THEORY OF CONSUMER

BEHAVIOUR I
By
Eric Ekobor-Ackah Mochiah

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 Introduction
• Our ability to Understand how the consumer makes his/her
purchasing decisions is key.

• How are consumer preferences used to determine demand?

How do consumers allocate income to the purchase of
different goods? Why do people demand goods and services?

• The theory of consumer behaviour is relevant in describing

how and why people prefer one good to another

• The proposition of this theory is that consumers buy a

product because of the satisfaction derived.
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 Assumptions
• The principal assumption is that a consumer attempts to
allocate his/her limited money income among available goods
and services to maximize his/her utility (satisfaction).

• The following assumptions underline the study of consumer

behaviour:

 The consumer is rational in his taste and spending decisions

 consumer has limited resources to satisfy the numerous

competing needs.

 Consumer faces price over which he has no influence.

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 Assumptions (cont…)
 Consumer knows what he/she wants and possesses a well-
defined set of preferences as a basis of making his/her choice.

 The consumer is consistent and transitive in his/her preferences

and these preferences are stable over a period of time.

• Utility maximization: consumer will always seek to maximize

his/her satisfaction or utility. The consumer will always prefer
more to less in any choice situations, given his/her income and
prices.

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 The Three Theories
• Three different theories arise in the
estimation of consumer’s choice in maximizing
his/ her satisfaction.

• These are
– The Cardinal Theory
– Ordinal Theory
– Revealed preference theory

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 The Cardinal Approach
• For the cardinal theory, an individual’s satisfaction derived
from consuming a particular good can be measured.
– E.g. If a consumer drinks a glass of fruit juice, the satisfaction he
derives from that glass can be represented with number like
1,2,4,5 etc.

• The satisfaction or utility is a cardinally measurable

quantity as length, weight and volume.

• Unit of measurement of utility is called “util”.

• The Utility function therefore describes the extent to

which one market basket is preferred to another
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 Utility Theory (U)
• Utility depends upon the units of one good which
a consumer is consuming. In other words utilities
are independently determined as U=f(Q).

• The utilities from different goods can be added. It

shows by additive utility function. U = U1(Q1) +
U2(Q2)+....+Un(Qn)
– Where U1, U2 are the utilities of commodity no. 1,2
etc, which are included in the bundle or basket of
goods which a consumer is purchasing. While Q 1, Q2
are the number of commodities.
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 Assumptions
• Consumer is rational

• The money is a measure which is employed to

measure the utility of the goods and service.
– There is no change in the marginal (additional)
utility of the money which means that marginal
utility of the goods may change while the marginal
utility of money remain the same.

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 Total Utility (TU)
• It is the entire amount of satisfaction that a
consumer derives from the consumption of a
given quantity of a product.

• TU increases for every additional unit of the good

that is consumed but at a diminishing rate.

• At some level, TU reaches its maximum and

thereafter, any increase in consumption gives a
negative satisfaction/ disutility.

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 Marginal Utility (MU)
• The desire cannot be measured directly, but
indirectly using the changes in total utility.

• MU is the extra/additional satisfaction/utility

derived from consuming one more unit of a
given good per period of time.
TU
MU 
Q
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 Marginal Utility (Cont…)
• It is important to note that your marginal utility begins to fall
after the very first unit you consume.
– Your very first fruit juice holds great utility. While you may
enjoy your second juice, it doesn’t bring as much utility as the
first.

• At some point, your MU becomes negative. (takes away from

your total satisfaction).

• The MU curve has a downward/negative sloping shape which

conforms to the Law of diminishing marginal utility

• Rational behavior will also ensure that the consumer can only
purchases a good if they get some positive utility from it.
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 TU and MU Relationship
• There are three relationship that can be
established between the TU and MU.

• Along with increase in use of any commodity, TU

increases at a decreasing rate, hence MU
decreases.

• When MU reaches 0, TU will be at its maximum.

• When MU is negative, TU then begins to fall.

