CHAPTER THREE

THEORY OF CONSUMER BEHAVIOR

 Chapter objectives
After successful completion 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 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 the consumer is prefers X to Y, then it is natural to say that this

.
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.
• 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.
• 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 concept of utility
Economists use the term utility to describe the satisfaction or
pleasure derived from the consumption of a good or service. In
other words, utility is the power of the product to satisfy human
wants.
In defining Utility remember the following
Utility’ and ‘Usefulness’ are not synonymous
ousefulness is product centric whereas utility is consumer
centric.
Utility is subjective. The utility of a product will vary from person
to person.
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.
 Approaches of measuring utility
There are two major approaches to measure or compare consumer‘s
utility:
1. Cardinal approaches: the cardinalist school postulated that utility
can be measured objectively.
2. Ordinal approaches: according to the ordinalist school, utility is can
rank or order the utility he derives from different goods and
services.
 The difference between Ordinal and Cardinal Utility

• Ordinal Utility Cardinal Utility

• Consumption can’t be measured Consumption can be measured
• Utility is used for grading/ranking Uses utils which help in understanding
of the products depending on how much utility is derived from
the preferences of the consumer consumption of a product.
• Much less compared Comparative study
• Conceptual and practical Preceded the ordinal approach
• Convex function Concave function
• Qualitative measure Quantitative
 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.
Assumptions of cardinal utility theory
1. Rationality of consumers. The consumer has to be rational
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 marginal utility of a commodity
diminishes as the consumer acquires larger quantities of it.

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 , X 2 ,...X n
, the total utility is given by TU = f ( X1 , X 2 Xn ).
 Total Utility
• Total Utility (TU) is the total satisfaction of 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.

• However, there is a saturation point for that commodity beyond

which the consumer will not be capable of enjoying any greater
satisfaction from it.
 Marginal Utility (MU)
• 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:

MU = ∆TU / ∆Q

where, ∆ TU is the change in total utility, and

∆ Q is the change in the amount of product consumed

1. Calculate the marginal utility
2. Draw the graph of TU and MU
3. Examine the relation ship b/n TU and MU
Quantity Total utility (TU) Marginal utility (MU)

0 0
1 10
2 18
3 24
4 28
5 30
6 30
7 28
Graphical representation
 Relation ship between TU and MU

• 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.

 The Law Of Diminishing Marginal Utility
 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. In
other words, the extra satisfaction that a consumer derives declines as he/she
consumes more and more of the product in a given period of time.
Assumptions.

 The consumer is rational

 The consumer consumes identical or homogenous product. The commodity to

be consumed should have similar quality, color, design, etc.

 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.
MU X = PX
Proof
Given the utility function
U=f(X)
 If the consumer buys commodity X, then his expenditure will be . The consumer
maximizes the difference between his utility and expenditure.
Max(U = QX PX )
 The necessary condition for maximization is equating the derivative of a function to zero.
Thus,
dU __ d (QX PX ) = 0
dQX dQX
dU - PX = 0 OR MU X - PX = 0
PX
MU X = PX
 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,

PX.X+ PY.Y = M

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.
 Income = 7 Birr, Price of banana = 1 Birr, Price of bread = 4 Birr

Banana Bread

Q TU MU MU/P Q TU MU MU/P

0 0 - - 0 0 - -

1 6 6 6 1 12 12 3

2 11 5 5 2 20 8 2

3 14 3 3 3 26 6 1.5

4 16 2 2 4 29 3 0.75

5 16 0 0 5 31 2 0.5

6 14 -2 -2 6 32 1 0.25
 The case of two or more commodities
• 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.
MU1=MU2 (Equilibrium) but MU1 > MU2 (spend more on good 1 than 2)
P1 P2 P1 P2

So, Saron will be at equilibrium when she consumes 3 units of banana and 1 loaf of
bread. At this equilibrium,
1. MUbanana=MUbread = 3/1=12/4 =3
Pbanana Pbread
2. PX.X+ PY.Y = M= 1*3+4*1=7birr
3. 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.
 The ordinal utility theory
• In the ordinal utility approach,
• it is not possible for consumers to express the utility of various commodities
they consume in absolute terms, like 1 util, 2 utils, or 3 utils but it is possible
to express the utility in relative terms.
• 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.
 Indifference curve
• The ordinal utility approach is explained with the help of indifference
curves. 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. It shows the various combinations of
goods from which the consumer derives the same level of satisfaction.

