Theory of Consumer Behavior

Consumer behavior studies the behavior of an individual or a group of consumers regarding how to
allocate their given limited income resources in such a way that it maximizes their level of satisfaction.
Consumers purchase products and services as and when their need arises. Consumer behavior is the study
of the process involved when individuals or groups select, purchase, use or dispose of products, services,
ideas, or experiences to satisfy their needs or desires.
Consumer process is influenced by psychological factors such as the personal thinking and consumer's
attitude, internal factors such as lifestyle, personality etc., and external factors such as culture, family,
race etc.

Indifference Curve

An Indifference Curve (IC) is the curve of all those points which represents different bundle of two
goods, which yields same level of satisfaction to the concerned
consumer.
In other words, an indifference curve is a set of points yielding the
same level of satisfaction, but offers a different combination of two
goods, so leaving consumers with more options.

Properties of indifference curves are as follows.

• An IC is downward sloping from left to right, i.e. it has a
negative slope. This is because to maintain the same level of
satisfaction along a particular IC, we need to sacrifice some
amount of commodity 2 to get more of commodity 1.
• Two different IC can never intersect.
• IC is convex to the point of origin, due to diminishing marginal rate of substitution.
• IC does not touch either axis.

Indifference Map
When more than one indifference curve is depicted in a single graph, then it is referred to as an
indifference map. In an indifference map, IC to the right depicts a higher level of satisfaction.

In the above graph, IC2 gives greater satisfaction than IC1 and IC4
gives the highest level of satisfaction.
 Two Indifference Curves cannot intersect each other.
An indifference curve consists of different combinations of two
goods giving the same satisfaction level to a consumer. It means
that every point on an indifference curve gives the same
satisfaction to the consumer.
If the figure is true and two indifference curves IC1 and
IC2 intersect each other, then it would mean that Point C provides
the same satisfaction level to the consumer. However, it has
already been proved under Indifference Map that two indifference
curves on a single graph show different satisfaction levels along
the curve. Therefore, two indifference curves can never intersect
each other.

Backward Bending Supply Curve

The supply curve may be backward bending also. This means a smaller quantity will be supplied at a
higher price than a lower price. The following figure
shows the backward sloping curve.
In the above figure when the price is P, the supply of
the product is Q. When the price increases to P1
from P, the supply decreases from Q to Q1. A
backward bending supply curve may occur in case
of labor supply. Initially, the worker offers more
hours of working with an increase in the price of
labor but after a certain level, the worker prefers
more leisure time even at a higher wage rate. At a
very high wage rate, the worker prefers leisure to
work as he may have earned enough income.

The demand curves for the industry and the firm in the perfect competition
We have said that individual
firms in the perfect
competition will be price
takers since they cannot affect
the price of the industry and so
must sell at whatever the
market price is. This means
that we can make certain
assumptions about demand
curves for both the firm and
the industry.
For the individual firms we know that they will have to sell at the industry price, P, because they are price
takers. If they try to sell at a higher price then consumers will simply buy the product from another firm,
since the goods are homogeneous and so there is no difference in looks or quality. If they sell at the
industry price the firm can sell as much as it wants, because as it increases output it does not affect the
industry supply curve and so it does not alter the industry price. If the firm can sell all that it wishes at the
price P, then it must face a perfectly elastic demand at that price. In the figure above we can see that the
firm derives its price of P from the equilibrium price in the industry, where the industry supply equals the
industry demand. This is another explanation of the term “price-taker”, because the firm must take the
price set in the industry.

Short-run profit maximization for the firm in perfect competition

Firms maximize profits when they
produce at the level of output where
MC = MR. For perfect competition, we
now have to add the marginal cost
curve.
We can see that the firm takes the price
P from the industry and, because the
demand is perfectly elastic, P = D = AR
= MR. Profit is maximized where MC =
MR, which is at the level of output q.
We must remember that although the
scale of the price axes is the same for the firm and the industry, this is not the case for output. The
quantity q is very small in relation to the total industry output, Q, and it would not even register on the
output axis for the industry. If it could, then it would be large enough to shift the supply curve and thus
alter the industry price.

Monopoly
It refers to a market situation in which there is a single seller of a product which has no close substitutes.

Consumer Exploitation
Monopolies are big companies that tend to take advantage of their position to set high prices to exploit the
consumer.
Market Control
Monopoly market is also called one firm industry in which the firm has total control over the market
supply of the product.
No Substitute
Consumer exploitation is prevalent as there is no other seller or substitute products for the consumers.

