5. Additively of utility: - even though dropped in the latter version of the approach,
utility was assumed to be additive in the earlier version. That is:

6. The total utility of a basket of goods and services depends on the quantities of the
individual commodities. That is:
)
 Equilibrium of the Consumer
Let’s assume that the consumer consumes a single commodity, x. The consumer can either buy x
or retain his money income Y. Under these conditions the consumer is in equilibrium when the
marginal utility of X is equated to its market price (px).
Symbolically,
Mathematically, we can derive the equilibrium of the consumer as follows:
- The utility function is
U = f (Qx), where utility is measured in monetary units and qx is the quantity of x
consumed by the consumer.
If the consumer buys Qx, his/her expenditure is PxQx. Presumably the consumer seeks to
maximize the difference between his/her utility and total expenditure. That is: –

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The necessary condition for a maximum is that the partial derivative of a function with respect to

Qx be equal to zero. Thus, =0

If the consumer can increase his/her welfare by purchasing more unit of X, and if
the M , welfare can be increased by reducing the consumption of X.

In the case there are more commodities, the condition for optimality of the consumer is the
equality of the ratios of MU of the individual commodities to their prices, i.e. the utility derived
from spending an additional unit of money must be the same for all commodities.

Derivation of the Demand Curve

The derivation of demand is based on the axiom of diminishing marginal utility. The MU of
commodity X is depicted by a line with a negative slope which is the slope of total utility
function, As successively increasing quantities of X are consumed, the total utility
increases but at a decreasing rate (recall the assumption of DMU), reaches a maximum at
quantity X* and then starts declining. Accordingly, the MUx declines continuously and becomes
negative beyond X*.

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Thus it can be shown that the demand curve for commodity X is identical to the positive
segment of the MUx curve. For example, at X1 the MU is MU1 which is equal to P1 at the
optimum point. Hence at P1 the consumer demands X1 quantity. Similarly at X2 the marginal
utility is MU2 which is equal to P2. Hence at P2 the consumer demands X2 and so on. This forms
the demand curve for commodity X. As negative price do not make sense in economics, the
negative potion of MUx does not form part of the demand curve.

4
 O X1 X2 X3 X*
Panel A: The MU curve Panel B: The demand curve
The demand curve is simply the graphical representation of the relationship between price and
quantity demanded.
Critiques of the Approach
1. The satisfaction derived from the various commodities cannot be measured objective.
The cardinality of the utility is extremely doubtful.
2. The assumption of constant MU of money is unrealistic because as income changes the
MU of money changes.
3. The additively assumption of utility is unrealistic.

2.2 The Ordinal Utility Theory

The ordinalist school suggests that utility is not measurable, but is an ordinal magnitude. That
is, to make his/her choice, the consumer need not know the utility of various commodities in
specific unit, but be able to rank the various basket of goods (order of preference) according
to the satisfaction that each bundle gives. There are two main theories in the ordinal approach:
1) The Indifference Curve Theory, and
2) The revealed preference hypothesis

2.2.1 The Indifference Curve Theory

Indifference curve (IC):- is the locus of points of different combinations of two goods (a bundle
of goods) which yields the consumer the same level of satisfaction (utility) so that he is
indifferent as to the particular combination he/she consumes.

5
An Indifference Map: - shows a set of all the ICs, which rank the preference of the consumer.
Combination of goods situated on an IC yields the same level of utility. Combination of goods
lying on a higher IC yields higher level of satisfaction and are preferred.

Assumptions
a. Rationality: - the consumer is assumed to be rational.
b. Utility is ordinal: - the consumer can rank his/her preference (order the various baskets
of goods) according to the satisfaction of each basket.
c. Diminishing marginal rate of substitution (DMRS):- preferences are ranked in terms
of ICs, which are assumed to be convex to the origin. This implies that the slope of IC
(MRS) decreases in absolute terms.
d. The total utility of the consumer depends on the quantities of the commodities consumed.
U = f (Q1, Q2… Qn)
5) Consistency and transitivity of choices:-
 If bundle , then B is not greater than A
 If bundle and , then
Types of Indifference Curve
There are various types of Indifference Curve. Some of the types of indifference curves are;
A. Perfect Substitutes:- is a consumer is willing to substitute two goods at constant rate the
goods are perfect substitutes. i.e the consumers is willing to exchange on one to one
basis. For such products the indifference curve is downward sloping line. The slope of
such indifference curve is -1.

