Chapter Three :Theory of Consumer

Behaviour

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 Chapter Three :Theory of Consumer Behaviour

Chapter objectives
ü After successful completion of this chapter, you will be able to:
ü Explain consumer preferences and utility
ü Differentiate between cardinal and ordinal utility approach
ü Define indifference curve and discuss its properties
ü Derive and explain the budget line
ü Describe the equilibrium condition of a consumer

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 3.1 Consumer preferences

ü A consumer makes choices by comparing bundle of goods.

ü Given any two consumption bundles, the consumer either decides that one of
the consumption bundles is strictly better than the other, or decides that she is
indifferent between the two bundles.
ü If she always chooses X when Y is available, then it is natural to say that this
consumer prefers X to Y.
ü We use the symbol ≻ to mean that one bundle is strictly preferred to another,
so that X ≻ Y should be interpreted as saying that the consumer strictly
prefers X to Y. 3
 3.2 The concept of utility

ü Economists use the term utility to describe the satisfaction or pleasure

derived from the consumption of a good or service.
ü In other words, utility is the power of the product to satisfy human wants.
ü Given any two consumption bundles X and Y, the consumer definitely wants
the X-bundle than the Y-bundle if and only if the utility of X is better than the
utility of Y.
Utility’ and ‘Usefulness’ are not synonymous. For example, paintings by
Picasso may be useless functionally but offer great utility to art lovers.
Hence, usefulness is product centric whereas utility is consumer centric. 4
 3.2 The concept of utility………

Utility is subjective. The utility of a product will vary from person to person
ü That means, the utility that two individuals derive from consuming the same
level of a product may not be the same.
ü For example, non-smokers do not derive any utility from cigarettes.
Utility can be different at different places and time: for example, the utility that we get

from drinking coffee early in the morning may be different from the utility we
get during lunch time.

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 3.3 Approaches of measuring utility

ü There are two major approaches to measure or compare consumer‘s utility:

cardinal and ordinal approaches.

ü The cardinalist school postulated that utility can be measured objectively.

ü According to the ordinalist school, utility is not measurable in cardinal numbers

rather the consumer can rank or order the utility he derives from different goods

and services.
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 3.3.1 The cardinal utility theory

ü According to the cardinal utility theory, utility is measurable by arbitrary unit

of measurement called utils in the form of 1, 2, 3 etc.
ü For example, we may say that consumption of an orange gives Bilisuma 10
utils and a banana gives her 8 utils, and so on.
ü From this, we can assert that Bilisuma gets more satisfaction from orange
than from banana.

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 3.3.1.1 Assumptions of cardinal utility theory

ü 1. Rationality of consumers. The main objective of the consumer is to

maximize his/her satisfaction given his/her limited budget or income.
ü Thus, in order to maximize his/her satisfaction, the consumer has to be
rational.
ü 2. Utility is cardinally measurable. According to the cardinal approach, the
utility or satisfaction of each commodity is measurable.
ü Utility is measured in subjective units called utils.

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 3.3.1.1 Assumptions of cardinal utility theory……’cont

ü 3. Constant marginal utility of money. A given unit of money deserves the

same value at any time or place it is to be spent.
ü A person at the start of the month where he has received monthly salary
gives equal value to 1 birr with what he may give it after three weeks or so.
ü 4. Diminishing marginal utility (DMU). The utility derived from each
successive units of a commodity diminishes.
ü In other words, the marginal utility of a commodity diminishes as the
consumer acquires larger quantities of it.
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 3.3.1.1 Assumptions of cardinal utility theory……’cont
ü5. The total utility of a basket of goods depends on the quantities of the
individual commodities.
ü If there are n commodities in the bundle with quantities X1 , X2 ,...Xn , the
total utility is given by TU = f ( X1 , X2 ......Xn ).