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 Total Utility and Marginal Utility
Total Utility

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(1) (2) (3) TU

Total Utility (Utils)

Ice cream Total Marginal
Consumed Utility, Utility,
Per Meal Utils Utils 20

0 0] 10 10
1 10 ]
8
2 18 ] 0
6 1 2 3 4 5 6 7
3 24
] 4
Marginal Utility (Utils)

4 28
] 2 10
5 30
] 0 8
6 30 6
] -2 4
7 28 2
0
-2
1 2 3 4 5 6 7 MU
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LO1 6-13
 Law Of Diminishing Marginal Utility
(DMU)
• The law states that “as more and more units of a particular
commodity is consumed, the additional utility derived from
each successive unit decreases” (ceteris paribus).

• Based on the law, we can conclude that

– eventually the marginal utility curve will be downward sloping.
– eventually the total utility curve will become “flatter.”
– Slope of the total utility curve is equal to marginal utility

• The law helps explain demand curve (have to cut prices to sell
more as MU diminishes)

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 Consumer Equilibrium/Utility
Maximization
• Utility maximization explains how consumers allocate their
money incomes among the many goods and services
available for purchase

• In the consumer’s desire to maximize utility, he/she faces

two constraints
– Price of the product
– Income of the consumer

• We would look at two different scenarios in which the

consumer can maximize his utility.
– First is the one commodity case
– Second is the two or more commodity case

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 One Commodity Case
• Let’s assume the consumer spends his income on only one
commodity, say good x.

• The equilibrium condition is that the consumer will maximize

his/her satisfaction/utility at the point where marginal utility
is equal to the price level (MUx = Px ).

• Assuming MUx > Px .

– Based on the non-satiation law (consumers prefer more to less)
the consumers will increase his/her consumption for good x
which causes the Mux to eventually fall (law of DMU).

• If MUx < Px
– In this situation, consumer’s consumption of good x will fall. As
consumption falls, MU of x increases till we get to the point
where Mux = Px 16
 Two (Or More) Commodity Case
• A consumer is in equilibrium when he spends his money income
on different goods in such a way that MU of the last units of
money spent on each good is equal.

• Consumer allocates income so that the marginal utility per

dollar spent on each good is the same for all commodities
purchased

• The second condition (which is necessary and sufficient) is that

the commodity mix of x and y with his budget constraint in
mind.
MU X MUY

PX PY 17
 An Example: Utility Table
A: price of pizza=$1; B: price of ice cream =$2; Income $10
Units A: MU A: MU/$ B: MU B: MU/$

1 10 10 24 12

2 8 8 20 10

3 7 7 18 9

4 6 6 16 8

5 5 5 12 6
 Consumer Equilibrium

• In summary, for utility maximization you need to

convert marginal utility to marginal utility per dollar.

• Then compare MU/P for the two goods and buy the
one that gives the greatest MU/P

• Subtract the price from your budget.

• Compare the next available units of both goods and

repeat the process until you are out of money.
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 Deriving The Demand Curve
• So we now know the utility maximizing
condition for the consumer in both a one
commodity case and two commodity case.

• Using this information, we can derive the

demand curve for the consumer of a
particular good(s) or service(s).

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 Utility Maximization And The Demand
Curve
MUB = PB
When price was 2,
quantity was 4 but
if price falls to 1,
MU now is greater
than price hence $2
Price per unit of Good B
one must increase
quantity to reduce
MU, so it is equal
to price again to
get an equilibrium.
1
Note:
MUB > PB
Qty dd increase
MUB < PB
DB
Qty dd falls 0
4 6
Quantity Demanded of Good B 21
 Discussion
• The rational consumer will therefore shift resources to the
consumption of good B (since utility for B now is greater
than good A), hence increased quantity from 4 to 6.

• For the two commodity case (say good A and B), if price of
good B falls from 2 to 1, the entire ratio for good B becomes
cheaper than A.

MU B MU A

PB PA

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