Chapter Three: Theory of Consumer Behavior

Learning outcomes:
 see how consumers allocate their limited income among different number of goods and services
 differentiate between two approaches of utility: cardinal and ordinal
 learn how consumer’s reach at its equilibrium given its budget constraint

1. Consumer preferences and choices

A consumer: is an individual or household who uses/ consumes final good and services with a primary objective of maximizing utility.
Utility: is the level of satisfaction/ enjoyment derived from consuming goods and services or undertaking an activity.
Consumer preferences:
o A consumer makes choices by comparing bundle of goods.
o For given any two commodities X and Y, the consumer either decides that one of the consumption bundles is strictly better than the other,
or decides that s/he is indifferent between the two bundles
Two preferences: Strict and weak /indifference preferences
o Strict preferences: for any two consumption bundles X and Y, if X >Y or if consumer chooses X when Y is available the consumer definitely
prefers the X-bundle than Y
o weak /indifference preferences: If the consumer is indifferent between two bundles of goods , 𝑿~𝒀 , i.e. the consumer would be just as
satisfied, according to his/her own preferences, consuming the bundle X as s/he would be consuming bundle Y.
o If the consumer prefers or is indifferent between the two bundles we say that s/he weakly prefers X to Y, i.e. 𝑿 ≥ 𝒀
 Chapter Three: Theory of Consumer Behavior
2. The concept of utility
o the satisfaction or pleasure derived from the consumption of a good or service
o the power of the product to satisfy human wants
o For any two consumption bundles X and Y, the consumer definitely wants the X-bundle than the Y-bundle if and only if the utility of X is
better than the utility of Y
Note that:
o Utility’ Vs. ‘Usefulness’: usefulness is product centric whereas utility is consumer centric
o Utility is subjective
o Utility can be different at different places and time
3. Approaches of measuring utility
There are two major approaches to measure or compare consumer‘s utility: cardinal and ordinal approaches
3.1 The Cardinal Utility Theory
Cardinalists: postulate that utility can be measured objectively in terms of 1,2,3…etc.
It is measured by arbitrary unit of measurement called Utils.
Assumptions of cardinal utility theory
i) Rationality of consumers: the main objective of the consumer is to maximize satisfaction given the limited resource. For this to happen,
s/he has to be rational.
ii) Utility is cardinally measurable: the utility or satisfaction of each commodity is measurable
iii) Constant marginal utility of money: a given unit of money deserves the same value at any time or place it is to be spent
 Chapter Three: Cardinal…
Assumptions of cardinal utility theory
iv) Diminishing marginal utility (DMU): The utility derived from each successive units of a commodity diminishes.
The marginal utility of a commodity diminishes as the consumer acquires additional unit of it
v) The total utility of a basket of goods depends on the quantities of the individual commodities.
If there are n commodities in the bundle with quantities X1, X2, …, Xn, the total utility is given by TU = f ( X1, X2,…, Xn).
Total and marginal utility
 Total Utility (TU) is the total satisfaction a consumer gets from consuming some specific quantities of a commodity at a particular time. As
the consumer consumes more of a good per time period, his/her total utility increases.
o However, there is a saturation point for that commodity beyond which the consumer will not be capable of enjoying any greater
satisfaction from it
 Marginal Utility (MU) is the extra satisfaction a consumer realizes from an additional unit of the product.
o It is the change in total utility that results from the consumption of one more unit of a product
o MU is the slope of total utility
∆𝑻𝑼
Mathematically, 𝑴𝑼 = ∆𝑸
 Chapter Three: Cardinal…
Table 3.1: Total and marginal utility

From table 3.1, we notice that:

the total utility first increases, reaches

the maximum (when the consumer
consumes 6 units) and then declines as the
quantity consumed increases
the marginal utility continuously
declines (even becomes zero or negative)
as quantity consumed increases

From the figure, we understand that:

When TU is increasing, MU is positive

When TU is maximized, MU is zero

When TU is decreasing, MU is
negative
 Chapter Three: Cardinal…
The law of diminishing marginal utility (LDMU)
 The law of diminishing marginal utility states that as the quantity consumed of a commodity increases per unit of time, the utility derived
from each successive unit decreases, consumption of all other commodities remaining constant
 the extra satisfaction that a consumer derives declines as he/she consumes more and more of the product in a given period of time
 Assumptions to he law of diminishing marginal utility
o the consumer consumes identical or homogenous product
o the commodity to be consumed should have similar quality, color, design, etc.
o there is no time gap in consumption of the good
o the consumer taste/preferences remain unchanged

