LESSON MANUSCRIPT

THEORY OF CONSUMERS BEHAVIOR

ECON 011 / Principles of Economics

Submitted to:
Sir Marlon P. Tuiza

Submitted by:
Buendia, Ericka Marie A.
Casabal, Gian Victor C.
Gomez, Lady Denise C.
Maghirang, Prencess A.
Mayuga,Tricia Gail D.

Bachelor of Science in Industrial

Engineering 2 – 1
Group 4
 LESSON MANUSCRIPT
THEORY OF CONSUMERS BEHAVIOR

MODULE OBJECTIVES
After successful completion of this module, the students should be able to:
1. Discuss the concept of the theory of consumers behaviour and its connection to the
subtopics.
2. To help customers make wise decisions about how to deploy their resources to
optimize their overall happiness or utility is the goal of marginal and total utility.
3. To explain how the additional satisfaction or utility derived from consuming each
additional unit of a good or service tends to decrease as one consumes more of it.
4. To teach students how consumers make choices and allocate resources effectively,
essential for real-world applications in economics.
5. To provide a comprehensive framework for understanding consumer behaviour by
visualizing the affordability limits through budget constraints, analyzing the impact of
price changes, income variations, and exploring optimal combinations, enabling
economists to predict and explain consumer decisions under different economic
conditions.
6. To understand how the substitution effect influences consumer behaviour in response
to changes in relative prices and how it plays a crucial role in consumer choice theory.

OVERVIEW

The theory of consumer behaviour is a foundation concept in economics, aiming to

elucidate how individuals make decisions regarding the utilization of their limited resources to
meet their desires and needs. This theory plays a pivotal role in comprehending how consumers
navigate choices in the marketplace and the broader influence of their preferences on the
economy.

This theory elucidates how people make decisions, taking into account their overall and
incremental satisfaction (total and marginal utility), guided by the principle of diminishing
additional satisfaction as consumption increases. It is visually represented through indifference
curves and budget constraints, aiming to identify the optimal combination of goods while
considering the substitution effect. Grasping this theory is vital for optimising resource
allocation, determining fair prices, advancing consumer well-being, crafting effective
government policies, and conducting insightful market analyses. Ultimately, it empowers
individuals and decision-makers to make informed choices that bolster overall economic
prosperity.
CONTENT / COURSE MATERIALS

In the realm of economics, understanding the theory of consumer behaviour is akin to

unlocking the fundamental principles that govern how individuals make choices and allocate
their resources. Within this intricate framework lie key subtopics that shed light on this
decision-making process. We delve into the fascinating world of consumer behaviour, exploring
concepts such as total and marginal utility, the law of diminishing marginal utility, indifference
curves, budget lines, the pursuit of combination optimum, and the intriguing dynamics of the
substitution effect. Embark on this intellectual journey as we dissect the core elements of
consumer behavior and their profound implications for economics and decision-making.

1. TOTAL AND MARGINAL UTILITY

In this case, we can better understand consumer behaviour and decision-making by

using key economic concepts like marginal utility and total utility. In order to study customer
preferences, demand trends, and price strategies in different marketplaces, it is essential to
understand key ideas in economics.

Total utility is a measurement of the level of enjoyment a person experiences after

consuming, purchasing, or otherwise getting a good or service. This metric is used by
economists to estimate customer demand for a good, and it's an important consideration for
economists or business owners when examining consumer behaviour. Total utility can be
calculated and combined with other measures like price, supply, or production costs.

The price, supply, and demand of a certain commodity or service can all be directly
impacted by marginal utility. By calculating the quantity of the product that their clients are
likely to purchase, businesses can also determine how much of a product to make. A customer's
payment for a larger quantity of an item or service might also be determined by them. Each unit
a consumer receives over time frequently causes marginal utility to fall.

The commensurate rise in consumption of a good or service results in an increase in

overall utility. The overall value continues to rise even when the utility may show signs of
diminishing returns. In contrast, when you consume more, the marginal utility might go down.
The value of marginal utility, in addition to the marginal utility, can provide information on the
patterns in the product's overall utility. A declining total utility indicates a negative marginal
utility, and an increasing total utility indicates a positive marginal utility. The saturation point is
reached when marginal utility is equal to zero, marking the height of total utility.
A. Here are some of the ways total utility and marginal utility differ:

Total utility calculation

Total utility is the total amount of utility a client receives from using a good, service, or
product. Utils, a unit of utility measurement, are used in the formula for total utility. Add the
marginal utility of the consumption for each unit to determine the overall utility. Total utility can
be calculated using the following equation:

● Marginal utility (MU) 1 plus MU 2 and MU 3 equals total utility.

How to determine marginal utility?

The formula for marginal utility likewise employs utils, but this calculation takes into
account the rate at which utility changes each time a person utilizes a good for a second time.
You can get marginal utility by dividing the variation in total utility by the variation in units.
Marginal utility can be calculated using the following equation:

● Total utility change / change in units equals marginal utility.

Here are a few real-world examples of total utility:

Potato chips: The benefit of the entire bag of chips is probably larger than the modest amount
of utility that consuming one chip from the bag may bring. The overall utility could rise over
time since you might eat a bigger bag of chips over a few days.

