Theory of Consumer

Preference
BBA(H)-Managerial-Economics
Semester-3
 Introduction
• Economists use the theory of consumer choice to analyze consumers’
decisions and to derive demand curves.
• To answer questions about individual consumer choice (or any kind of
individual decision making) we need a model of individual behavior.
• The standard economic model of consumer behavior is based on the
following premises or assumptions.
• Individual tastes or preferences determine the pleasure or satisfaction
people derive from the goods and services they consume.
• Consumers face constraints or limits on their choices, particularly because
their budgets limit how much they can buy.
• Consumers seek to maximize the level of satisfaction they obtain from
consumption, subject to the constraints they face. People seek to “do the
best they can with what they have.
• Consumers spend their money on the bundles of products that give
them the most pleasure or satisfaction.
• Someone who likes music and does not have much of a sweet tooth
might spend a lot of money on concerts and relatively little on sweet
desserts.
• By contrast, a consumer who loves chocolate and has little interest in
music might spend a significant amount on gourmet chocolate and
never go to a concert
• Consumers must make choices about which goods to buy.
• Limits on the amount they can spend (called “budget constraints”)
prevent them from buying everything that catches their fancy. Other
constraints such as legal restrictions on items such as alcohol and
recreational drugs may also restrain their choices.
• Therefore, consumers buy the bundles of goods they like best subject
to their budget constraints and subject to legal or other relevant
constraints
• If Jason gets pleasure from smoking, an economist does not confuse
the economic analysis of Jason’s choices by interjecting his or her
own personal judgment that smoking is undesirable.
• Economists accept the consumer’s tastes and seek to predict the
resulting behavior.
• Accepting each consumer’s tastes is not the same as condoning the
resulting behaviors.
• An economist might reasonably believe that smoking should be
avoided. However, if the economist wants to know whether Jason will
smoke more next year if the price of cigarettes decreases by 10%
Consumer Preferences
• Consumer Preferences: We use three properties of preferences to
predict which combinations or bundles of goods an individual
prefers to other combinations.

