CHAPTER ONE

Theory of Consumer Behavior

Introduction

In our day –to- day life, we buy different goods and services for consumption. As consumer, we
act to derive satisfaction by using goods and services. But, have ever thought of how your
mother or any other person whom you know decides to buy those consumption goods and
services? Consumer theory is based on what people like, so it begins with something that we
can‘t directly measure, but must infer. That is, consumer theory is based on the premise that we
can infer what people like from the choices they make.

Consumer behavior can be best understood in three steps. First, by examining consumer‘s
preference, we need a practical way to describe how people prefer one good to another. Second,
we must take into account that consumers face budget constraints – they have limited incomes
that restrict the quantities of goods they can buy. Third, we will put consumer preference and
budget constraint together to determine consumer choice.

1.1. Consumer preferences

A consumer makes choices by comparing bundle of goods. Given any two consumption bundles,
the consumer decides either that one of the consumption bundles is strictly better than the other
is, or decides that she is indifferent between the two bundles. In order to tell whether one bundle
is preferred to another, we see how the consumer behaves in choice situations involving two
bundles. If she always chooses X when Y is available, then it is natural to say that this consumer
prefers X to Y. 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 relations of strict preference, weak preference, and indifference are not independent
concepts; the relations are themselves related. For example, if X ⪰ Y and Y ⪰ X, we can
conclude that X ~Y. That is, if the consumer thinks that X is at least as good as Y and that Y is at
least as good as X, then she must be indifferent between the two bundles of goods. Similarly, if
X ⪰ Y but we know that it is not the case that X~ Y, we can conclude that X≻Y. This just says
that if the consumer thinks that X is at least as good as Y, and she is not indifferent between the
two bundles, then she thinks that X is strictly better than Y.

1.2. 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. Given any two consumption bundles X and Y, the consumer definitely wants the
X-bundle than the Y-bundle if and only if the utility of X is better than the utility of Y.

In defining utility, it is important to bear in mind the following points.

 Utility’ and ‘Usefulness’ are not synonymous. For example, paintings by Picasso may be
useless functionally but offer great utility to art lovers. Hence, usefulness is product
centric whereas utility is consumer centric.
 Utility is subjective. The utility of a product will vary from person to person. That
means, the utility that two individuals derive from consuming the same level of a product
may not be the same. For example, non-smokers do not derive any utility from cigarettes.
 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.
1.3. Approaches of measuring utility

There are two major approaches to measure or compare consumer‘s utility: cardinal and ordinal
approaches. The cardinalist school postulated that utility could be measured objectively.
According to the ordinalist school, utility is not measurable in cardinal numbers rather the
consumer can rank or order the utility he derives from different goods and services.

1.3.1 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. For example, we may say that consumption of an orange
gives Bilen 10 utils and a banana gives her 8 utils, and so on. From this, we can assert that Bilen
gets more satisfaction from orange than from banana.

1.3.1.1 Assumptions of cardinal utility theory

The cardinal approach is based on the following major assumptions.

1. Rationality of consumers. The main objective of the consumer is to maximize his/her

satisfaction given his/her limited budget or income. Thus, in order to maximize his/her
satisfaction, the consumer has to be rational.

2. Utility is cardinally measurable. According to the cardinal approach, the utility or

satisfaction of each commodity is 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. A person at the start of the month where he has received monthly
salary gives equal value to 1 birr with what he may give it after three weeks or so.

4. Diminishing marginal utility (DMU). The utility derived from each successive units of a
commodity diminishes. In other words, 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 X , X ,...Xn 1 2 , the total
utility is given by TU = f ( n X , X ......X 1 2 ).

1.3.1.2 Total and marginal utility

Total Utility (TU) is the total satisfaction 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) 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:

Where
consumed. To explain the relationship between TU and MU, let us consider the following
hypothetical example.
The total utility first increases, reaches the maximum (when the consumer consumes 6 units) and
then declines as the quantity consumed increases. On the other hand, the marginal utility
continuously declines (even becomes zero or negative) as quantity consumed increases.
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.

