The Theory of Consumer Behavior

Faculty Member
 Outline
• The basic of Choice: Utility
• Cardinal Approach and Ordinal Approach
• Total Utility and Marginal Utility
• Law of Diminishing Marginal Utility
• Ordinal Approach
• Definition of indifference curve
• Budget line/Budget Constraint
• Budget Equation
• Preferences & Indifference Curve
• Indifference Map
• Property of Indifference Curve
• Marginal Rate of Substitution
 The basic of Choice: Utility
Definition: Utility can be defined as the satisfaction that a consumer
receives by consuming a particular good or service.
“The property of a good that enables it to satisfy human wants is
called utility or ability of a good to satisfy a want”.
(Slavatore,2008)
Examples:
We receive some satisfaction if we eat McDonalds Burger or if we
drink a glass of water. Utility is a subjective concept.
Basic Assumption: Consumers are utility maximizers
 Cardinal & Ordinal Approaches
There are two approaches of measuring utility

Cardinal Approach
Cardinal utility means that an individual can attach specific values or
numerical value (numbers of utils) from consuming each quantity of a
good or basket of goods. The distance between two levels of utility is
known.

e.g. Hussain receives 20 utils from having a burger but 10 utils from having
a hotdog.
 Cardinal & Ordinal Approaches
Ordinal Approach
Utility represented by a rank, received from consuming various
amounts of a good or baskets of goods. and distance between ranks
is un-know.
e.g. Ali prefers a glass of Pepsi to a cup of tea and a cup of tea to a
glass of water

Ordinal utility only ranks various consumption bundles, whereas

cardinal utility provides an actual index or measure of satisfaction.

Slavatore,2008
 Total Utility & Marginal Utility
Total Utility: Total satisfaction a consumer receives by consuming
all the units of a particular good or service or a combination of goods
over a given consumption period.

Marginal utility is the additional satisfaction or extra utility

received from consuming one more unit of a good or change in total
utility if a consumer changes the consumption by an additional unit.

Marginal utility is the utility which a consumer can obtain from the last
unit of a good she or he consumes (during a given consumption period).
 Total Utility & Marginal Utility
Marginal Utility
Total Utility 50
80
40
70
60 30
50 20
40
10
30
20 0
10 0 1 2 3 4 5 6
-10
0
0 1 2 3 4 5 6 Marginal Utility --

Total Utility
 Law of Diminishing Marginal Utility
The law of diminishing marginal utility states that over a given
consumption period, as a consumer consumes more and more units
of specific good, the less satisfaction (utility) generated by consuming
each additional unit of the same good or beyond a certain point, the
marginal utility of additional units begins to fall.

If we keep on consuming a particular good or service, holding other

things constant, the marginal utility associated with each additional
unit diminishes per time period.
 Law of Diminishing Marginal Utility

Bottles of water consumed

Total Utility Marginal Utility
(250ml)
0 0 --
1 40 40
2 60 20
3 70 10
4 75 5
5 73 -2
 Introducing the Budget Constraint

• Budget constraints represent the plausible combinations of products and services a buyer can
purchase with the available capital on hand.

• The concept of budget constraints in the field of economics revolves around the idea that a given
consumer is limited in consumption relative to the amount of capital they possess.

• As a result, consumers analyze the optimal way in which to leverage their purchasing power to
maximize their utility and minimize opportunity costs.

• This is achieved through using budget constraints, which represent the plausible combinations of
products and/or services a buyer is capable of purchasing with their capital on hand.
• Trade-offs: To expand upon this definition further, the business concept of opportunity cost via trade -offs is a central
building block in understanding budget constraints. An opportunity cost is defined as the foregone value of the next best
alternative in a given action. To apply this to a real-life situation, pretend you have $100 to spend on food for the month.
You have a wide variety of options, but some will provide you with higher opportunity costs than others. You could
purchase enough bread, rice, milk and eggs to feed yourself for the full month or you could buy premium cut steak and
store-prepared dinners by the pound (which would last about one week). The opportunity cost of the former is the high
quality foods which have the convenience factor of already being prepared for you while the opportunity cost of the latter
is having enough food to feed yourself for the entire month. In this circumstance the decision is easy, and the trade off
will be sacrificing convenience and high quality food for the ability to have enough food on the table over the course of
the whole month.

Understanding these trade-offs underlines the true function of budget constraints in economics, which is identifying which
consumer behaviors will maximize utility. Consumers are inherently equipped with an infinite demand and a finite pool of
resources, and therefore must make budgetary decisions based on their preferences. The way economists demonstrate this
arithmetically and visually is through generating budget curves and indifference curves.
 Definition of indifference curve
An indifference curve is a line that shows different combinations of two goods
among which a consumer is indifferent and from which the consumer draws
the same amount of utility.

An indifference curve shows combinations of two goods or services which

give the same level of satisfaction or utility to the consumer.

An indifference curve is a line that shows different combination of goods X

and Y, all of which yields the same total utility.

