Unit 2 Grade 10

Unit 2.
Theory of Consumer Behavior

Class one Tuesday Nov 21,2023
Introduction
 Consumer a decision making unit (an individual or a household) who uses or consumes a
commodity or service.
 Concerned with how a consumer decides on the basket of goods and services he/she consumes
in order to maximize his/her satisfaction.
 important assumptions;
 The consumer has a limited income.
 The consumer is assumed to be rational. Given the consumer’s income and the
market prices of the commodities,
 he/she spends the income on goods and services that give the highest possible
satisfaction or utility.
 Consumer has relevant information to make a decision, is aware of his or her income,
and is aware of the commodities available and their prices.
1.1 The Concept of Utility
 Utility is level of satisfaction or pleasure derived from the consumption of a good or

service.
 Utility is power of a commodity to satisfy human wants.
 For example,
Bread has the power to satisfy hunger,
While water quenches our thirst. I
 in defining utility, it is important to bear in mind the following points
 Relativity of Utility: The utility of a commodity is subjective to a person’s needs. It
is not absolute (objectively determined).The same commodity provides different
utilities to different consumers.
For example, non-smokers do not derive any utility from cigarettes. y
 The utility of a product can be different at different places and times.
For example, the utility that we get from wearing jackets during the cold season is
not the same as during the hot season. For the same consumer, utility varies from
unit to unit, from time to time, and from place to place.
For example, the utility we get from drinking tea early in the morning may be
different from the utility we get during lunch time. y ‘Utility’ and ‘usefulness’ are
not synonymous: usefulness is the concern of a product whereas utility is the
concern of the consumer
1.2. The Cardinal Utility Theory
 Utility is measurable like weight, height, and temperature, and they suggested a unit of
measurement of satisfaction called ‘utils’.
 The Cardinal School postulated that utility can be measured in monetary units (i.e., by the
amount of money that the consumer is willing to pay for another unit of a commodity) or
by subjective units called ‘utils’. Thus, the school assumes that the level of utility can be
expressed in number
1.2.1. Assumptions of Cardinal Utility Theory
I . The consumer is Rational: The main objective of the consumer is to maximize his/her satisfaction
given his/her limited budget or income.
II . Cardinal Utility: Utility is a cardinal concept, which means the utility of each commodity is
measurable, with the most convenient measure being money.
III . Constant Marginal Utility of money: the utility that one derives from each consecutive unit of
money income remains constant.
IV . Diminishing Marginal Utility: The utility gained from the successive units of a commodity
diminishes. In other words, the marginal utility of a commodity diminishes as the consumer consumes
larger quantities of it. This is the law of diminishing marginal utility.
V . 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 4 ,...X n , the total utility is given by TU = f ( X1 ,
X 2; ……Xn)
1.2.2. Measurement of Utility (Total and Marginal Utility)

Total Utility (TU):
 refers to the total amount of satisfaction a consumer gets from consuming or possessing some
specific quantities of a commodity (X) at a particular time.
 As the consumer consumes more of a good (X) per time period, his/her total utility increases.
However, there is a saturation point for that commodity after which the consumer will not be
capable of enjoying any greater satisfaction from it. Therefore,
 TUn refers to the total utility derived from consuming n units of a commodity X.
Marginal Utility(MU):
 Refers to the additional utility obtained from consuming an additional unit of a commodity.
Mathematically, the formula for marginal utility is:
 The concept used to determine how much of an item consumers are willing to purchase
MU  TU/Q Where,
TU is the change in total utility, and,
Q is change in the amount of product consumed

Example
Quantity TU MU
Consumed
1 15 15
2 28 13
3 38 10
4 43
5 44
6 44
7 41
SOLUTION
MUn1=TUn-TUn-1 ,MU1=TU1-TU(1-1), =TU1-TU0 , =15-0 =15
MU2=TU2-TU1(2-1), TU2-TU1=28-15=13
MU3=TU3-TU(3-1)=TU3-TU2=38-28=10
MU4=TU4-TU(4-1)=TU4-TU3=43-38=5
FIGURE 1.1. Relationship between total utility and marginal utility

