CHAPTER IV

THEORY OF CONSUMER BEHAVIOUR

In the preceding chapter, we discussed the concept of consumer demand, the factors
affecting it and how consumers and producers alike respond to any changes in factors such as
prices, income and prices of related goods. We derived a demand curve which relates the
quantities of goods and services that consumers will purchase at alternative prices, holding
other factors such as taste and preferences, income and prices of substitute and
complementary goods constant. In this chapter, we will pursue an alternative way of looking at,
and viewing the downward sloping demand curve. We shall be using two approaches in trying
to explain the theory of consumer choice in more detail: the utility approach and the
indifference curve approach.

Utility Concepts and Measurement

Nineteenth century economists (e.g. Jevons, Walras, and Marshall) considered the
amount of satisfaction derived from the consumption of a commodity called utility, as
measured like the weight of objects. This implies that the consumer is capable of assigning to
every good (e.g., a cone of ice cream) or a combination of goods (e.g., a cone of ice cream and
a slice of cake). This is a simplistic definition of cardinal Utility (assumes that we can assign
values for utility).

utils -a number representing the amount or degree of utility associated.

Twentieth century economists (e,g., Pareto, Hicks, Slutsky) proposed a more realistic way to
state consumer preferences over bundles of goods to choose from. They articulated that
instead of assigning number representing the level of satisfaction or utility derived from the
consumption of goods; it is enough to be able to just rank bundles of commodities according to
the order of preference. They labeled this handling of the utility concept as the ordinal utility
(does not assign values, instead works with ranking of preferences).

Example: Let assume that there are only two goods: Honda CRV and Mazda 323. Let also
assume that Carl derives 500 utils from driving the Honda CRV and only 100 utils from driving
the Mazda 323.

Cardinal Utility -We can say that Carl prefers driving Honda CRV five times more than the
Mazda 323.
Ordinal Utility- It is enough to say that Carl prefers driving Honda CRV than Mazda 323.

Total utility and marginal utility

The law behind the downward sloping demand curve is explained by the theory of
consumer behavior. Basic terminologies in understanding the concept include the following:

Utility. The satisfaction obtained from the goods and services that a consumer
consumes.

Total utility (TU). The overall level of satisfaction derive from consuming a good and
service. Generally, it increases as the amount of commodity increases but only up to a certain
maximum level which we call the saturation point. Beyond this point, total utility will tend to
decline.
Marginal Utility (MU). The additional satisfaction obtained from the consumption of an
additional unit of goods and services. Mathematically, MU is the slope of the TU. The formula is
as follows:

MU = change in total utility or ∆TU

change in quantity ∆Q

For a better understanding of the above-mentioned concepts, let us refer to the table
below that hypothetically gives the total and marginal utility levels, respectively of a student
who was asked to drink successive glasses of water as part of classroom experiment. Let us
assume that the student, who came in rushing from a previous class in another building, is
quite thirsty.

Table 1. Schedule of total and marginal utility of a student.

No. of glasses of water Total Utility Marginal Utility

consumed (Q) (TU) (MU)
0 0 -
1 20 20
2 27 7
3 32 5
4 35 3
5 35 0
6 34 -1
To provide a numerical example, refer to table 1. The first column may be referred to
glasses of water. The first glass of water gives 20 units of satisfaction measured by utils. The
second glass, on the other hand, provides an additional 7 utils thereby making your total
satisfaction equal to 27 units. The third glass of water adds 5 units of satisfaction, hence the
total satisfaction is already 32 utils. When you had the 5th glass of water, notice that there is no
additional satisfaction derived (zero), while the 6th glass of water resulted to a negative 1 unit of
satisfaction which resulted to a decrease in total satisfaction from 35 utils to 34 utils.
The law of diminishing marginal utility (MU)- The law states that as more and more a
goods and services are consumed, the process of consumption will yield smaller additions to
utility.
Figure 4.1 Total Utility Curve
TU
Satiation point
40

