CHAPTER THREE

THEORY OF CONSUMER BEHAVIOUR

Chapter Objectives
 At the end of this chapter, you will be able to:
 explain consumer preferences and utility
 differentiate between cardinal and ordinal utility approach
 define indifference curve and discuss its properties
 derive and explain the budget line
 describe the equilibrium condition of a consumer
 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.
Third, we will put consumer preference and budget constraint
together to determine consumer choice.
3.1 Consumer preferences
 A consumer makes choices by comparing bundle of goods. Given
any two consumption bundles, the consumer either decides that
one of the consumption bundles is strictly better than the other, or
decides that she is indifferent between the two bundles.
 If He/she always chooses X when Y is available, then it is natural to
say that this consumer prefers X to Y.
o 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.
o 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.
o 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 relations of strict preference, weak preference, and indifference
are not independent concepts; the relations are themselves related.
For example, if X ⪰ Y and Y ⪰ X, we can conclude that X ~Y.
 That is, if the consumer thinks that X is at least as good as Y and
that Y is at least as good as X, then she must be indifferent
between the two bundles of goods.
 Similarly, if X ⪰ Y but we know that it is not the case that X~ Y,
we can conclude that X≻Y.
 This just says that if the consumer thinks that X is at least as good
as Y, and she is not indifferent between the two bundles, then she
thinks that X is strictly better than Y.
3.2 The concept of utility
 Economists use the term utility to describe the satisfaction or
pleasure derived from the consumption of a good or service.
 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.
Q. Do you think that utility and usefulness are synonymous? Do
two individuals always derive equal satisfaction from consuming
the same level of a product?
Answer: Utility’ and ‘Usefulness’ are not synonymous.
 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.
 3.3 Approaches of measuring utility
Q. How do you measure or compare the level of satisfaction (utility)
that you obtain from goods and services?
 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.
3.3.1 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.
 E.g, we may say that consumption of an orange gives Rahel 10
utils and a banana gives her 8 utils, and so on.
 From this, we can assert that Rahel gets more satisfaction from
orange than from banana.
 Assumptions of cardinal utility theory
1. Rationality of consumers. The main objective of the consumer is to
maximize his/her satisfaction given his/her limited budget or income.
2. Utility is cardinally 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.
4. Diminishing marginal utility (DMU). The utility derived from
each successive units of a commodity diminishes.
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 X1 , X2 ,...Xn , 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.
 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:

 where, TU is the change in total utility, and Q is the change in

the amount of product consumed.
 To explain the relationship between TU and MU, let us consider
the following hypothetical
example.
 The total utility first increases, reaches the maximum (when the
consumer consumes 6 units) and then declines as the quantity
consumed increases.
 On the other hand, the marginal utility continuously declines (even
becomes zero or negative) as quantity consumed increases.
 As it can be observed from the above figure,
 When TU is increasing, MU is positive.
 When TU is maximized, MU is zero.
 When TU is decreasing, MU is negative.
Law of diminishing marginal utility (LDMU)
Q.Is the utility you get from consumption of the first orange the same as
the second or the third orange?
 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.
 The law of diminishing marginal utility is based on the following
assumptions.
 The consumer is rational
 The consumer consumes identical or homogenous product.
 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.
a) the case of one commodity
 The equilibrium condition of a consumer that consumes a single
good X occurs when the marginal utility of X is equal to its
market price.
 At any point above point C (like point
A) where MUX > PX, it pays the
consumer to consume more.
 When MUX < PX (like point B), the
consumer should consume less of X.
 At point C where MUX = PX the
consumer is at equilibrium.
b) The case of two or more commodities
 For the case of two or more goods, the consumer‘s equilibrium is
achieved when the marginal utility per money spent is equal for
each good purchased and his money income available for the
purchase of the goods is exhausted. That is,

where, M is the income of the consumer.