• Utility: We summarize a consumer’s preferences using a utility

function, which assigns to each possible bundle of goods a numerical
value, utility, that reflects the consumer’s relative ranking of these
bundles.
• The Budget Constraint: Prices and consumers’ limited budgets
constrain how much they can buy and determine the rate at which a
consumer can substitute one good for another.
• Constrained Consumer Choice: Consumers maximize their utility
from consuming various possible bundles of goods given their
available budgets.
• Deriving Demand Curves: We use consumer theory to derive demand
curves and show how a change in price causes a movement along a
demand curve.
• Behavioral Economics: Experiments indicate that people sometimes
deviate from rational, maximizing behavior.
• A consumer faces choices involving many goods.
• Would ice cream or cake make a better dessert? Is it better to rent a large
apartment or rent a single room and use the savings to pay for trips and
concerts?
• In short, a consumer must allocate his or her available budget to buy a
bundle (also called a market basket or combination) of goods. How do
consumers choose the bundles of goods they buy?
• One possibility is that consumers behave randomly and blindly choose one
good or another without any thought. However, consumers appear to
make systematic choices.
• For example, most consumers buy very similar items each time they visit a
grocery store. A consumer typically ignores most items and buys a few
particular items repeatedly.
• A consumer who likes apple juice and dislikes orange juice repeatedly buys
apple juice and rarely if ever buys orange juice.
• In contrast, a consumer who chose randomly would be as likely to buy
apple juice as orange juice.
• By observing a consumer’s consistent purchase of apple juice rather than
orange juice, we can reject the hypothesis of random choices.
• To explain consumer behavior, economists assume that consumers have a
set of tastes or preferences that they use to guide them in choosing
between goods.
• These tastes differ substantially among individuals. Let’s start by specifying
the underlying assumptions in the economist’s model of consumer
behavior.
Properties of Consumer Preference
• Completeness. The completeness property holds that, when facing a
choice between any two bundles of goods, a consumer can rank them
so that one and only one of the following three relationships is true.
• The consumer prefers the first bundle to the second.
• The consumer prefers the second bundle to the first
• The consumer likes the two bundles equally and therefore is
indifferent between the two bundles.
• This property rules out the possibility that the consumer cannot
decide on his or her preferences. Indifference is allowed, but
indecision is not
Properties of Consumer Preference
• Transitivity. We assume that preferences are transitive.
• More specifically, we say that if a consumer weakly prefers Bundle a
to Bundle b—likes a at least as much as b— and weakly prefers
Bundle b to Bundle c, the consumer also weakly prefers Bundle a to
Bundle c.
• Transitivity of weak preference implies that indifference is also
transitive: If a consumer is indifferent between Bundle a and Bundle
b, and is indifferent between Bundle b and Bundle c, then the
consumer must also be indifferent between Bundle a and Bundle c.
• Strict preference must also be transitive:
• If a is strictly preferred to b and b is strictly preferred to c, it follows
that a must be strictly preferred to c.
• Also, if a is preferred to b and the consumer is indifferent between b
and c, then the consumer must also prefer a to c.
• More Is Better. The more-is-better property holds that, all else being
the same, more of a good is better than less.
• This property is really just a statement of what we mean by a good: a
commodity for which more is preferred to less, at least at some levels
of consumption.
• In contrast, a bad is something for which less is preferred to more,
as with pollution
Preference Map
• Surprisingly, with just these three properties, we can say a lot about
consumer preferences.
• One of the simplest ways to summarize information about a
consumer’s preferences is to create a graphical
interpretation—sometimes called a preference map.
• For graphical simplicity, we concentrate on choices between only two
goods, but the model can be generalized algebraically to handle any
number of goods.
• Each semester, Lisa, who lives for fast food, decides how many pizzas and
burritos to eat.
• The various bundles of pizzas and burritos she might consume are shown in
panel a of Figure 1, with (individual-size) pizzas per semester on the
horizontal axis and burritos per semester on the vertical axis.
• At Bundle e, for example, Lisa consumes 25 pizzas and 15 burritos per
semester. By the more-is-better property, Lisa prefers all the bundles that
lie above and to the right (area A) to Bundle e because they contain at least
as much or more of both pizzas and burritos as Bundle e.
• Thus, she prefers Bundle f (30 pizzas and 20 burritos) in that region
• By using the more-is-better property, we know that Lisa prefers e to all the
bundles that lie in area B, below and to the left of e, such as Bundle d (15 pizzas
and 10 burritos).
• All the bundles in area B contain fewer pizzas or fewer burritos or fewer of both
than does Bundle e.
• From panel a, we do not know whether Lisa prefers Bundle e to bundles such as b
(30 pizzas and 10 burritos) in area D, which is the region below and to the right of
e, or c (15 pizzas and 25 burritos) in area C, which is the region above and to the
left of Bundle e.
• We can’t use the more-is-better property to determine which bundle is preferred
because each of these bundles contains more of one good and less of the other
than e does.
