THEORIES OF CONSUMER BEHAVIOUR

 The theories seek to explain how consumers behave when they are faced with the
problem of scarcity.
 In order to maximise their satisfaction consumers are assumed to be rational.
 There are two different schools of thought when analyzing consumer behavior.
THE MARGINAL UTILITY THEORY

 Also known as the Cardinalist Theory

Assumptions
i. Utility can be measured in units called utils.
 Utility means satisfaction.
 Some Economists believe that utility can be measured in monetary units by the
amount the consumer is willing to sacrifice another unity of a good.
 Others have suggested the measurement of utility in subjective units called utils.
 It is assumed that it is possible to compare the utility of different goods and services
quantitatively.
ii. Rationality
 Consumers are able to use common sense and reason in order to maximise
satisfaction.
iii. Continuous consumption of homogeneous products
 Consumption should be standard, not too big or too small
iv. Diminishing marginal utility
 Marginal (additional) utility declines as more of a good is consumed.
v. Constant utility of money
 the marginal utility of money remains constant whatever the level of income.
 A dollar in the hands of a millionaire has the same value as the dollar in the hands of
a beggar.
Total utility

 This refers to the total satisfaction derived from the consumption of a good.
Marginal utility

 Marginal means additional or incremental.

 It is the additional/ extra satisfaction a consumer derives from consuming an
additional unit.
 M.U=T Un-T Un-1

Law of diminishing marginal utility

 It states that as consumption increases, total utility will be increasing at a decreasing

rate while marginal utility will be falling.

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  If an identical good is consumed, marginal utility declines until it reaches zero and
eventually becomes negative.
 The law of diminishing marginal utility can be expressed using the following
relationship between total utility and marginal utility:

Units consumed Total utility Marginal utility

1 15 15
2 25 10
3 33 8
4 38 5
5 40 2
6 40 0
7 39 -1

 Total utility increases as long as marginal utility is negative.

 Total utility reaches its maximum i.e. the point of satiation when marginal utility is
zero and then decreases when marginal utility is negative.
 Negative marginal utility is also known as disutility or dissatisfaction.
 As more and more of a good is consumed total utility increases at a decreasing rate,
reaches a peak and then starts to decrease.
 This trend is known as the law of diminishing marginal utility.

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  Given no budget constraint a consumer should consume up to a point where M. U=0
(T.U will be maximized).

Consumer Equilibrium
One good model

 Using a one good model e.g. good X, the consumer is in equilibrium when M. Ux= P X.
 If M. Ux is greater than Px a rational consumer would consume more since the
additional satisfaction derived from consuming a good would be greater than the
cost of acquiring the good.
 If M. Ux is less than Px, the consumer would consume less.
 There is no need for the rational consumer to adjust consumption patterns only
when M. Ux=Px.
 According to the axiom/ principle of rationality consumer will pay more of an extra
unit of a product that will give them greatest possible satisfaction.
 The consumer is therefore assumed to be in a position to arrange his or her wants in
order of importance and draw up a list of things that he or she would prefer to
purchase.
 This list which reflects the taste of the consumer is known as the scale of preference.
More than one good model (The equi marginal principle)

 A consumer is said to be in equilibrium, assuming a given level of income, when it is

not possible to switch any expenditure from the consumption of one good to the
consumption of another good in order to increase total utility.
 This is often referred to as the equilibrium marginal utility principle (equi marginal
principle)
 According to the equi marginal principle, consumers maximise their utility when
marginal valuation (weighted marginal utility) for each product purchased is the
same.
 Assuming a household I consuming two goods, X and Y, the equimarginal condition
will be as follows:

 The utility derived from spending an additional unit of money must be the same for
all commodities.

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  To obtain consumer’s equilibrium position we must determine which combinations
are affordable and at which these combinations the weighted marginal utility is the
same for all the goods in question.
 The consumer’s consumption patterns are determined by the budget.
Example
Let’s consider the following situation:

 The budget constraint for the consumer is $12.

 Price of bread is $1.
 Price of meat is $3.
 Price of rice is $2.
Using the above information, how many units should this person consume to maximise
satisfaction?