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 3.3.1.2 Total and marginal utility

ü Total Utility (TU) is the total satisfaction a consumer gets from consuming
some specific quantities of a commodity at a particular time.
ü As the consumer consumes more of a good per time period, his/her total
utility increases.
ü Marginal Utility (MU) is the extra satisfaction a consumer realizes from an
additional unit of the product.
ü In other words, marginal utility is the change in total utility that results from
the consumption of one more unit of a product. Graphically, it is the slope of
total utility. 11
 3.3.1.2 Total and marginal utility….

ü Mathematically, marginal utility is:

ü where, TU is the change in total utility, and Q is the change in the amount
of product consumed.
ü To explain the relationship between TU and MU, let us consider the
following hypothetical example.

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3.3.1.2 Total and marginal utility….

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 3.3.1.2 Total and marginal utility….

ü Graphically, the above

data can be depicted
as follows.

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 3.3.1.2 Total and marginal utility……

ü As it can be observed from the above figure,

ü When TU is increasing, MU is positive.
ü When TU is maximized, MU is zero.
ü When TU is decreasing, MU is negative.

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 3.3.1.3 Law of diminishing marginal utility (LDMU)
ü The law of diminishing marginal utility states that as the quantity consumed
of a commodity increases per unit of time, the marginal utility derived from
each successive unit decreases, consumption of all other commodities
remaining constant.
üThe law of diminishing marginal utility is based on the following
assumptions.
ü The consumer is rational
üThe consumer consumes identical or homogenous product. The commodity to
be consumed should have similar quality, color, design, etc.
ü There is no time gap in consumption of the good
ü The consumer taste/preferences remain unchanged
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 3.3.1.4 Equilibrium of a consumer

ü However, given his limited income and the price level of goods and services,
what combination of goods and services should he consume so as to get the
maximum total utility?
a) the case of one commodity
ü The equilibrium condition of a consumer that consumes a single good X
occurs when the marginal utility of X is equal to its market price.

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 3.3.1.4 Equilibrium of a consumer

Proof
Given the utility function
U  f (X)
If the consumer buys commodity X, then his expenditure will be
maximizes the difference between his utility and expenditure.

The necessary condition for maximization is equating the derivative of a

function to zero. Thus,
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 3.3.1.4 Equilibrium of a consumer

Proof

Figure 3.2: Equilibrium condition of consumer with only one commodity

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Utility

E Px (Mum)

MUx

X Quantity of X
 3.3.1.4 Equilibrium of a consumer

ØAt any point above point C (like point A) where MUX > PX, it pays the
consumer to consume more.

ØWhen MUX < PX (like point B), the consumer should consume less of X.

ØAt point C where MUX = PX the consumer is at equilibrium.

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 b) the case of two or more commodities

ØFor the case of two or more goods, the consumer‘s equilibrium is achieved
when the marginal utility per money spent is equal for each good purchased
and his money income available for the purchase of the goods is exhausted.

ØExample: Suppose Saron has 7 Birr to be spent on two goods: banana and
bread. The unit price of banana is 1 Birr and the unit price of a loaf of bread is
4 Birr.

ØThe total utility she obtains from consumption of each good is given below.
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 b) the case of two or more commodities

ØTable 3.2: Utility schedule for two commodities

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 Example 2:
Find the equilibrium consumption of two good, X and Y if the total income is $28, px=5 and
py=2, given the following information in addition.

Qx TUx MUx MUx/Px Qy TUy MUy MUy/Py

0 0 0 0

1 20 1 10

2 35 2 16

3 45 3 20

4 50 4 22

5 40 5 18

6 25 6 10

7 5 7 1
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 3.3.2 The ordinal utility theory

Ø In the ordinal utility approach, it is not possible for consumers to express the
utility of various commodities they consume in absolute terms, like 1 util, 2
utils, or 3 utils but it is possible to express the utility in relative terms.

ØThe consumers can rank commodities in the order of their preferences as 1st,
2nd, 3rd and so on.

ØTherefore, the consumer need not know in specific units the utility of various
commodities to make his choice.