1.3.1.3 Law of diminishing marginal utility (LDMU)

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.
This gives sense in that the first banana a person consumes gives him more marginal utility than
the second does and the second banana gives him higher marginal utility than the third and so on
(see figure 3.1).

The law of diminishing marginal utility is based on the following 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

1.3.2 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.

1.3.2.1 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 rate at which one good can be substituted for another in
consumer‘s basket of goods diminishes as the consumer consumes more and more of the good.
 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. 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.

1.3.2.2 Indifference curve and map

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.
1.3.2.3 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. In other words, in order to keep
the utility of the consumer constant, as the quantity of one commodity is increased the quantity
of the other must be decreased.

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. The convexity of indifference curves is the reflection of the diminishing marginal rate of
substitution. This assumption implies that the commodities can substitute one another at any
point on an indifference curve but are not perfect substitutes.

3. A higher indifference curve is always preferred to a lower one. The further away from the
origin an indifferent curve lays, the higher the level of utility it denotes. Baskets of goods on a
higher indifference curve are preferred by the rational consumer because they contain more of
the two commodities than the lower ones.

4. Indifference curves never cross each other (cannot intersect). The assumptions of
consistency and transitivity will rule out the intersection of indifference curves. Figure 3.4 shows
the violations of the assumptions of preferences due to the intersection of indifference curves.

In the above figure, the consumer prefers bundle B to bundle C. On the other hand, following
indifference curve 1 (IC1), the consumer is indifferent between bundle A and C, and along
indifference curve 2 (IC2) the consumer is indifferent between bundle A and B. According to the
principle of transitivity, this implies that the consumer is indifferent between bundle B and C
which is contradictory or inconsistent with the initial statement where the consumer prefers
bundle B to C. Therefore, indifference curves never cross each other.
1.3.2.4 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.

From the above graph, MRSX,Y associated with the movement from point A to B, point B to C
and point C to D is 2.0,1.6, and 0.8 respectively. That is, for the same increase in the
consumption of good X, the amount of good Y the consumer is willing to scarify diminishes.
This principle of marginal rate of substitution is reflected by the convex shape of the indifference
curve and is called diminishing marginal rate of substitution. It is also possible to derive MRS
using the concept of marginal utility. MRSx,y is related to MUX and MUY as follows.

1.3.2.5 The budget line or the price line

Indifference curves only tell us about consumer preferences for any two goods but they cannot
show which combinations of the two goods will be bought. In reality, the consumer is
constrained by his/her income and prices of the two commodities. This constraint is often
presented with the help of the budget 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.

y, X and Y.

X and PY.

Assuming that the consumer spends all his/her income on the two goods (X and Y), we can
express the budget constraint as:

By rearranging the above equation, we can derive the following general equation of a 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.
1.4 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 ( XY
MRSXY ) is equal to the slope of the budget line (Px /Py ). In figure 3.10, the equilibrium of the
consumer is at point ‗E‘ where the budget line is tangent to the highest attainable indifference
curve (IC2).
 Chapter summary

A consumer makes choices by comparing bundle of goods. Given any two consumption bundles,
the consumer decides either that one of the consumption bundles is strictly better than the other,
or decides that he is indifferent between the two bundles. Economists use the term utility to
describe the satisfaction or pleasure derived from consumption of a good or service.

In other words, utility is the power of the product to satisfy human wants. There are two
approaches to measure or compare consumer‘s utility derived from consumption of goods and
services. These are cardinal and ordinal approaches. The cardinalist school postulated that utility
can be measured objectively. However, the assumption of cardinal utility is doubtful because
utility may not be quantified. Unlike the cardinal theory, the ordinal utility theory says that utility
cannot be measured in absolute terms but the consumer can rank or order the utility he derives
from different goods and goods.

The ordinal/indifference curve approach is based on the consumer‘s budget line and indifference
curves. An indifference curve shows all combinations of two goods, which yield the same total
utility to a consumer, and the budget line represents all combinations of two products that the
consumer can purchase, given product prices and his or her money income. The consumer is in
equilibrium (utility is maximized) at the point where the budget line is tangent to the highest
attainable indifference curve.