Units BREAD MEAT RICE

T.UB M.UB M.UB/PB T.UM M.UM M.UM/PM T.UR M.UR M.UR/PR
1 54 90 66
2 102 171 126
3 144 243 180
4 180 306 228
5 210 360 270
6 234 405 306
7 252 441 336
8 264 468 360
9 270 486 378
10 270 490 390

QUESTION: HOW DOES ECONOMIC THEORY EXPLAIN THE OPTIMUM CONSUMPTION

PATTERN OF AN INDIVIDUAL CONSUMER? [12]
Derivation of the individual and market demand curves

 the marginal utility theory can be used to derive and individual demand curve.
 The fundamental principle of demand is that an increase in the price of a good leads
to a decrease in the quantity demanded.
 Suppose a household is in equilibrium when consuming two goods as follows:

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  Assume the price of good X has increased. The household will no longer be in a state
of equilibrium as shown below:
 The left side will now be less than the right side.
 Since the price of good X has increased, the consumer will respond by consuming
less of good X and more of good Y which will be relatively cheaper.
 The consumer will increase total utility of good Y by spending more on that good and
less on good X.
 As more of good Y is consumed, the value of the marginal utility will be decreasing
until equilibrium for the consumer is restored.
 The demand curve for good X has been derived since the consumer has reduced the
consumption of good X when its price rose as shown below:

Market demand curve

 The market demand curve is found by horizontally adding individual demand.

Limitations of the marginal utility theory

i. Utility is difficult to measure as it varies from person to person since consumers are
different and have different preferences.
ii. Utility varies from person to person and according to the situation e.g. utility for a
cigarrete from a smoker is very high while for a non-smoker it is zero. In the middle
of a desert, a drink of cold water will possess greater utility but the same person on a
cold wet day in London will derive very little if any from the product.
iii. In the case of addictive goods utility may actually increase as consumption increases
hence the law of diminishing marginal utility does not apply.

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 iv. The axiom of constant marginal utility of money is not realistic e.g. as income rises
the marginal utility of money may actually fall (law of diminishing marginal utility)
v. Consumers are not always rational when making purchasing decisions. Consumers
can act in an irrational way in cases where there are special offers, adverts of
products and deferment of payments.
vi. Every commodity is not an independent commodity- the analysis is based on the
assumption that every commodity is an independent commodity. In real life, utility
of a commodity is very much dependent on the utility of other commodities.
Consumers’ behavior cannot therefore be precisely measured through utility
analysis.

THE INDIFFERENCE CURVE THEORY

 Also known as the ordinalist theory

 This approach does not require measurement of utility but requires ordering or
ranking of utility bundles i.e. combinations yielding the same satisfaction to the
consumer.
 An indifference curve is a line which shows all combinations of two goods which yield
the same level of satisfaction to the consumer i.e. the consumer is indifferent
between bundles of combinations along this line.
Assumptions

 Consumers are rational. This means they use common sense when making decisions
and always prefer more to less.
 Consumers have a limited budget i.e. there is a budget constraint.
 Goods are combined to form bundles (combinations). Each bundle yields the same
amount of satisfaction to the consumer.
 Utility cannot be measured.
 Consistency and transitivity of choices- since the consumer is assumed to be rational,
his choice of goods has to be consistent. If a consumer prefers bundle A to B and
bundle B to C, then bundle A must be preferred to bundle C.
 There must be two baskets of goods for the analysis to be complete. The indifference
curve analysis will not be complete if the bundles are used in isolation of the other
basket.

Indifference curves

 An indifference curve is a line which shows all combinations of two goods which yield
the same level of satisfaction to the consumer i.e. the consumer is indifferent
between bundles of combinations along this line.
 These are diagrammatical presentations of consumer preferences.
Properties/ characteristics of indifference curves

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 i. Negative slope
 Indifference curves slope downwards from left to right. This means consumption of
two goods along the indifference curve is negatively related to each other i.e. If the
quantity of one commodity consumed increases, the quantity consumed of the other
must decrease to maintain the same amount of satisfaction.
Example

Combination (bundles) Bottles of cola Bottles of apple

A 5 30
B 6 20
C 7 15
D 8 12
E 9 10
F 10 9

 The above information can be used to derive an indifference curve

ii. Non intersection

 Indifference curves must not intersect.
 If the two curves intersect, the point at which the intersection occurs will represent
two different levels of satisfaction hence violating the consistency theory.

