Theory of Consumer Behavior

Dr. Samir Ul Hassan

 Case: Designing New Automobiles
• Ford Motor Company
• New Models
• Where should be the Emphasize? Size, Mileage, Space, Horsepower, Color, Seats etc.
• To decide, you need to know how much people value the various attributes of a car.
• More desirable the attributes, the more people would be willing to pay for a car.
• But, better the attributes, the more the car will cost to manufacture.
• How should ford trade off these different attributes and decide which one to emphasize.
• One way to do this is by knowing consumer behavior through his preference.
• How much people are willing to pay for a wide range of models with a range of attributes.
• People will be willing to pay based on the satisfaction they derived from each preferred
attribute.
Consumer Behavior
 Theory of consumer behavior explains how consumers allocate their income
among different goods and services to maximize their well-being.
These allocative decisions determine the demand for the goods and services.

Consumer behavior is best understood in three distinct steps:

1. Consumer preferences

2. Budget constraints

3. Consumer choices
 CONSUMER PREFERENCES
Market Basket or Bundle
● List with specific quantities of one or more goods.

TABLE Alternative Market Baskets

Market Basket Units of Food Units of Clothing

A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40

To explain the theory of consumer behavior, we will ask whether consumers

prefer one market basket to another.
Unlimited Human Wants Resources are limited

Choices
 Utility

• The value a consumer places

on a unit of a good or service
depends on the pleasure or
satisfaction he or she expects
to derive from having or
consuming it at the point of
making a consumption
(consumer) choice.

• It is the “want satisfying

power” of the commodity.
 Utility
• Consumers, however, cannot have every
thing they wish to have. Consumers’
choices are constrained by their incomes.

• Within the limits of their incomes,

consumers make their consumption
choices by evaluating and comparing the
available consumer goods with regard to
their “utilities.”
 How to Measure Utility
Measuring utility in “utils” (Cardinal):
Analyze utility by describing how much one market basket is preferred to another
 Total Utility Vs Marginal Utility
• Marginal utility is the utility a consumer
derives from the last unit of a consumer
good she or he consumes (during a given
consumption period), ceteris paribus.

• Total utility is the total utility a consumer

derives from the consumption of all of the
units of a good or a combination of goods
over a given consumption period, ceteris
paribus.
Total utility = Sum of marginal utilities
 Marginal Utility analysis
Quantity of Ice Cream Utility Total Utility Marginal Utility
1 80
2 60
3 40
4 20
5 0
6 -20
The Law of Diminishing Marginal Utility

• Over a given consumption period, the

more of a good a consumer has, or has
consumed, the less marginal utility an
additional unit contributes to his or her
overall satisfaction (total utility).

• Alternatively, we could say: over a

given consumption period, as more
and more of a good is consumed by a
consumer, beyond a certain point, the
marginal utility of additional units
begins to fall.
 Consumer Equilibrium
Quantity of Ice Cream Total Utility Marginal Utility Price
1 80 80
2 140 60
3 180 40
4 200 20
5 200 0
6 180 -20
• Utility is a psychic entity and it cannot therefore be measured in quantitative cardinal terms. In
other words, utility being a psychological feeling is not quantifiable.
• The assumption of ordinal utility, is quite reasonable and realistic. The ordinal utility implies
that the consumer is capable of simply comparing the different levels of satisfaction’.
• In other words, according to the ordinal utility hypothesis, while the consumer may not be able
to indicate the exact amounts of utilities that he derives from commodities or any combination
of them, but he is capable of judging whether the satisfaction obtained from a good or a
combination of goods is equal to, lower than, or higher than another.
• Indifference curve approach
 Notions of Preference and Indifference
• For deriving the theory of consumer’s behaviour, it is sufficient to assume that the consumer is
able to rank his preferences consistently.
• Thus, the basis of indifference curve analysis of demand is the preference-indifference
hypothesis.
• This means that if the consumer is presented with a number of various combinations of goods,
he can order or rank them according to his ‘scale of preferences.
• If the various combinations are marked A, B, C, D, E, etc. the consumer can tell whether he
prefers A to B, or B to A or is indifferent between them.
• Similarly, he can indicate his preference or indifference between any other pair of
combinations.
• The concept of ordinal utility implies that the consumer cannot go beyond stating his
preference or indifference.
•Completeness
•Transitivity
•Non-Satiation
•Consistency
 CONSUMER PREFERENCES
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.