Price of water: During a drought, a city's water prices may rise to encourage customers to save
more overall. If water costs more, people can decide to use it more wisely overall by conserving
more of it.

Here are a few real-world examples of marginal utility:

Time spent preparing: You might decide to put in an extra hour of practice the night before a
big sales presentation you have to give at work. The marginal value of the extra time is the
amount of utility you obtain from preparing for three hours rather than two.

Cost of insurance: When consumers purchase insurance, they frequently seek a high return on
investment. The marginal utility of acquiring more insurance may rise for the clients if an
insurance provider provides a little discount for each insured item they add.
 In summary, it is essential for economic decision-making to comprehend total and
marginal utility. By balancing the marginal value and price of items, consumers try to maximise
their overall utility. This idea is fundamental to many economic theories, including utility
maximization, demand theory, and consumer choice.

The ideas of total utility and marginal utility are crucial to economics and are used in a
variety of different academic disciplines. It is crucial for businesses and stakeholders to
understand utility theories since they project customer choice. Consumer behavior could not be
predicted or mapped without knowledge of utility.

The concept of supply and demand for products and services in a specific market is
derived from the micro-economic analysis of total and marginal utility and the variations
between them. As a result, in order to comprehend market fluctuations and leverage them to
their advantage, firms and societies must pay attention to these two economics subjects.

For example, If the first chocolate had a marginal utility of 85 and the second had a
marginal utility of 79, for instance, the overall utility from eating two chocolates would be 164.
Three chocolates have a combined utility of 237 (85 + 79 + 73). Our total utility increases as long
as our marginal utility is positive, however it does so at a slower rate while our marginal utility is
declining.

Table 1 & Figure 1 Total and Marginal Utility

2. LAW OF DIMINISHING MARGINAL UTILITY

The law of diminishing marginal utility can be taught in relation to the idea of the
indifference curve and is essential in understanding economics.

According to the law of diminishing marginal utility, the additional pleasure from taking
another bite will gradually decrease as more of the good is consumed. The enjoyment received
from each additional bite is the marginal utility. We get less additional enjoyment from
consuming another unit of the good as more of it is consumed. As a result, even if a good were
free and you could eat as much as you wanted, the law of diminishing marginal utility would
place a limit on how much you could.

History of Law of Diminishing Marginal Utility

Herman Gossen established the law of diminishing marginal utility in 1854, stating that
"the magnitude of one and the same satisfaction, when we continue to enjoy it without
interruption, continually decreases until satisfaction is reached."

Many economists, like Dr. Marshall (1920, 1961) continued this line of thinking. He defines the
law of diminishing marginal utility as the phenomenon wherein an individual's additional gain
from an increase in his stock of anything decreases as his existing stock increases.

Diminishing Marginal Utility Examples

There is no industry-specific exception to the law of diminishing marginal utility. Its wide
notion has various connections to several sectors. Consumers generally exercise greater caution
and attention when presented with higher utility propositions, according to statistical evidence.

Here are some ways diminishing marginal utility influences processes along a business
process.

● Sales
Depending on the current marginal utility potential of the consumer, the method of
selling items changes drastically. Think about a salesperson who is attempting to sell you
your first smart phone. With any functional cellphone, your marginal utility is very high,
making the sale simple. If you already own a cellphone, the salesperson's strategies
(such as proposing a different phone for business, a backup phone, or upgrading your
current model) will vary.
● Marketing
Marketers employ the law of diminishing marginal utility because they seek to maintain
a high marginal utility for the things they offer. Consuming a product results in
satisfaction, but consuming too much of it may result in customers becoming satiated
and the marginal utility of the product falling to zero. Of course, the customer and the
product being consumed have an impact on marginal utility.

Relationship between Marginal Utility and Total Utility:

Marginal utility can be positive, negative, or zero.
● Total utility rises in a diminishing manner when marginal utility decreases but is
positive. Suppose you like eating a slice of cake, but a second slice would bring you
some extra joy. Then, your marginal utility from consuming cake is positive.
● Total utility is at its highest when marginal utility is zero. For example, you might feel
fairly full after two slices of cake and wouldn't really feel any better after having a third
slice. In this case, your marginal utility from eating cake is zero.
● Total utility decreases when marginal utility is negative. For instance, the fourth slice of
cake might even make you sick after eating three pieces of cake. Therefore, your
marginal utility is negative.

Limitations of the Law of Diminishing Marginal Utility

The law does not operate in the following cases:
● Very Small Units: The law is ineffective if the units of a commodity are extremely small.

● Dissimilar units: The unit should be comparable in terms of size, quality, etc. If the
units consumed are not equivalent in size and quality, the law of diminishing marginal
utility will not apply.

● Too long an interval: If the units are consumed after a lot of time has passed, the law
will also not work.

● Mentally unstable people: Alcoholics and drug addicts will experience more pleasure
with each additional dose. As a result, the law is ineffective in certain situations.

● Rare collections: Rare coin and stamp collectors, for instance, report greater
satisfaction with each addition to their stock or collection. Therefore, the law is
ineffective.
 ● Not applicable to money: Both the rich and the poor value money as a commodity.
According to a proverb, a person's desire for money increases as his wealth increases,
hence the law does not apply to matters of wealth.