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iii. Higher indifference curves represent higher levels of satisfaction.
 Combination of goods lying on a higher indifference curve will be preferred by a
consumer to a combination which lies on a lower indifference curve.
An indifference map

 Two or more indifference curves will make an indifference map, with higher
indifference curves yielding greater satisfaction than lower indifference curves,
although the level of satisfaction cannot be measured.
 The diagram below shows an indifference map:

iv. Indifference curves are concave or bowed inward to the origin signifying the law of
diminishing marginal rate of substitution.
v. Indifference curves never touch the axis
vi. Law of Diminishing marginal rate of substitution
 Marginal rate of substitution (MRS) is the rate at which a consumer is willing to
substitute one good for another (the amount of one good a consumer is willing to
sacrifice in order to obtain an additional unit of another good).
 The MRS is the slope of the indifference curve and is negative over the entire length
of the indifference curve.
 The law of diminishing MRS means that as a rational consumer moves from left to
right, the willingness to substitute one good for the other decreases.
 Using the above diagram, the quantity of apples given up to gain a unit of cola
diminishes as we move down the curve

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  As more of cola and less of apples are consumed the marginal utility of cola will
diminish while that of apples will increase. The consumer will thus be prepared to
give up less and less of apples for each additional unit of cola consumed hence the
law of diminishing MRS.

The budget lines

 It is a line which shows all possible combinations of two goods that a consumer can
buy with a given income and fixed prices.
 A consumer cannot purchase a combination of goods outside the budget line unless
his income increases or prices fall.

Construction of the budget line

 The budget constraint/ equation is as follows:

M=PxX+ PyY where M is income, Px is price of X, X is quantity of X, Py is price of Y, Y is quantity
of Y, PxX is expenditure on good X, PyY is expenditure on good Y

 Suppose a consumer has to spend $200 on two products X and Y. Assume the price
of X is $20 and Y is $10. Each combination would cost $200 in total.

Quantity of Good Quantity of good

X @$20 each Y @ $10 each
10 0
9 2
8 4
7 6
6 8
5 10
4 12
3 14
2 16
1 18
0 20

 If the consumer decides to buy good X only given the price and income 10 units
would be purchased. If the consumer made a decision to buy god Y only 20 units
would be purchased.
 The budget line would as follow:

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  Th sum of expenditure on good x and good y should be equal to the income.
 The budget line shows the combinations of good x and good y that a consumer can
buy using his income.
 It is the consumption possibilities of the society.
 When a consumer is using all his income, he is allocatively efficient since it is
impossible to increase the consumption of one good without reducing the
consumption of the other. Any point to the left of the budget line is allocatively
inefficient because the consumer is not exhausting his income.
 Any point to the right of the budget line is unattainable given the budget constraint
hence shows scarcity.
 Any point along the budget line will produce an outcome where consumption is
maximized for this level of income.

Changes in the position of the budget line

 The budget line can change its position with time.

i. Pivotal shifts.
 Pivotal shift of the budget line is caused by a change in the price of the product e.g. if
the price falls there will be an outward pivotal shift of the budget line in favor of the
product whose price has fallen.
 A price rise will result in an inward pivotal shift of the budget line. Slope of the
budget line changes since the price of the product has changed.

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  Pivotal shifts are shown below:

ii. Parallel shifts

 Parallel shifts are caused by changes in incomes.
 An increase in incomes causes an outward parallel shift whereas a decrease in
incomes causes an inward parallel shift of the budget line.
 The slope of the budget line does not change since the price of the product has not
changed.
 Parallel shifts are shown below:

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 Consumer equilibrium

 The consumer is in equilibrium when he obtains the maximum satisfaction for the
amount of income he spends.
 The equilibrium position of the household is shown when the budget line is tangent
to the furthest out indifference curve.
 At equilibrium the slope of the budget line is equal to the slope of the indifference
curve as shown below:

Derivation of the demand curve using the indifference curve theory

 Assuming there is a fall in the price of good X below, the budget line rotates to the
right, hence allowing the consumer to consume on a higher indifference curve.
 This means the consumer is now consuming more of good X at a lower price
resulting in a downward sloping demand curve as shown below:

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Effects of a change in the budget
i. Changes in income
 A consumer’s choice is optimal at the point where the budget line touches or is at a
tangent to the highest indifference curve.
 An increase in income will cause the budget line to shift to the right hence the
consumer can choose to purchase more of one or both goods.
 The slope of the budget line remains unchanged but the new budget line will be
tangent to a higher indifference curve than before.
 On the diagram below, E1 will give the consumer the maximum combined
consumption of goods X and Y given the budget constraint shown by the budget line
X1Y1.
 If income increases the new optimal position for both goods will be E2 with a new
budget line X2Y2 where more of both goods are being consumed.
 The change in position from E1 to E2 is what occurs when both goods are normal
goods. If the increase in income or budget constraint results in less of one good
being consumed then this is an inferior good.

