Objectives for Chapter 5

At the end of the Chapter, you will be able to answer the

following:
1. Give the various factors that affect the consumer
behavior.
2. What is utility? What is the difference between total
utility and marginal utility? Explain why utility is
subjective for each individual.
3. What is the indifference curve? What are the
characteristics of the indifference curve and how is it
related with the budget line?
4. Discuss the theory and application of the law of
diminishing marginal utility.
5. Explain what does Adam Smith means when he
mentions about the paradox of value.
6. What is consumer surplus? Explain how consumer
surplus is accounted for.

Chapter 5
The Theory of Consumer Behavior

Everything is worth what its purchaser will pay for it.

-Publilius Syrus (1st century
B.C.E.)

When you walk into a store, you are confronted with

thousands of goods that you might buy. Because your
financial resources are limited, however, you cannot buy
everything that you want. You therefore consider the prices
of the various goods offered for sale and buy a bundle of
goods that, given your resources, best suits your needs

and desires.
In this chapter, we develop a theory that best describes
how consumers behave and make decisions about what to
buy. In the previous chapter on demand, we have already
summarized consumers decisions with the demand curve.
As we have seen, the demand curve for a good reflects the
consumers willingness to pay for it. When the price of a
good rises, consumers are willing to pay for fewer units, so
the quantity demanded falls. We now look more deeply at
the decisions that lie behind the demand curve.
The theory of consumer behavior examines the trade-offs
that people face in their role as consumers. When Mang
Pandoy buys more of a good, he can afford less of other
goods. When he spends more time enjoying leisure and
less time working, he has lower income and can afford less
consumption. When he spends more of his income in the
present and saves less of it, he must accept a lower level
of consumption in the future. The theory of consumer
behavior examines how consumers facing these trade-offs
make decisions and how they respond to the changes in
their environment.
What Generally Affects Our Choices as Consumers?
The primary reason behind consumption is to meet our
needs and wants. We eat to satisfy our hunger, we drink to
quench our thirst, and we watch television because we
want to be entertained. In economics, utility refers to the
power of a commodity of satisfy a human want. For
example clothes have a utility for us because we can wear
it. It will be irrational to consume something for the
purpose of disutility or dissatisfaction.
The question now is can we measure utility?
There are attempts to quantify
satisfaction in the past using the
cardinal utility theory. Utility
analysis based on cardinal
measurement of utility. The main
assumptions are:
In the Cardinal utility theory,

Table 1. Utility Schedule

Q
TU
MU
0
0
1
4
4
2
7
3
3
9
2
4
10
1
5
10
0
* the utility schedule of
MangPandoy for chocolate
bars

utility is measured and quantifiable entity. The utility of

goods expressed in cardinal numbers tell us a great deal
about the preference of the consumer like (10 Units, 20
Units).
The Cardinalist school assumes that the behavior marginal
utility in the mind of another person can be selfobservation.
In the 1930s, however, a number of economists became
disenchanted with the cardinal utility theory because they
doubted the attempt to measure utility and contended that
the assumption of cardinality is superfluous. The ordinal
utility theory emerged as an alternative to cardinal utility
theory. The Ordinalists asserted that the only thing
consumers can do is to rank their preferences, referred to
as the ordinal ranking preferences, hence the name ordinal
utility.
The Law of Diminishing
Marginal Utility
This theory states that as an
individual consumes more
units of a commodity per
unit at a time, his total utility
increase
reaches
its
maximum and starts to decrease. It
means that as more goods are
consumed, the extra or additional
satisfaction, known as the marginal
utility decreases.

Total Utility is
the aggregate
utility attained by a
consumer for every
level of
consumption of the
good or service.

Consider Table 1, which is the Utility

schedule
of
Mang
Pandoy
for
chocolate bars. If Mang Pandoy does Marginal Utility
not consume any chocolate bars, then is the additional or
his total utility is at 0. No consumption extra utility
leads to zero satisfaction, but if you attained for every
additional unit of
would notice, as Mang Pandoy
consumption of the
consumes a unit of chocolate bar, his good or service.
total utility his total utility changed
from 0 to 4. That makes his marginal utility 4.
Marginal utility is computed with this formula:

MU

TU2 TU1
Q2-Q1

The movement in his total utility and marginal utility

continues as Mang Pandoy increase his consumption. This
movement is generally upwards, while marginal utility is
diminishing. This will continue up to a point that the total
utility is on its peak, which is known as the saturation
point. Consequently, when the total utility is at its peak, its
corresponding marginal utility is at 0. As shown by Table 1
and Figure 1. This phenomenon is called as the law of
diminishing Marginal Utility. If Mang Pandoy will continue
consuming chocolate bars after the 5 th bar, theoretically,
his total utility will start to decline, and he will have a
negative marginal utility, thus experience disutility or
dissatisfaction.