• To be able to state with certainty whether Lisa prefers particular bundles in areas
C or D to Bundle e, we have to know more about her tastes for pizza and burritos
• Preferences and Indifference Curves.
• Suppose we asked Lisa to identify all the bundles that give her the
same amount of pleasure she gets from consuming Bundle e.
• In panel b of Figure 2, we use her answers to draw curve I 1 through
all bundles she likes as much as she likes e. Curve I 1 is an indifference
curve: the set of all bundles of goods that a consumer views as being
equally desirable.
• Indifference curve I 1 includes Bundles c, e, and a, so Lisa is indifferent
about consuming Bundles c, e, and a.
• From this indifference curve, we also know that Lisa prefers e (25 pizzas
and 15 burritos) to b (30 pizzas and 10 burritos).
• How do we know that? Bundle b lies below and to the left of Bundle a, so
Bundle a is preferred to Bundle b by the more-is-better property.
• Both Bundle a and Bundle e are on indifference curve I 1 , so Lisa likes
Bundle e as much as Bundle a.
• Because Lisa is indifferent between e and a and she prefers a to b, she
must prefer e to b by transitivity
 Properties of Indifference Curves
• All indifference curve maps must have the following four properties
• Bundles on indifference curves farther from the origin are preferred
to those on indifference curves closer to the origin.
• An indifference curve goes through every possible bundle.
• Indifference curves cannot cross.
• Indifference curves slope downward.
 Non-satiation
• A consumer is never satiated permanently.
• More is always wanted; if “some” is good, “more” of the good is
better.
• A bigger pizza is preferred to a smaller one; two burgers are preferred
to one pizza and two pizzas to one burger.
• A package of one pizza and two burgers is preferred to the bundle of
only one pizza and one burger.
• However, non-satiation is not a fundamental condition, because
rational consumers get satiated after a certain limit.
• These assumptions are meant to create the foundation of consumer
satisfaction and behaviour in your mind, and help develop an
understanding of utility analysis.
 Utility Analysis
• We make our consumption decisions on the basis of utility (or
usefulness) of different commodities.
• Commodities are desired because of their utility, i.e., their ability to
satiate wants.
• The notion of utility owes its origin to Jeremy Bentham (1748–1832).
So what is utility?
• Utility is the satisfaction a consumer derives out of consumption of a
commodity.
• It may also be defined to be an attribute of a commodity to satisfy or
satiate a consumer’s wants.
• You would agree that the concept of utility is somewhat abstract;
• Utility analysis is one of the corner stones of consumer behaviour,
because consumption as an act itself is driven by utility
• Mathematically, we can express utility as the function of the
quantities of different commodities consumed.
• If an individual consumes
• quantity m1 of a commodity M,
• quantity n1 of N, and r1 of R,
• then the utility function U of the consumer can be expressed as:
• U = f(m1, n1,r1)
• A rational consumer would aim at maximizing his utility from
consumption of different commodities, subject to budget constraint.
Now, in order to maximize utility, we need to ascertain how much
value is associated with the utility function of each consumer.
• . This has been an issue of concern to economists for long, and they
have produced different views on such optimization behaviour of
consumers.
• Primarily, these can be divided into cardinal utility analysis and
ordinal utility analysis.
• The cardinal school believes that utility is quantifiable in units,
• The ordinal school posits that utility cannot be measured, rather can
be only shown as higher than or less than ranks.
• Earlier economists like Marshall and Jevons opined that utility is
measurable like any other physical commodity and proposed “utils”
as its unit.
• According to them, utility is a cardinal concept, and we can assign
number of utils to any commodity.
• Moreover, according to the cardinalists, utility is additive, i.e., we
can add the utility of commodities
 A particular consumer a banana can have 2 utils, while a mango may
have 3 utils.
If an individual consumes a mango and a banana, then, following the
same example, total utility derived by the consumer is equal to 2 + 3 =
5 utils.
In this way, the total utils of a consumption basket for any consumer
may be calculated and comparison can be made across individual
consumers on the basis of utils over their baskets.
 Total and Marginal Utility
• Total utility (TU) refers to the sum total of utility levels out of each
unit of a commodity consumed within a given period of time, or in
other words, total satisfaction from consumption.
• Thus, if a consumer has three apples, his total utility will be the sum
of the utility derived out of each apple.
• Marginal utility (MU) is the change in total utility due to a unit
change in the commodity consumed within a given period of time.
• In other words, marginal utility is the total utility of the additional
(or nth) unit consumed of the commodity
• MU = TUn – TUn–1 …(2)
• MU: marginal utility as: change in total utility/change in quantity.
Law of Diminishing Marginal Utility
• As you consume more and more units of a commodity, total utility
would go on increasing, but only up to a certain point, beyond which,
if you continue to consume any subsequent unit, the total utility will
start decreasing
• This can be explained with the help of the law of diminishing marginal
utility. Let us explain the law with a simple example. Suppose Saumil
has strong liking for sandwiches; his utility function for consumption
of sandwiches
• Till Saumil had not consumed any sandwich, his satisfaction level was nil;