30

20

10

0 Q
1 2 3 4 5 6 7

Figure 4.2 Marginal Utility Curve

MU
30

20

10

0 Q
1 2 3 4 5 6
-10
 The graphical illustration of total utility showed in figure 4.1 and marginal utility showed
in figure 4.2. The total utility curve shows an increasing trend until the 5th item (quantity), the
maximum point of the TU. After which the TU curve slopes downward. On the other hand, the
values of marginal utility are diminishing (from 20 to 7, then from 5 to 3 and so on). The
positive values of MU signifies that there is an added satisfaction (although diminishing) derived
from the additional consumption of the goods. The zero value suggests that there is no added
satisfaction because the maximum is already reached. The negative MU means that the
additional consumption will result to negative satisfaction (dissatisfaction) because it causes the
total utility to decrease.

Assumptions about the consumer’s behavior:

1. Consumers are able to rank their preferences for the goods and services.
2. Consumers are consistent or transitive.
3. Consumers prefer “more” of the goods than “less” of it.

Indifference Curve Approach

Indifference curve is a curve which shows different combinations of two goods which
yield the same level of satisfaction. This is an economic tool that reflects consumer taste and
preferences.

Table 2. Indifference Schedule

Points Quantity Y Quantity X

A 11 3
B 8 4
C 5 6
D 3 10
E 2 15

Figure 4.3.Indifference Curve.

Quantity Y 12
A
10
8 B
6 ∆Y
C
4
∆X D
2 E
0 Quantity X
3 4 6 10 15

Marginal Rate of Substitution of X for Y (MRSxy)- refers to the maximum amount of Y

that consumer is willing to give-up for additional unit of X while maintaining the same level of
satisfaction. MRSxy is also the slope of the indifference curve.

MRSxy= change in Y or ∆Y Y2-Y1

change in X ∆X U=U0 X2-X1 U=U0

MRSxy = MUx = ∆Y
MUy ∆X
MRSxy of point B to C of figure 4.3

MRSxy = ∆Y = 5-8 = -3/2 or -1.5

∆X 6-4
An indifference curve map (as shown in figure 4.4) is a set or collection of
indifference curves which represents various levels of satisfaction or utility. Specifically, an
indifference curve which lies above and to the right of another indicates a higher level of utility.
Provided below are various indifference schedules for utilities 100, 200 and 300. These data are
plotted in figure 3.

Table 3. Indifference schedules.

Utility = 100 Utility = 200 Utility = 300

Y X Y X Y X
11 12 20 20 35 35
15 7 22 15 37 20
20 5 25 10 40 17
28 3 35 8 45 14
38 2 50 7 53 13

Figure 4.4 Indifference Map

Quantity Y

U = 300

U = 200
U = 100
Quantity X

The Budget Line

A budget line shows the infinite points of combinations in the consumption of two
commodities that the same budget can buy at constant prices. It serves as the boundary
between the feasible and non-feasible combinations of goods and services that are available to
the consumer and which s/he can buy at existing prices, given his/her income level.

From the previous discussion, we learned that it is possible that several combinations of
goods X and Y will yield the same level of satisfaction. But, let us remember that in reality we
are constrained with prices of goods and the amount of money that we have in order to
purchase such commodities. Thus, to satisfy the income or budget constraint (i.e., to make sure
that the total expenditures on goods X and Y meet the total income) the following condition
must also be met:
I = PxX + PyY
where I= stands for income; Px, Py represent prices of goods x and y, respectively; and X and
Y stand for the quantity of goods X and Y bought, respectively. Of course, this condition will
later serve as determinant to decide which combinations of goods satisfy the equilibrium
condition for utility maximization.
 Below is a budget schedule showing the various combinations of goods Y and X that will
satisfy the conditions embodied in the above equation. Notice that regardless of how much of
good Y combined with good X you consumed.

The schedule is then graphically illustrated in figure 4.

Table 4. Budget Schedule.