3. INDIFFERENCE CURVE

In this part, indifference curves will be defined, and their features will be discussed. The
English economist F.Y. Edgeworth initially proposed indifference curves in the 1880s. Vilfredo
Pareto, an economist from Italy, developed the idea and applied it widely in the early 1900s.
Two more English economists, R.G.D. Allen and John R. Hicks, popularized and considerably
expanded the use of indifference curves in the 1930s. Indifference curve is an essential
analytical tool, which depicts an ordinal assessment of the consumer's behavior and
preferences and demonstrates how the consumer maximizes utility when spending money.

What does the Indifference Curve show?

Ordinal utility can be used to analyze consumer's behavior. Three presumptions form
the basis of an ordinal utility measure:

1. We presume that when given a choice between any two baskets of goods, the buyer can
decide whether they prefer basket A to basket B, B to A, or they are indifferent between the
two or unsure.
2. We presume that the consumer's tastes are constant or transferable. That is, if the
customer says that he or she prefers basket A to basket B and also that he or she prefers
basket B to basket C, then the customer will choose A over C.
3. We presume that more of a product is preferable to less, or that the consumer will never be
satisfied with the commodity because we believe it to be a good rather than a bad.

Indifference curves can be used to illustrate a person's preferences according to the

three presumptions. We will suppose that there are just two goods, X and Y, in order to perform
the analysis using plane geometry.

An indifference curve shows the various combinations of two goods that give the
consumer equal utility or satisfaction. More satisfaction is indicated by a higher indifference
curve, and less satisfaction is shown by a lower indifference curve. However, we are unable to
determine how much more value or satisfaction a greater indifference curve would suggest. In
other words, various indifference curves merely offer an ordering or ranking of the person's
behavior or preferences.

Figure 2.1 - Indifference Curves

For instance, the figure 2.1 provides a schedule of acceptable combinations of

hamburgers (good X) and soft drinks (good Y) that satisfy customers equally. This data is
represented graphically in Figure 2.1 left panel as the indifference curve U1. The indifference
curve U1 is repeated together with a higher indifference curve (U2) and a lower one (U0) in the
right panel.

Indifference curve U1 shows that one hamburger and ten soft drinks per unit of
time(combination A) give the consumer the same level of satisfaction as two hamburgers and
six soft drinks (combination B), four hamburgers and three soft drinks (combination C), or
seven hamburgers and one soft drink (combination F). On the other hand, combination R(four
hamburgers and seven soft drinks) has both more hamburgers and more soft drinks than
combination B (see the right panel of Figure 2.1), and so it refers to a higher level of satisfaction.
Thus, combination R and all the other combinations that give the same level of satisfaction as
combination R define higher indifference curve U2. Finally, all combinations on U0 give the same
satisfaction as combination T, and combination T refers to both fewer hamburgers and fewer soft
drinks than (and therefore is inferior to) combination B on U1.

Although in Figure 2.1 we have drawn only three indifference curves, there is an
indifference by curve going through each point in the XY plane (i.e., referring to each possible
combination of good X and good Y). That is, between any two indifference curves, an additional
curve can always be drawn. The entire set of indifference curves is called an indifference map
and reflects the entire set of tastes and preferences of the consumer.
Characteristics of Indifference Curves

Indifference curves are usually negatively sloped, cannot intersect, and are convex to the
origin (see Figure 2.1). Indifference curves are negatively sloped because if one basket of goods
X and Y contains more of X, it will have to contain less of Y than another basket in order for the
two baskets to give the same level of satisfaction and be on the same indifference curve. For
example, since basket B on indifference curve U1 (see figure 2.1) contains more hamburgers
(good X) than basket A, basket B must contain fewer soft drinks (good Y )for the consumer to be
on indifference curve U1.

A positively sloped curve would suggest that a basket with more of either commodity
gives the consumer the same utility or satisfaction as a basket with less of either (and no other
commodity). Such a curve could not possibly be an indifference curve since we are dealing with
goods rather than bads. The positively sloped curve on which B and A lie cannot be an
indifference curve, for instance, because combination B in the left panel of Figure 2.2 contains
more of X and more of Y than combination A. In other words, if X and Y are both goodies, B
must be on a higher indifference curve than A.

Figure 2.2.

Indifference Curves Cannot Be Positively Sloped or Intersect

Additionally, indifference curves cannot meet. Curves that intersect are incompatible
with indifference curves' definition. If curves 1 and 2 in the right panel of Figure 2.2 were
indifference curves, for instance, they would show that basket A is comparable to basket C
because both A and C are on curve 1, as well as that basket B is equivalent to basket C. Given
that both B and C are on curve 2, B and C are equivalent. B should then be comparable to A
according to transitivity. This is not conceivable, though, as basket B has more good X and good
Y than basket A. For this reason, indifference curves intersect.