hence his total utility derived was zero.
• The very first sandwich gives him maximum satisfaction, i.e., 20 units,
because he had strong desire to have one.
• You would see that total utility is increasing with each successive sandwich,
but marginal utility is declining.
• The sixth sandwich gives him no additional satisfaction and MU for the
sixth sandwich is zero; thus, total utility derived from the fifth and sixth
units is same.
• Any consumption beyond this point will lead to a fall in total utility to 50
units, because marginal utility from the seventh unit of sandwich is minus
five, which implies disutility or dissatisfaction out of excess consumption.
No rational consumer would continue consumption till this level.
• In Graph 3.1, you can see that when MU is zero (at the sixth unit), TU
is at its maximum and is constant at the previous level. As explained,
no rational consumer would continue consumption beyond the sixth
unit. This will be the point of saturation or satiety of Saumil’s desire
to consume sandwich for the particular time. The downward trend of
the MU curve is the outcome of the law of diminishing marginal utility
• Assumptions The law of diminishing marginal utility is based on certain
assumptions, absence of which may create exceptions to the law. Such
assumptions are as follows:
• (i) The Unit of Consumption must be a Standard One Too large or too small
units would not validate the law. Thus, in the above example, if Saumil was
given a small bite every time, the law would not hold good.
• (ii) Consumption must be Continuous Gap between consumption of two
successive units will invalidate the law. As in our example, if every next
sandwich is taken at an interval of two hours, the utility will not diminish
with successive units of consumption because the need for hunger will
remerge
• (iii) Multiple Units of the Commodity should be Consumed In other
words, demand for the commodity should be of a recurring nature.
The law normally does not apply to durable consumer goods like
house, cars, etc.
• Let us change our example to understand this assumption. Suppose
Saumil wants to buy a luxury car. At any point of time, he will not buy
two luxury cars; he may buy a car today and will only like to replace it
after substantial number of years of use. Hence, the law of
diminishing marginal utility cannot be explained in case of durable
goods.
• (iv) The Tastes and Preferences of the Consumer should Remain
Unchanged during the Course of Consumption You can see that we
started our example with the statement that Saumil has strong liking
for sandwiches.
• If after three sandwiches he is offered cold coffee which he likes a lot,
he may not continue consumption beyond the third unit.
• Because it is possible that utility from the fi rst glass of cold coffee for
Saumil is equal to nine; thus he maintains his total utility at 55.
• (v) The Good should be Normal and Not Addictive in Nature Many
goods like cigarettes, alcohol etc., are consumed due to addictions, in
such cases it is likely that the law does not set in.
• Such consumption is governed by compulsive behaviour and does
not follow the rule of rationality.
Law of Equimarginal Utility
• So far we have explained utility with a single commodity.
• But in real life a consumer buys multiple commodities at the same
time to satisfy diverse wants.
• As Saumil may like to consume sandwiches with cold coffee, he may
also like to buy a luxury car, send his children to good schools and
take membership of a health club and all at the same time, say in the
same month!
• How would he know what amount of his income to spend on each of
these commodities?
• The law of equimarginal utility explains how a consumer would spend
his income on different commodities.
• We begin with the assumption that the consumer has a fixed income
and determines purchase decision on the basis of prices of different
commodities to be consumed.
• According to the law of equi-marginal utility, a consumer will
maximise utility when the marginal utility of the last unit of money
(say, Rupee) spent on each commodity is equal to the marginal utility
of the last Rupee spent on any other commodity.
• The consumer, thus, has to distribute his/her income in purchasing
different commodities in such a manner that the utility derived from the
last unit of each commodity is equal for all commodities in the
consumption basket.
• Thus, as per this law, marginal utilities of all commodities should be equal.
• The underlying logic is simple.
• If the utility from a commodity M is more than that from another
commodity N, then the consumer would reduce consumption of N and
increase consumption of M.
• The common marginal utility per Rupee spent on all commodities is
referred to as the marginal utility of income.
Ordinal Utility
• Ordinal utility theory is a major departure from the cardinal school, as it negates
the physical measurement of utility.
• The most prominent propounders of this school were Edgeworth and Fisher.
• According to ordinal utility theory, utility cannot be measured in physical units
rather the consumer can only rank utility derived from various commodities.
• Thus, according to the ordinal approach, utility is not additive. However, it is
possible that the consumer may find two different bundles of goods equal in
terms of utility.
• Saumil may like to consume either (a) three sandwiches and one glass of cold
coffee or (b) two sandwiches and two glasses of cold coffee; thus he is indifferent
between (a) and (b).
• Or he may prefer three sandwiches and two glasses of cold coffee to two
sandwiches and two glasses of cold coffee. When these combinations of two
goods are shown on a graph, they represent a curve which is called indifference
curve.
Indifference Curve Analysis

