theory of consumer behavior in btech.pdf

Theory of Consumer
Behavior
References: Koutsoyiannis, Pindyck & Rubinfeld
1

Introduction:
To introduce the theory of consumer behavior, it
is important to think for a moment about your
own behavior as a consumer…
Imagine you have Rs.100 to spend this week:
Suppose
5 goods you would spend your money on. The approximate
price of each product, and the quantity you would buy are
decided
Questions:
 How did you decide which items to put in your “basket”?
 Is your basket identical to your classmates? Why or why not?
 How would a change in the price of one of the items affect
the quantity you buy?
 How would a change in your budget affect the composition of
your basket? 2

Chances are, every member of your class had entirely different goods in his or her table than
you did. Precisely WHY every individual consumes a different “basket of goods” from every
other individual in a market economy can be understood by the following:
• Every consumer behaves rationally: Consumers try to get the "most for their money" to
maximize their total utility
• Every consumer has different preferences: Consumers have clear cut preferences and can
determine how much marginal utility they get from consuming more units of a product
• Every consumer is under a budget constraint: All consumers face a budget constraint,
therefore must make decisions about what they buy based on their limited budget
• Every product has a price: Every product has a price, so consumers must weigh their
purchasing decisions based on their marginal utility from consumption and the price of the
goods they consume
3

The principle assumption upon which the theory of
consumer behavior is built is: a consumer attempts
to allocate his/her available limited money income
among goods and services so as to maximize
his/her utility (satisfaction).
4

UTILITY
Utility - amount of satisfaction derived from the
consumptionof a commodity
It isthe power or capacityof a commodityto satisfy
humanwants.
5

Different Concepts of Utility
◦ The Cardinal Utility Theory (Utility
approach)
analysis
 Utility is measurable in a cardinal sense
 Cardinal utility - assumes that we can assign
values for utility, E.g., derive 100 utils from
eating a slice of pizza
◦ The Ordinal Utility Theory (Indifference curve
approach)
 Utility is not measurable in an ordinal sense
 Ordinal utility approach - does not assign values,
instead works with the order of preference of
consumers for the goods.
 It indicates consumers preference or choice for
one commodity over another.
6

Assumptions
• Rationality- Hesatisfies his wants in the orderof
the utility.
• Limited moneyincome
• Maximization of satisfaction
• Diminishing MU
7

The Cardinal Approach
Total utility (TU)
 The overall level of satisfaction derived from consuming a good or service. It
may be defined as the sum of the utility derived from each unit consumed of the
commodity.
 If consumer consumes four units of a commodity derives U1, U2, U3, U4 utils
from the successive units consumed, then
TU = U1 + U2 + U3 + U4
Marginal utility (MU) -
 Additional satisfaction that an individual derives from consuming an additional
unit of a good or service.
 It is the addition to TU derived from the consumption of commodity.
Formula :
MU = Change in total utility
Change in quantity
= ∆ TU
∆ Q
8

The Cardinal Approach
Law of Diminishing Marginal Utility = As more and
more units of a commodity are consumed, marginal
utility derived from each successive unit goes on falling.
i.e. MU as Q
Assumptions of the law-
1.The units of the goods must be standard
2. Consumers taste and preference remains unchanged.
3. There must be continuity in consumption.
4. The mental condition of consumers remains normal during
consumption.
9

Number
Purchased
TotalUtility Marginal Utility
0 0 0
1 4 4
2 7 3
3 8 1
4 8 0
Example
10

The Law of Diminishing Marginal Utility
The greater the level of consumption of a particular
good, the less utility consumers derive from each
additional unit of the good.
Consider the total and marginal utility one derives from
consuming ice cream. Notice the following:
• The first scoop provides you with 5 utils, so TU = 5 at Q=1
• Additional scoops of ice cream provide you with less and less
additional happiness. Nothing tastes quite as good as that first
scoop! MU declines beyond the first scoop, but TU continues
to increase, until…
• The fourth scoop: At four scoops your TU is maximized, but
the 4th scoop provided you with no additional utility.
• Beyond four scoops, you’ve “had too much”. TU begins
decreasing while MU becomes negative. 11

Consumer Equilibrium: Two commodities
• A rational consumer consumes commodities in
the order of their utilities.
• He picks up the commodity which yield the
highest utility and next the one which yields
second highest utility and so on…
• He switches his expenditure from one commodity
to another in accordance with their MU.
• He continues to switch till MU of each
commodity per unit of money expenditure is the
same. This is called the law of equi-MU.
𝑀𝑈𝑥
𝑃𝑥
=
𝑀𝑈𝑦
𝑃𝑦
Where x and y are two goods
12

The Utility Maximization Rule
•The Utility Maximization Rule: To maximize
your total utility, one should instead consume
the combination of good that maximizes your
marginal utility per dollar spent, so that:
𝑀𝑈𝑥
𝑃𝑥
=
𝑀𝑈𝑦
𝑃𝑦
13

The Ordinal Approach
•Economists following the lead of Hicks,
Slutsky and Pareto believe that utility is
measurable in an ordinal sense--the utility
derived from consuming a good, is a function
of the quantities of X and Y consumed by a
consumer. U=f ( X,Y)
•only reflects an order
•the difference between the numbers assigned is
meaningless
14