Indifference curves typically lie above any tangent to the curve and are convex to the
origin. Next, we explain how convexity arises from or is a reflection of a declining marginal rate
of substitution.
The Marginal Rate of Substitution

The amount of one good that a person will trade in for an additional unit of another
good in order to retain their level of satisfaction or to stay on the same indifference curve is
known as the marginal rate of substitution (MRS). For example, the marginal rate of substitution
of good X for good Y (MRSXY) refers to the amount of Y that the individual is willing to exchange
per unit of X and maintain the same level of satisfaction. Note that MRSXY measures the
downward vertical distance (the amount of Y that the individual is willing to give up) per unit of
horizontal distance (i.e., per additional unit of X required) to remain on the same indifference
curve.
That is, MRSXY = −∆Y/∆X. Because of the reduction in Y, MRSXY is negative. However, we multiply
by −1 and express MRSXY as a positive value.

For example, starting at point A on U1 in Figure 3.4, the individual is willing to give up
four units of Y for one additional unit of X and reach point B on U1. Thus, MRSXY =−(−4/1) = 4.
This is the absolute (or positive value of the) slope of the chord from point A to point B on U1.
Between point B and point C on U1, MRSXY = 3/2 = 1.5 (the absolute slope of chord BC).
Between points C and F, MRSXY = 2/3 = 0.67. At a particular point on the indifference curve,
MRSXY is given by the absolute slope of the tangent to the indifference curve at that point.
Different individuals usually have different indifference curves and different MRSXY (at points
where their indifference curves have different slopes).

We can relate indifference curves to the preceding utility analysis by pointing out that all
combinations of goods X and Y on a given indifference curve refer to the same level of total
utility for the individual. Thus, for a movement down a given indifference curve, the
gain in utility in consuming more of good X must be equal to the loss in utility in consuming less
of good Y. Specifically, the increase in consumption of good X (∆X) times the marginal utility that
the individual receives from consuming each additional unit of X(MUX) must be equal to the
reduction in Y (−∆Y) times the marginal utility of Y (MUY).That is,

(∆X)(MUX) = −(∆Y)(MUY)

so that,

MUX/MUY = −∆Y/∆X = MRSXY

Thus, MRSXY is equal to the absolute slope of the indifference curve and to the ratio of
the marginal utilities.
 Figure 2.3 Marginal Rate of Substitution (MRS)

Note that MRSXY (i.e., the absolute slope of the indifference curve) declines as we move
down the indifference curve. This follows from, or is a reflection of, the convexity of the
indifference curve. That is, as the individual moves down an indifference curve and is left with
less and less Y (say, soft drinks) and more and more X (say, hamburgers), each remaining unit of
Y becomes more valuable to the individual and each additional unit of X becomes less valuable.
Thus, the individual is willing to give up less and less of Y to obtain each additional unit of X. It is
this property that makes MRSXY diminish and indifference curves convex to the origin.

Some Special Types of Indifference Curves

Despite the fact that indifference curves often have a negative slope and are convex to
the origin, occasionally, they could take on other forms, as seen in Figure 2.4. Horizontal
indifference curves, like the one in the top left panel of Figure 2.4, would suggest that
commodity X is a neuter, meaning that the consumer is neutral regarding how much of the
commodity they have. Instead, vertical indifference curves, like the one in the top right corner
of Figure 2.4, would suggest that commodity Y is a neuter.

Indifference curves are depicted as negatively sloping straight lines in the bottom left
panel of figure 2.4. The absolute slope of the difference curves, or MRSXY, is constant in this
case. This suggests that a person is always willing to sacrifice the same quantity of good Y (like
two cups of tea) in exchange for a higher quantity of good X (like an extra cup of coffee). So, for
this person, good X and two units of good Y are perfect replacements.
 Figure 2.4 Some Unusual Indifference Curves

Finally, the bottom right panel shows indifference curves that are concave rather than
convex to the origin. This means that the individual is willing to give up more and more units of
good Y for each additional unit of X (i.e., MRSXY increases). For example, between points A and B
on U1, MRSXY = 2/2 = 1; between B and C, MRSXY = 3/1 = 3;and between C and F, MRSXY = 3/0.5
= 6.

4. BUDGET LINE AND OPTIMUM COMBINATION

The Budget Line

To understand how households make decisions, economists look at what consumers can
afford. To do this, it is necessary to map consumers' budget constraints. Within the budget
constraint, the quantity of one good is measured on the horizontal axis and the quantity of
another good is measured on the vertical axis. The budget constraint represents all
combinations of two products that the customer can successfully purchase at the given market
price and within a specified income level. The budget constraint intercept is calculated by
dividing income by the price of the good.

For example, if the consumer has $56 to spend and the price of a t-shirt is $14 and
movies were $7. Plotting the budget constraint is a fairly simple process. Each point on the
budget line has to exhaust all $56 of consumer's budget. The easiest way to find these points is
to plot the intercepts and connect the dots. Each intercept represents a case where he spends
all of his budget on either T-shirts or movies.
 - If the consumer spends all his money on movies, which cost $7, he can buy
$56/$7, or 8 of them. This means the y-intercept is the point (0,8). Here, he buys 0
T-shirts and 8 movies.
- If the consumer spends all his money on T-shirts, which cost $14, he can buy only
4 of them ($56/$14). This means the x-intercept is the point (4,0). Here, he buys 4
T-shirts and 0 movies.

By connecting these two extremes, you can find every combination that the consumer
can afford along his budget line. For example, at point R, he buys 2 T-shirts and 4 movies. This
costs him:

T-Shirts @ $14 x 2 = $28

Movies @ $7 x 4 = $28
Total = $24 + $28 = $56
This point indeed exhausts his budget.

