Theory of Consumer Behavior

The Theory of
Consumer Behavior
The Theory of Consumer
Behavior
The principle assumption upon which the
theory of consumer behavior and demand is
built is: a consumer attempts to allocate
his/her limited money income among
available goods and services so as to
maximize his/her utility (satisfaction).
Theory of Consumer Behavior
Useful for understanding the demand side of
the market.
Utility - amount of satisfaction derived from the

consumption of a commodity .measurement
units utils
Theories of Consumer Choice
Utility Concepts:
The Cardinal Utility Theory (TUC)
Utility is measurable in a cardinal sense
cardinal utility - assumes that we can assign values
for utility, (Jevons, Walras, and Marshall). E.g.,
derive 100 utils from eating a slice of pizza
The Ordinal Utility Theory (TUO)
Utility is measurable in an ordinal sense
ordinal utility approach - does not assign values,
instead works with a ranking of preferences. (Pareto,
Hicks, Slutsky)
The Cardinal Approach
Assumptions
The principle of equi-marginal utility is based on the following assumptions:
(a) The wants of a consumer remain unchanged.
(b) He has a fixed income.
(c) The prices of all goods are given and known to a consumer.
(d) He is one of the many buyers in the sense that he is powerless to alter the
market price.
(e) He can spend his income in small amounts.
(f) He acts rationally in the sense that he want maximum satisfaction
(g) Utility is measured cardinally. This means that utility, or use of an item,
can be expressed in terms of "units" or "utils". This utility is not only
comparable but also quantifiable.
The Principle
Suppose there are two goods 'x' and 'y' on which the consumer
has to spend his given income. The consumers behavior is
based on two factors:
(a) Marginal Utilities of goods 'x' and 'y'
(b) The prices of goods 'x' and 'y'
The consumer is in equilibrium position when marginal utility of
money expenditure on each good is the same.
The Law of Equi-Marginal Utility states that the consumer will
distribute his money income in a way that the utility derived
from the last unit of payment spent on each good is equal.
The consumer will spend his money income in such a way that
marginal utility of each good is proportional to its unit of
payment.
Nineteenth century economists, such as Jevons,
Menger and Walras, assumed that utility was
measurable in a cardinal sense, which means
that the difference between two measurement is
itself numerically significant.
UX = f (X), UY = f (Y), ..
Utility is maximized when:
MUX / MUY = PX / PY
Total utility (TU) - the overall level of satisfaction
derived from consuming a good or service
Marginal utility (MU) additional satisfaction that an
individual derives from consuming an additional
unit of a good or service.
Formula :
MU = Change intotalutility
Change inquantity
= TU
Q
Law of Diminishing Marginal Utility (Return) = As more
and more of a good are consumed, the process of
consumption will (at some point) yield smaller and
smaller additions to utility
When the total utility maximum, marginal utility = 0
When the total utility begins to decrease, the

marginal utility = negative (-ve)
EXAMPLE
Number Total Marginal

Purchased Utility Utility
0 0 0
1 4 4
2 7 3
3 8 1
4 8 0
5 7 -1
TU, in general, increases with
Q
At some point, TU can start
falling with Q (see Q = 5)
If TU is increasing, MU > 0
From Q = 1 onwards, MU is
declining principle of
diminishing marginal utility
As more and more of a
good are consumed, the
process of consumption will
(at some point) yield smaller
and smaller additions to utility
Consumer Equilibrium
So far, we have assumed that any amount

of goods and services are always
available for consumption
In reality, consumers face constraints
(income and prices):
Limited consumers income or budget
Goods can be obtained at a price
Some simplifying
assumptions
Consumers objective: to maximize
his/her utility subject to income
constraint
2 goods (X, Y)
Prices Px, Py are fixed
Consumers income (I) is given

Marginal utility per price additional

utility derived from spending the next
price (RM) on the good
MU per RM = MU
P
Optimizing condition:
MU X MU Y

