Chapter Three

Theory of Consumer Behaviour

Consumer behaviour can be best understood in three
steps.
First, by examining consumer‘s preference, we need a
practical way to describe how people prefer one good
to another.
Second, we must take into account that consumers
face budget constraints – they have limited incomes
that restrict the quantities of goods they can buy.
Third, we will put consumer preference and budget
constraint together to determine consumer choice.
 Consumer preferences
• In order to tell whether one bundle is preferred to another, we see
how the consumer behaves in choice situations involving two
bundles.
• If she always chooses X when Y is available, then it is natural to say
that this consumer prefers X to Y.
• We use the symbol ≻ to mean that one bundle is strictly preferred
to another, so that X ≻Y should be interpreted as saying that the
consumer strictly prefers X to Y, in the sense that she definitely
wants the X-bundle rather than the Y-bundle.
• If the consumer is indifferent between two bundles of goods, we
use the symbol∼ and write X~Y.
• Indifference means that the consumer would be just as satisfied,
according to her own preferences, consuming the bundle X as she
would be consuming bundle Y.
• If the consumer prefers or is indifferent between the two bundles
we say that she weakly prefers X to Y and write X ⪰ Y.
 The concept of utility
• Economists use the term utility to describe the
satisfaction or pleasure derived from the
consumption of a good or service.
• In other words, utility is the power of the
product to satisfy human wants. Given 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.
• In defining utility, it is important to bear in mind the
following points.
• ‘Utility’ and ‘Usefulness’ are not synonymous. For example,
paintings by Picasso may be useless functionally but offer
great utility to art lovers. Hence, usefulness is product
centric whereas utility is consumer centric.
• Utility is subjective. The utility of a product will vary from
person to person.
• That means, the utility that two individuals derive from
consuming the same level of a product may not be the
same.
• For example, non-smokers do not derive any utility from
cigarettes.
• Utility can be different at different places and time. For
example, the utility that we get from drinking coffee early
in the morning may be different from the utility we get
during lunch time.
 Approaches of measuring utility
• There are two major approaches to measure
or compare consumer‘s utility: cardinal and
ordinal approaches.
• The cardinalist school postulated that utility
can be measured objectively.
• According to the ordinalist school, utility is not
measurable in cardinal numbers rather the
consumer can rank or order the utility he
derives from different goods and services.
 The cardinal utility theory
• According to the cardinal utility theory, utility
is measurable by arbitrary unit of
measurement
• called utils in the form of 1, 2, 3 etc. For
example, we may say that consumption of an
orange gives Bilen 10 utils and a banana gives
her 8 utils, and so on.
• From this, we can assert that Bilen gets more
satisfaction from orange than from banana.
Assumptions of cardinal utility theory
The cardinal approach is based on the following major assumptions.
1. Rationality of consumers. The main objective of the consumer is to
maximize his/her Sat is faction given his/her limited budget or income.
Thus, in order to maximize his/her satisfaction, the consumer has to be
rational.
2. Utility is cardinally measurable. According to the cardinal approach, the
utility or satisfaction of each commodity is measurable. Utility is
measured in subjective units called utils.
3. Constant marginal utility of money. A given unit of money deserves the
same value at any time or place it is to be spent. A person at the start of
the month where he has received monthly salary gives equal value to 1
birr with what he may give it after three weeks or so.
4. Diminishing marginal utility (DMU). The utility derived from each
successive units of a commodity diminishes. In other words, the marginal
utility of a commodity diminishes as the consumer acquires larger
quantities of it.
5. 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 X , X ,...Xn 1 , the total utility is given by TU = f ( X1 , X2 ......X n
).
 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.
• 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. In other
words, marginal utility is the change in total utility that
results from the consumption of one more unit of a
product.
• Graphically, it is the slope of total utility. Mathematically,
marginal utility is:
Mathematically, marginal utility is:
Continued….
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.
In other words, the extra satisfaction that a consumer
derives declines as he/she consumes more and more of
the product in a given period of time.
• The law of diminishing marginal utility is
based on the following assumptions.
• The consumer is rational
• The consumer consumes identical or
homogenous product.
• The commodity to be consumed should have
similar quality, color, design, etc.
• There is no time gap in consumption of the
good
• The consumer taste/preferences remain
unchanged
 Equilibrium of a consumer
• The objective of a rational consumer is to
maximize total utility.
• As long as the additional unit consumed
brings a positive marginal utility, the
consumer wants to consumer more of the
product because total utility increases.
 The ordinal utility theory
• In the ordinal utility approach, it is not possible
for consumers to express the utility of various
commodities they consume in absolute terms, like
1 util, 2 utils, or 3 utils but it is possible to express
the utility in relative terms.
• The consumers can rank commodities in the
order of their preferences as 1st, 2nd, 3rd and so
on.
• Therefore, the consumer need not know in
specific units the utility of various commodities to
make his choice.
 Assumptions of ordinal utility theory
• The ordinal approach is based on the following assumptions.
• Consumers are rational - they maximize their satisfaction or
utility given their income and market prices.
• Utility is ordinal - utility is not absolutely (cardinally)
measurable. Consumers are required only to order or rank
their preference for various bundles of commodities.
• 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 at which one good can be substituted for another in
consumer‘s basket of goods diminishes as the consumer
consumes more and more of the good.
• 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. For
example, if there are three goods in a given
• consumer‘s basket, say, X, Y, Z and if he 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.
The ordinal utility approach is explained with the
help of indifference curves.
• Therefore, the ordinal utility theory is also known
as the indifference curve approach.
 Indifference set, curve and map
• Indifference set/ schedule is a combination of
goods for which the consumer is indifferent.
• It shows the various combinations of goods
from which the consumer derives the same
level of satisfaction.
 Properties of indifference curves
1. Indifference curves have negative slope (downward sloping to the right).
Indifference curves are negatively sloped because the consumption level
of one commodity can be increased only by reducing the consumption
level of the other commodity.
2. Indifference curves are convex to the origin. This implies that the slope of
an indifference curve decreases (in absolute terms) as we move along the
curve from the left downwards to the right.
• The convexity of indifference curves is the reflection of the diminishing
marginal rate of substitution.
3. A higher indifference curve is always preferred to a lower one. The further
away from the origin an indifferent curve lies, the higher the level of utility
it denotes.
• Baskets of goods on a higher indifference curve are preferred by the
rational consumer because they contain more of the two commodities
than the lower ones.
4. Indifference curves never cross each other (cannot intersect). The
assumptions of consistency and transitivity will rule out the intersection of
indifference curves. Figure 3.4 shows the violations of the assumptions of
preferences due to the intersection of indifference curves.