Figure 3.1 Budget Line

Budget Constraints
We now know that the consumer must purchase at some point along the budget line,
depending on his preferences. Note that any point within the budget line is feasible. On the
other hand, any point beyond the budget line is not feasible.
 Figure 3.2 Budget Constraints

● Slope
Though we can easily just connect the X and Y intercepts to find the budget line
representing all possible combinations that expend consumer's entire budget, it is important to
discuss what the slope of this line represents. Remember, the slope is the rate of change. In
economics, the slope of the graph is often quite important. In this situation, the slope is QY/QX.
If we want to represent slope in terms of prices it is equal to PX/PY. This can seem unintuitive at
first, as we are used to seeing slope as Y/X., but the reason this is not true for prices is because
the y-axis represents quantity, not price. As we saw above, as price doubles, the quantity the
consumer could previously purchase is halved.

If consumer is making $56:

When the price of movies is $7, he can buy 8 of them

When the price of movies is $14, he can buy 4 of them
Since price and quantity have this inverse relationship, we can use either Px/PY or QY/QX to find
the slope. Since price is often the information given, it is important to remember that the slope
can be calculated either way.
What Does Slope Mean?

● The meaning of the budget line’s slope or price ratio is the same as the slope of a PPF.
(The difference between these two curves is that the PPF shows all the different
combinations given time a time/production constraint, whereas a budget line shows
different combinations given budget constraint. Otherwise, the two graphs are basically
the same). This means the slope of the curve is the relative price of the good on the
x-axis in terms of the good on the y-axis. The price ratio of 2 means that the consumer
must give up 2 movies for every T-shirt. Likewise, the inverse slope of 1/2 means that
he must give up 1/2 a T-shirt per movie.

When Income Changes

● Because budget and prices are prone to change, the consumer's budget line can shift
and pivot. For example, if his budget drops from $56 to $42, the budget line will shift
inward, as he is unable to purchase the same number of goods as before.

To plot the new budget line, find the new intercepts:

Budget: $42
Price of movies: $7
Price of T-shirts: $14

Maximum number of movies (y-intercept): $42/$7 = 6

Maximum number of T-shirts (x-intercept): $42/$14 = 3

Figure 3.3 When Income Changes

As a result of the shift, the consumer's budget line has shifted inward, leaving less consumption
opportunities available.

When Price Changes

● In addition to income changes, sometimes the prices of movies and T-shirts rises and
falls. Suppose, from our original budget of $56, movies double in price from $7 to $14.
Again, to plot the new graph, simply find the new intercepts:

Budget: $56

Price of movies: $14

Price of T-shirts: $14
Maximum number of movies (y-intercept): $56/$14 = 4
Maximum number of T-shirts (x-intercept): $56/$14 = 4

Figure 3.4 When Price Changes

As a result of the pivot, the consumer has fewer consumption opportunities available and the
slope of the line changes. This has two effects:
-The Size Effect: There are fewer opportunities for consumption (as a result of the price
change, the purchasing power of José’s dollar has fallen).
 - The Slope Effect: The relative price of movies is now higher, while the relative price of
T-shirts is now lower.

When Price and Income Changes

● The last type of change is when both price and income change. Suppose the price of
movies increases from $7 to $12 and his budget increases to $63. To plot the new
budget line, follow the same steps as before:

Budget: $63

Price of movies: $12

Price of T-shirts: $14
Maximum number of movies (y-intercept): $63/$12 = 5.25
Maximum number of T-shirts (x-intercept): $63/$14 = 4.50

Figure 3.5 When Price and Income Changes

These changes have interesting effects. José now has access to some new consumption
opportunities, but many others are now unavailable. While the slope effect has clearly made
the relative price of T-shirts lower, the size effect is uncertain.
Optimum Factor Combination:
All factors of production are subject to change. The profit maximization firm will choose
the least cost combination of factors to produce at any given level of output. The least cost
combination or the optimum factor combination refers to the combination of factors with which
a firm can produce a specific quantity of output at the lowest possible cost.

Methods of explaining the optimum combination of factor:

● The Marginal Product Approach: In the long run, a firm can vary the amounts of factors
which it uses for the production of goods. It can choose what technique of production
to use, what design of factory to build, what type of machinery to buy. The profit
maximization will obviously want to use that mix of factors of combination which is
least costly to it. In search of higher profits, a firm substitutes the factor whose gain is
higher than the other. When the last rupee spent on each factor brings equal revenue,
the profit of the firm is maximized. When a firm uses different factors of production or
least cost combination or the optimum combination of factors is achieved when:

Formula:

Mppa = Mppb = Mppc = Mppn

Pa Pb Pc Pn

In the above equation a, b, c, n are different factors of production. Mpp is the marginal
physical product. A firm compares the Mpp / P ratios with that of another. A firm will reduce its
cost by using more of those factors with a high Mpp / P ratios and less of those with a low Mpp
/ P ratio until they all become equal.
● The Isoquant / Isocost Approach: The least cost combination of-factors or producer's
equilibrium is now explained with the help of iso-product curves and isocosts. The
optimum factors combination or the least cost combination refers to the combination
of factors with which a firm can produce a specific quantity of output at the lowest
possible cost. As we know, there are a number of combinations of factors which can
yield a given level of output. The producer has to choose, one combination out of these
which yields a given level of output with least possible outlay. The least cost
combination of factors for any level of output is that where the iso-product curve is
tangent to an isocost curve. The analysis of producers equilibrium is based on the
following assumptions.

