THEORY OF CONSUMER BEHAVIOUR

We now understand that consumers have a choice problem.

 However despite this fact, consumers still aim to get maximum satisfaction from whatever a good or
combination of goods they choose to take.
 It means very typical consumer is a rational decision maker.
 Economists have long been interested in the way consumers behave hence the theory of consumer
behaviour.
 It is an analysis of what lies behind the demand curve.
 After learning the theory of consumer behaviour students are expected to answer the following
questions:
 Why is it a case that people buy more of a good at a lower than a higher price.
 Why is it that very essential goods are lowly priced whilst others less important in life are highly
priced?
 Why is it given the same money different consumers consuming different combination of goods?
 When is consumer satisfaction maximised.
 The theory of consumer behaviour is divided into two :
 Cardinal approach /marginal utility theory
 Indifference curve analysis theory.
WHAT IS UTILITY
 A degree of satisfaction that a person obtains from a good or service.
 Level of happiness or enjoyment that a person obtains from a particular good or service.
 Satisfying power of a good or service.
 By cardinal utility it means that although utility is subjective, it can be measured and recorded using
cardinal numbers.
TOTAL UTILITY (TU)
 Refers to total satisfaction or gain from consumption of a good or service.
 Is the overall satisfaction obtained from all the units of goods or service consumed?

Assumptions

 Utility can be measured in units called utils. Thats after consuming one unit get 10 utils and the
second gets 8 utils.
 Consumer is rational that is his main aim is to maximise his satification.

MARGINAL UTITLITY (MU)

 It is the additional satisfaction derived from consuming an additional unit of a product.
 Extra satisfaction derived from consuming an extra unit of a product.
 Change in total utility as a result of changing consumption by one unit.
 MU = change in TU
o = change in qty of goods consumed
Units of ice cream Total utility Marginal utility
0 - -
1 15 15
2 25 10
3 31 6
4 35 4
5 37 2
6 39 2
7 39 0
8 38 -1
FORMULAR OF MARGINAL UTILITY
i. MUn = TUn - TUn-1 ii. MU = change nTU
E.g. from table change in units of output
MU2 = TU2 – TU2-1
= TU2 – TU1
= 25 – 15
= 10

LAW OF DIMINISHING / MARGINAL UTILITY

 The law of diminishing marginal utility states that as consumer takes more and more of a commodity,
additional utility from each unit continuously falls.
 As shown by the table, each successive unit brings less utility than the one coming before it.
 E.g. take a person consuming ice cream on a hot day, the 1 st unit will generate a lot of satisfaction, 2nd
will still generate some satisfaction but not as much as the 1 st unit and the 3rd will generate even less
satisfaction than the 2nd and so on.
 As the consumption of ice cream increases TU will be increasing reaches a max and eventually
declines.
 It means if consumption continues the individual will come to a point where he/she will no longer be
interested in the ice creams.
 This is when utility is negative, reflecting dissatisfaction or dis-utility.
 Following is a graph of the utilities an individual derives from consuming an ice cream on a hot day.

+ total utility

0 Qty consumed

- Marginal utility

Maximising total utility when consuming one good

 In every economic activity, satisfaction is maximised when economic agents consumes an output
whose last unit will equal to marginal cost of doing so with the marginal benefit.
 Every consumer has a desire to maximise satisfaction when consuming any good.
 The benefit from consuming a good is measured by the level of satisfaction(marginal utility obtained
from the good).
 On the other hand the cost of consumption is the price that a consumer is to pay in order to get the
good or the service.

When marginal utility is greater than price.

 In this case the benefit from consumption is greater than the sacrifice or the cost of consumption.
 A consumer can increase overall satisfaction by continued consumption
 It means there is every reason to encourage the consumer more of the commodity.
 It means that as long as MU>P TU increases.
 This is disequilibrium position.
When marginal utility is less than price.

 It means the value of satisfaction from additional consumption is exceeding by the value of money
spent on the unit.
 Benefit from consumption is exceeded by the cost of consuming.
 It means the consumer is discouraged as consumption of the unit concerned will reduce TU.
 When MU < P there is tendency to reduce consumption hence a disequilibrium condition
 The above analysis therefore leaves us with a position that TU is maximised only when a consumer is
at equilibrium.
 A good is consumed up to a qty whose last unit will be equal

When marginal utility is equal to price.