3.1.2. Equilibrium of a consumer under Cardinal approach

• The objective of a rational consumer is to maximize total utility.
• Whenever marginal utility is positive, the consumer wants to consumer more of the product because total utility increases
a) the case of one commodity
• The equilibrium condition of a consumer that consumes a single good X occurs when the marginal utility of X is equal to its market price
 𝑴𝑼𝒙 = 𝑷𝒙
 Given, 𝑼𝒙 = 𝒇 (𝑿) ~For commodity X, consumer’s expenditure will be 𝑷𝒙 𝑸𝒙 .
Then, the consumer maximizes the difference between utility and expenditure, i.e. 𝒎𝒂𝒙 (𝑼𝒙 − 𝑷𝒙 𝑸𝒙 )
 Chapter Three: Cardinal…
The necessary condition for maximization is equating the derivative of a function to zero.
𝒅𝑼 𝒅 (𝑷𝒙 𝑸𝒙 ) 𝒅𝑼
− =𝟎  − 𝑷𝒙 = 𝟎  𝑀𝑈𝑥 = 𝑃𝑥
𝒅𝒙 𝒅𝒙 𝒅𝒙

b) the case of two or more commodities

o consumer‘s equilibrium is achieved when the marginal utility per money spent is equal for each good purchased and his
money income available for the purchase of the goods is exhausted
𝑴𝑼𝒙 𝑴𝑼𝒚 𝑴𝑼𝑵
= =⋯= and 𝑃𝑥 𝑄𝑥 + 𝑃𝑦 𝑄𝑦 + ⋯ + 𝑃𝑁 𝑄𝑁 = M where, M is the income of the consumer
𝑷𝒙 𝑷𝒚 𝑷𝑵

Table 3.2 Consumption bundles of two goods for a given consumer

For this hypothetical consumer, equilibrium is at:

𝑀𝑈𝑥 𝑀𝑈𝑦 3 12
= =1= =3
𝑃𝑥 𝑃𝑦 4
All income is spent out
𝑃𝑥 𝑄𝑥 + 𝑃𝑦 𝑄𝑦 = M  1(3)+ 4(1) = 7

Total utility at equilibrium is

𝑈𝑥 + 𝑈𝑦 = TU TU= 14+12 = 26
 Chapter Three: Cardinal…
Limitation of the cardinal approach
1. It is doubtful because utility may not be quantified
Utility cannot be measured absolutely (objectively)
2. The assumption of constant MU of money is unrealistic because as income increases, the marginal utility of money changes
3.2 The Ordinal Utility Theory
 In this approach, it is impossible to express utility in absolute terms
 Utility can be ranked subjectively in order of preference as 1st, 2nd, 3rd and so on
Assumptions of ordinal utility theory
 Consumers are rational - they maximize their satisfaction or utility given their income and market prices
 Utility is ordinal - utility is not absolutely (cardinally) measurable
 Diminishing marginal rate of substitution: The marginal rate of substitution is the rate at which a consumer is willing to substitute one
commodity for another commodity so that his total satisfaction remains the same. The rate diminishes.

 The total utility of a consumer is measured by the amount (quantities) of all items he/she consumes from his/her consumption basket.
 Consumer’s preferences are consistent or transitive
If consumer prefers X to Y and Y to Z, then the consumer is expected to prefer X to Z
This property is known as axioms of transitivity.
 Chapter Three: Ordinal…
The ordinal utility approach is explained with indifference curves. Thus, we call it as the indifference curve approach
3.2.1. Indifference set, curve and map
o Indifference set/ schedule is a combination of goods for which the consumer is indifferent.
o It shows the various combinations of goods from which the consumer derives the same level of satisfaction.
o Indifference curve: shows different combinations of two goods which yield the same utility (level of satisfaction) to the
consumer.
o A set of indifference curves is called indifference map.
Properties of indifference curves
Indifference curves have negative slope (downward sloping to
the right): in order to keep the utility of the consumer constant,
as the quantity of one commodity is increased the quantity of
the other must be decreased
Indifference curves are convex to the origin: the slope of an
indifference curve decreases (in absolute terms) as we move
along the curve from the left downwards to the right—the
diminishing marginal rate of substitution