Assumptions of Optimum Factor Combination:

The main assumptions on which this analysis is based areas under:
(a) There are two factors X and Y in the combinations.
(b) All the units of factor X are homogeneous and so is the case with units of factor Y.
(c) The prices of factors X and Y are given and constants.
(d) The total money outlay is also given.
(e) In the factor market, it is the perfect completion which prevails. Under the conditions
assumed above, the producer is in equilibrium, when the following two conditions are fulfilled.
(1) The isoquant must be convert to the origin.
(2) The slope of the Isoquant must be equal to the slope of isocost line.

Diagram/Figure:
The least cost combination of factors is now explained with the help of figure ().

Figure 3.6 Optimum Factor Combination

Here the isocost line CD is tangent to the iso-product curve 400 units at point Q. The
firm employs OC units of factor Y and OD units of factor X to produce 400 units of output. This is
the optimum output which the firm can get from the cost outlay of Q. In this figure any point
below Q on the price line AB is desirable as it shows lower cost, but it is not attainable for
producing 400 units of output. As regards points RS above Q on isocost lines GH, EF, they show
higher cost.

These are beyond the reach of the producer with CD outlay. Hence point Q is the least cost
point. It is thepoint which is the least cost factor combination for producing 400 units of output
with OC units of factor Y and OD units of factor X. Point Q is the equilibrium of the producer.

At this point, the slope of the isoquants equal to the slope of the isocost line. The MRT of the
two inputs equals their price ratio.

Thus we find that at point Q, the two conditions of producer's, equilibrium in the choice of
factor combinations, are satisfied.

(1) The isoquant (IP) is convex the origin.

(2) At point Q, the slope of the isoquant ΔY / ΔX(MTYSxy ) is equal to the slope of the isocost
in Px / Py. The producer gets the optimum output at least cost factor combination.

- An isoquant in economics is a curve that, when plotted on a graph, shows all the
combinations of two factors that produce a given output. Often used in manufacturing,
with capital and labor as the two factors, isoquants can show the optimal combination
of inputs that will produce the maximum output at minimum cost.

5. SUBSTITUTION EFFECT

When discussing why the demand curve slopes downward, we emphasized the
significance of the substitution effect. While we can observe changes in the quantity demanded
as prices change along the demand curve, using indifference curves and budget constraints
allows us to gauge the size of the substitution effect in particular.

What does the term ‘substitution effect’ signify?

Substitution Effect refers to the change in consumption patterns that occurs when the
price of one good or service changes, leading consumers to shift their preference and purchase
more of a substitute good or service that has become relatively cheaper. This effect illustrates
how consumers respond to changes in relative prices by substituting one product for another to
maximize their utility or satisfaction while keeping their overall expenditure constant.

Certainly, in every case, the income effect and the substitution effect are
interconnected components explaining how consumers respond to price changes. When
discussing the demand curve's downward slope, we emphasized the importance of the
substitution effect. Through indifference curves and budget constraints, we can assess the
magnitude of this effect, highlighting its role in shaping consumer choices.

For example, say the consumer's income is $15 and the price of apples is $1 and the
price of oranges is $3. At these prices the consumer purchases six apples and three oranges.
When the price of oranges falls to $1, the consumer purchases eight apples and seven oranges.
Thus on the demand curve for oranges, the consumer purchases three oranges when the price
is three dollars and seven oranges when the price is one dollar.
 Figure 4 Income & Substitution Effects

Bringing the new budget constraint back to the original indifference curve allows us to
break down the income and substitution effects. Since the slope of the budget constraint
reflects the ratio of prices, the substitution effect is the increase in the number of oranges that
would be purchased given the new prices, while staying on the original indifference curve that is
moving from point A to point B. The movement from point B to point C is the income effect, the
additional consumption of oranges due to the increased purchasing power. With a decrease in
the price of oranges, the relative price of apples has increased and fewer apples would be
consumed due to the substitution effect; however, due to increased purchasing power, more
apples are purchased as well as more oranges.

The income effect and the substitution effect are two components of the total effect of
a price change on the quantity demanded of a good. They are interconnected and work
together to explain how consumers respond to changes in the price of a good. When the price
of a good decreases, both the income effect and the substitution effect work in the same
direction, encouraging consumers to buy more of that good. The income effect makes them feel
wealthier, while the substitution effect makes the good more attractive due to its lower relative
price. Conversely, when the price of a good increases, both effects also work together, leading
consumers to reduce their consumption of that good. The income effect reduces their
purchasing power, and the substitution effect makes the good less attractive because it has
become relatively more expensive.

Calculation: Substitution Effect = (∆Q₁/∆P₁) / (∆Q₂/∆P₂)

● ∆Q₁ and ∆Q₂ represent the change in the quantity consumed of two goods (usually a good
that has become relatively cheaper and a good that has become relatively more expensive).