AssumptionsUnderlyingOrdinal
Approach
• Rationality: The consumer is assumed to be
rational. He aims at maximizing his benefits
from consumption, given income and prices.
all conceivable combinations
• Ordinality: The consumer is capable of
of
according to the satisfaction they
ranking
goods
yield. Thus if he is given various
combinations say A, B, C, D, E he can rank
them as first preference, second preference
and so on.
• Diminishing marginal rate of substitution:15

• Consistency: It means if good X is preferred
over good Y in one time, then consumer will
not prefer Y over X in another time period.
• Transitivity of choice: If the consumer
prefers combination A to B, and B to C, then
he must prefer combination A to C. In other
words, his choices are characterised by the
property of transitivity.
• Non-satiation: If combination A has more
commodities than combination B, then A must
be preferred to B.
• A = (2,4) B=(4, 8) then BPA
• A = (2,4) B = (2, 6) then also BPA 16

INDIFFERENCE CURVE (IC)
• An indifference curve is the set of all
combinations of commodities X and Y that
yield the same level of total utility or
satisfaction.
• It is a curve representing different baskets
of goods giving the same utility to an
individual.
17

INDIFFERENCE CURVE (IC)
18
Utility at A = Utility at B = Utility at C=Utility at D

INDIFFERENCE MAP
• Indifference Map: A set of indifference curves is
called indifference map.
• An indifference map depicts complete picture
of consumer's tastes andpreferences.
• In an figure indifference map of a consumer is
shown which consists of three indifference
curves.
19

INDIFFERENCE MAP
Good Y
Good X
0
U=30
U=20
U=10
20

PROPERTIES OF INDIFFERENCE CURVE
(i) Indifference curves slope downward to the
right: This property implies that when the amount
of one good in combination is increased, the amount
of the other good is reduced. This is essential if the
level of satisfaction is to remain the same on an
indifference curve.
(ii) Indifference curves are always convex to the
origin: It has been observed that as more and more
of one commodity (X) is substituted for another (Y),
the consumer is willing to part with less and less of
the commodity being substituted (i.e. Y). This is
called diminishing marginal rate of substitution.
21

PROPERTIES OF
INDIFFERENCE CURVE
(iii) Indifference curvescannever intersect
eachother:
B
C A
22

PROPERTIES OF
INDIFFERENCE CURVE
(iv) A higher indifference curve represents a
higher level of satisfaction than the lower
indifference curve: This is because
combinations lying on a higher indifference
curve contain more of either one or both goods
and more goods are preferred to lessof them.
23

Marginal Rate of Substitution
Def.: the marginal rate of substitution, X for Y, (written
MRSXY) indicates the number of units of Y that must be given
up to acquire one additional unit of X while satisfying the
condition of constant total utility.
MRSXYis defined as the slope of the indifference curve at a
certain point.
When the MRSXYdiminishes along the indifference curve, the
indifference curve is convex.
X MUY
MRS 
Y

MUX
24

BUDGET LINE
• A higher indifference curve shows a higher level of
satisfaction than alower one.
• Therefore, a consumer in his attempt to maximise
satisfaction will try to reach the highest possible
indifference curve.
• But in his pursuit of buying more and more goods
and thus obtaining more and more satisfaction he
has to work under two constraints : firstly, he has to
pay the prices for the goods and, secondly, he has a
limited money income with which to purchase the
goods.
25

BUDGET LINE
• These constraints are explained by budget line or
priceline.
• In simple words a budget line shows all those
combinations of two goods which the consumer
can buy spending his given money income on the
two goods at their given prices.
• All those combinations which are within the
reach of the consumer will lie on the budgetline.
26

BUDGET LINE
• Line showing all
combinations of
items can be
purchased for a
particular level of
income (M) ;
M =PxQx + PyQy
• Slope of budget line is
-(Px / Py).
27

CONSUMER EQUILIBRIUM
• A consumer is in equilibrium when he is deriving
maximum possible satisfaction from the goods and is in
no position to rearrange his purchases of goods. We
assume that :
• the consumer has a given indifference map which
shows his scale of preferences for various combinations
of two goods X and Y.
• he has a fixed money income which he has to spend
entirely on goods X and Y.
• prices of goods X and Y are given and are fixed for
him.
28

• To show which combination of two goods X and Y
the consumer will buy to be in equilibrium we bring
his indifference map and budget line together.
• the indifference map depicts the consumer’s
preference scale between various combinations of
two goods and the budget line shows various
combinations which he can afford to buy with his
given money income and prices of the two goods.
29

• IC1, IC2, IC3, IC4 and IC5 are shown together
with budget line PL for good X and good Y.
Every combination on budget line PL costs the
same. Thus combinations R, S, Q, T and H cost
the same to the consumer.
• The consumer’s aim is to maximize his satisfaction
and for this he will try to reach highest indifference
curve.
• But since there is a budget constraint he will be
forced to remain on the given budget line, that is he
will have to choose any combinations from among
only those which lie on the given price line.
• Which combination will hechoose?
31

• At the tangency point Q, the slopes of the price line PL and
indifference curve IC3 are equal. The slope of the
indifference curve shows the marginal rate of substitution of
X for Y (MRSxy) which is equal to MUx / MUy while the
slope of the price line indicates the ratio between the prices
of two goods i.e., Px /Py
• At equilibrium point Q,
MRSxy = MUx /MUy =Px /Py
• Thus, we can say that the consumer is in equilibrium
position when price line is tangent to the indifference curve
or when the marginal rate of substitution of goods X and Y
is equal to the ratio between the prices of the two goods.
32

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