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 3.3.2.1 Assumptions of ordinal utility theory

 Consumers are rational - they maximize their satisfaction or utility given

their income and market prices.

 Utility is ordinal - utility is not absolutely (cardinally) measurable.

Consumers are required only to order or rank their preference for various
bundles of commodities.

• Diminishing marginal rate of substitution: The marginal rate of substitution

is the rate at which a consumer is willing to substitute one commodity for
another commodity so that his total satisfaction remains the same.
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 3.3.2.1 Assumptions of ordinal utility theory……

• The total utility of a consumer is measured by the amount (quantities) of all

items he/she consumes from his/her consumption basket.

• Consumer’s preferences are consistent: For example, if there are three

goods in a given consumer‘s basket, say, X, Y, Z and if he prefers X to Y and Y
to Z, then the consumer is expected to prefer X to Z. This property is known as
axioms of transitivity.

• The ordinal utility approach is explained with the help of indifference curves.

• Therefore, the ordinal utility theory is also known as the indifference curve
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 3.3.2.2 Indifference set, curve and map
üIndifference set/ schedule is a combination of goods for which the consumer
is indifferent.
ü It shows the various combinations of goods from which the consumer derives
the same level of satisfaction.
üConsider a consumer who consumes two goods X and Y (table 3.3).

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 3.3.2.2 Indifference set, curve and map
• Indifference curve: An indifference curve shows different combinations of
two goods which yield the same utility (level of satisfaction) to the consumer.
• A set of indifference curves is called indifference map.

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 3.3.2.3 Properties of indifference curves

1. Indifference curves have negative slope (downward sloping to the right).

• Indifference curves are negatively sloped because the consumption level of

one commodity can be increased only by reducing the consumption level of
the other commodity.

2. Indifference curves are convex to the origin. The convexity of indifference

curves is the reflection of the diminishing marginal rate of substitution.
3. A higher indifference curve is always preferred to a lower one. The further
away from the origin an indifferent curve lies, the higher the level of utility it
denotes. 31
 3.3.2.3 Properties of indifference curves
• 4. Indifference curves never cross each other (cannot intersect).
• The assumptions of consistency and transitivity will rule out the intersection of
indifference curves. Figure 3.4

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 3.3.2.4 Marginal rate of substitution (MRS)

• Marginal rate of substitution of X for Y is defined as the number of units of

commodity Y that must be given up in exchange for an extra unit of
commodity X so that the consumer maintains the same level of satisfaction.
• Since one of the goods is scarified to obtain more of the other good, the MRS
is negative.

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 3.3.2.4 Marginal rate of substitution (MRS)…….
•
Ø From the above graph, MRSX,Y associated with the
movement from point A to B, point B to C
and point C to D is 2.0,1.6, and 0.8 respectively.

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 3.3.2.4 Marginal rate of substitution (MRS)
• It is also possible to derive MRS using the concept of marginal utility. MYS is XY ,

related to MUX and MUY as follows.

• Proof: Suppose the utility function for two commodities X and Y is defined
as: U  f (X,Y)
• Since utility is constant along an indifference curve, the total differential of the
utility function will be zero.

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 3.3.2.4 Marginal rate of substitution (MRS)…

• Example: Suppose a consumer‘s utility function is given by U(X,Y)  X4 Y2 .

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Find MRSX,Y.

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 3.3.2.5 The budget line or the price line
üIn reality, the consumer is constrained by his/her income and prices of the two
commodities.
üThis constraint is often presented with the help of the budget line.
ü The budget line is a set of the commodity bundles that can be purchased if the
entire income is spent.
üIt is a graph which shows the various combinations of two goods that a consumer
can purchase given his/her limited income and the prices of the two goods
üIn order to draw a budget line facing a consumer, we consider the following
assumptions.
q There are only two goods bought in quantities, say, X and Y.
q Each consumer is confronted with market determined prices, PX and PY.
q The consumer has a known and fixed money income (M). 37
 3.3.2.5 The budget line or the price line
• Assuming that the consumer spends all his/her income on the two goods (X
and Y), we can express the budget constraint as:
• M  P X P Y
X Y By rearranging the above equation, we can derive the
following general equation of a budge t line.

