CHAPTER THREE

THE THEORY OF CONSUMER

BEHAVIOR
• Consumer behaviour is the study of individuals,
groups, or organizations and the processes they
use to select, secure, and dispose of products,
services, experiences, or ideas to satisfy needs
and the impacts that these processes have on the
consumer and society.
• It blends elements from psychology, sociology,
social anthropology andeconomics.
• It attempts to understand the decision-making
processes of buyers, both individually and in
groups.
• It studies characteristics of individual consumers
such as demographics and behavioural variables
in an attempt to understand people's wants.
 Con’t
• economists assume that an average
consumer is rational. That means, among
other things,
• A consumer has a clear-cut preference. By
this we mean that the consumer is able to
compare any two bundles 'a' and 'b' and
decide which one he/she prefers.
• A consumer has a persistent preference. If the
consumer prefers bundle 'a' to 'b' and 'b' to 'c',
then he/she prefers 'a' to 'c'.
• the consumer is not free in his/her choice.
 Con’t
• consumers’ decision to buy goods and/or
services for consumption purpose is based on
the notion that people tend to choose those
goods and services they value most highly.
• The satisfactions obtained from the goods and
services are referred to as utilities
Utility: Utility is the power of a product to
satisfy human wants . In strict sense of the
word, utility does not mean [realized]
satisfaction. It refers to expected satisfaction.
 con’t
• Total Utility: Total utility refers to the total
accumulated level of satisfaction obtained after a
consumer consumed a certain goods and services
in a given period of time.
• the level of utility obtained from the consumption
of each additional consumption of goods and
services is referred to marginal utility.
• The marginal utility that consumers derive from
each extra unit of consumption of a commodity is
not ever increasing. It increases only to some level
of satisfaction
 Con’t
• The fact that each extra or additional
consumption of units of a good results in less
and less utility to the consumer after some
level is termed as the law of diminishing
marginal utility.
• The Law of Diminishing Marginal Utility: The
law of diminishing marginal utility states that
the marginal utility of a good tends to
diminish as the consumer increases the
consumption of a good beyond a certain level.
• that utility is subjective
 Theories of Utility

Cardinalist approach or utility approach

• The concept of cardinal utility assumes that the
measurement of utility of different
commodities is possible. For example, the
consumption of an apple may give 50 units
of utility whereas an orange may give only
40 units
• utility could be measured in subjective units called
“utils”.
Assumptions of cardinal utility theory

• 1. Rationality: the consumer is rational .it

means he or she aims at the maximization of
his or her utility subject to the constraint
imposed by his or her income.
• 2. Utility is measurable. The utility of each
commodity is measurable. The most
convenient is money
• 3. Constant marginal utility of money. This
assumption is essential if the monetary unit is
used as the measure of utility
 Con’t
4. Diminishing marginal utility : the utility gained
from successive unit of a commodity goes on
diminishing as the consumer acquires larger
quantities of it.
5. The total utility of “a basket of goods”
depends on the quantities of the individual
commodities. U=f (good X, good Y, good Z…)
Total Utility, Marginal and Diminishing Marginal Utility

• Total utility is the sum of the utilities obtained from all

units of a commodity consumed. The more of a
commodity consumed per unit of time, the greater will
be the total utility or satisfaction from it up to a certain
point

• At some point total utility will reach a maximum and

this is called the saturation point beyond which there is
no satisfaction from the consumption. After attaining
the saturation point, if there is more consumption, it will
cause the total utility to decrease.
 Con’t
• Marginal utility (MU): is the extra satisfaction
a consumer realizes from an additional unit of
that product. (MU is the slope of the TU
curve.)
• Look the table below
Con’t
The law of diminishing marginal utility (LDMU)
• states that the marginal utility of an item tends to
decline as more is consumed over any given period.
Although TU increases, the extra, or MU received from
consuming each additional unit of the commodity
decreases.
• The LDMU based on the following assumptions
• The consumer is a rational economic man
• Single homogenous commodity
• No changes in the tastes ( fashions)and the income of
the consumer within a given period
• Commodities are of ordinal type; otherwise, if they are
commodities like diamonds, jewels, liquor, etc the
LDMU may not be applied.
Con’t
 Indifference Curve Approach: Assumes Ordinal
Measurement

• The Ordinalist school (approach) maintained that

utility is not measurable but it is only comparable

• The consumer need not know in specific units of the

utility of various baskets of goods according to the
satisfaction that each basket gives him or her.