Price Discrimination
A monopoly firm has no fear of economic competition and hence adopts a policy of price discrimination
to maximize its profit.
Revenue curves for the firm that can control price: monopoly, monopolistic competition, oligopoly.
This table shows total, marginal, and
average revenue from price and
quantity information in the case where
the firm has some influence over prices.
The difference in the price data
showing that the price at which the
good is sold changes as the quantity of
output changes. The lower the price the
greater the quantity of output,
illustrating the law of demand. This
occurs under all market models that we
will study other than perfect
competition.
Calculating total, marginal, and average
revenue when price varies: the firm has
some control over price; the cases of
monopoly, monopolistic competition,
oligopoly.

Looking at Table we may note the

following:
• As price (P) falls, output (Q) increases
giving rise to the downward-sloping
demand curve.
• Marginal revenue, showing the change
in total revenue resulting from a change
in output, falls continuously; MR is equal
to zero when total revenue is at its
maximum (at seven units of output), and
becomes negative when total revenue
falls. It may be noted that the MR curve
shows the slope (gradient) of the TR
curve. Therefore, when TR is maximum,
MR = 0. When TR is falling, MR is
negative.
• Average revenue (column 5 of Table) is
equal to price (see column 2).
However, the addition to revenue from selling the extra unit is less than the price charged. To see this
point, consider the following diagram. This figure shows the demand curve represented in Table above.

As you can see. when the prices are $7 and $6 respectively. total revenue is $28 and $30. respectively.
Marginal revenue is, however. $2. To increase its sales by one unit from 4 to 5. the monopolist must lower
its price from $7 to $6. However, the revenue generated is less than the price charged. The gain from
selling the 5" unit is the difference between the two shaded rectangles. The seller gains the checked area
and loses the hatched area. The loss is equal to 6 x (5-4) = $6, while the gain is 4 x (7-6) = $4. Therefore,
the net (extra or marginal) gain is 6-4 = $2. which is lower than the price charged $6.

Consumer’s Equilibrium
• Consumer equilibrium is a point at which a consumer gets maximum satisfaction from the
commodities, given their income prices of commodities remain unchanged.
• Depends on marginal utility i.e., satisfaction and the price consumers are willing to pay.

When consumer spend all income on single commodity

Assumption:
• Consumer buys only 1 commodity.
• Price of commodity is fixed.
• Consumer acts rationally to maximize total level of satisfaction.
• Consumer has enough money to purchase.
Use the law of diminishing marginal utility to explain the equilibrium in this case where,
MUx = Px

When consumer spend all income on two or more commodities

Use the law of diminishing equity-marginal utility to explain the equilibrium in this case where,

(MUa/Pa) = (MUb/Pb)
MU/P is utility in monetary terms.
In this graph, IC1, IC2, and IC3 are three
indifference curves, and AB is the budget
line. The highest indifference curve that a
consumer can reach with the budget line’s
constraint is IC2. The budget line AB is
tangent to the indifference curve IC2 at point
E. This point is the point of equilibrium,
where the consumer buys OM quantity of
Good X and ON quantity of Good Y.
The other points, i.e., F and G to the left or
right of point E lie on the lower indifference
curve IC1, indicating a lower level of
satisfaction. Also, as the budget line can be
tangent to only one indifference curve, the
consumer maximizes his level of satisfaction
at point E when he meets both conditions of
the consumer’s equilibrium.

Is there any difference between Marginal Utility (MU) and Marginal Rate of Substitution (MRS)?
The added satisfaction that a consumer gets from having one more unit of a good or service.
MUnth = ΔTU / ΔQ

MRS is the slope of the indifference curve. It measures the amount of good (Y) that a consumer is willing
to give up getting one extra unit of another good (X), or vice versa.
MRSxy = ΔX / ΔY

The Budget Line

The budget line shows the various combinations of two goods that a consumer can afford with given
prices of two goods and money income.
Budget Constraints
It depicts the budget constraints of a consumer i.e., combination of (price, quantity) which are attainable
or not attainable at the given income.
Budget Line Equation
If C and V denote the quantities of chocolate and vanilla, respectively, the budget constraint must satisfy
the following equation:
M = PcC + PvV
Slope = -Pc/Pv
 Shifts in Budget Line
Budget line shifts on account of any changes in prices of commodities and income of consumer, i.e.