 Shows that total utility initially increases, and reaches ‘its pick (saturation) point’. This
saturation point indicates that by consuming 7 quantities of banana, the consumer attains its
highest satisfaction level of 37 utils. However, consumption beyond this point results in
dissatisfaction, because consuming the 8th and more quantities of banana brings negative
additional utility.
 On the other hand, the marginal utility continuously diminished and became zero when the
total utility reached maximum,
 and then became negative as consumption increased beyond the saturation point of the total
utility.
1.2.3 The Law of Diminishing Marginal Utility (LDMU)

 The utility that a consumer gets by consuming a commodity for the first time is not the same
as the consumption of the good for the second, third, fourth, etc.
 In simple terms, the law of diminishing marginal utility means that the more of an item
that you use or consume, the less satisfaction you get from each additional unit
consumed or used.
 For example, three bites of candy are better than two bites, but the twentieth bite does
not add much to the experience beyond the nineteenth (and could even make it worse).
1.3. The Consumer Maximization Problem

Concept: When his/her allocation of expenditure that last birr spent yield same utility
 Assumptions of Consumer Equilibrium
1. Consumer is rational
2. Cardinal utility is possible
3. If utility measure by money MU of Money is constant
4. LDMU operates
5. Consumer Income is given and constant
6. Commodity Price is given and constant
Consumer Equilibrium: The Case of one commodity

 Concept; Consumer is in equilibrium, when Mux is equated to its Market
price (Mpx)
Symbolically: Mux=Px
 Important Points
1).If Mux >Px, Consumer increase his/her welfare by purchasing More units of X
2).If Mux<Px, Welfare increase by reducing Consumption of X
Figure 1.2: Consumer equilibrium and derivation of demand curve
1. At Q*x the marginal utility is MU*x which is equal to P*x.
2. At P*x consumer demands Q*x and this forms the demand curve for commodity X.
3. The demand curve is the graphical representation of the relationship between price and quantity
demanded.
Consumers’ budget equation
PX QX =Income/budget of the consumer

1.4. Introduction to the Ordinal Utility Theory
 Utility cannot be measured absolutely, but different consumption bundles are ranked
according to preferences.
 It is practically possible for the consumers to rank commodities in the order of their
preference, as 1st, 2nd, 3rd, and so on.
Assumptions ordinal utility Theory
1. Rationality: The consumer is assumed to be rational
2. Utility is ordinal: utility is not absolutely (cardinally) measurable.
3. The consumer can rank his/her preference (order the various baskets of goods) according to the
satisfaction of each basket.
4. The Diminishing marginal rate of substitution (DMRS):

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Unit 2.

Theory of Consumer Behavior

1.1 The Concept of Utility

 Utility is level of satisfaction or pleasure derived from the consumption of a good or

1.2.1. Assumptions of Cardinal Utility Theory

1.2.2. Measurement of Utility (Total and Marginal Utility)

Q is change in the amount of product consumed

MUn1=TUn-TUn-1 ,MU1=TU1-TU(1-1), =TU1-TU0 , =15-0 =15

FIGURE 1.1. Relationship between total utility and marginal utility

1.2.3 The Law of Diminishing Marginal Utility (LDMU)

1.3. The Consumer Maximization Problem

 Assumptions of Consumer Equilibrium

2. Cardinal utility is possible

3. If utility measure by money MU of Money is constant

5. Consumer Income is given and constant

6. Commodity Price is given and constant

Consumer Equilibrium: The Case of one commodity

Figure 1.2: Consumer equilibrium and derivation of demand curve

1. At Q*x the marginal utility is MU*x which is equal to P*x.

Consumers’ budget equation

PX QX =Income/budget of the consumer

Assumptions ordinal utility Theory

1. Rationality: The consumer is assumed to be rational

2. Utility is ordinal: utility is not absolutely (cardinally) measurable.

4. The Diminishing marginal rate of substitution (DMRS):

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1. At Qx the marginal utility is MUx which is equal to P*x.