Chapter 4: Theory of Consumption
o [Age and Life-cycle Stage] People
Terms to Remember
Budget Line – contains infinite points of
combinations of commodity items that the
same budget can buy at a given price
Convergence – often referred to as “catch-up
effect” in economics
Income Effect – potential increase in the
consumption of two commodities
Indifference Curve – a useful tool for
analyzing consumption behavior on utility
theory
Isocost Line – shows all combinations of
inputs, which cost the same total amount
Marginal Rate of Substitution (MRS) – rate
at which a consumer is ready to give up one
good in exchange for another good while
maintaining the same level of utility
Marginal Utility (MU) – additional
satisfaction derived from consumption of
additional goods and services; also defined as
the utility or dissatisfaction from the last unit
of consumption
UTILITY AND BEHAVIORAL FUNCTIONS
Utility – the satisfaction derived from the consumption of a commodity which determines
consumption and demand behavior. The foundation of consumer’s behavior
Figure 1: Model of Factors Influencing Behavior
Cultural Factors Personal Factors
o Broadest and deepest influence on change the goods and services they
consumer behavior buy over their lifetime. Young
o One of the ‘ most fundamental single people have different
Maslow’s Theory of Motivation – diagram
determinants of a person’s wants and consumption needs from retirees
that explains why people are driven by
behaviors and newly married couples to older
particular needs at particular times
o Social classes show distinct product married couples.
Optimum Combination – implies that a
and brand preferences o [Occupation] Company president
consumer can increase the level of
o Values of individuals or people are will buy expensive clothes, blue
satisfaction, despite a fixed income, by
highly influenced by cultural collar worker will buy work
altering the consumption mix
environment clothes
Paradox Value – discusses why absolute
o [Lifestyle and Economic
necessities in life (i.e., water) are cheaper as
Social Factors Condition] Traditionalist would
compared to luxuries in life (i.e., diamonds)
buy the usual kind of goods, unlike
Reference Groups – groups that have a direct
Reference Groups – groups that have direct those experimental
or indirect influence on person’s attitudes or
or indirect influence on person’s attitudes or o [Personality and Self Concept
behaviors
behaviors
Substitution Effect – an idea that when price
Psychological Factors
increases or income decreases, consumption
Ex. Teenager may buy shoes that are in
will replace expensive items with cheaper
accordance to the taste of his peer group, while Maslow’s Theory of Motivation, sought to
alternatives
a more matured person would prefer more explain why people are driven by particular
Total Utility (TU) – total amount of
durable or conservative shoes needs at particular time
satisfaction derived from consuming foods
and services
Family – can exercise a strong influence on Based on the theory, a person will try to
Utility – satisfaction derived from the
buyer’s behavior satisfy the most important needs first.
consumption of a commodity
When a person succeeds in satisfying an
Ex. From parents, a person acquires religion, important need, he will be motivated to
economics, personal ambitions and love satisfy the next most important need.
Husband-wife, husbands are dominant in the
purchase of insurances and cars, wives are Perception – process by which an individual
dominant in the purchase of washing machines selects, organizes, and interprets information
and kitchenware to create meaningful picture of the world
Role and Status - a person’s position in each Learning – describes changes in an
group. Role consists of the activities a person individual’s behavior arising from experience
is expected to perform according to the person
around him. Each role carries a status Belief – a descriptive thought that a person
reflecting the general esteem accorded to it by holds about something
society.
Attitude – a person’s enduring favorable and
Ex. Role – kind of clothing you wear, Status – unfavorable cognitive evaluations, emotional
company president drive Mercedes Benz, wear feelings, and action tendencies toward some
expensive clothes and eat in posh restaurant object or ideas
*Maslow’s Hierarchy of Needs – a theory in psychology, proposed by Abraham Maslow,
which is often portrayed in the shape of a pyramid, with the largest and most fundamental
levels of needs at the bottom, and the need for self-actualization at the top.
 The law of Diminishing Marginal Utility and the Shape of the Curve