• If income increases, the budget line shifts rightward in parallel.

• If income decreases, the budget line shifts leftward in parallel.
• If price of Good X goes down, budget line shifts rightward on X axis.
• If price of Good X goes up, the budget line shifts leftward on X-axis.
• If there is proportionate change in prices and income of consumer, then there will be no shift in
budget line.

In addition to being able to buy any of the bundles along her budget constraint, the consumer is also able
to purchase any bundle that lies within the budget triangle bounded by it and the two axes. D is one such
bundle in Figure 5A.2. Bundle D costs $65 per year, which is well below the consumer’s ice cream
budget of $100 per year. Bundles like E that lie outside the budget triangle are unaffordable. At a cost of
$140 per year, E is simply beyond the consumer’s reach.
 Price Changes
The slope and position of the budget constraint are fully determined by the consumer’s income and the
prices of the respective goods. Change any one of these and we have a new budget constraint. Figure
5A.3 shows the effect of an increase in the price of chocolate from PC1 = $5 per pint to PC2 = $10 per pint.
Since both her budget and the price of vanilla are unchanged, the vertical intercept of the consumer’s
budget constraint stays the same. The rise in the price of chocolate rotates the budget constraint inward
about this intercept, as shown in the diagram.

Income Changes
The effect of a change in income is much like the effect of an equal proportional change in all prices.
Suppose, for example, that our hypothetical consumer’s income is cut by half, from $100 per year to $50
per year. The horizontal intercept of her budget constraint will then fall from 20 pints per year to 10 pints
per year and the vertical intercept from 10 pints per year to 5 pints per year, as shown in Figure 5A.4.
Thus, the new budget, B2, is parallel to the old, B1, each with a slope of –1/2. In terms of its effect on
what the consumer can buy, cutting income by half is thus no different from doubling each price.
Precisely the same budget constraint results from both changes.
 Microeconomics
Key Concept:
The study of the behavior and decisions of households and firms, and the performance of individual
markets.
Objectives and Instruments
• Microeconomics studies the decisions of individuals and firms to allocate resources of
production, exchange, and consumption.
• Microeconomics deals with prices and production in single markets and the interaction between
different markets but leaves the study of economy-wide aggregates to macroeconomics.
• Microeconomists formulate various types of models based on logic and observed human behavior
and test the models against real-world observations.

Fiscal Policy
Any action by the government affects the size or composition of government revenue or expenditure.

Inescapable interdependencies
Government often deploys its weapons to correct important market failures of which following are
important:
• Breakdown of perfect competition.
• Externalities and public goods, public health or knowledge research and development. Reduce
smoking, pollution, and public health.

Reducing Economic Inequality

• Taxpayers increasingly resist. Re-distribution and progression.
• Stabilizing the Economics through Macroeconomics Policies
• Smooth out the ups and downs of the business cycles to avoid either large scale unemployment or
price inflation at the top of the cycle.
• Governments are concerned with finding economic policies which boost long term economic
growth.

Conducting International Economic Policy

• Reducing trade barriers
• Conducting assistance programs
• Coordinating macroeconomic policies
• Forex, smoothing foreign exchange rate, IMF role ‘FLU’ and ‘COVID-19.’
 Public Choice Theory
• Public choice theory is a branch of economics that emerged in the 50s and received
widespread public attention in 1986 when James Buchanan was awarded the Nobel Prize.
• Economists assume that people are motivated mainly by self-interest in the marketplace
whether they are employers, employees, or consumers.
• Public choice theory analyzes the rules that guide the collective decision-making process
itself and gives more information for public benefit about the availability of choices of
various public services people have at affordable prices.

Imperfect competition
Monopolists, and other imperfect markets, restrict output to push up prices and maximize profits.
Because of this, they are not producing at the socially efficient level of output.

Monopoly
It refers to a market situation in which there is a single seller of a product which has no close substitutes.
Such as Microsoft Corporation

Oligopoly
A market structure with a small number of firms, none of which can keep the others from having
significant influence. Such as Automobile industry and Telecommunication industry.

Monopolistic Competition
It occurs in markets where there are multiple similar products that are not perfect substitutes to one
another. Such as Restaurants.

Changes in Income Effect

The income effect of a price change refers

to the change in consumption or quantity
demanded of a good due to a change in
the real income of the consumer, keeping
money income constant. The income
effect is part of the price effect.