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 ii. Changes in price of a good.
 Whenever there are changes in the price of a good, the effects can be divided
between the income and substitution effects. T. E= S. E+Y.E
 When the price of a good falls, a consumer will experience a rise in real income
(purchasing power), money income remaining the same.
 In terms of indifference curve analysis, an increase in real income means that the
consumer is able to reach a higher level of satisfaction by moving to a higher
indifference curve.
Substitution effect

 A decrease in the price of a good means that the good becomes cheaper relative to
other goods if their prices remain constant.
 The good therefore becomes a more attractive option to purchase.
 If the consumer buys only two goods, X and Y and the price of X falls, there is an
incentive for the consumer to buy more of X and less of Y.
 This is known as the substitution effect as the consumer replaces the good that has
become relatively expensive.
 For the S.E the consumer remains on the same indifference curve means the level of
satisfaction is still the same since the consumer has only changed the bundle or
combinations of the two goods being consumed.
Income effect

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  When the price falls, a consumer will experience a rise in real income (purchasing
power), money income remaining the same.
 In terms of indifference curve analysis, the consumer is able to reach a higher level
of satisfaction by moving on to a higher indifference curve.
 The change in consumption that follows is known as the income effect.
 The income and substitution effects can be used to classify goods into normal,
inferior and giffen goods.

Income and substitution effects of normal, inferior and giffen goods.

i. Normal Good
 A normal good is a good whose quantity demanded increases as incomes rise.
 For a normal good, the substitution effect and the income effect both go in the same
direction, however, the substitution effect outweighs the income effect.
 If the price of good X falls, it becomes cheaper and good Y becomes relatively
expensive, yielding a normal demand curve which is downward sloping.
 The consumer ends up substituting good Y for good X and this is the substitution
effect of a price change as shown by movement from A to B.
 An imaginary budget line or a shadow budget line (dotted line) has to be drawn
showing the equilibrium on the old indifference curve after a price change.

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  The satisfaction is still the same since the consumer is on the same indifference
curve even though the bundles/combinations of the two goods have not changed.
 However, a fall in the price of good X makes the consumer better off resulting in him
buying more of both Good X and good Y. this is because even though money
(nominal) income has not changed, real income (purchasing power) of the money
has increased.
 The consumer can now buy more of good Y because the increase in real income
enables the consumer to purchase more of good Y as well.
 Movement from B to C becomes the income effect.
 For a normal good, the substitution and the income effects are both positive since a
rise in income enables greater consumption resulting in a downward sloping demand
curve.

ii. Inferior good.

 It is a good whose consumption increases as incomes fall.
 Assuming the price of good X has fallen. The consumer is induced to substitute good
Y with good X which is now relatively cheaper resulting in the substitution effect
from A to B.

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  For an inferior good the substitution effect is positive however a fall in the price of
good X makes a consumer better off and induces the consumer to buy more of both
goods X and Y.
 The consumer buys less of good X and more of good Y because an increase in income
forces him to abandon good X for Y.
 For an inferior good the income is effect is always negative. However, it is
outweighed by a positive substitution effect resulting in a downward sloping demand
curve.

iii. Giffen Goods

 A giffen good is a special type of an inferior good whose consumption increases due
to a significant fall in incomes.
 Giffen goods are strongly inferior so if the price goes up, real income shall fall forcing
consumers to abandon other goods.
 If the price goes down, real income shall increase forcing consumers to purchase
other goods.
 This means as the price of the good falls, less of it shall be demanded resulting in an
upward sloping demand curve.

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 Although the S.E is positive, it is outweighed by a negative Y.E resulting in an upward
sloping demand curve
 Assuming the price of good X, a giffen good has fallen, the effects would be split
using a diagram as follows:

 The indifference curve shows what the consumer wants to buy whereas the budget
line shows what the consumer is able to buy.
 A budget line represents the extent of a consumer’s income, an indifference curve
indicates the possible choices available.
 When combined, they show how the consumer can maximise satisfaction.
 Budget lines and indifference curves assume we are dealing with rational consumers;
the reality is that this is not necessarily true for many consumers.

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