PX PY
If MU X MU Y

PX PY
spend more on good X and less of Y
Numerical Illustration
Qx TUX MUX MUx QY TUY MUY MUy
Px Py
1 30 30 15 1 50 50 5
2 39 9 4.5 2 105 55 5.5
3 45 6 3 3 148 43 4.3
4 50 5 2.5 4 178 30 3
5 54 4 2 5 198 20 2
6 56 2 1 6 213 15 1.5
Simple Illustration
Suppose: X = bath soap

Y = bath lotion
Assume: PX = 2
PY = 10
Cont.
2 potential optimum positions

Combination A: X = 3 and Y = 4
TU = TUX + TUY = 45 + 178 = 223
Combination B: X = 5 and Y = 5
TU = TUX + TUY = 54 + 198 = 252
Cont.
Presence of 2 potential equilibrium positions
suggests that we need to consider income. To
do so let us examine how much each
consumer spends for each combination.
Expenditure per combination
Total expenditure = PX X + PY Y
Combination A: 3(2) + 4(10) = 46
Combination B: 5(2) + 5(10) = 60
Cont.
Scenarios:
If consumers income = 46, then the
optimum is given by combination A. .
Combination B is not affordable
If the consumers income = 60, then the
optimum is given by Combination
B.Combination A is affordable but it
yields a lower level of utility
The Ordinal Approach
Economists following the lead of Hicks,

Slutsky and Pareto believe that utility is
measurable in an ordinal sense--the utility
derived from consuming a good, such as X,
is a function of the quantities of X and Y
consumed by a consumer.
U = f ( X, Y )
Cont.
OrdinalUtilityTheory(TUO)
Can be measuredinqualitative,
notquantitative, but onlylists
themainoptions(indifference
curves&budget line).
Rational human beingswill choose
tomaximize theutilityby
selectingthe highestutility
Difference consumers, difference
utilities.
INDIFFERENCECURVE (IC)
Curvewhere the pointsrepresenta

combination ofitemswhen the consumerat
indifference situation (satisfaction).
Axes:both axes refer to the quantityof
goods
For thecombinationthat producesa
higherlevel of satisfaction, the curvesshift
to the right(IC2) from the firstcurve(IC1)
In contrast, the curves shift to the left(IC- 1)
INDIFFERENCE CURVE
An indifference curve is a graph
showing combination of two
goods Y goods that give the consumer
M
equal satisfaction and utility.
S
A
C
T D IC2
IC1
IC-1
O
4 7 11
goods X
PROPERTIES OF INDIFFERENCE
CURVE
Downward sloping fromleft to right:Thisshowsan
increase inquantityof certain good.
Convextothe origin:the marginalrate
ofsubstitution(MRS) decreased
MRS = quantity of goods Y willing to substitute to obtain one
unit of goods X & this substitution is to maintain its position at the
same level of satisfaction
Do not cross (intersect):consumer preferencestransitive
Eg : QuantitiesXandYfor the combination ofA>a
combination ofB; utilityA>B*
Whencross=C, sothe utilityA =C&B=C;
utilityA =B=C.This isnottransitiveas above*
DifferentICsshowdifferentlevel of satisfaction.Farfrom
the origin, the higher the satisfaction.
IC curves can not intersect
Good Y
C A IC1
B
IC2
Good X
Budget line (BL)
Lineshowing allcombinations ofitemscan be

purchasedfor a particularlevel of income (M) ;
M =PxQx + PyQy
The slopedepends on theprices of
goodsXandY,the slope = Px/Py
Slope -ve:tousemoregoodsX,Yshouldreduce &
vice versa
In theX-axis,whenthe quantityY=0,allMused
to purchase X; M = PxQx Qx =M/Px
At theYaxis,whenthe quantityX=0,allMused
to purchase Y; M = PyQy Qy =M/Py
FACTORS SHIFT THE BUDGET LINE
Changes in prices of goods X