• The realms of consumer behaviour were expanded to new horizons with the
introduction of indifference curve analysis by J.R. Hicks and R.G.D. Allen.
• The crux of this analysis is that utility is ordinally measurable. From the above
discussion on ordinal approach, you can promptly infer that given two
commodities M and N, a consumer is able to rank different combinations of the
commodities in order of preference or indifference.
• If we plot the quantities of the two commodities on the two axes, then we can
draw a set of points that would represent alternative combinations of M and N,
between which the consumer would be indifferent.
• The curve formed by joining such points is known as an indifference curve.
• Each point on an indifference curve represents a consumption basket,
having a combination of the two goods consumed.
• Thus, point A on the curve shows a combination of 1 sandwich and 6
glasses of cold coffee, which would give the consumer the same level of
satisfaction as 3 sandwich and 3 glasses of cold coffee, shown by point B,
• or 5 sandwich and 2 glasses of cold coffee, shown by point C, or 7 sandwich
and 1 glasses of cold coffee, shown by point D.
• You may, thus, infer that the level of satisfaction remains the same at all
points on the same indifference curve and the consumer would as such
be indifferent between all such combinations of the two goods
consumed.
• The consumer can make many more combinations of the two goods, with less of any
one, or both of the goods.

• Points below an indifference curve will have lesser utility than any point on the curve.

• In Panel “a” of Figure 3.5, an indifference curve (say, I0) can be drawn through points
below I1;

• Each point on such a curve would give lesser satisfaction than points on I1. Similarly, an
indifference curve (say, I2) can be drawn through points above I1; each point on such a
curve would render greater satisfaction than those on I1. In fact, it is possible to draw
numerous such curves like I0, I2 and I3, each representing a unique level of utility and
none intersecting any other.

• The family of such indifference curves, shown in Panel “a”, is referred to as the
indifference map
Assumptions
• You know that the basic premise is that the consumer is rational; besides the
indifference curves analysis is based on certain other assumptions:
i. At any given point of time, the consumer has only two goods in his/her
consumption basket.
ii. It is not possible to quantify the utility availed from the consumption rather the
consumer is able to rank his/her preferences on a scale.
iii. The consumer is never completely satisfied; this is in accordance to the
assumption on non-satiation you have read earlier in this chapter. In other words,
more is always wanted.
iv. The consumer is consistent in his choices. This implies that if a consumer is
indifferent between butter and ghee, and between ghee and cheese, he would be
indifferent between butter and cheese as well.
Yes, you got it right: this is the same as the assumption of transitivity discussed
earlier.
v. The two goods under consideration are perfectly divisible in small units. This
implies that indifference curves would be continuous in nature.
 Properties of Indifference Curves
(i) Downward Sloping-
• Indifference curves are downward sloping. This is because of the
assumption of non-satiation. You know that an indifference curve
shows various such combinations of two goods which give same
utility to the consumer.
• As per assumption of non-satiation, more is better; this will be
negated on an upward sloping indifference curve
(ii) Higher Indifference Curve Represents Higher Utility
• An indifference curve placed higher will represent higher level of
utility. Let us explain how.
• Observe the curves in Panel “a” of Figure 3.5. If we consider point A
on the curve I1 and point C on I2, then you can follow from the figure
that C has more of both M and N.
• However, a point on a higher indifference curve may not necessarily
have greater amounts of both the goods; but it will have greater
quantity of at least one of the two commodities and a greater
quantity of any one of the two commodities will render a higher level
of utility
(iii) Indifference Curves can Never Intersect
• Indifference curves cannot intersect.
• This follows from the assumptions of transitivity and higher utility at a higher
indifference curve.
• Let us start with the assumption that indifference curves do intersect; we would
check the feasibility of this assumption to prove that indifference curves do not
intersect.
• Suppose I1 and I2 are two indifference curves that intersect at point C in Panel
“b” of Figure 3.5. Points A and C lie on I2 and points B and C lie on I1; I2 is higher
than I1.
• You can readily infer from the assumption of transitivity that since A and C give
same utility and B and C give same utility, therefore A and B also give same utility
to the consumer.
• Now since a higher indifference curve represents higher utility, then following the
properties of indifference curves, A must be preferred to B.
• This is nothing but a contradiction. Hence, indifference curves can never intersect
(iv) Convex to the Origin

• Indifference curves are convex to the origin, i.e., they are bowed out
towards the origin.
• This is because two goods cannot be perfect substitutes of each
other.
• Therefore, as you have more of one commodity, you would like to
sacrifice less of the other commodity for an additional unit of the fi
rst commodity. The explanation of this property needs an elaboration
on another concept, namely that of marginal rate of substitution.