Graphically,

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 3.3.2.5 The budget line or the price line
• Note that:The slope of the budget line is given is by (the ratio of the prices
of the two goods).
 Any combination of the two goods within the budget line (such as point A) or
along the budget line is attainable.
 Any combination of the two goods outside the budget line (such as point B) is
unattainable (unaffordable).

• Example: A consumer has $100 to spend on two goods X and Y with prices $3
and $5 respectively.
• Derive the equation of the budget line and sketch the graph.

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 3.3.2.5 The budget line or the price line
üSolution: The equation of the budget line can be derived as follows.

ü When the consumer spends all of her income on good Y, we get the Y-
intercept (0,20).
üSimilarly, when the consumer spends all of her income on good X, we obtain
the X- intercept (33.3,0). Using these two points we can sketch the graph of
the budget line. 40
 Change in Income
üIf the income of the consumer changes (keeping the prices of the commodities
unchanged), the b udget line also shifts (changes).

üIncrease in income causes an upward/outward shift in the budget line that

allows the consumer to buy more goods and services and decreases in income
causes a downward/inward shift in the budget line that leads the consumer to
buy less quantity of the two goods.

üIt is important to note that the slope of the budget line (the ratio of the two
prices) does not change when income rises or falls.
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 Change in Income

Figure 3.7: Effects of increase (right) and decrease (left) in income on the
budget line

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 Change in prices:
üAn equal increase in the prices of the two goods shifts the budget line inward.

üSince the two goods become expensive, the consumer can purchase the lesser
amount of the two goods.

üAn equal decrease in the prices of the two goods, one the other hand, shifts the
budget line out ward.

ü Since the two goods become cheaper, the consumer can purchase the more
amounts of the two goods.

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 Change in prices:
üFigure 3.8: Effect of proportionate increase (inward) and decrease (out ward)
in the prices of both goods

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 Change in prices:
üFigure 3.9: Effect of decrease in the price of only good X on the budget line

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 3.3.2.6 Equilibrium of the consumer
üThe preferences of a consumer (what he/she wishes to purchase) are indicated by
the indifference curve.

ü The budget line specifies different combinations of two goods (say X and Y) the
consumer can purchase with the limited income.

üTherefore, a rational consumer tries to attain the highest possible indifference

curve, given the budget line.

üThis occurs at the point where the indifference curve is tangent to the budget line
so that the slope of the indifference curve (MRS XY ) is equal to the slope of the
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budget line ( Px/ Py).
 3.3.2.6 Equilibrium of the consumer……
üFigure 3.10: Consumer equilibrium under indifference curve approach

ü Mathematically, consumer optimum

(equilibrium) is attained at the point where:
ü Slope of indifference curve
= MRSxy = MUx/Muy
ü Slope of the budget line = Px/Py
ü Slope of indifference curve = Slope of the
budget line, then

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 3.3.2.6 Equilibrium of the consumer
üExample: A consumer consuming two commodities X and Y has the utility
function U(X,Y) =XY + 2X . The prices of the two commodities are 4 birr and 2
birr respectively. The consumer has a total income of 60 birr to be spent on the
two goods.

üa) Find the utility maximizing quantities of good X and Y.

üb) Find the MRSX,Y at equilibrium.

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 3.3.2.6 Equilibrium of the consumer

• Solution
• a) The budget constraint of the consumer
is given by:
• PX.X+ PY.Y = M
• 4X+2Y= 60 …………….…………. (i)

• Substituting equation (ii) into (i), we obtain Y =14 and X = 8.

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 3.3.2.6 Equilibrium of the consumer

• Solution

• (At the equilibrium, MRS can also be calculated as the ratio of the prices of the two
goods)

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 End of the Chapter

• .

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