The Paradox of Value

More than two centuries ago, in The Wealth of Nations,
Adam Smith posed the paradox of value:
Nothing is more useful than water; but it will scarce
purchase anything. A diamond on the contrary, has
scarce any value in use; but a very great quantity of
other goods may frequently be had in exchange for
it.
Concept of the Consumer Surplus

The paradox of value emphasizes that the

recorded monetary value of a good may be a
misleading indicator of the total economic value
of that good. The measured economic value of
the air we breathe is zero, yet airs contribution
to welfare is immeasurably large.
The gap between the total utility of a good and
its total market value is called consumer surplus.
The surplus that arises because we receive
more than we pay for as a result of the law of
diminishing marginal utility.
We have consumer surplus basically because we
pay for the same amount for each unit of a
commodity that we buy, from the first to the
last.

The figure shows that

the
willingness
of
Mang Pandoy to pay
for the good which is
represented by the
marginal
utility
decreases
as
consumption
increases. In the first
unit of consumption,
the marginal utility is
at 8 pesos. Assuming
that the price of the
good is at 5 pesos, this means that Mang Pandoy
experienced 3 pesos worth of consumer surplus, since he is
willing to pay for 1 unit of the good is at 8 pesos, but only
paid 5 pesos. If he consumed the second unit of the good,
and paid 5 pesos again, the marginal utility is at 7 pesos.
Thus, the consumer surplus is at 2 pesos. Mang Pandoy is
expected to consume units of good until his consumer
surplus is equivalent to zero. That is when the marginal
utility is equals the price of the good. Any additional good,
given the same price, Mang Pandoy will not be willing to
pay for it anymore.
Assumptions
About Preferences

Indifference
Analysis

Curve

Indifference curve is an economic

model which shows an infinite
combination of two goods or
services that yields the same
level of utility to the consumers. It
is used to understand and
describe
individual
human
behavior and is based on the
concept of utility maximization.
This model is simply written as:
max U = f(X,Y)
where the arguments on the righthand side 'X' & 'Y' represent

individuals are able

to make choices
and
rank
their
preferences
for
different goods and
services.

Individuals
are
rational
in
the
choices they make.

more is preferred
to less.

additional
units
consumed provide
less
additional
satisfaction relative
to previous units
consumed
(the
more you have of a
particular good, the
less
satisfaction
you receive with
additional

measurable quantities of goods or services. Unfortunately

the term on the left-hand side of the expression, utility 'U',
is neither observable nor measurable. Thus we have to
resort to the notion of individual preferences for goods and
services to indirectly represent the utility (satisfaction)
gained from consumption of these items.
We will make
preferences:

several

assumptions

about

these

The first assumption states that given several goods 'a', 'b',
and 'c', a consumer can define his preferences for these
goods and put these preferences in some type of order. For
example 'b' may be preferred to 'a', and 'a' may
be preferred to 'c'. We summarize this assumption by
saying that preferences are complete.
The second assumption states that if 'b' is preferred
to 'a' and 'a' is prefered to 'c' then it must be true that
'b' is
preferred
to 'c'.
This
is
known
as
the transitivity condition.
The third assumption is
straight-forward in that
greater quantities provide
greater
levels
of
satisfaction
to
the
individual. This is known
as non-satiation.
The last assumption states
that
consumers
prefer
bundles (or combinations)
of goods and services that
contain some variety of
those goods rather than
extreme
bundles
that
contain large amounts of
just one particular good.
This
is
the
concept
of diminishing marginal
utility.
If we consider two goods:
books and movies, as
shown in the left diagram

Figures 2 and 3. Preference

and the Indifference Curve

of figure 1 below. Both goods are desired by a given

consumer (known as economic goods rather than
economic bads). Points a, b, c, d, e each represents
different combinations of these two goods.
From assumptions 1 and 2 we find that the consumer will
decide on one of the following:

b > c, a preference for the bundle with more movies

c > b, a preference for the bundle with more books
b ~ c, indifference between a bundle that contains
more movies and fewer books and the bundle with
more books and fewer movies. In the case
where preferences for the two goods are defined, it
must be the case that one good will provide more
satisfaction (utility) relative to the other good.
When indifference is the case, it must be true that
the two bundles provide equal levels of satisfaction.