6
 Y

IC

X
Indifference curve of perfect substitutes
B. Perfect Complements:- such goods are consumed together at fixed proportion. One
good can’t consume without the other. The indifference curve of the perfect complements
is L-shape.

IC2
IC1
X
Indifference curve of perfect complements
C. Bads: is a commodity that consumers do not like to consume. The indifference curve of
bads is upward sloping. Assume commodity Y is bad and X is good for a consumer the
indifference curve is increasing to the right.

7
 Indifference curve when Y is Bad
D. Neutrals: a good is neutral if the consumer does not care about the commodity. The
indifference curve will be parallel to the neutral product. If good Y is neutral the
indifference curve is vertical and if x is neutral the indifference curve is horizontal.

Indifference curve when Y is neutral

E. Well defined indifference curve:- if the two products are normal the indifference curve
is downward sloping from left to right, convex to the organ.

Properties of Well Behaved Indifference Curves

1. An indifference curve has a negative slope: - which denotes that if the quantity of one
commodity (Y) decreases the quantity of the other (X) must increase, if the consumer is
to stay on the same level of satisfaction.
2. The further away from the origin an IC lay, the higher level of utility it denotes.
3. ICs do not intersect. If they did, the point of their intersection would imply two different
level of satisfaction, which is impossible.
4. ICs are convex to the origin: - this implies that the slope of an IC (MRS) decreases (in
absolute terms) as we move along the curve from the left down wards to the right.
The Marginal Rate of Substitution (MRS): The marginal rate of substitution of X and Y
( ) is defined as the number of units of commodity Y that must be given up in exchange

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for an extra unit of commodity X so that the consumer maintains the same level of satisfaction. It
is the negative of the slope of an IC at any one point and is given by the slope of the tangent line
at that point:

The concept of marginal utility is implicit in the definition of MRS since it can be proved that the
MRS (the slope of IC) is equal to the ratio of the marginal utilities of the commodities in the
utility function.
or
Proof:
The total utility function in the case of two commodities X &Y is
The equation of an IC is
, where K is constant.
At equilibrium, the total derivative of U is equal to zero.

Budget Line
Recall that the consumer is willing to maximize his/her satisfaction by consuming more goods
and services. But consumption of consumers is limited because of their budget constraint.
Assume the consumer consumes two products X & Y with income M. The expenditure of the
consumer will be . So budget line is the bundle of goods that costs the same

income. The slope of the budget line is the ratio of the prices i.e .

The negative sign is not the magnitude rather the direction.

X
Budget Line

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The budget lines will changes if the income of the consumer, price of one of the products is
changed or both changes.
2.3. The Optimum of the Consumer
The consumer is in equilibrium when he/she maximizes his/her utility, given income and the
market prices. Two conditions must be fulfilled for the consumer to be in equilibrium.
1) , which is the necessary condition.
2) The IC be convex to the origin (decreasing MRSx,y)
Graphically, the equilibrium of the consumer is at the point of tangency of the budget line and
the highest possible IC (at point e).

At the point of tangency (point e) the slope of the budget line (Px/Py) and of the IC (MRSx,y =
MUx/MUy) are equal. MRSx,y = MUx/MUy = Px/Py, which is the FOC.
The SOC is implied by the convex shape of the IC. Thus, the consumer maximizes utility by
buying X* & Y* of the two commodities.

Mathematical derivation of the equilibrium of the consumer is as follows:

 Assume that there are two commodities, X & Y. The consumer is in equilibrium when
he/she maximizes utility given hi/her income and the market price of the commodities.
 Formally the problem can be stated as:
Maximize
Subject to

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 - By using the lagrangian method, the steps involved are:
a) rewrite the constraint as –
b) Multiply the constraint by a constant  (lagrangian multiplier)
 –
C) Subtract from the objective function to obtain a composite function.
 –
D) Derivate L with respect to X, Y, &  and equate to zero.

