The Theory of

Consumer
Behavior

1
 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).

2
 UTILITY

• Utility - amount of satisfaction derived from the

consumption of a commodity
• It is the power or capacity of a commodity to satisfy
human wants.
• measurement units ⇒ utils
• Useful for understanding the demand side of the
market.

3
 Utility Concepts:
◦ The Cardinal Utility Theory (Utility analysis
approach)
 Utility is measurable in a cardinal sense
 Cardinal utility - assumes that we can assign
values for utility, E.g., derive 100 utils from
eating a slice of pizza
◦ The Ordinal Utility Theory (Indifference curve
approach)
 Utility is not measurable in an ordinal sense
 Ordinal utility approach - does not assign values,
instead works with the order of preference of
consumers for the goods.
 It indicates consumers preference or choice for
one commodity over another.
4
 The Cardinal Approach
 Total utility (TU) –
 The overall level of satisfaction derived from consuming a good or service. It
may be defined as the sum of the utility derived from each unit consumed of the
commodity.
 If consumer consumes four units of a commodity derives U1, U2, U3, U4 utils
from the successive units consumed, then
TU = U1 + U2 + U3 + U4
 Marginal utility (MU) -
 Additional satisfaction that an individual derives from consuming an additional
unit of a good or service.
 It is the addition to TU derived from the consumption of additional unity of a
commodity.
 Formula :
MU = Change in total utility
Change in quantity
= ∆ TU
∆Q

5
The Cardinal Approach
Law of Diminishing Marginal Utility  =  As
more and more units of a commodity are
consumed, marginal utility derived from each
successive unit goes on falling.
Assumptions of the law-
1.The units of the goods must be standard e.g. a cup
of tea or a bottle of coke, not sip of tea and coke.
2.Consumers taste and preference remains
unchanged.
3.There must be continuity in consumption.
4.The mental condition of consumers remains
normal during consumption.

6
 Example
Number
Total Utility Marginal Utility
Purchased

0 0 0

1 4 4

2 7 3

3 8 1

4 8 0

5 7 -1

7
 Continue….
When TU is rising,
MU is falling but it is
greater than zero
(+ve).
When TU is
maximum, MU is
zero.
And when TU starts
declining, MU
becomes negative.

8
 Consumer Equilibrium:
Cardinal utility approach
definition
It means a situation under which consumer spends his
given income on purchase of a commodity in such a
way that gives him maximum utility (satisfaction) and
he feels no urge to change.
It is a position of rest because he does not want
consume less or more than that.
A consumer attains his equilibrium when he
maximizes his TU given his income, consumption
expenditure and price of the commodity he consumes.

9
 Assumptions
• Rationality- He satisfies his wants in the order of 
their utility.
• Limited money income
• Maximization of satisfaction
• Diminishing MU
• Constant MU of money  explanation  from book

• Favourite 
10
Consumer Equilibrium: A
single commodity case
• Consumer equilibrium in purchase of a single good is
attained when:
MU in terms of money = price of the commodity
i.e., MU of a product / MU of a rupee = price of a
product.
• A consumer while purchasing a good will compare its
price (cost) with is expected utility(benefits).
• He will buy the good if the benefit derived in form of
utility is greater than or at least equal to its price.
• It is difficult to compare MU of good (utils) with its
price (Rs.), therefore MU of good is converted in
terms of money by dividing MU of good by MU of
rupee.DIAGRAM WITH EXPLANATION FROM
BOOK.
11
 Continue..
• MU of one rupee is defined as the additional utility
when an additional rupee is spent on purchase of
commodity. Example : Let MU of a Rupee is 2 utils.
• Consumer will consume 4 units of oranges to attain
equilibrium.
Units of MU of MU in terms Price of
orange orange of money orange
consumed (utils)
1 10 10/2=5 1
2 8 4 1
3 5 2.5 1
4 2 1 1
5 1 0.5 1
6 0 0 1
12
 Consumer Equilibrium: In
case of two commodities
• A rational consumer consumes commodities in
the order of their utilities.
• He picks up the commodity which yield the
highest utility and next the one which yields
second highest utility and so on…
• He switches his expenditure from one commodity
to another in accordance with their MU.
• He continues to switch till MU of each
commodity per unit of money expenditure is the
same. This is called the law of equi-MU.

