Introduction to Consumer Behaviour

What is Consumer Behaviour?

• Theory of consumer behavior is the description of how consumers allocate
incomes among different goods and services to maximize their well-being.
• The demand curve is not a wish-list.
• Consumer behavior is best understood in three distinct steps:
1. Consumer preferences
2. Budget constraints TABLE: Alternative Utility Baskets

3. Consumer choices Basket Hours Sleeping Hours Playing

A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
 Some Basic Assumptions about Preferences
1. Completeness: Preferences are assumed to be complete. In other words,
consumers can compare and rank all possible baskets. Thus, for any two
market baskets A and B, a consumer will prefer A to B, will prefer B to A, or
will be indifferent between the two. By indifferent we mean that a person will
be equally satisfied with either basket.
2. Transitivity: Preferences are transitive. Transitivity means that if a consumer
prefers basket A to basket B and basket B to basket C, then the consumer
also prefers A to C.
3. More is better: Goods are assumed to be desirable—i.e., to be good.
Consequently, consumers always prefer more of any good to less. In addition,
consumers are never satisfied or satiated; more is always better, even if just a
little better.
• Of course, some goods, such as air pollution, may be undesirable, and consumers will always prefer
less. We ignore these “bads” in the context of our immediate discussion.
 CONSUMER PREFERENCES

Because more of each good is

preferred to less, we can
compare market baskets in the
shaded areas. Basket A is
clearly preferred to basket G,
while E is clearly preferred to A.
However, A cannot be
compared with B, D, or H
without additional information.
 INDIFFERENCE CURVES

Indifference curve: curve representing

all combinations of market baskets
that provide a consumer with the
same level of satisfaction.
The indifference curve U1 that passes
through market basket A shows all
baskets that give the consumer the
same level of satisfaction as does
market basket A; these include
baskets B and D.

Our consumer prefers basket E, which

lies above U1, to A, but prefers A to H
or G, which lie below U1.
 INDIFFERENCE MAPS

Graph containing a set of indifference

curves showing the market baskets
among which a consumer is
indifferent.

An indifference map is a set of

indifference curves that describes a
person's preferences.

Any market basket on indifference curve

U3, such as basket A, is preferred to
any basket on curve U2 (e.g., basket
B), which in turn is preferred to any
basket on U1, such as D.
 Properties of IC (1/2)

If indifference curves U1 and U2

intersect, one of the assumptions of
consumer theory is violated.

According to this diagram, the

consumer should be indifferent
among market baskets A, B, and D.
Yet B should be preferred to D
because B has more of both goods.
 Properties of IC (2/2)
•The Shape of the IC is convex. Why? It
depends on your tradeoff.
• Marginal rate of substitution
(MRS):Maximum amount of a good that a
consumer is willing to give up in order to obtain
one additional unit of another good.
•The magnitude of the slope of an indifference
curve measures the consumer’s marginal rate
of substitution (MRS) between two goods.
•In this figure, the MRS between clothing (C)
and food (F) falls from 6 (between A and B) to 4
(between B and D) to 2 (between D and E) to 1
(between E and G).
•Convexity The decline in the MRS reflects a
diminishing marginal rate of substitution.
When the MRS diminishes along an
indifference curve, the curve is convex.
 Law of Diminishing Marginal Utility
• The law of diminishing marginal
utility means that as a person consumes
an item or a product, the satisfaction or
utility that they derive from the product
reduces as they consume more and more
of that product.
• For example, an individual might buy a
certain type of chocolate for a while.
Soon, they may buy less and choose
another type of chocolate or buy cookies
instead because the satisfaction they
were initially getting from the chocolate
is diminishing.
 Example: Car Owner Preferences
• Car owners have to make a trade-off between interior space and acceleration.
 STEP 2: UNDERSTANDING BUDGET CONSTRAINTS
Budget constraints: Constraints that consumers face as a result of limited incomes.

Budget line: All combinations of goods for which the total amount of money spent is
equal to income.
PF F + PC C = I

TABLE: Market Baskets and the Budget Line

Market Basket Food (F) Clothing (C) Total Spending

A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80

The table shows market baskets associated with the budget line F + 2C = $80
 THE BUDGET LINE
A budget line describes the
combinations of goods that can be
purchased given the consumer’s
income and the prices of the goods.
Line AG (which passes through
points B, D, and E) shows the
budget associated with an income
of $80, a price of food of PF = $1 per
unit, and a price of clothing of PC =
$2 per unit.
The slope of the budget line
(measured between points B and D)
is −PF/PC = −10/20 = −1/2. C = ( I / PC ) − ( PF / PC )F
 BUDGET CONSTRAINTS: IMPACT OF INCOME

• Income Changes A change in

income (with prices
unchanged) causes the budget
line to shift parallel to the
original line (L1).
• When the income of $80 (on L1)
is increased to $160, the
budget line shifts outward to
L2.
• If the income falls to $40, the
line shifts inward to L3.
 BUDGET CONSTRAINTS: IMPACT OF PRICE CHANGE

• Price Changes A change in the

price of one good (with income
unchanged) causes the budget
line to rotate about one
intercept.
• When the price of food falls
from $1.00 to $0.50, the
budget line rotates outward
from L1 to L2.
• However, when the price
increases from $1.00 to $2.00,
the line rotates inward from L1
to L3.
 TRY IT YOURSELF

• A consumer has initial income of $100 and faces Px= $1 and Py=$5. Graph
the budget line.
• Suppose Px increases to $4, how does the budget line change?
• What is the market rate of equilibrium?
 STEP 3: DETERMNING CONSUMER CHOICE
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.
2. It must give the consumer the most preferred combination of goods and services.

Therefore, the consumer

maximizes satisfaction by
choosing market basket A.
At this point, the budget line and
indifference curve U2 are tangent.

Can D be attained?
 CONSUMER CHOICE: THE EQUILIBRIUM

Satisfaction is maximized (given the budget constraint) at the point where

MRS = PF / PC
MU / P = MU / P
F F C C

Equal marginal principle: Utility is maximized when the consumer has equalized the
marginal utility per dollar of expenditure across all goods.
 Practice Question:

• A consumer has $300 to spend on good X and Y. The market prices of

these goods are Px=$15 and Py=$5.
a. What is the market rate of substitution between goods X and Y?
b. What is the marginal rate of substitution for an individual who wants
to be at the equilibrium?
c. Write the budget equation for the individual.
d. Suppose the individual finds $100 lying on the road. Does it affect the
market rate of substitution?
Practice Question
• Given: Ux=x2+2, Uy=3y2, Px=5, Py=15, Income=60
• Find the point (x,y) of consumer choice.

• Answer: x=y=3
 m
Illustration: Locating the Eq Point
• The concept of utility curve U(x,y)
• Need to know basic derivatives.
• Given: Ux=x2, Uy=2y, Px=5, Py=1, Income=50
• We know MRS= MUX/MUy
• MUx= 2x, MUy=2
• Therefore MRS= 2x/2= x
• We also know that MRS=Px/Py. Therefore 5/1 = x. Hence x=5
• Putting this in Budget equation: 5X+1Y=50
• Therefore Y=25