• 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.
 Indifference set/ schedule

Bundle (Combination) A B C D
Orange 1 2 4 7
Banana 10 6 3 1

In table 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
Food

15

5
Clothes
 Indifference map
Food
What about point E?
E has more clothes than
C, but C has more food
than E, how can we tell
B whether E is preferred
A to C?
15

E
D

5
Clothes
 Properties of indifference curves
1. Indifference curves have negative slope (downward sloping to the right).
Indifference curves are negatively sloped because the consumption level of one
commodity can be increased only by reducing the consumption level of the other
commodity.

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.
 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.
 The Marginal Rate of Substitution

Quantity
of Cola
The marginal rate of substitution between cola
and pizza is the rate at which the consumer is
14
willing to give up cola to get more pizza

MRS = 6

A
8
1

4 B
MRS = 1
3
1
Indifference
curve

0 2 3 6 7 Quantity
of Pizza
Copyright©2004 South-Western
Marginal Rate of Substitution Mathematically

Dy dy MUx
MRSx, y = - = =
Dx dx MUy
Memorize/
Derive the formula:
U ( x, y) - Totally Differentiate derive
¶U ¶U
dU = dx + dy
dx dy
Along the indifference curve dU is zero so,
¶U ¶U
0= dx + dy - rearrange
dx dy
dy ¶U ¶U MUx
- = / =
dx dx dy MUy

29
 The budget line or the price 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.
o There are only two goods bought in quantities, say, X and Y.
o Each consumer is confronted with market determined prices, PX and PY.
o The consumer has a known and fixed money income (M).
• Assuming that the consumer spends all his/her income on the two goods (X and Y),
we can express the budget constraint as:
PX.X+ PY.Y = M
By rearranging the above equation, we can derive the following general
equation of a budget line.
M-PX.X = PY.Y Y= M/Py-PX.X/Py
 Figure : The Budget line
Number of With $150 per month, Max can afford 15
Movies per movies and no concerts, . . .
Month
15 12 movies and 1 concert or any other
A combination on the budget line.
12 B
Points below the line are
9 C also affordable.
H
6 D points above the line
G are also unaffordable.
3 E
F
1 2 3 4 5 Number of
Concerts
per Month
Lieberman & Hall; Introduction to Economics, 2005 31
 The budget line
• 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
PX. X + PY .Y =M
3X+5Y= 100
5Y=100-3X
Y= 100/5 - 3/5X
Y= 20- 3/5X
Y= 20- 3/5(0)
Y= 20
0=20-3/5X=20=3/5X
20*5/3=3/5X*5/3
100/3=X, X=33.3
 Change in income

o If the income of the consumer changes (keeping the prices of the

commodities unchanged), the budget line also shifts (changes).

o 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.

o 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 income
g
 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, one 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.
 Change in prices:
g
 Change in prices:
• 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.
 Changes in the Budget Line
(b)
Number of Movies
per Month
30 2.A decrease in the price of movies
rotates the budget line upward.

15

5 15 Number of
Concerts per
Month 38
 Changes in the Budget Line

(c)
Number of Movies
per Month 3.while a decrease in the price of
30
concerts rotates it rightward.

15

5 15 Number of
Concerts per
Month 39
 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 (
MRS XY ) is equal to the slope of the budget line (PX / PY ). In the next figure
the equilibrium of the consumer is at point ‗o‘ where the budget line is tangent
to the highest attainable indifference curve (IC2).
Food (g)
Optimal choice

40

A C

20
Clothes (unit)
 Optimal choice
• Mathematically, consumer optimum (equilibrium) is attained at
the point where:
• Slope of indifference curve = Slope of the budget line
MRS XY = PX /PY
MU X /MUY = PX /PY
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 MRSX ,Y at equilibrium.
 Optimal choice
Solution
a) The budget constraint of the consumer is given by: PX.X+ PY.Y = M
4X+2Y= 60 ................................................................................... (i)
Moreover, at equilibrium
MU X / MUY = PX/ PY
Y+2= 4
X 2
Y+2 =2
X
Y = 2X - 2 ............................................................................. (ii)
Substituting equation (ii) into (i), we obtain Y = 14 and X = 8.
b) MRS xy = MU X / MUY = Y + 2 = 14+2 = 2
X 8
• (At the equilibrium, MRS can also be calculated as the ratio of the prices of the two goods)
Thank you!