Note that these preferences ignore

costs. A consumer might prefer steak
to hamburger but buy hamburger
because it is cheaper.
Some Basic Assumptions about Preferences

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.
Transitivity is normally regarded as necessary for consumer
consistency.
 Some Basic Assumptions about Preferences

3.More is better than less

(Non-satiety): 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.
 Indifference Schedule
Combination Shoes (Good X) Shirts (Good Y)
A 1 12
B 2 8
C 3 5
D 4 3
E 5 2
The Marginal Rate of Substitution
The slope at any point on an indifference curve is the marginal rate of
substitution.
It is the rate at which a consumer is willing to substitute one good for another.
It is the amount of one good that a consumer requires as compensation to give up
one unit of the other good.
 The Consumer’s Preferences...
Quantity
of Pepsi

B D
MRS I2
1
A Indifference
curve, I1
0 Quantity
of Pizza
We can express the MRS for any basket as a ratio of
the marginal utilities of the goods in that basket

 Suppose the consumer changes the level of

consumption of x and y. Using differentials:
dU = MUx . dx + MUy . dy
 Along a particular indifference curve, dU = 0, so:
0 = MUx . dx + MUy . dy
34
 Solving for dy/dx:
dy = _ MUx
dx MUy
 By definition, MRSx,y is the negative of
the slope of the indifference curve:
MRSx,y = MUx
MUy

35
Properties of Indifference Curves

Higher indifference curves are preferred to lower ones.

Indifference curves are downward sloping.

Indifference curves do not cross.

Indifference curves are Convex to the Origin.

 Property 1: Higher indifference curves are
preferred to lower ones.

Consumers usually prefer more of something to

less of it.

Higher indifference curves represent larger

quantities of goods than to lower indifference
curves.
Property 2: Indifference curves are downward sloping.

A consumer is willing to give up one good only if he or

she gets more of the other good in order to remain
equally happy.

If the quantity of one good is reduced, the quantity of

the other good must increase.

For this reason, most indifference curves slope

downward.
Property 3: Indifference curves do not cross.

Quantity
of Pepsi

0 Quantity
of Pizza
Property 4: Indifference curves are bowed inward.
 People are more willing to
Quantity
of Pepsi trade away goods that they
have in abundance and less
14
willing to trade away goods of
MRS = 6 which they have little.

8 A
1

4 MRS = 1 B
3 Indifference
1
curve

0 2 3 6 7 Quantity
of Pizza
An indifference curve exhibits a diminishing marginal
rate of substitution:

1. The more of good x you have, the more you are willing
to give up to get a little of good y.

2. The indifference curves

• Get flatter as we move out along the horizontal axis
• Get steeper as we move up along the vertical axis.

41
Example: The Diminishing Marginal Rate of Substitution

42
Perfect Substitutes

Pepsi

I1 I2 I3
0 1 2 3 Coke
Perfect Complements

Left
Shoes

I2
7
5 I1

0 5 7 Right Shoes
 Consumer Equilibrium Through Indifference Curve
The Budget Line

The budget line depicts the consumption “bundles” that

a consumer can afford.
People consume less than they desire because their spending is
constrained, or limited, by their income.
Combination Shoes (Price 1) X Shirts (Price 2) Y
A 0 10
B 4 8
C 8 6
D 12 4
E 16 2
F 20 0
The Consumer’s Budget Line...
Quantity
of Pepsi
B
500

C
250
Consumer’s
Budget line

A
0 50 100 Quantity
of Pizza
The Consumer’s Budget Line
The slope of the budget line equals the relative price of the two goods,
that is, the price of one good compared to the price of the other.
It measures the rate at which the consumer will trade one good for the
other.
CONSUMER Equilibrium using IC
When Consumer spends his income on different goods in
such a way that he get maximum satisfaction, he is said to
have reached equilibrium position.
 In order to explain the equilibrium of a consumer with the
help of indifference curve analysis, we require the following
data:
(a) Consumer’s different scales of preferences for the two
goods, each scale is being represented by one indifference
curve.
(b) The income of the consumer. It is assumed that he spends
his income fully on both the goods and does not save anything.
(c) The prices of the two commodities are given in the market.
It is assumed that the prices remain constant.
 In other words, we must know scales of preference (which is
also called an indifference map) and the price line of the
consumer
 IC Budget line (income =80)
X (food) Y (clothing) Comb. food (Price 1) X Clothing (Price 2) Y
20 30 A 0 40
10 50 B 20 30
40 20 C 40 20
30 40 D 60 10
10 20 E 80 0
 The utility 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.
A consumer maximizes
satisfaction by choosing market
basket A. At this point, the
budget line and indifference
curve U2 are tangent.
No higher level of satisfaction
(e.g., market basket D) can be
attained.
At A, the point of maximization,
the MRS between the two goods
equals the price ratio. At B,
however, because the MRS [−
(−10/10) = 1] is greater than the
price ratio (1/2), satisfaction is
not maximized.
The Consumer’s Optimum...

Clothing

Optimum
B
A

I3
I2
I1
Budget constraint
0
Food
How Changes in Income Affect the
Consumer’s Choices

An increase in income shifts the budget line outward.