=>  
=> 

 

 –
From (1) and (2), we can infer that


We observe that the equilibrium conditions are identical in the cardinal’s approach and in the
Indifference curve approach. In both theories we have:

Income Consumption Curve (ICC)

Increase in income shifts the budget line outward in a parallel manner (if commodities prices are
kept constant). If we go on increasing income (i.e., shifting the budget line outward), we will have
a set of optimum points corresponding to each budget line. The curve which connects these
optimum points is called the Income Consumption Curve (ICC). It is the locus consumer
optimum points resulting only when the consumer income changes. The ICC is also known as the
Income Offer Curve or the Income Expansion Path. From the ICC we can then derive the
consumer Engle Curve. The Engle curve shows the amount of a good (X) that the consumer

11
 would purchase per unit of time at various income levels. To derive the Engle curve we keep the
same horizontal scale as in the top panel but measure money income on the vertical axis.

Y A’’

A’

A ICC
E2 E3
E1
U2 U3
U1

O X1 X2 X3 B B’ B’’ X
M

Engle curve

M3
E3’
M2
E2’
M1
E1’

O X
X1 X2 X3
At income level M1, the consumer is in equilibrium at point E1 by consuming X1 units of X on the
M-X plane. When income of the consumer increases to M2, the budget line shifts to A’B’ and the
consumer will at higher IC U2 at point E2 by purchasing X2 units of X. Similarly, when income
increase to M3, the consumer is in equilibrium at point E3 by purchasing X3 of X and this is
shown by point E3’ on the second panel. If we connect equilibrium points of the consumer in the
first panel we obtain the Income Consumption Curve. Similarly, if we connect the points on the
second panel, we obtain the Engle Curve. This is true if the product is Normal Good. A normal
good is one of which the consumer purchases more with an increase in income. An inferior good
is one of which the consumer purchases less with an increase in income. For normal goods have

12
positively sloping income consumption curve and the Engle curve. However, for an inferior good,
the income consumption curve and the Engle curve are negatively sloping because as income
increases, the consumer purchases less of these commodities.
Y

A’
ICC
E2
A
U2

E1

U1

O X
X2 X1 B B’
M

M2 E2

E1
M1

Engle curve

O X
X2 X1
 The classification of goods as normal or inferior depends only on how a specific consumer
views the particular good. Thus, the same good X can be regarded as a normal good by
another consumer.
 Furthermore, a good can be regarded as a normal good by a consumer at a particular level of
income and as an inferior good by the same consumer at a higher level of income.
 A normal good can be further classified as a necessity or a luxury depending on whether the
quantity purchased increases proportionately more or less than the increase in income.
PRICE CONSUMPTION (OFFER) CURVE
When the price of a good (say X) decreases the budget line becomes flatter (rotates to the right)
from its initial position (AB) to a new position (AB’) due to the increase in the purchasing of the
given income of the consumer. The new budget line is tangent to a higher IC at point E2 showing
that as price of X falls, more of commodity X will be bought. If we allow price of X to fall

13
continuously and we join the points of tangencies of successive budget lines and the higher ICs,
We form the so called price consumption curve from which we derive the demand curve for
commodity X. at point E1 the consumer buys quantity X1 at price P1. At point E2 the price P2 is
lower than P1 and the quantity demanded has increased to X2 and so on.
Y

PCC
E3
E2
E1 I3
I2
I1
O
X1 X2 B X3 B’ B’’ X
P

P1

P2

P3
DD-Curve

O X
X1 X2 X3
Thus, we derive the demand curve by plotting the price quantity pairs defined by the points of
equilibrium (on the price consumption curve) on the price quantity space. The demand curve for
normal goods (goods whose demand increases with increase in income) will always have a
negative slope denoting the law of demand which states that the quantity demanded increases as
price increases and vice versa. In the case of giffen goods the demand for a good decreases when
its price decreases.
Mathematical derivation of the demand curve:
Derive the demand function for good X and Y given
U , Px, Py, &M.
Solution

