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Theory of Consumer Behavior
Theory of Consumer Behavior
Behaviour
TOPIC: 3
Topic Outline
Introduction of Consumer Behavior Theory
Principal assumption of the theory
Importance of the theory
Meaning of Utility
Consumer Behavior Theories
Cardinal Utility Approach
Ordinal Utility Approach
Theory of Consumer Behaviour
The principle assumption upon which the theory of
consumer behaviour and demand is built is:
a consumer attempts to allocate his/her limited money
income among available goods and services so as to
maximize his/her utility.
Recall Our assumption in the law of demand:
Consumer always wish to maximize satisfaction.
Importance of the Theory
The Covered Law of demand does not give answers
to the question of;
How doe a consumer decide to consume at a given price
of a commodity?
Thus by learning on how a consumer behaves at
consumption we will be able to understand the
demand side of the market in detail.
Why a consumer exchange their money income for a
given particular quantity of a good at a certain price.
Meaning of Utility
Utility;
amount of satisfaction derived from the consumption
of a commodity.
Therefore in abstract sense, Utility is the power of
the commodity to satisfy human needs.
For example;
Why do you drink water?
Why do you pay tuition fee?
Why do you buy a car?
Why do you buy a cell phone?
Understanding Utility
Utility is a relative in nature and not absolute.
That is utility of a commodity depends on the need of
the commodity to a consumer.
Therefore the greater the need of a commodity the
greater is the utility of that commodity to a consumer.
Utility of a commodity depends on the availability
of complement goods.
Example: electrical gadgets yield utility where there is
electricity.
Understanding Utility
Utility is ethically neutral
Neutrally ranges from something being bad or good.
For-instance, some drugs are bad and harmful to
consume but they yield utility to addicts.
OR Vegetarians regard eating meat as immoral, but if
they do it satisfies their hunger.
Measurement of Utility
Question:
Can we measure the utility we get from goods we
consume.
Answer:
A number of theories have developed by economists in
order to aid measurement of utility obtained from
consuming a commodity.
Consumer Behaviour Theories
The Cardinal Utility Theory
Utility is measurable in a cardinal sense
cardinal utility - assumes that we can assign values for
utility, E.g. derive 10 utils from drinking a glass of
water.
The Ordinal Utility Theory
Utility is measurable in an ordinal sense
ordinal utility approach - does not assign values,
instead works with a ranking of preferences.
Cardinal Utility Theory
Nineteenth century economists, such as Jevons,
Menger and Walras, assumed that utility was
measurable in a cardinal sense, which means that
utility can be measured quantitatively.
They used the term “util” meaning units of utility,
just like kilograms as a unit of weight.
Utility Concepts as per Cardinalist
• Total utility (TU): the overall level of satisfaction
derived from consuming a good or service
7 7 7
4 4
3 3
1 1
0 0 0
0 1 2 3 4 5
-1 -1
-2
Total Utility Marginal Utility
Exception of Law of Diminishing Marginal Utility
The law of diminishing marginal utility does not hold
in account of the following scenarios;
Accumulation of Money.
Collection of items, like stamps, books, and
paintings.
In these situations and others of similar nature, a
person marginal utility increase as he/she increases
consumption, although it will decrease eventually.
Consumer Equilibrium
So far, we have assumed that any amount of goods
and services are always available for consumption.
In reality, consumers face constraints (income and
prices):
Limited consumers income or budget
Goods can be obtained at a price
Some simplifications
Consumer’s objective: to maximize his/her utility
subject to income constraint
2 goods (X, Y)
Prices Px, Py are fixed
Consumer’s income (I) is given
Marginal utility of money (Mum) is constant
Consumer Equilibrium
The law of equi-marginal utility
This is the law which govern how a consumer comes to an
equilibrium
The law states that:
Consumer will distribute his money income between the
goods in such a way that the utility derived from the
last shilling spent on each good is equal.
Consumer Equilibrium
•
Consumer Equilibrium
•
Numerical Illustration:
Qx TUX MUX MUx QY TUY MUY MUy • Suppose: X = Cake
Px Py Y = Pepsi
1 30 30 1 50 50
• Assume: PX = 2
2 39 9 2 105 55 PY = 10
3 45 6 3 148 43 • Income : 60
4 50 5 4 178 30
5 54 4 5 198 20
6 56 2 6 213 15
Numerical Illustration: Calculated Values
Qx TUX MUX MUx QY TUY MUY MUy
Px Py
1 30 30 15 1 50 50 5
3 45 6 3 3 148 43 4.3
4 50 5 2.5 4 178 30 3
5 54 4 2 5 198 20 2
6 56 2 1 6 213 15 1.5
Numerical Illustration: Equilibrium Points.