13
 Example
• Suppose consumer has Rs. 5 income to be
spent on two goods, each costing Re.1 per
unit. How he will attain equilibrium.
Rupees spent MU of oranges MU of apples (utils)
(utils)
1 10 (1) 9 (2)
2 8 (3) 6 (4)
3 6(5) 4
4 4 2
5 2 1

• So he will consume 3 units of oranges and 2 
units of apples to get maximum satisfaction. 

14
 The Law of Equi-MU
• Let us suppose that a consumer consumes
only two commodities X and Y, their
prices given as Px and Py respectively.
Following the equilibrium rule of single
commodity case, the consumer distributes
his income between commodities X and Y
such that
•                                                                              
       
15
 Continue..
• Alternatively consumer is in equilibrium,

16
 Continue…

Since MU of money is constant

Hence a utility maximizing consumer consumes till MU 
of each commodity per unit of money expenditure is 
the same. 
17
 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,  is  a 
function  of  the  quantities  of  X  and  Y 
consumed by a consumer.   U = f ( X, Y )
•only reflects an order
•but the difference between the numbers
assigned is meaningless

18
Assumptions Underlying Ordinal
Approach
• Rationality: The consumer is assumed to be
rational. He aims at maximizing his benefits
from consumption, given income and prices.
• Ordinality: The consumer is capable of
ranking all conceivable combinations of
goods according to the satisfaction they
yield. Thus if he is given various
combinations say A, B, C, D, E he can rank
them as first preference, second preference
and soon.
• Diminishing marginal rate of substitution: 19
• Consistency: It means if good X is
preferred over good Y inn one time, then
consumer will not prefer Y over X in
another time period.
• Transitivity of choice: If the consumer
prefers combination A to B, and B to C,
then he must prefer combination A to C. In
other words, his choices are characterised
by the property of transitivity.
• Non-satiation: If combination A has more
commodities than combination B, then A
must be preferred to B.
20
 INDIFFERENCE CURVE
(IC)
• An indifference curve is the set of all
combinations of commodities X and Y that
yield the same level of total utility or
satisfaction.
• It is a curve representing different baskets
of goods giving the same utility to an
individual.

21
INDIFFERENCE CURVE
(IC)

22
 INDIFFERENCE MAP
• Indifference Map: A set of indifference
curves is called indifference map.
• An indifference map depicts complete picture
of consumer's tastes and preferences.
• In an figure indifference map of a consumer is
shown which consists of three indifference
curves.

23
 INDIFFERENCE MAP
Good Y

U=30
U=20
U=10

0
Good X
24
 PROPERTIES OF INDIFFERENCE
CURVE
(i) Indifference curves slope downward to the
right: This property implies that when the amount
of one good in combination is increased, the amount
of the other good is reduced. This is essential if the
level of satisfaction is to remain the same on an
indifference curve.
(ii) Indifference curves are always convex to the
origin: It has been observed that as more and more
of one commodity (X) is substituted for another (Y),
the consumer is willing to part with less and less of
the commodity being substituted (i.e. Y). This is
called diminishing marginal rate of substitution.
25
 PROPERTIES OF
INDIFFERENCE CURVE
• (iii) Indifference curves can never intersect
each other:

B
C
A

26
 PROPERTIES OF
INDIFFERENCE CURVE
• (iv) A higher indifference curve represents a
higher level of satisfaction than the lower
indifference curve: This is because
combinations lying on a higher indifference
curve contain mere of either one or both
goods and more goods are preferred to less of
them.

27
 Marginal Rate of Substitution
Def.: the marginal rate of substitution, X for Y, (written
MRSXY) indicates the number of units of Y that must be given
up to acquire one additional unit of X while satisfying the
condition of constant total utility.
∆ Y MU X
MRS ≡ − =
∆ X MUY
MRSXY is defined as the slope of the indifference curve at a
certain point.

When the MRSXY diminishes along the indifference curve, the

indifference curve is convex.