 It is consumer satisfaction maximisation condition in the case of one good e.g. when a consumer is
declining the qty he/she is advised to consume the apples until the MU from consumption is = to the
price of the apples.
 However in reality households consume a combination of goods at the same time.
 The satisfaction maximisation condition MU=P that the ratio of MU:P is one
 In the case of many goods satisfaction can be maximised when MU:P ratio is equated for all goods
consumed.
 In other words it means MU:P ratio should be the same.
 This concept is called equi marginal utility (eMU)

equi marginal utility

 Mx = Px = MUy = Py = MUz = Pz = Mum = Pm

 MUx = MUy = MUz = Mum

Px Py Pz Pm

 MUx = Px = MUz = Pz
MUY Py Mum Pm
 This eMU concept above advocates that consumers will maximise utility when expenditure is
allocated in such a way that utility derived from the last $ is spent on each commodity is the
same.

LAW OF DIMINISHING MARGINAL UTILITY AND DEMAND CURVE

 The law of diminishing MU states that MU continuously falls with each unit of commodity.
 It means that the MU curve is downward sloping.
 The 1st unit of a good consumed, yields the highest level of satisfaction and MU falls as consumption
increases approaching zero.
 When MU is high consumer is prepared to pay a high price this is because ceteris paribus consumers
pay for happiness, satisfaction, enjoyment etc derived from the good.
 As the level of satisfaction (MU) falls, the price the consumer is prepared to pay reduces in order to
match the level of satisfaction.
 It has the highest level of satisfaction and the consumers are prepared to pay the highest price of $20.
 As the MU decreases (2nd and 3rd units) the price decrease as well with each successive unit.
 A consumer reduces the price to pay because the price should always match the satisfaction derive
from each unit.
 Therefore the slope of the MU curve is the same shape to be taken by the dd curve of the good
concerned.
 The dd curve of a good is explained by the law of dMU.

QUESTION

1. Using the law of diminishing MU explain why the dd curve is downward sloping.
2. Using the eMU concept explain the behaviour of the demand curve.

Indifference curve analysis

 It is the 2nd version of explaining consumer behaviour.

 The indifference analysis is based on the notion that a consumer is never satisfied when
consuming any good (a consumer needs more of every good).

The budget Line concept

 The budget line (BL) concept explains what actually happen when customers purchase goods
or services.
 It states that a typical consumer is constrained by the factors when making consumption
decisions :
 The two factors are:
o The consumer size of income
o The prices of the goods
 It therefore follows that every consumer has a BL.

The budget Line

 A budget line (BL) shows all combinations of two commodities which can be purchased with
a given money income.
 It is a graphical presentation of the maximum bundle or combination of goods that a
consumer can buy.
 A BL shows what a consumer can actually buy given a level of income and price of goods
assuming that a consumer must spend all of his income on one or two goods X and Y

Assumptions

 Only two goods can be presented

 Size of income is given and constant
 Price of the goods does not change
 Tastes and preferences are constant
 Units of each good are identical.

Example

 The following example can be used to explain the BL concept. A consumer has $20 to be
spent on goods X and Y.
 Good X is @ $2 per unit.
 Good Y is @ $4 per unit.
  The following table can be extracted

Good Quantities
X 10 9 8 7 6 5 4 3 2 1 0
Y 0 0,5 1 1,5 2 2,5 3 3,5 4 4,5 5


 From the numerical information provided by the table, a graph can be provided as below:
Budget Line Curve
 A budget line shows the combination of goods that can be afforded with your current
income.

 If an apple costs £1 and a banana £2, the above budget line shows all the combinations of
the goods which can be bought with £40. For example: 20 apples @ £1 and 10 bananas @£2
10 apples @£1 and 15 bananas @£2.
 Points outside the budget line that is points to the right of the boundary represent
combinations of the two goods that are not affordable given the consumer’s income.