Qx TUX MUX MUx QY TUY MUY MUy
Px Py
1 30 30 15 1 50 50 5
3 45 6 3 3 148 43 4.3
4 50 5 2.5 4 178 30 3
5 54 4 2 5 198 20 2
6 56 2 1 6 213 15 1.5
Equilibrium Points
2 potential optimum positions
Combination A: X = 3 and Y = 4
TU = TUX + TUY = 45 + 178 = 223
Combination B: X = 5 and Y = 5
TU = TUX + TUY = 54 + 198 = 252
With two possible preferences, the choice will
depend on the income of the consumer at present.
Equilibrium points: Income & Budget
To determine the affordable preference a
consumer has to make a budget since his/her money
income is fixed.
Consumer Budget per combination is give by:
Total expenditure = PX X + PY Y
Total Expenditure per combination in our illustration:
Combination A: 3(2) + 4(10) = 46
Combination B: 5(2) + 5(10) = 60
Cont.
Therefore:
Q1 Q2 Q3 Quantity
D
Q Q2 Q3
Quantity
QUIZ
Suppose the MU of good X is 20, its price is Tsh. 4, and the
MU of good Y is 50 and its price is Tsh. 5. The individual
whom this information applies is spending Tsh. 20 on each
good. Is he or she maximizing satisfaction? Why or why not?
A 25 5
B 15 7
C 10 12
D 6 20
E 4 30
F 25 5
Example: Graphical representation
Good Y
25 A
20 B
15 C
10 D
6 E
F
5
5 7 12 15 20 25 Good X
The Indifference Map
Indifference Map: A collection of indifference curves.
A higher indifference curve represents a higher level of
satisfaction
Good Y
IC3
IC2
IC1
Good X
Marginal rate of Substitution
Given a number of bundles a consumer can substitute one
bundle for another given they yield the same level of
satisfaction.
This involves a substitution of quantities of X for Y being
consumed.
Therefore, the quantity of Y given up for additional quantity of
X is the marginal rate of substituting X for Y.
Combination Good X Good Y MRSxy
Example:
A 1 12 4
B 2 8
3
C 3 5
D 4 3 2
MRS and Indifference Curve.
•
Marginal Rate of Substitution and MU.
•
MRS and MU
Recall: An Indifference Curve
Is a curve which indicate preferences to a consumer that
yield same level of utility to a consumer.
In this regard given two commodities consumers total
utility will be the same as he substitute one commodity for
the other.
Thus a change in total utility of commodity X will offset a
change in total utility of commodity Y.
Principle of Diminishing MRS
•
Why MRS decreases..
Question: Why is it that consumer is willing to give up less
and less of Y for a given increment in X as he slides down
on the curve?
Answer:
Wants for a particular good is satiable.
That is as consumer has more and more of a particular
good the intensity of his want for that good goes on
decreasing.
The goods are imperfect substitute.
Properties of Indifference Curve
Downward sloping from left to right: This shows an
increase in quantity of certain good.
Convex to the origin: the marginal rate
of substitution (MRS) decreased
MRS = quantity of goods Y willing to substitute to
obtain one unit of goods X & this substitution is to maintain
its position at the same level of satisfaction
Do not cross (intersect): consumer preferences transitive
Eg : Quantities X and Y for the combination of A> a
combination of B; utility A> B *
When cross = C, so the utility A = C & B = C; utility A
= B = C. This is not transitive as above *
Properties of Indifference Curve
Different ICs show different level of satisfaction.
Far from the origin, the higher the satisfaction.
Recall: the Indifference Map.
Good Y
IC3
IC2
IC1
Good X
Properties of Indifference Curve
Indifference curve do not intersect, if they do there is a
violation of a transitivity rule of preferences.
Good Y
From the Graph Bundle A is
Common to both indifference
curves, thus;
A = B; and A = C.
A By transitivity principle
B IC1
B = C.
However, from the graph;
C B>C
IC2 This is a violation of
transitivity principle.