From our third assumption we can state that:

d > b > a and d > c > a
Finally the fourth assumption allows for comparison
between the two extreme bundles 'b' and 'c' and an
average bundle 'e'. In this case if bundles b and c provide
the same level of satisfaction then bundle e (which
represents an arithmetic average of the former,
i.e., e = ab+ (1-a)c for 0 < a < 1), will be preferred.
Using these notions with respect to preferences, we can
define a mapping that includes additional bundles of books
and movies. This mapping is shown with the addition of the
curves in the diagram on the right of figure 2 and 3.
All points on IC1 represent bundles of books and movies
that provide the same level of satisfaction as bundle b (8
movies, 1 book) or bundle c (2 movies, 3 books). All
bundles on IC2 provide more satisfaction than bundles
included on IC1 which provide more satisfaction than
bundles on IC0.
The position and general shape of
these curves are defined through
assumptions 1 and 2. In addition,
assumption 2 prevents these

Indifference curves
-represent
combinations of the
two
goods
that
provide equal levels of
satisfaction.
Budget Constraint is the limit on the
consumption bundles
that a consumer can

curves from intersecting. For example, suppose that

IC1 and IC2 intersected at point b. This would imply that:
c~b~e
but e is contains more books and movies than certain
points on IC1 (points to the interior of e) such that e must
be preferred to these points as well as point c. Behavior in
the case of intersecting indifference curves would be
inconsistent and irrational.
These curves are downward sloping consistent with
assumption 3 (if they were upward sloping, horizontal, or
strictly vertical they would violate the condition of more is
preferred to less). Finally assumption 4 (averages are
preferred to extremes) leads to the convexity of the
curves-- given e > c ~b implies that IC1 must contain
points to the interior of e.
In different models these indifference curves can be used
to identify preferences for combinations of: different
products, consumption spending in the present and in the
future, work-time and leisure time, or financial risk and
return.
Why is the Indifference Curve convex in shape?
The indifference curves are drawn as bowl-shaped, or
convex to the origin. , Hence, you are moved downward
and to the right along
the curve-a movement
that implies increasing
the quantity of food and
reduction of units of
clothing-the
curve
becomes flatter. The
curve is drawn in this
way to illustrate a
property that seems
most often to be true in
reality in which we call
the law of Substitution:
The scarcer a good, the greater its relative
substitution value; its marginal utility rises relative
to the marginal utility of the good that has become
plentiful.

The Indifference Curve as a good explanation to the

Paradox of Value posted by Adam Smith.

What the Consumer Can Afford

Indifference curves and budget constraints
Using indifference
Figure 4. Indifference Curve at
curves and an
Constant Prices and Income
assumption
of
constant
prices
and
a
fixed
income in a two
good world will
give the following
diagram, we will
call as Figure 4.
The
consumer
can choose any
point on or below
the
budget
constraint line BC.
This line is diagonal since it comes from the equation.
In other words, the amount spent on both goods together
is less than or equal to the income of the consumer.
The consumer will choose the indifference curve with the
highest utility that is within the budget constraint. I3 has
all the points outside of their budget constraint so the best
that they can do is I2. This will result in them purchasing X*
of good X and Y* of good Y.
Price effects

Figure 5. Price Effect

Figure 6. Indifference
Curve with Shifting
Prices

More usefully, this can now

be used to predict the effect
of various shifts in the
constraint. Figure 5 shows
the effect of a price shift for
good y. If the price of Y
increases from where it is at
BC2, the budget constraint
will shift to BC1. Notice that since the price of X does not
change, the consumer can still buy the same amount of X if
they only choose to buy good X.
On the other hand, if they choose to buy only good Y, they
will be able to buy less of good Y since its price increased.
This causes the amount of good Y bought to shift from Y2
to Y1, and the amount of good X bought to shift from X2 to
X1. Opposite effect will happen if the price of Y decreases
causing the shift from BC2 to BC3.
If these shifts are repeated with many different prices for
good Y, a demand curve for good Y can be constructed. If
the price for good Y is fixed and the price for good X is
varied, a demand curve for good X can be constructed.
Figure 6 shows this for good y.
Income effect
Another important item that can change is the income of
the consumer. As long as the prices remain constant,
changing the income will create a parallel shift of the
budget constraint. Increasing the income will shift the
budget constraint right since more of both can be bought,
and decreasing income will shift it left.