 On the other hand points inside the boundary are attainable but the consumer will not be
spending all his income.
 Only points along the boundary represent combinations of the goods when a consumer is
spending all his income
 Thus the location of the budget line varies with money income and price levels
 Any changes in money income or price will change the position of the budget line.

a) Increase in income b) Fall in the price of a good Y

Qty gd X Qty gd X

B1 B2 Qty gd y B1 B2 Qty gd Y

 Ant increase in income will cause a shift of the budget line from b1 to b2 as shown in (a).
 If there is an fall in price of good Y or increase in good X the budget line pivots outwards as
shown in (b).

The slope of the Budget Line AB

 The slope is calculated as follows:

Gradient = change in X =5 =1
change in Y 10 2
 It means that in order to increase X by one unit the consumer has to forgo 0.5 units of Y.
 The slope therefore measures opportunity cost.
 The gradient is determined by the price ratios of the two goods.

Price Ratios

 The price of a good X and Y is X:Y 2:4 mans that if a consumer decides to increase
consumption of X by one unit , $2 is less for the consumption of Y.
 The $2 can be by 0,5 units of Y forgone.
 Opportunity cost of X:Y is o,5.
 This agrees with the gradient of the slope.

Indifference curve

 It is a curve that represents all combinations or bundles that yield the same amount of
satisfication to the consumer.
 The consumer derives the same amount of satisfication from combinations of the two goods
along an indifference curve.
 In this way the consumer will be indifferent between these combinations.
 That is a consumer cannot prefer one combination to another simply because he gets the
same amount of satisfication he can have any those combinations on the curve.
 It shows what a consumer would like to consume if he/she was not constrained by Y and P
what ought to be.
 It is based on the concept on non satiation axion.
 It means that a typical consumer is never satisfied and prefers more of a good or less of all it.
 An indifference curve connects combinations/bundles of goods that contain the same
amount of satisfication to a consumer.
 The term indifferent means being in a position whereby one is undecided – whereby one
cannot easily make a decision because alternatives have the same amount of satisfication.

Basis of the indifference in curve

 The curve is derived from the non satisfication axion theory.

 The theory states that a typical consumer prefers more of any good to less of it.

Derivation of the indifference curve

 By definition an indifference curve is a line that connects combinations of goods that yield
the same amount of satisifcation.
  An indifference curve is a line showing all the combinations of two goods which give a
consumer equal utility. In other words, the consumer would be indifferent to these different
combinations.
 On the diagram above point b represents a combination of same units of good Y and good X.
 At point E represents a bundle of less satisification.
 On the other hand point A yields higher satisification.
 Points B,C,D reflect the fact that in order to increase consumption of one good a consumer
has to reduce that of the other.
 They are therefore combinations of equal satisification.
 The line that connects B, C, and D is referred to an indifference curve.

Properties of indifference curve

 An indifference curve can be drawn from any point by simply joining the point given to
any other point downwards
 A consumer has many levels of satisfication and hence a set of indifference curves or
indifference map.
 ICs are space filling.
 ICs do not intersect, once they do so the transitivity principal is violated.
 If ICs interact a consumer is indifferent point on both the lower and higher ICs as shown
below.

Indifference curve map

 We can also show different indifference curves.

 All choices on IC2 give the same utility. But, it will be a higher net utility than
indifference curve IC1.
 IC4 gives the highest net utility. Basically, IC4 would require higher income than IC1.

Consumer equilibrium
 It is the optimal choice of the consumer.
 The BL tell us what a consumer can do.
 A consumer can select any consumption bundle on the BL to exhaust his income.
 It means a consumer is satisfied when he can realise his wishes.
 It means when the BL agrees /concides with the IC the following can be used to explain
this :-
  The points on the BL 1 are attainable that is a consumer has to select among them to
maximise satisfication IC1.
 Given a budget line of B1, the consumer will maximise utility where the highest indifference
curve is tangential to the budget line (20 apples, 10 bananas).
 This point represents a condition of consumer equilibrium that is a point of consumer
satisfication max.
 The BL is intangent with the IC.
 Given current income, any point above the BL that is IC2 is unobtainable or unattainable.
 IC3 is inside the the consumer budget line and therefore leave some income unused.
 IC3 is obtainable but gives less utility than the higher IC1

Income-consumption curve
 A change in consumer’s money income will shift the whole BL to the left or the right
citeris paribus.
 When Y increases the BL shifts outwards (rightward shift), when income decreases the
budget line shifts inwards (leftward shift).