28
 BUDGET LINE
A higher indifference curve shows a higher level of
satisfaction than a lower one.
Therefore, a consumer in his attempt to maximise
satisfaction will try to reach the highest possible
indifference curve.
But in his pursuit of buying more and more goods
and thus obtaining more and more satisfaction he
has to work under two constraints : firstly, he has to
pay the prices for the goods and, secondly, he has a
limited money income with which to purchase the
goods.
29
 BUDGET LINE
• These constraints are explained by
budget line or price line.
• In simple words a budget line shows all
those combinations of two goods which
the consumer can buy spending his given
money income on the two goods at their
given prices.
• All those combinations which are within
the reach of the consumer (assuming that
he spends all his money income) will lie
on the budget line.
30
 BUDGET LINE
Line showing
all combinations
of items can be
purchased for a
particular level of
income (M) ;
M =PxQx + PyQy
Slope of budget line
is Px / Py.

31
FACTORS SHIFT THE  BUDGET LINE

• Changes in prices of goods X

Y

Px Px X

32
EFFECTS OF PRICE CHANGES ON
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)
33
FACTORS SHIFT THE  BUDGET LINE

• Changes in the price of goods Y

Y
Py

Py
X

34
 FACTORS SHIFT THE BUDGET
LINE

Changes in income
Y

 X

35
EFFECTS OF INCOME CHANGES ON
THE BUDGET LINE
• 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.

36
 CONSUMER
EQUILIBRIUM
• A consumer is in equilibrium when he is
deriving maximum possible satisfaction from
the goods and is in no position to rearrange his
purchases of goods. We assume that :
• (i)the consumer has a given indifference map
which shows his scale of preferences for
various combinations of two goods X and Y.
• (ii)he has a fixed money income which he has
to spend wholly on goods X and Y.
• (iii)prices of goods X and Y are given and are
fixed for him.

37
 CONSUMER
EQUILIBRIUM
• To show which combination of two goods X and Y
the consumer will buy to be in equilibrium we bring
his indifference map and budget line together.
• the indifference map depicts the consumer’s
preference scale between various combinations of
two goods and the budget line shows various
combinations which he can afford to buy with his
given money income and prices of the two goods.

38
 CONSUMER
EQUILIBRIUM

39
 CONSUMER
EQUILIBRIUM
• IC1, IC2, IC3, IC4 and IC5 are shown together with
budget line PL for good X and good Y. Every
combination on budget line PL costs the same. Thus
combinations R, S, Q, T and H cost the same to the
consumer.
• The consumer’s aim is to maximize his satisfaction and
for this he will try to reach highest indifference curve.
• But since there is a budget constraint he will be forced
to remain on the given budget line, that is he will have
to choose any combinations from among only those
which lie on the given price line.
• Which combination will he choose?

40
 CONSUMER
EQUILIBRIUM
At the tangency point Q, the slopes of the price line PL and
indifference curve IC3 are equal. The slope of the
indifference curve shows the marginal rate of substitution of
X for Y (MRSxy) which is equal to MUy / MUx while the
slope of the price line indicates the ratio between the prices
of two goods i.e., Px / Py
At equilibrium point Q,
MRSxy = MUx / MUy = Px / Py
Thus, we can say that the consumer is in equilibrium
position when price line is tangent to the indifference curve
or when the marginal rate of substitution of goods X and Y
is equal to the ratio between the prices of the two goods.

41
Exceptions to the convex shape
of indifference curve

• (1) X and Y are perfect substitutes:

The two goods are perfect substitutes when the
marginal rate of substitution of one good for
another is a constant. The indifference curves
are straight lines.
• (2) X and Y are perfect
complements: The two goods are
perfect complements when the marginal
rate of substitution of one good for
another is infinite. The indifference curves are
shaped as right angles.
42
Continue…..

43
An Income-Consumption Curve
For Normal Good

44
Explanation and meaning from book
Cont…

45
 An Income-Consumption Curve
Income-consumption curve (ICC): for a
good X is the set of optimal bundles traced on
an indifference map as income varies
(holding the prices of X and Y constant).
Engel curve: curve that plots the
relationship between the quantity of X
consumed and income.

46
Cont….

47
 THE IMPACT OF A PRICE
CHANGE
• Economists often separate the impact of a
price change into two components:
– the substitution effect; and
– the income effect.
• The substitution effect involves the
substitution of good x1 for good x2 or vice-versa
due to a change in relative prices of the two
goods.