Depending
on
the
indifference
curves
the
amount of a good bought
can either increase, decrease
or stay the same when
income increases. In Figure
7, good Y is a normal good
since the amount purchased
increased as the budget
constraint shifted from BC1
to the higher income BC2.
Good X is an inferior good
since the amount bought
decreased as the income
increases.

Figure 7. Income Effect

Figure 8. Substitution
Effect

Substitution effect
Every price change can be
converted into an income
effect and a substitution
effect. The substitution effect
is basically a price change that changes the slope of the
budget constraint, but leaves the consumer on the same
indifference curve.
This effect will always cause the consumer to substitute
away from the good that is becoming comparatively more
Summary
expensive.
If the good in question is a normal good, than
the income effect will re-enforce the substitution effect. If
Ourisanalysis
demand
permitseffect
us towill
determine
the good
inferior,of
then
the income
lessen the
the underlying
factors
affecting
theopposite
level ofand
substitution
effect. If the
income
effect is
consumer
a given
commodity.willAnbuy
stronger
than thedemand
substitionofeffect,
the consumer
increase
in when
the price
of a commodity,
we expect
more of
the good
it becomes
more expensive.
There
consumers
to
react
by
decreasing
the
quantity
is no generally agreed upon example of this happening,
buy.
known they
as a want
Giffentogood.
There are two theories that seek to explain
consumer behavior. These are the utility theory
and the indifference preference theory.
The fundamental assumption of utility theory of
demand is that the satisfaction that a person
derives in consuming a particular product
diminishes or declines as more and more of a
good is consumed. In other words, as successive
quantity of goods is consumed, the utility we
derive diminishes. This is called the law of
diminishing marginal utility.
An indifference curve is a locus of points each of
which represents a combination of goods and
services that will give equal level of satisfaction

Questions for Review and Application

1. What generally affects our decision as consumers?
2. Application: Fill your shopping cart with all the goods
and services you plan to buy in the next two months,
including quantities.
a. What factors determine the items you placed in
your cart?
b. does your cart contain different items than the
person sitting next to you?
c. your income were to change in the next six
months, would your cart contain different
items? Why or why not?
d. If the price of some of the goods in your cart
were to change, would the contents of your
cart change? Why or why not?

Quiz 1 for Chapter 5. The Theory of

Consumer Behavior
Name:
____________________________________
_________________
Section:
_______________
Date:
____________
_________________

Score:
Professor:

Test I. Direction: Multiple Choice: Choose the best answer.

1. Statement I: Utility and usefulness are the same thing.
Statement II: Utility is measured by how much you are
willing to pay for something.
A. Statement I is true and statement II is false.
B. Statement II is true and statement I is false.
C. Both statements are true.
D. Both statements are false.
2. Who held this view? Individuals make choices in order to promote
pleasure and to avoid pain.
A. Adam Smith
B. Jeramy Bentham
C. John Maynard Keynes
D. Karl Marx
E. W. Stanley Jevons
3. Statement I. As you consume more and more units of a service,
your marginal utility rises.
Statement II. A person's demand schedule for a product is identical
to her marginal utility schedule.
A. Statement I is true and statement II is false.
B. Statement II is true and statement I is false.
C. Both statements are true.
D. Both statements are false.
4. If a service were free, you would consume additional units of
that service until your marginal utility.
A. was rising.
B. was falling.
C. was positive.
D. was zero.
5. You should buy more units of a product until its marginal utility is:

A. is greater than price.

B. equal to price.
C. less than price.
Test II. Matching Type. Choose the answer
from Column B which corresponds to Column
A
Column A
_____1.
_____2.
_____3.
_____4.

Utility
Marginal utility
Law of diminishing marginal utility
Saturation Point

_____5. Substitution effect

_____6. Income Effect
_____7. Price Effect
_____8. Indifference Curve
_____9. Budget Constraint
_____10. Total Utility
Column B.
A. Additional utility that a consumer derives from consuming one
additional unit of a good.
B. Explains that when the price of a good increases, consumers will
consume less of the good because their real incomes are lower after
the price increase.
C. Consumers' ranking of different goods and services.
D. Derived by summing the demands of the individual consumers.
E. Explains that when the price of a good increases, consumers will
consume less of the more expensive good and more of some other
good.
F. One's utility grows at a slower and slower rate as you consume
more and more units of a good.
G. Shows an infinite combination of two goods that provides the
same level of satisfaction.
H. Is the limit on the consumption bundles that a consumer can
afford given limited resources.
I. Attained when total utility is maximize and marginal utility is at 0.
J. Illustrates the change in Mang Pandoys preferences when he
receives a promotion with a salary increase.