 On the diagram B2 is the initial budget line with the initial level of income.
 The initial equilibrium is represented by the point E1.
 An increase in income will shift the BL to B3 to a higher equilibrium point E2 is reached.
 As income rises, you can afford to consume on higher indifference curves. This optimal
choice will shift to the right.
 On the other hand a decrease in income shifts the BL inwards say to B1 equilibrium E3 is
reached.
 If we join up the points of equilibrium we trace out a line called income consumption line.
 Income consumption line or curve shows the changes in consumption bundles as consumer
income changes price held constant.
 Impact of lower price
With a lower price of bananas (from £2 to £1.50), we can now afford more bananas with the same
income. The budget line shifts to the right

 With lower prices, we can now consume at a higher indifference curve of IC2, enabling more
bananas and apples.
 Income and substitution effect of a rise in price
 When the price of a good rises. People buy less for two reasons

 Income and Substitition effect

 Money income vs real income
 -

 Income effect. 

 This looks at the effect of a price increase on disposable income.

 If the price of a good increases, then consumers will have relatively lower disposable
income.
 For example, if the price of petrol rises, consumers may not be able to afford to drive as
much, leading to lower demand.
 Income effect is as a result of a price change.

 Substitution effect. 

 Refers to the response of Qd to a change in relative prices of goods.

 This looks at the effect of a price increase compared to alternatives.
 Substitution effect is caused by a change in price ratios of goods, this is because every good
has substitutes in one way or the other thus a change in price of one good will affect Qd of
both goods.
 An decrease in the price of beef makes beef cheaper than its substitutes (pork, chicken,
fish), beef become cheaper way of satisfying consumer needs and wants hence its demand
will increase or If the price of petrol rises, then it is relatively cheaper to go by bus.

Income and substitution for a normal good

 Normal goods have a negative relationship between price and Qd.
 Have a downward sloping dd curve
 Have a positive relationship between income and Qd.
 Positive income effect of a price fall is smaller than substitution effect.
 Positive substitution effect of a price fall is greater than income effect.
 A rise in price of bananas changes the budget line (pivotal shift) from B1 to B2. You can now
buy less of good Bananas. The budget curve shifts to B2.
 Consumption falls from point A to point C (fall in Quantity of bananas from Q3 to Q1
 To find different substitution and income effects.

 We draw a new budget line parallel to B2 but tangential to the first indifference curve.
 Being tangential to first indifference curve it enables the consumer to obtain the same utility as
before (as if there was no change in income.)
 By focusing on B-3, we are examining the effect of price change – ignoring any income effect.
 The change from A to B (Q3 to Q2) is purely due to the substitution effect and relative price change.

Income effect

 However, income has fallen causing the consumer to choose from a lower indifference curve IC2.
The change due to income is therefore b to C (Q2 to Q1.)
 In this case of a normal good, the income and substitution effect reinforce each other – both leading
to lower demand.

Effect of rise in price for inferior good

 Goods whose dd decrease as consumers’ disposable income increases e.g chucks
 As income increases consumers switch to superior goods and reduce the purchase and
consumption of inferior ones.
 They are taken with low regard by consumers and only consumed when income levels are
low.
 e.g public transport, necessities.
 Inferior goods are normally consumed by low income earners.

Characteristics
 Inferior goods have a negative relationship between income and Qd.
 Have a downward sloping dd curve
 Have a positive relationship between price and Qd.
 Positive substitution which outweighs the negative income effect.
 Negative income effect weaker than the positive substitution effect.
  The substitution effect (using parallel budget line of B-3) causes big fall from a to b.
 However, the income effect leads to an increase in demand (Q1 to Q2)
 Overall demand falls, but the substitution effect is partly offset by the income effect.
 This is because when income falls, the decline in income causes us to buy more inferior
goods because we can’t afford normal / luxury goods any more.