48
 Cont…
• The income effect results from an increase or
decrease in the consumer’s real income or
purchasing power as a result of the price
change.
• The sum of these two effects is called the price
effect.
• The decomposition of the price effect into the
income and substitution effect can be done in
several ways: The Hicksian method.

49
 Y (units) The Price Consumption
Curve
The price consumption curve for good x plots
all the utility maximization points as the price of
x changes. This reveals an individual’s demand
curve for good x.

10
Price consumption curve
•
• •
PX = 1

PX = 4 PX = 2
0 XA=2 XB=10 XC=16 20 X (units)
50
 Individual Demand
PX
Curve for X
The points found on the price consumption
curve produce the typically downward-sloping
demand curve we are familiar with.

PX = 4 •
PX = 2 • U increasing
PX = 1 •
X
XA=2 XB=10 XC=16
51
 THE HICKSIAN METHOD
• Sir John R.Hicks (1904-1989)
• Awarded the Nobel Laureate in Economics
(with Kenneth J. Arrrow) in 1972 for work
on general equilibrium theory and welfare
economics.

52
 THE HICKSIAN METHOD
X2 Optimal bundle is Ea, on
indifference curve I1.

Ea

I1
xa
X1

53
 THE HICKSIAN METHOD
A fall in the price of X1
X2
The budget line pivots out
P * from P

Ea

I1
xa
X1

54
 THE HICKSIAN METHOD
The new optimum is Eb on
X2 I2 .
The Total Price Effect is xa
to xb

Eb
Ea I2

I1
xa xb
X1

55
 THE HICKSIAN METHOD
• To isolate the substitution effect we ask….
“what would the consumer’s optimal bundle be if
s/he faced the new lower price for X1 but
experienced no change in real income?”
• This amounts to returning the consumer to the
original indifference curve (I1)

56
 THE HICKSIAN METHOD
The new optimum is Eb on
X2 I2 .
The Total Price Effect is xa
to xb

Eb
Ea I2

I1
xa xb
X1

57
 THE HICKSIAN METHOD
Draw a line parallel to the new
X2 budget line and tangent to the old
indifference curve

Eb
Ea I2

I1
xa xb
X1

58
 THE HICKSIAN METHOD
The new optimum on I1 is at Ec.
X2 The movement from Ea to Ec (the
increase in quantity demanded from
Xa to Xc) is solely in response to a
change in relative prices

Eb
Ea I2
Ec I1

xa xc xb
X1

59
 THE HICKSIAN METHOD
This is the substitution
X2 effect.

Eb
Ea I2
Ec
I1

X1
Xa Substitution Xc
Effect 60
 THE HICKSIAN METHOD
• To isolate the income effect …
• Look at the remainder of the total price effect
• This is due to a change in real income.

61
 THE HICKSIAN METHOD
The remainder of the total effect is
X2 due to a change in real income. The
increase in real income is
evidenced by the movement from I1
to I2

Eb
Ea I2
Ec
I1

X1
Xc Income Effect
Xb 62
 THE HICKSIAN METHOD

Final diagram....
X2

Eb
Ea I2
Ec
I1
xa xc xb
X1
Sub Income
Effect Effect
63
64
65
66
• The individual’s demand curve can be seen as the
individual’s willingness to pay curve.

• On the other hand, the individual must only actually pay the
market price for (all) the units consumed.

• For example, you may be willing to pay $40 for a haircut,

but upon arriving at the stylist, discover that the price is only
$30

• The difference between willingness to pay and the amount

you pay is the Consumer Surplus
67
Definition: The net economic benefit to the
consumer due to a purchase (i.e. the willingness to
pay of the consumer net of the actual expenditure on
the good) is called consumer surplus.

The area under an ordinary demand curve and above

the market price provides a measure of consumer
surplus.

Note that a consumer will receive more surplus from

the first good than from the last good.
68
 Consumer Surplus
Consumer Surplus: The difference
Price
between what a consumer is willing to
pay and what they pay for each item
Consumer
Surplus
Equilibrium
P* Or market
Price

Q* Quantity 69
Efficiency of the Equilibrium Quantity
Price Consumer Surplus = area of triangle
$16 =1/2bh
=1/2(16-8)(10)
=40
Consumer
Surplus This calculation
$8 Only works for
A linear demand
curve

10 Quantity 70
71