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 Demand function for X, and Demand function for Y,
1/3 2/3
Example: given utility U(x, y) = X Y , Px = 2, Py = 5 and M = 400, find:
(1) The demand equation for X and Y.
(2) The utility maximizing levels of X and Y.
(3) The maximum utility
(4) The MRSx,y at the optimum level.
Solution:

1. Demand equation for X;

2. Demand equation for Y; Y
3.
4. is the maximum utility.
5. At the equilibrium or at the optimum point,

2.4. Decomposition of Income and Substitution Effects

 A reduction in the price a product increases the demand of the product. This is because of
two effects:
1. The consumer will tend to buy more of a good that has become cheaper and less of those
goods that are now relatively expensive. The consumer will tend to substitute cheaper
commodity for relatively expensive one. This response to the change in relative prices of
goods is called the substitution effect.
2. Because one of the goods is now cheaper, the consumer enjoys an increase in real
purchasing power. The consumer is better off because he/she can buy the same amount of
the good for less money and thus money left over for additional purchases. The change in
demand resulting from this change in real purchasing power is called the income effect.

The substitution effect is the increase in the quantity bought as the price of the commodity
falls after adjusting income so as to keep the real purchasing power of the consumer the same
as before. This adjustment in income is called compensating variation and is shown
graphically by a parallel shift of the new budget line until it becomes tangent to the initial IC.
The purpose of the compensating variation is to allow the consumer to remain on the same
level of satisfaction as before the price change.

In the following graph, the consumer was initially at point E1 on the budget line AB. When
the price of X falls, the budget line has rotated from AB to AB’ results in a new equilibrium
point E2. The increase in the consumption of X from X1 to X3 is the total effect of a fall in

15
 the price of X which can be split into substitution effect and income effect. In order to split
these two effects we draw a parallel budget line (compensating budget line) which is parallel
to the new budget line and tangent to the initial indifference curve. . This allows the real
purchasing power of the consumer to remain as before and thus to reject the income effect so
the consumer will be on the same level of satisfaction as before. Accordingly, the movement
from point E1 to E1’ shows the substitution effect of the price change (the consumer buys
more of X now that it cheaper, substituting X for Y).
Y

A’
E1
E2 U2

E1’
U1

O X1 X2 B X3 A’ B X
’
The substitution effect is negative for all goods since the consumer substitutes the cheaper
for more expensive one. This implies a decrease in price leads to an increase in quantity
demanded. The movement from E1’ to E2 is the income effect of the fall in the price of X. To
isolate the income effect, we assume that the relative price of the goods has not changed (shown
by the parallel line AB’ and A’A’). The income effect in this case can be thought of as being
negative (comparing the direction of the change in price and quantity demanded of a good) or a
positive (comparing the direction of the change in the purchasing power of the consumer and the
quantity demanded).

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  For normal good, income effect of a price change is negative, i.e. Px =>PP=> Qx.
Ultimately, Px => Qx.
 For inferior good, income effect of a price change is positive, i.e. Px =>PP=> Qx.
Ultimately, Px => Qx.
PANEL A PANEL B
Y Y

A
A
E2

A’
A’ E2
E1
E1 U2

U2 E1’
E1’

U1 U1
O B XO X
X1 X3 X2 A’ B’ X3 X1 X2 B A’ B’
SE
SE IE
IE TE
TE

TE = SE + IE TE = SE + IE
X1X3 = X1X2 +X2X3 X1X3 = X1X2 +X2X3

For an inferior good whose negative substitution effect more than offsets the positive income
effect (panel A above), the total effect will be negative (Px  => Qx) and thus the law of
demand holds. If, however, the IE is positive and very strong that it more than offsets the
negative SE, the demand curve will have a positive slope (Px => Qx)  the GIFFEN
PARADOX. A Giffen good is a good whose demand curve slopes down ward because the
positive IE is larger than the negative SE (panel B).
Good IE SE TPE
Normal Negative Negative Negative
Inferior Positive Negative Ambiguous