The indifference curve far from the origin, the greater the level of utility of
the consumer gain.
Definition of indifference curve
 Indifference Schedule

All combinations give him equal satisfaction or happiness. consumers have

taken only one combination, but any number of schedules can be taken for the
two commodities. They may represent higher or lower satisfaction or
pleasure of the consumer
 Budget Line

A budget line is a line that shows various combinations of two goods

which the consumer can purchase at given market prices within a
certain level of income.

The Budget Line, is called as Budget Constraint shows all the

combinations of two commodities that a consumer can afford at given
market prices and within the particular income level.
 Equation of Budget Line

The concept of the budget equation is precisely explained through the

following equation:

Where, Px is the price of goods X;

Qx is the quantity of goods X;
Py is the price of goods Y;
Qy is the quantity of goods Y;
M is the income of the consumer.
 Budget schedule
Income $30
Combination Soda Movie Budget allocation
@ $3/pack @6/movie
a 10 0 10*3 + 0*6= 30
b 8 1 8*3 + 1*6= 30
c 6 2 6*3 + 2*6= 30
d 4 3 4*3 + 3*6= 30
e 2 4 2*3 + 4*6= 30
f 0 5 0*3 + 5*6= 30
The above Budget schedule or table can be plotted on a graph to
obtain the appropriate budget line.
 Budget Line
Consumer’s budget line.
The budget line is a constraint on

Soda (packs per month)

consumer’s choices.
Income $30
This is the budget constraint when
a Movies $6 each
income equals $30 dollars per month,
10 Soda $3/pack
the price of Soda is $3/pack, and the b
price of a movies is $6 each.
8
Consumer can afford any point on the c Unaffordable
budget line or inside it. 6
d
Consumer cannot afford any point
4
outside his budget line. e
Affordable
Point inside does not exhaust the 2
entire income available
f
0 1 2 3 4 5 6 7 8
Movies (per month)
 Preferences and Indifference Curves
At point C, consumer consumes 2

Soda (Packs per month)

movies and six packs soda per
month.
Consumer can sort all possible
combinations of goods into three 10
groups: preferred, not preferred,
and indifferent. 8
An indifference curve joins all those C
points that consumer says are just 6
as good as C. 4
G
G is such a point consumer is 2
indifferent between C and G.

0 2 4 6 8
Movies (per month)
 Preferences and Indifference Curves
All the points above the
indifference curve are preferred
to the points on the curve.

Soda (Packs per month)

10
And all the points on the
indifference curve are preferred 8
to the points below the curve. C Preferred
6
Indifferent between C and G.
4
G
2 Not
preferred

0 2 4 6 8
Movies (per month)
 Indifference Map

Soda (Packs per month)

An indifference map is a 10
series of indifference
8
curves.
C
I0 is an indifference curve 6
below I1.
4
Consumer prefers any G

point on I1 to any point on I0 . 2

I0 I1

0 2 4 6 8
Movies (per month)
 Indifference Map

Soda (Packs per month)

I2 is an indifference curve
10
above I1.
8
Consumer prefers any point
on I2 to any point on I1 . C
6 J

For example, Ali prefers point 4

J to either point C or point G. G
I2
2
I0 I1

0 2 4 6 8
Movies (per month)
 Properties of Indifference curves
• Indifference curves for two “goods” are generally negatively sloped

• The slope of an indifference curve reflects the degree of substitutability of

two goods for one another

• Indifference curves are generally convex, reflecting the principle of

diminishing returns

• Indifference curves never cross

• Indifference curves that are farther from the origin represent higher
levels of utility
 Marginal Rate of Substitution

• The marginal rate of substitution, (MRS) is the rate at which a

person is willing to give up good y, (the good measured on the
y-axis) to get an additional unit of good x (the good measured
on the x-axis) and at the same time remain indifferent (remain
on the same indifference curve).

• The magnitude of the slope of the indifference curve measures

the marginal rate of substitution.
 Marginal Rate of Substitution

▪ If the indifference curve is relatively steep, the MRS is high.

In this case, the person is willing to give up a large quantity of
y to get a bit more x.

▪ If the indifference curve is relatively flat, the MRS is low. In

this case, the person is willing to give up a small quantity of y
to get more x.
 Diminishing Marginal Rate of Substitution

▪ A diminishing marginal rate of substitution is the key assumption

of consumer theory.

▪ A diminishing marginal rate of substitution is a general

tendency for a person to be willing to give up less of good y to get
one more unit of good x, and at the same time remain indifferent,
as the quantity of good x increases.
 Diminishing Marginal Rate of Substitution

Soda (Packs per month)

Figure shows the diminishing
MRS of movies for soda.
At point C, consumer is willing
to give up 2 packs to see one
10
more movie- his MRS is 2.
8 MRS = 2
At point G, Ali is willing to give
6 C
up 1/2 packs to see one more
movie- his MRS is 1/2 4 MRS = 1/2
2
G
I1

0 2 4 6 8
Movies (per month)
Reference:
Dominick Salvatore, (2008), Microeconomics: Theory and
Application, 5th Edition, Internal Version, Oxford University
Press.