Y
Px Px X
EFFECTS
OFPRICECHANGESON THE
BUDGET LINE
When price of good X increases, the quantity of good
X is reduced (by maintaining the quantity of Y) & vice
versa.
Points on the X axis shifted to the left (a
small quantity of X)
When the price of Y increases, the quantity Y is
reduced (by maintaining the quantity of X) & vice versa
Point on Y axis move to the bottom (small quantity in
Y)
Changes in the price of goods Y

Y
Py
Py
X
Changes in income
Y
X
EFFECTS OF INCOME
CHANGES ON THE
BUDGETLINE
When M increases, QX and QY can be

bought even more, a point on the X
axis shifted to the right & a point on
the Y axis move on; & vice
versa when M decreases.
CONSUMEREQUILIBRIUM
Withincome(M)somecombination ofgoods
thatconsumers choosethe highest
satisfaction
Satisfiedthe
samecurvesandbudgetlinesare connected
The point where thecurveICand BLtangent
Slope IC = BL
Consumer choice influenced by income
Increasedincome,increasedconsumerequili
brium point
MAXIMIZECONSUMERSATISFACTION
Y
M
F
C Indifference Curves (IC)
E Budget line (BL)

IC1
B
IC2
A D
IC3
IC4
O M1 X
Price Consumption Curve (PCC)
changes in Px
Y
Price Consumption Curve (PCC)
PCC = Line connecting the equilibrium points, E the event of changes to

the prices of goods.
Formation ofDemand Curve
Outcome of PCC
Px
Dd
Qty X
Demand
CurveforNormalGoodsandInferior Goods
X axis,Yaxis ofthe quantity ofgoods,the price of goods
Px
Normal goods
Inferior goods
Qty X
Normal goods= P , Dd
Inferior goods= P , Dd
INCOMECONSUMPTION CURVE
(ICC)
Ifa fixedpriceand incomeincreases,the
budgetlineshiftsto the right,
thusshiftingthe equilibriumpointhigher.
Equilibrium pointsome
incomeitemsassociated with theline-can
be income consumptioncurve (ICC).
ICC showsthe pointsfor the combination
ofgoods that can bepurchasedwhen
income change andfixed in price.
INCOME CONSUMPTION
CURVE (ICC)
Y
M
ICC
IC3
IC2
IC1
O
M1 M2 M3 X
ENGEL CURVE
M
Engel curve for x
40
30
20
10
O
12 16 20 22 X
ENGEL CURVE
Relationshipof incometo the

quantityofan item
RetrievedfromICC
Get aquantity of goodsXorYthat can
be purchasedgoodswithanincome
Plotthe quantity
ofXorYagainstincome
Linkingincomechangeswith changes
indemand forgoodsat a fixed price
Engel curve for luxury goods
and normal goods
M Normal goods
Luxury goods
O X
Conclusion
ToCB showing how it provides users a combination of sources of income
for many goods /services
There are two types of utility theory:
Cardinal TU and MU
Ordinal curve IC and BL
Equilibrium and utility maximization can be either TUC or TUO
Equilibrium points of connection to produce PCC (change IN PRICE)
and ICC (change in income)
Displaying Publication = PCC curve DD & ICC = Engel curve (EC)
The types of goods obtained displaying income or price changes.
Thank
You

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Theory of Consumer Behavior

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The Theory of

Utility - amount of satisfaction derived from the

When the total utility maximum, marginal utility = 0

When the total utility begins to decrease, the

Number Total Marginal

So far, we have assumed that any amount

Prices Px, Py are fixed

Consumers income (I) is given

Marginal utility per price additional

Suppose: X = bath soap

2 potential optimum positions

Economists following the lead of Hicks,

Curvewhere the pointsrepresenta

Lineshowing allcombinations ofitemscan be

Changes in prices of goods X

Changes in the price of goods Y

When M increases, QX and QY can be

Consumer choice influenced by income

E Budget line (BL)

PCC = Line connecting the equilibrium points, E the event of changes to

Relationshipof incometo the

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