Hierarchy of Indifference Curves

The Budget Line and the Optimum Combination

The Budget Line

The Optimum Combination

DYNAMICS

o Consumption can change due to the consumer or the goods themselves

o Prices can change to make goods relatively cheap or costly
o Relative preference can also change the consumption mix
o The crux of the process is how the consumer spends his income from the first peso
to the last

Figure 2: Maslow’s Hierarchy of Needs

THE UTILITY FUNCTIONS

Utility is the technical term for satisfaction

Total Utility (TU) – total amount of satisfaction derived from consuming foods and services

Marginal Utility (MU) – additional satisfaction derived from consumption of additional goods
and services Figure 31: Relative Price

TU (Total Utility) – Function of Q (Consumption) o The consumer adjusts to point B to maximize satisfaction by buying what is cheaper
in exchange for what is more costly. Consuming less food and more clothing at point
Δ(𝑇𝑈) (Satisfaction from A is now beyond the budget B2.
𝑀𝑈 = an additional unit
Δ𝑄
of consumption)
Where: Δ = change

CONSUMPTION

The Indifference Curve

Indifference curve and isocost is a useful tool for analyzing consumption behavior on the
utility theory.

ΔFood Consumption
MRS =
ΔClothing Consumption Figure 32: Relative Preference
 o The MRS of I2 is higher as the consumer is now willing to give up more food in In the graph, the movement from point A to B is the income effect showing that both
exchange for clothing which has become more valuable. commodities was consumed due to higher income but the point from B to C shows the
substitution of Pepsi to Coke due to lesser price of Pepsi.
MU of Commodity Y MU of Commodity X
=
Price of Commodity Y Price of Commodity X

o The optimum condition at the equilibrium point of the indifference curve and the
budget line where their marginal rates of substitution (MRS) are equal.
INCOME AND SUBSTITUTION EFFECTS
Income Effect – potential increase in the consumption of two commodities
Substitution Effect – an idea that when price increases or income decreases, consumption will
replace expensive items with cheaper alternatives
UTILITY AND DEMAND
Derivation of the Demand Curve
o The potential consumption for a certain commodity is also called Demand which is
the quantity that the demand which consumers are willing to buy
o The potential demand for a product at varying price levels and given a certain degree
of influence of the non-price factors (such as population, taste or preference and
speculation) determines its demand curve
o The inverse relationship that exists between price and quantity of demand results
from the income and substitution effects

Here’s an example of how these two apply, for example, Coke and Pepsi is a two close Consumer Surplus
substitutes. And Coke is what people prefer than Pepsi, so the demand in Pepsi is not as equal
with the demand in Coke. It happens that Pepsi decreased in price, so there is a change in the o The net benefit from the exchange
consumer equilibrium. However, the potential increase in the consumption of both products is o It is an indicator of Social welfare and can help make correct social decisions
what we call Income Effect. Thus, the condition of substituting Pepsi to Coke due to a price
decrease is what we call, Substitute Effect. Paradox Value

The paradox value is the answer to the question that troubled Adam Smith in the 18 th century,
whose book, “The Wealth of Nation,” marked the beginning of Modern Economics. The
question is “How is it that water, which is so useful, that life is impossible to live without it,
has such a low price, while diamonds which are not quite necessary have such a high price?”

The answer lies in the equilibrium theory of supply and demand, as well as the theory of
marginal utility.

Despite its importance, the price of water is low as consumers are only willing to pay less for
its abundance and low level of marginal utility. Paul Samuelson, a noted educator in Modern
Economics, “The total utility of water does not determine its price or demand”

SUMMARY

Utility and Behavioral Factors

1. Cultural
o Culture
o Subculture
o Social Class
2. Social
Figure 33: Income and Substitution Effects o Reference Groups
 o Family
o Roles and Statuses
3. Personal
o Age and life-cycle stage
o Occupation
o Economic circumstances
o Personality and self-concept
4. Psychological
o Motivation
o Perception
o Learning
o Beliefs and attitudes

Maslow’s Hierarchy of Needs

1. Biological and physiological needs

2. Safety needs
3. Belongingness and love needs
4. Esteem needs
5. Self-actualization