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 2.4.1. Elasticity of Demand
The concept of elasticity is used to measure the amount by which the quantity demanded changes
when its determinants change. There are as many elasticity of demand as there are its
determinants. The most important of these elasticity demands are:
A. The price elasticity of demand
B. The income elasticity of demand
C. The cross-elasticity of demanded
The Price Elasticity of Demand
The price elasticity is a measure of the responsiveness of demand to changes in the commodity’s
own price. If the changes in price are very small we use as a measure of the responsiveness of
demand the point elasticity of demand. If the changes in price are not small we use the arc
elasticity of demand as a relevant measure. The point elasticity of demand is defined as the
proportionate change in the quantity demanded resulting from a very small proportionate change
in price. Symbolically, we may write as:

or or

If the demand is linear – , the price elasticity demand is the product of the slope

and the the ratio of price to quantity. The slope of the demand function is dQ/dP = -b1.

Substituting in the formula we obtain . Graphically, the point elasticity of a linear

demand curve is shown by the ratio of the segments of the line to the right and to the left of the
particular point. For example, in the figure below the elasticity at point F is the ratio:

P1--------------- F

P2---------------------- F’
E

Q
O Q1 Q2 D’

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Proof:
From the above figure we see that:
P = P1P2 = EF
Q = Q1Q2 = EF’
P = OP1
Q = OQ1
If we consider very small change in P and Q, then P = dP and Q. Thus, substituting in the
formula for the point elasticity, we obtain:

Given this graphical measurement of point elasticity it is obvious that at the mid-point of a linear
demand curve (point M). At any point to the right of M the point elasticity is less than
unity ( < 1); finally at any point to the left of M, ep > 1. At point D, the ep  , while at
point D’ the . The price elasticity is always negative because of the inverse relationship
between Q and P implied by the law of demand. However, the negative sign is omitted when
writing the formula of the elasticity.
The range of values of the elasticity is O  ep  .
1. If , then the demand is perfectly inelastic
2. If then the demand is unitary elastic
3. If  then the demand is perfectly elastic
4. If , then the demand is inelastic
5. If  then the demand is elastic

Px
D ep

ep>1

M ep = 1

ep<1

o ep = O

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The above formula for the price elasticity is applicable only for infinitesimal changes in the
price. If the price changes appreciably we use the following formula, which measures the arc
elasticity of demand:

The arc elasticity is a measure of the average elasticity, i.e. the elasticity at the mid-point of the
two points A and B on the demand curve defined by the initial and the new price levels.
P

P1---------- A

P2-----------------------------B

D
Q
O Q1 Q2

Determinants of Price Elasticity of Demand

The basic determinants of the elasticity of demand of a commodity with respect to its own price
are:
1. The availability of substitute; the demand for a commodity is more elastic if there are
close substitute for it.
2. The nature of the need that the commodity satisfies. In general, luxury goods are price
elastic, while the necessity is price inelastic.
3. The time period; demand is more elastic in the long run.
4. The number of uses to which a commodity can be put. The more the possible uses of a
commodity, the greater its price elasticity will be.
5. The proportion of income spent on the particular commodity.
Income Elasticity of Demand

The income elasticity is defined as the proportionate change in the quantity demanded resulting
from a proportionate change in income.

, y is income of the consumer

If then the commodity is normal.

If then the commodity is inferior.

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If then the commodity is luxury.
If , the commodity is necessity.

The main determinants of income elasticity are;

i. The nature of the need that the commodity covers: the percentage of income spent on
food declines as income increases.
ii. The initial level of income of a country. For example, a TV set is a luxury in
underdeveloped countries while it is a necessity in a country with high per capital
income.
iii. The time period, because consumption patterns adjust with a time lag to changes in
income.
The Cross- Elasticity of Demand
The cross elasticity of demand is defined as the proportionate change in quantity demand of X
resulting from a proportionate change in the price of Y.

If , then X & Y are complementary goods.

If , then X & Y are substitute goods.
If , then X & Y are unrelated goods.

The main determinants of the cross elasticity is the nature of the commodities relative to their
use. If two commodities can satisfy equally well the same need, cross elasticity is high and vice
versa.

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