Example: Suppose Saron has 7 Birr to be spent on two goods:
banana and bread. The unit price of banana is 1 Birr and the unit
price of a loaf of bread is 4 Birr. The total utility she obtains from
consumption of each good is given below.
 Utility is maximized when the condition of marginal utility of one
commodity divided by its market price is equal to the marginal
utility of the other commodity divided by its market price.
 In table 3.2, there are two different combinations of the two goods
where the MU of the last birr spent on each commodity is equal.
 However, only one of the two combinations is consistent with the
prices of the goods and her income.
 Saron will be at equilibrium when she consumes 3 units of banana
and 1 loaf of bread. At this equilibrium,
 The total utility that Saron derives from this combination can be
given by:
 TU= TU1 + TU2
 TU= 14 + 12
 TU= 26
 Limitation of the cardinal approach
1. The assumption of cardinal utility is doubtful because utility may
not be quantified. Utility cannot be measured absolutely
(objectively).
2. The assumption of constant MU of money is unrealistic because as
income increases, the marginal utility of money changes.
3.3.2 The ordinal utility theory
 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.
 It suffices for him to be able to rank the various baskets of goods
according to the satisfaction that each bundle gives him.
 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 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.
o The ordinal utility approach is explained with the help of
indifference curves.
o 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. Consider a consumer who consumes two
goods X and Y (table 3.3).
 In table 3.3 above, each combination of good X and Y gives the consumer
equal level of total utility. Thus, the individual is indifferent whether he
consumes combination A, B, C or D.
Indifference curve: When the indifference set/schedule is expressed
graphically, it is called an indifference curve. An indifference curve shows
different combinations of two goods which yield the same utility (level of
satisfaction) to the consumer.
A set of indifference curves is called indifference map.
Properties of indifference curves
1. Indifference curves have negative slope (downward sloping to the right).
As the quantity of one commodity is increased the quantity of the other
must be decreased.
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.
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.
4. Indifference curves never cross each other (cannot intersect). The
assumptions of consistency and transitivity will rule out the intersection of
indifference curves.
3.3.2.4 Marginal rate of substitution (MRS)
 Marginal rate of substitution is a rate at which consumers are willing to
substitute one commodity for another in such a way that the consumer
remains on the same indifference curve.
 It shows a consumer‘s willingness to substitute one good for another
while he/she is indifferent between the bundles.
 Marginal rate of substitution of X for Y is defined as the number of units
of commodity Y that must be given up in exchange for an extra unit of
commodity X so that the consumer maintains the same level of
satisfaction.
 Since one of the goods is scarified to obtain more of the other good, the
MRS is negative. Hence, usually we take the absolute value of the slope.
 From the above graph, MRSX,Y associated with the movement
from point A to B, point B to C and point C to D is 2.0,1.6, and
0.8 respectively.
 That is, for the same increase in the consumption of good X, the
amount of good Y the consumer is willing to scarify diminishes.
 This principle of marginal rate of substitution is reflected by the
convex shape of the indifference curve and is called diminishing
marginal rate of substitution.
 It is also possible to derive MRS using the concept of marginal
utility MRSxy , is related to MUx and MUy as follows:
3.3.2.5 The budget line or the price line
Q. Do you think that the indifference curve tells us whether a given
combination of goods is affordable to the consumer? If no, what are
the major constraints to the consumer in maximizing his/her total
utility?
 Indifference curves only tell us about consumer preferences for
any two goods but they cannot show which combinations of the
two goods will be bought.
 In reality, the consumer is constrained by his/her income and
prices of the two commodities.
 This constraint is often presented with the help of the budget line.
The budget line is a set of the commodity bundles that can be
purchased if the entire income is spent. It is a graph which shows the
various combinations of two goods that a consumer can purchase given
his/her limited income and the prices of the two goods.
 In order to draw a budget line facing a consumer, we consider the
following assumptions:
 There are only two goods bought in quantities, say, X and Y.
 Each consumer is confronted with market determined prices, PX and
PY.
 The consumer has a known and fixed money income (M).
o Assuming that the consumer spends all his/her income on the two
goods (X and Y), we can express the budget constraint as:
By rearranging the above equation, we can derive the following
general equation of a budget line.
Note that:
  The slope of the budget line is given is by (the ratio of
the prices of the two goods).
  Any combination of the two goods within the budget line
(such as point A) or along the budget line is attainable.
 Any combination of the two goods outside the budget line (such
as point B) is unattainable (unaffordable).
Example: A consumer has $100 to spend on two goods X and Y
with prices $3 and $5 respectively. Derive the equation of the budget
line and sketch the graph.
Solution: The equation of the budget line can be derived as follows.
 When the consumer spends all of her income on good Y, we get the
Y- intercept (0,20).
 Similarly, when the consumer spends all of her income on good X,
we obtain the X- intercept (33.3,0). Using these two points we can
sketch the graph of the budget line.
 Recall that a budget is drawn for given prices and fixed consumer‘s
income. Hence, the changes in prices or income will affect the
budget line.
Change in income: If the income of the consumer changes (keeping
the prices of the commodities unchanged), the budget line also shifts
(changes).
 Increase in income causes an upward/outward shift in the budget
line that allows the consumer to buy more goods and services and
decreases in income causes a downward/inward shift in the budget
line that leads the consumer to buy less quantity of the two goods.
 It is important to note that the slope of the budget line (the ratio of
the two prices) does not change when income rises or falls.
 Change in prices: An equal increase in the prices of the two
goods shifts the budget line inward.
• Since the two goods become expensive, the consumer can
purchase the lesser amount of the two goods.
 An equal decrease in the prices of the two goods, on the other
hand, shifts the budget line out ward.
 Since the two goods become cheaper, the consumer can purchase
the more amounts of the two goods.
 An increase or decrease in the price of one of the two goods, keeping
the price of the other good and income constant, changes the slope of
the budget line by affecting only the intercept of the commodity that
records the change in the price.
 For instance, if the price of good X decreases while both the price of
good Y and consumer‘s income remain unchanged, the horizontal
intercept moves outward and makes the budget line flatter.
 The reverse is true if the price of good X increases. On the other
hand, if the price of good Y decreases while both the price of good X
and consumer‘s income remain unchanged, the vertical intercept
moves upward and makes the budget line steeper.
 The reverse is true for an increase in the price of good Y
3.3.2.6 Equilibrium of the consumer
 The preferences of a consumer (what he/she wishes to purchase)
are indicated by the indifference curve.
 The budget line specifies different combinations of two goods (say
X and Y) the consumer can purchase with the limited income.
 Therefore, a rational consumer tries to attain the highest possible
indifference curve, given the budget line.
 This occurs at the point where the indifference curve is tangent to
the budget line so that the slope of the indifference curve ( MRSxy)
is equal to the slope of the budget line indifference curve (IC2).
 Mathematically, consumer optimum (equilibrium) is attained at
the point where: Slope of indifference curve = Slope of the
budget line
Example: A consumer consuming two commodities X and Y has
the utility function:
U(X,Y)  XY  2X. The prices of the two commodities are 4 birr
and 2 birr respectively. The consumer has a total income of 60 birr
to be spent on the two goods.
a) Find the utility maximizing quantities of good X and Y.
b) Find the MRSxy ,at equilibrium.
Solution
a) The budget constraint of the consumer is given by:
Px.X+ Py.Y = M
4X+2Y= 60 …………….…………. (i)
Moreover, at equilibrium:

Substituting equation (ii) into (i), we obtain Y 14 and X  8.

 THE END OF CHAPTER
THREE!!!

NEXT WILL BE CHAPTER FOUR

“THEORY OF
PRODUCTION AND COST”