Quiz 2 for Chapter 5. The Theory of

Consumer Behavior
Name:
____________________________________
_________________
Section:
_______________
Date:
____________
_________________

I.

Score:
Professor:

Identification:

__________________ 1. It is the technical term for

satisfaction; also known as economic benefit.
__________________ 2. It is the primary variable that affects
the consumption.
__________________ 3. Unit use to measure utility.
__________________ 4. The sociological phenomenon where
in persons base their consumption from what they see
from other people.
__________________ 5. It is the aggregate satisfaction a
person attains dependent on level of consumption.

__________________ 6. It is the additional or extra satisfaction

attained from every additional unit of consumption.
__________________ 7. It is a way of expressing utility by
using scale.
__________________ 8. It is a way of expressing utility
through the use of ranking.
__________________ 9. It shows an infinite combination of 2
goods that would yield the consumer the same level of
utility.
__________________ 10. It shows an infinite combination of 2
goods that can be attained given limited resources.
II.

True or False.

__________ 1. U1 provides the higher level of utility than

with U2.
__________ 2. The point to consume is at point c because it
provides the highest level of utility among all points along
the graph.
__________ 3. Point c and point f has the same level of utility
and cost.
__________ 4. The consumer will attain the same level of
utility at point a as with point e.
__________ 5. Point b is along the attainable region.

Quiz 3 for Chapter 5. The Theory of

Consumer Behavior
Name:
____________________________________
_________________
Section:
_______________
Date:
____________
_________________

Score:
Professor:

Direction: Write the letter of your answer at the left of each

number. USE CAPITAL LETTER ONLY.

1. Consumer behavior is the study of individuals, groups, or

organizations and the processes they use to select,
secure, use, and dispose of products, services,
experience, or ideas to satisfy needs and the impacts that
these processes have on the consumer and society.
A. True
B. False
2. Situational factors that affect people's buying behavior
include all of the following EXCEPT _________.
A. Demonstration Effect
B. Effect of Urbanization
C. Psychological Factors
D. All of the Above
E. None of the Above
3. Which of the following effects causes the demand curve to
be downward sloping?
A. Substitution Effect
B. Income Effect
C. Both of the Above
D. None of the Above
4. Refer to the figure below. From the information in the
graph, we can deduct that the marginal utility curve
would be:

A. Downward sloping.
B. Upward Sloping
C. Horizontal
D. Vertical
E. None of the Above
5. Refer to the figure below. When total utility is maximized:

6.

7.

8.

9.

A. Marginal utility is equal to total utility.

B. Marginal utility equals zero.
C. Marginal utility is also maximized.
D. Marginal utility is minimized.
Refer to the figure above. If marginal utility is negative,
then total utility must be:
A. Increasing
B. Decreasing
C. Negative
D. Zero
A consumer maximizes total utility when:
A. Choosing more of one good and less of another
increases utility.
B. Choosing more of one good and less of another no
longer increases utility.
C. Marginal utility is maximized.
D. Marginal utility per dollar spent on each good is
highest.
Suppose you have a fixed budget for two goods, X and Y.
Px = 10 and Py = 5. MUx= 60 utils and MUy = 15 utils.
Should the consumption of X and/or Y be higher, lower, or
remain the same?
A. Consumption of good X should increase, and
consumption of good Y should decrease.
B. Consumption of good X should decrease, and
consumption of good Y should increase.
C. The current combination of goods maximizes total
utility. Consumption should remain the same.
D. The consumption of goods X and Y should
increase.
Refer to the figure below. What explains the moves in the
budget lines in graph A and B, respectively?

A. Both moves are explained by changes in income.

B. Both moves can be explained by changes in the
price of X.
C. The move in graph A is caused by changes in
income, and the move in graph B is caused by
changes in the price of X.
D. The move in graph A is caused by changes in the
price of X, and in graph B by changes in income.
10.Refer to the figure below. Suppose that the price of good Y
equals 20. How much is the income of the consumer?

A. There is insufficient information to answer the

question.
B. 100
C. 200
D. 300