The consumer is able to choose a better combination of goods on a
higher indifference curve.
An Increase in Income...
Quantity
of Pepsi New budget line

1. An increase in income shifts

the budget line outward…

New optimum

3. …and Pepsi Initial

consumption. optimum
I2
Initial
budget line
I1
0 Quantity
of Pizza
2. …raising pizza consumption…
How Changes in Prices Affect Consumer
Choices
A fall in the price of any good rotates
the budget constraint outward and
changes the slope of the budget line.
 A Change in Price...
Quantity
of Pepsi
1,000 New budget constraint

New optimum 1. A fall in the price of Pepsi

rotates the budget constraint
500 outward…
3. …and
raising Pepsi
consumption. I2

Initial budget I1
constraint
0 100 Quantity of Pizza
2. …reducing pizza consumption…
 INCOME AND SUBSTITUTION EFFECTS

A fall in the price of a good has two implications:

1. Consumers will tend to buy more of the good that has

become cheaper and less of those goods that are now
relatively more expensive.

2. Because one of the goods is now cheaper, consumers

enjoy an increase in real purchasing power.
 Income and Substitution Effects
A price change has two effects on consumption.
An income effect
A substitution effect

 The income effect is the change in consumption that

results when a price change moves the consumer to a
higher or lower indifference curve.
 The substitution effect is the change in consumption
that results when a price change moves the consumer
along an indifference curve to a point with a different
marginal rate of substitution.
 INCOME AND SUBSTITUTION EFFECTS

● substitution effect Change in consumption of a good associated with a

change in its price, with the level of utility held constant.

● income effect Change in consumption of a good resulting from an increase in

purchasing power, with relative prices held constant.

The total effect of a change in price is given theoretically by the sum of the substitution
effect and the income effect:
 Price Consumption Curve
• Price-consumption curve
shows consumption
impact of price changes.
• Reflects movement along
demand curve.
Income Consumption Curve
• Income-consumption curve shows consumption impact of income
changes.
• Reflects shift from one demand curve to another.
 Engel Curve
• Engle curves plot
income and
consumption.
• Normal good
consumption rises
with income.
• Inferior good
consumption falls
with income rise.
 Numerical Worksheet
1. Joey’s budget line relating to Goods X and Y has intercepts of 40 units of Good X and 25 units of Good Y. If
the price of Good X is Rs.15, what is Joey’s budget on the two goods? What is the price of Good Y? What is
the slope of the budget line?
2. Assume that Ross has $100 per month to divide between dinners at a Chinese restaurant, Song Hay and a
pizzeria, Pizza Corner. Assume that going to Song Hay costs $20 and eating at Pizza Corner costs $10.
Suppose Ross has 2 dinners at Song Hay and 6 dinners at Pizza Corner.
a. Draw Ross’s budget line and show that he can afford the above combination.
b. Assume that Ross gets a higher pay and can now spend $200 per month. Draw the new budget
constraint.
c. As a result of the income increase, Ross decides to eat 8 times at Song Hay and 4 times at Pizza Corner.
Draw the Income Consumption Curve. How would you classify the two goods i.e. dinners at Song Hay
and Pizza Corner?
3. What is Marginal rate of substitution? A consumer’s indifference curve contains the following market baskets
of apples and bananas. Market Apples (X) Bananas (Y)
• What is the consumer’s marginal rate of substitution at the Basket
different combinations? 1 3 24
• Why does MRS diminish? 2 5 18
• If the price ratio between apples and bananas is 2,
3 7 13
which combination would the consumer choose assuming she is rational?
4 9 9
4. Monica has a monthly budget of Rs.5000 on food and clothing. The price of food is Rs.250 and that
of clothing is Rs.100. and her monthly consumption of food is 10 units and that of clothing is 25
units. If the MRS of food for clothing (MRSFC) at this level is 3, is Monica at equilibrium. If not,
which commodity should she substitute for the other to reach equilibrium.
5. Rachael’s marginal utilities for 2 goods X and Y are given as follows.
• MUX = 60 – 6 X; MUY = 12 – 3 Y. What is the MRS when she is at a combination of
• X = 8 and Y = 2. If PX is Rs.30 and PY = Rs.15, is the combination a consumption equilibrium?
6. It is given that the price of goods X and Y are both Rs.10 each, a consumer consumes 10 units of X
and 10 units of Y at equilibrium.
• Draw the budget line and indifference curve and show the point of consumer equilibrium.
• If the price of X falls to Rs.5, PY and money income remaining the same. At the new equilibrium caused by a fall in
price of X, the consumer has a combination of 16 units of X and 12 units of Y. Show the price effect of a change in
price of X using the PCC.
• Why are more units of Y consumed even though its price has not fallen?
7. Derive Engel’s curve from the income consumption curve for
a) Necessity b) luxury good