(Assume that the budget is P60; Px = 2; Py = 10)

Good X Good Y
30 0
25 1
20 2
15 3
10 4
5 5
0 6

Figure 4.5 Budget Line

Good Y 7

Y= I/Py 6

0 Good X
0 5 10 15 20 25 30
X= I/Px

As illustrated in Table 4, each of these combinations will exhaust the given budget of
P60. For instance, if we want to consume 20 units of good X and 2 units of good Y, the total
expenditures for good X plus the total expenditures for good Y will equal to the budget of P60.
Mathematically, it can be shown as:

I = PxX + PyY

60 = 2(20) + 10(2)
60 = 40 + 20
60 = 60
The slope of the Budget line = Px/Py

Consumer’s Utility Maximizing Equilibrium Approach

Having discussed the concepts of indifference curves and the budget line, how do we
choose which sets of goods to consume? A consumer will maximize the satisfaction that will be
derived from consuming goods, X and Y, given the prices of such goods and the income by
choosing that combination of X and Y that must completely exhaust the budget and at which
the amount of Y that this consumer is willing to give up is equal to the amount of Y that will be
required by the market.
Mathematically :

Consumers Objectives: TO MAXIMIZE HIS/HER UTILITY

Subject to : INCOME CONSTRAINTS

Optimizing Condition: The tangency condition has important implications where two curves
are tangent, they have the same slope of the Indifference curve is equal to the slope of the
budget line at the point of tangency.

Px
MRSxy =
Py

Cross multiply:
MUx Px
=
MUy Py

MUx MUy
=
Px Py

Example :
Good X = Fishball Price of X= 2
Good Y = Kwek2x Price of Y= 10
Qx TUx MUx MUx/ Px Qy TUy MUy MUy/Py
1 30 30 15 1 50 50 5
2 39 9 4.5 2 105 55 5.5
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

Potential Optimum Positions:

Combination A: Quantity of x=3 and y= 4

TU= TUx + TUy = 45+178= 223

Combination B: Quantity of x=5 and y= 5

TU= TUx + TUy = 54+198= 252

Combination A and B are potential equilibrium positions suggest that we need to consider
Income (Deciding factor).

Total Expenditures = Px X + Py Y

Combination A: 2(3) + 10 (4) = 46

Combination B: 2(5) + 10 (5) = 60

Scenarios:

-If consumer’s Income = 46 then the optimum is given by combination A. Combination B is not
affordable.
- If consumer’s Income = 60 then the optimum is given by combination B. Combination A is
affordable but yields a lower level of utility.

Graphically, equilibrium occurs at that point where the indifference curve is tangent to the
budget line (see figure 4.5).

Figure 4. 5 Consumer equilibrium.

Indifference curve

Consumer equilibrium

Budget line
 Exercise No. 4

Name: ________________________________ Date: _______

Year/Course/Section: ____________________ Score: ______

I. True of False. No erasures on all final answers.

________1. Two indifference curves can intersect only when one of the goods being studied is
a high-priced item.
________2. Economists generally assume that indifference curves always lie above their
tangents.
________3. Indifference curves are always concave to the origin.
________4. Utility theory assumes that market baskets on higher indifference curves have
higher utilities.
________5. If a consumer’s income rises, he will probably buy the same amount of goods.
________6. A person’s tastes are like his fingerprints; they don’t change.
________7. A budget line is convex in shape.
________8. The optimum combination of two goods can be obtained at the tangency of the
budget line and indifference curve.
________9. The farthest right indifference curve suggests the highest utility.
________10. Total utility increases at a diminishing rate when marginal utility is decreasingly
positive.
II. Answer the following problems.
The following are the possible combinations of goods A and B, that a consumer can
choose from:

UTILITY = 100 UTILITY = 200

GOOD A GOOD B GOOD A GOOD B
3 18 5 20
5 14 10 12
12 7 22 9
19 5 30 8
30 4 45 7

a. Plot the above combinations of goods A and B (in the graphing space provided below).
Please label your graph properly.
b. Complete the budget schedule below assuming budget is P800 and the price of good X
is P20 and price of good Y is P50.

GOOD X GOOD Y
30
25
20
15
10
5
0