• The consumer would be able to determine his or her

order of preference among the different baskets of
goods.
 Con’t
• Indifference schedule is a tabular list showing
various combinations of two commodities
among which the consumer is indifferent.
• Indifference curve: A graph shows all
combinations of the two commodities that
yield the same level of satisfaction or utility to
the consumer. Alternatively, a curve that
shows all combination of goods or services
that provides the same level of satisfaction.
 Assumptions of Indifference curve analysis

1. More is better
2. Transitivity. If A is preferred to B and B is
preferred to C, then A is preferred to C
3. Diminishing marginal rate of
substitution(MRS)
Properties (characteristics) of Indifference curve (ICs)

• ICs are convex to the origin-because they exhibit

Diminishing Marginal Rate of Substitution
• ICs slope downward from left to right or are sloped
negatively
• ICs cannot intersect each other or do not intersect
• No ICs can touch either axis
• ICs are continuous & every where dense (assuming
divisibility)
• A higher IC represents higher level of satisfaction than
the IC at lower level(more is better
 Consumer equilibrium (equilibrium principle)

• The objective of a rational consumer is to maximize

the TU or satisfaction derived from spending his or
her income.

• This objective is reached or as said to be in

equilibrium, when the consumer spends his or her
income in such a way, that the utility or satisfaction
of the dollar (Br) spent on the various goods is the
same
 Marginal Rate of Substitution (MRS)

• The MRS is the rate by

which the consumer is
willing to give up a good
so as to obtain more of
another good, holding the
total utility constant. It
shows a consumer‘s
willingness to substitute
one good for another
while getting the same
level of total utility
 Con’t
• From the above table,
we see that as a
consumer consumes
more and more of
lemon the amount of
orange he is willing to
forgo diminishes. This
principle of marginal
rate of substitution is
reflected by the slope of
the indifference curve.
 Budget Line

• A budget line is a graph

that shows the various
combinations of two
goods that a consumer
can buy given his/ her
limited income and the
prices of the goods.
• An increase in the
consumer’s income
shifts the budget line
outward [to the
right]. Because the
purchasing ability of
the consumer
increases. On the
other hand, a
decrease in income
shifts the budget line
inward.
• An equal increase in
the prices of the two
goods shifts the budget
line inward. Since the
two goods become
expensive, the
consumer can buy
lower amounts of the
two goods. An equal
decrease in the prices
of the two goods, on
the other hand, will
shift the budget line
outward.
• An increase or decrease
in the price of one of the
two goods changes the
slope of the budget line.
• Consider that the price of
good X decreases from
Birr 10 to Birr 5, while
both the price of good ‘y’
and the consumer’s
income remain
unchanged.
• In this case, the horizontal
intercept shifts from 10 to
20 units of X. this causes a
change in the slope of the
budget line.
 Maximizing Total Utility
A consumer gets the
maximum possible total
utility when he buys that
combination of the
goods at which the
budget line is tangent to
the highest attainable
indifference curve.
Effects of Change in Consumer’ Income on
the Satisfaction Unit
• An increase in
consumer’s income
means an increase in
her/his purchasing
power, assuming the
prices of the goods
remain unchanged.
 Effects of Change in Price on the
Satisfaction Unit
• What if the prices of the
two goods decrease?
 purchasing power
increase
 Shift the budjet line to
the right
 The satisfaction unit or
the equilibrium point
shifts from point Z to
point Q.
 What if the only price of good X only
decreases?

 budget line shifts from

AA to AA’
 The satisfaction unit or
the equilibrium point
shifts from point Z to
point R.
 The slope of the budget
line changes.
 O U
K Y
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