A higher indifference curve is always preferred to a lower one

Indifference curves never cross each other (cannot intersect):
Intersection of Indifference curves intersection means violation of consistency and transitivity
 Chapter Three: Ordinal…
3.2.2.Marginal rate of substitution (MRS)
 Marginal rate of substitution is a rate at which consumers are willing to substitute one commodity for another in such a
way that the consumer remains on the same indifference curve.
 MRS of X for Y is defined as the number of units of commodity Y that must be given up in exchange for an extra unit of
commodity X so that the consumer maintains the same level of satisfaction.
 MRS is negative b/c one of the goods is scarified to obtain more of the other good

 MRS is reflected by the convex shape of the indifference curve and is called diminishing marginal rate of substitution
 𝑴𝑹𝑺𝒙,𝒚 can al be derived from marginal utility as
𝑴𝑼𝒙
𝑴𝑹𝑺𝒙,𝒚 = (Proof)
𝑴𝑼𝒚

Example: Find the 𝑴𝑹𝑺𝒙,𝒚 for U X, Y = 𝑋 4 𝑌 2

3.2.3. The budget line of the consumer

o The consumer is constrained by his/her income and prices of the two commodities
o The budget line is a graph which shows the various combinations of two goods that a consumer can purchase given
his/her limited income and the prices of the two goods.
 Chapter Three: Ordinal…
Assumptions for the budget line
o There are only two goods bought in quantities, say, X and Y
o Each consumer is confronted with market determined prices, PX and PY
o The consumer has a known and fixed money income , M
o
Budget line equation
𝑃𝑥 𝑄𝑥 + 𝑃𝑦 𝑄𝑦 = M
𝑷
The slope of the budget line is given is by − 𝑷𝒙 (the ratio of the prices of
𝒚
the two goods)
Points inside the budget line are attainable but inefficient
Points on the budget line are attainable but inefficient
Points outside the budget line are unattainable (unaffordable)

o Example: A consumer has $100 to spend on two goods X and Y with prices $3 and $5 respectively. Derive the equation of
the budget line and sketch the graph.
o Solution:
PxX+ PyY= M  3X+5Y = 100  Y = 20-3/5X
Y = 20-3/5X is the budget line
 Chapter Three: Ordinal…
Factors affecting the budget line
o the changes in prices or income will affect the budget line
Change in income: If the income of the consumer changes (keeping the prices of the commodities unchanged), the budget
line also shifts (changes).
The effect of change in income
Increase in income causes an upward/outward shift in the budget line

Decreases in income causes a downward/inward shift in the budget line

The slope of the budget line (the ratio of the two prices) does not change
when income rises or falls

The slope of the budget line (the ratio of the two prices) does not change
when income rises or falls
 Chapter Three: Ordinal…
Factors affecting the budget line
Change in prices: A change in the prices of one or two goods, keeping income constant, shifts the budget line.

The effect of change in Price

An equal increase in the prices of the two goods shifts the budget
line inward
An equal decrease in the prices of the two goods shifts the
budget line out ward

proportional increases or decreases in the price of the two

commodities (keeping income unchanged) do not change the slope
of the budget line if it is in the same direction

An increase or decrease in the price of one of the two goods,

keeping the price of the other good and income constant, changes
the slope and position of the budget line by affecting only the
intercept of the commodity that records the change in the price
 Chapter Three: Ordinal…
3.2.4. Equilibrium of a Consumer under Ordinal Approach
o The preferences of a consumer are indicated by the indifference curve
o The budget line specifies different combinations of two goods the consumer can purchase with the limited income
o Therefore, a rational consumer tries to attain the highest possible indifference curve, given the budget line
o Equilibrium of the consumer occurs at the point where the indifference curve is tangent to the budget line so that the
slope of the indifference curve ( MRS XY ) is equal to the slope of the budget line ( Px/Py )
o Graphically,

The equilibrium of the consumer is at point ‘E’ where

the budget line is tangent to the highest attainable
indifference curve (IC2)
At point E, Slope of indifference curve = Slope of the
budget line
𝑷𝒙 𝑴𝑼𝒙
𝑴𝑹𝑺𝒙,𝒚 = =
𝑷𝒚 𝑴𝑼𝒚
 Chapter Three: Ordinal…
o Example: A consumer consuming two commodities X and Y has the utility function U(X,Y) = XY+2X . The prices of the two
commodities are 4 birr and 2 birr respectively. The consumer has a total income of 60 birr to be spent on the two goods.
a) Find the utility maximizing quantities of good X and Y
b) Find the MRS X,Y at equilibrium

~Ch-3 Ended!~
Any Question?