● ∆P₁ and ∆P₂ represent the change in the prices of those two goods.
Example:

Suppose you're a consumer, and you have a fixed budget to spend on fruits. At the current prices:

Apples cost $1 each.

Oranges cost $2 each.
You decide to buy 10 apples and 5 oranges with your budget.

Now, let's say the price of apples increases to $2 each while the price of oranges remains the same
at $2 each. To calculate the substitution effect:

1. Calculate the initial expenditure:

Initial expenditure = (Quantity of Apples x Price of Apples) + (Quantity of Oranges x Price of
Oranges)
Initial expenditure = (10 apples x $1) + (5 oranges x $2) = $10 + $10 = $20

2. Calculate the new expenditure with the price change:

New expenditure = (Quantity of Apples x New Price of Apples) + (Quantity of Oranges x Price of
Oranges)
New expenditure = (10 apples x $2) + (5 oranges x $2) = $20 + $10 = $30

3. Calculate the substitution effect:

Substitution Effect = (New Expenditure - Initial Expenditure) / Initial Expenditure
Substitution Effect = ($30 - $20) / $20 = $10 / $20 = 0.5

In this example, the substitution effect is 0.5. This means that in response to the price increase of
apples, you reduced your consumption of apples and increased your consumption of oranges
because the relative price of apples became less attractive. For every 1% increase in the price of
apples, you reduced your consumption of apples by 0.5%.

To grasp a more fundamental concept in consumer choice theory, it's essential to be familiar
with several key topics, including:
I. Price Elasticity of Demand: Distinguish the relationship between substitution effect
and price elasticity of demand and how they affect consumer behavior.

Elastic goods in economics are products or services for which changes in price result in
relatively larger changes in the quantity demanded. On the other hand, Inelastic goods are
products or services for which changes in price result in relatively smaller changes in the
quantity demanded.
How the substitution effect is related to price elasticity of demand?
Elastic goods
● Have a price elasticity of demand (PED) greater than 1 (in absolute value), typically
between 1 and infinity.
● In elastic goods, consumers are highly responsive to price changes. When the price
of an elastic good increases, the quantity demanded decreases significantly, and
when the price decreases, the quantity demanded increases substantially.
● The substitution effect is particularly strong in elastic goods because consumers
readily switch to alternative goods when prices change.
● An example of an elastic good is soft drinks. If the price of a particular brand of soft
drink rises by 10%, consumers may switch to alternative brands or other
beverages, leading to a more than 10% decrease in quantity demanded.

Inelastic goods
● Have a price elasticity of demand (PED) less than 1 (in absolute value), typically
between 0 and 1.
● In inelastic goods, consumers are less responsive to price changes. When the price
of an inelastic good increases, the quantity demanded decreases only slightly, and
when the price decreases, the quantity demanded increases modestly.
● The substitution effect is weaker in inelastic goods because consumers have fewer
readily available substitutes that provide similar utility.
● An example of an inelastic good is prescription medication. If the price of a
necessary medication increases by 10%, patients may have little choice but to
continue purchasing it, resulting in a less than 10% decrease in quantity demanded.

In summary, the substitution effect is related to price elasticity of demand by highlighting how
consumers respond to changes in relative prices. The elasticity of demand determines the
degree to which consumers will substitute one good for another when prices change. In elastic
goods, the substitution effect is strong because consumers readily switch to substitutes, while in
inelastic goods, the substitution effect is weaker because consumers are less responsive to price
changes and are less likely to switch to alternatives.
II. Market Structures: Discuss how market structures, such as monopolies, oligopolies,
and perfect competition, can influence the strength of the substitution effect.

Monopoly:
● In a monopoly, there is a single seller or producer controlling the entire market.
● The substitution effect is often weak in a monopoly because consumers have limited or
no alternatives. They can't easily switch to substitute goods since there's only

Oligopoly:
● An oligopoly consists of a small number of large firms dominating the market.
● The substitution effect varies depending on the behavior of the oligopolistic firms. If
they engage in price competition, the substitution effect can be stronger as consumers
have more options. However, if they collude and maintain high prices, the substitution
effect is weaker.

Perfect Competition:
● In perfect competition, numerous small firms produce identical goods, leading to a
strong substitution effect. With many similar choices, minor price shifts prompt
consumers to switch between suppliers. Firms are price takers, having no control over
prices, intensifying the substitution effect.
III. Policy Implications: Explore the policy implications of the substitution effect.
The substitution effect has important policy implications, as it sheds light on how
government actions, such as taxation, price controls, and various policies, can impact consumer
choices and overall market dynamics. Here's a further explanation of these implications:

● Taxation: Taxes on goods can alter their prices, prompting consumers to switch to lower-
taxed or untaxed alternatives.
● Price Controls: Price controls set limits on prices, affecting the supply and demand for
goods. For example, rent controls may lead to housing shortages.
● Government Regulations: Regulations, like environmental or safety standards, can change
consumer preferences by influencing the desirability of certain products.
● Subsidies and Incentives: Government incentives and subsidies can make certain choices
more appealing to consumers. For instance, EV subsidies encourage electric vehicle
adoption.
● Consumer Behavior Research: Policymakers study consumer behavior to make informed
decisions, helping shape policies that resonate with consumer preferences.
● Public Health Initiatives: Initiatives like anti-smoking campaigns use price changes and
awareness to discourage unhealthy habits and promote healthier choices.
● Environmental and Energy Policies: Policies promoting clean energy and sustainability aim
to encourage consumers to swap out polluting practices for greener alternatives.