Because they are on
Good X
different indifference
curves.
Budget Constraint
•
Budget Line (BL)
Budget Line….
Good Y Budget Line
Line showing all combinations
of items can be
purchased for a
Budget Line particular level of income (M)
.
Good X
Slope of the Budget Line
•
Factors Shifting the Budget Line
Changes in prices of goods X or good Y
When price of good X increases, the quantity of good X is
reduced (by maintaining the quantity of Y) & vice vers
Points on the X axis shifted to the left (a decrease
in quantity of X)
Good X
Shift of budget line due to change in price of Y
Good Y
Good X
Factors Shifting the Budget Line
Changes in income
When income increases, QX and QY can be bought even
more, because consumer’s purchasing power increases.
For the sake that they are normal goods.
Good X
Consumer Equilibrium
A consumer is at equilibrium when he is buying such a
combination of goods as leaves him with no tendency to
rearrange his purchase of goods.
Therefore;
Consumer choice influenced by income; and
Price of the two goods prevailing in the market
Simplifications of Ordinal Utility Theory.
Consumer is rational being.
Consumer has indifference map showing his scale of
preferences.
There is transitivity and consistency of choices.
Consumer prefer large quantity of both goods
(Nonsatiety).
There is diminishing marginal rate of substitution.
Price of commodities are given and constant.
Consumer has a fixed amount of money to spend on the
two goods.
Consumer Equilibrium.
Give the conditions a consumer is at equilibrium when the
budget line and indifference curves are tangent.
Good Y
Equilibrium point
A A consumer cannot
rearrange the two
goods.
Qy E
IC2 Slopes
IC2 Slope of budget line
B equal that of
IC1
Indifference curve
Qx Good X
Consumer Equilibrium
At point A and point B the slopes of indifference curve
and slope of the budget line they are equal but a
consumer is not at equilibrium. Why???
Because both A and B they are on lower indifference curve,
which indicates a lower level of satisfaction.
Furthermore, a consumer is capable of attaining a higher
level of satisfaction at point E because he can afford.
NOTE:
A consumer to be at equilibrium, the tangency of budget
line and indifference curve must be on the highest
indifference curve a consumer can afford.
Effect of Change in Income on equilibrium
A change in income
Result to a change in consumers purchasing power of the
goods.
Suppose Income of consumer increases.
Good Y Income Consumption Curve
Is the curve that traces
equilibrium points of a
ICC
E2
consumer due to an
Qy3 increase in consumers
Qy2 IC3
income.
E2
Qy E1 ICC – also it is known as an
IC2
IC1 Engle Curve.
Q Qx2 Q Good X
Effect of Change in Income on equilibrium
Recall: A change in income can result to;
Quantity to increase – incase a good is normal
Quantity to decrease – in case a good is an inferior
Qx4
Qx3
Qx2
Qx1
Good X
Reading Task
Recall: A change in income can result to;
Quantity to increase – incase a good is normal
Quantity to decrease – in case a good is an inferior
Furthermore, a normal good can either be;
A luxury – if the quantity purchased increase more than
proportionately to the increase in consumers income.
A necessity – if the quantity purchased increases less than
proportionately to the increase in consumers income.
Therefore; On your time go and find out the nature of
income consumption curves of a luxury and a necessity
goods.
Effect of Change in price on equilibrium
When price change we have a tilt of a budget line, in a direction of
price change.
This will result to a change in equilibrium of a consumer.
Suppose price of good X decreases.
Good Y
Price Consumption Curve
Is the curve that traces
equilibrium points of a
consumer as a result of
Qy E change in price of one of
E the commodity.
Qy2
Qy3 E
PCC
IC1 IC2 IC3
Qx2
Good X
Q Qx3
Derivation of Demand Curve
Good Y
Qy E
Qy2 E
Qy3 IC1 E
IC2 IC3 PCC
Qx Qx2 Qx3 Good X
Px
Px E1
P E2
x
P E3
x
D
Qx Qx2 Qx3 Qx
Application and Use of Indifference Curve
The concept is used to in understanding the
following;
Substitutability and Complementarity of goods
Several principles of welfare economics
Burden of direct and indirect tax
Effect of administration of in-kind – subsidy and Lump-
sum cash subsidy
Effect of rationing on consumers welfare.
Supply curve of labor of an individual.
Gains from International Trade.
THE END