In summary, the substitution effect plays a pivotal role in shaping the outcomes of
various government policies and regulations. Understanding how consumers respond to price
changes and make choices among substitute goods is essential for policymakers seeking to
achieve specific economic, social, or environmental goals. By considering the substitution effect,
policymakers can design more effective interventions that align with consumer behavior and
preferences.

Here are some real-world examples to illustrate the substitution effect.

The substitution effect is not just a theoretical concept; it has tangible real-world implications
that shape consumer behavior. Here are some examples that illustrate how the substitution
effect plays out in everyday life:

1. Brand Loyalty and Price Changes: Consider a consumer who is loyal to a particular brand
of coffee. If the price of their preferred brand rises significantly, the substitution effect
may come into play. They might switch to a different, more affordable brand to maintain
their coffee consumption.

2. Transportation Choices: When it comes to commuting, consumers often face choices

between different modes of transportation, such as driving a car, taking public transit, or
using ride share services. The substitution effect is evident when gas prices increase.
 3. Grocery Shopping and Price Discounts: Supermarkets frequently offer discounts or
promotions on various products. Consumers may take advantage of these price
reductions by substituting the purchase of more expensive items with those on sale. For
instance, if the price of a particular brand of cereal decreases, consumers may switch to
that brand, resulting in increased sales for the discounted product.

4. Housing Choices and Rent Changes: In the housing market, tenants facing rent hikes
may opt to move to a different apartment or location with lower rental rates. This
demonstrates how changes in housing costs influence housing choices, emphasizing the
substitution effect in the context of housing.

CONCLUSION

Understanding total and marginal utility is essential for deciphering consumer behavior.
Total utility measures overall satisfaction from a product, while marginal utility gauges added
satisfaction from consuming one more unit. These concepts are vital for economists and
businesses, offering insights into consumer preferences and pricing. The Law of Diminishing
Marginal Utility explains how satisfaction declines with increased consumption, impacting
decisions on production, consumption, and welfare. Indifference curves reveal trade-offs in
consumer choices based on preferences. The budget line shows affordable combinations of
goods. The substitution effect, adjusting preferences for cheaper substitutes, influences
demand and market dynamics. Comprehending it is pivotal for economic fundamentals and
decision-making.

Grasping total and marginal utility is crucial for comprehending consumer choices. Total
utility measures overall satisfaction derived from consuming a product, while marginal utility
gauges the extra satisfaction gained from consuming one more unit. These concepts are vital for
economists and businesses when analyzing consumer preferences and pricing strategies.
Real-world examples, like buying a bag of chips or insurance, illustrate their practical relevance.
Balancing marginal utility and price allows consumers to maximize overall satisfaction, forming
the foundation of economic theories like utility maximization and demand theory.

The Law of Diminishing Marginal Utility is a fundamental principle in economics that

states that as a person consumes more units of a good or service, the additional satisfaction or
utility derived from each additional unit decreases. This law helps explain consumer behavior,
pricing strategies, and resource allocation in markets. Understanding this concept is crucial for
businesses, policymakers, and economists to make informed decisions about production,
consumption, and welfare. It underscores the importance of balancing resources to maximize
overall well-being and efficiency in economic systems.

Indifference curves are graphical tools in economics representing different combinations

of goods that provide the same level of satisfaction for consumers. They have a
negative slope, meaning if you get more of one item, you're willing to sacrifice some of the
other to stay equally happy. The curves are convex, indicating that as you have more of one
item, you value additional units of the other item less. Indifference curves never intersect, and
the slope of these curves, known as the Marginal Rate of Substitution (MRS), shows how much
of one good a person is willing to give up for a bit more of another while maintaining the same
level of satisfaction. Special cases include horizontal lines (indicating indifference to one good),
vertical lines (indicating indifference to the other good), and concave curves (reflecting changing
preferences). In essence, these curves help us understand how people make choices based on
their preferences and satisfaction levels.

The budget line represents all affordable combinations of goods for a consumer, based
on income and prices. Changes in income and prices shift or pivot the budget line, affecting
consumption opportunities. The optimum factor combination in production occurs when the
isoquant (output) is tangent to the isocost (cost) curve, ensuring the producer achieves the
desired output at the lowest possible cost.

The substitution effect, a fundamental economic concept, explains how consumers

adjust their preferences toward more affordable substitutes when prices change. It works
alongside the income effect to clarify shifts in demand. This phenomenon relates to price
elasticity, budget constraints, and consumer theory, affecting choices in diverse market
conditions. Policymakers leverage this knowledge to shape rules and incentives. Tangible real-
world instances highlight its impact on consumer choices, rendering it pivotal for understanding
economic conduct and policy implications. Comprehending the substitution effect is vital, as it
unveils how consumers respond to price shifts, influencing both market dynamics and
consumer behavior. Policymakers can formulate effective regulations, and businesses can make
informed pricing strategies. It constitutes a cornerstone in grasping economic fundamentals and
consumer decision-making.
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