CHAPTER TWO

THEORY OF CONSUMER BEHAVIOR

 
 Utility
Economist use utility as a satisfaction or enjoyment
derived from the consumption of a good or service.
is the level of satisfaction that is obtained by
consuming a commodity or undertaking an activity.
utility of a product Characterized as:-
 Utility is subjective.
 Utility of a product differ at different place and time.
 Con’t..
To get maximum utility consumer
consider the following points.
 How much satisfaction he get from buying and then
consuming an extra unit of a good or service.
 The price he pay to get the good.
 The satisfaction he get from consuming alternative
products.
 The prices of alternative goods and services.
Approaches to measure utility
There are two major approaches/views about
measurability of utility.
These are Cardinal and ordinal approaches.
The Cardinal Utility theory
 utility is quantitatively measurable in terms of
money or simple number.
the unit of measurement of utility is called “util”.
Assumptions of Cardinal Utility theory
1. Rationality of Consumers:- given his/her limited
budget or income the main objective of the
consumer is to maximize his/her satisfaction .
2. Utility is cardinally Measurable:-
the utility or satisfaction of each commodity is
measurable.
Money is the most convenient measurement of utility.
The last birr that consumers prepared to pay for
another unit of commodity measure utility or
satisfaction.
 Con’t.
3. Constant Marginal Utility of Money.
From assumption number two, money is the most
convenient measurement of utility.
However, if the marginal utility of money changes
with the level of income (wealth) of the consumer.
Then money can not be considered as a measurement
of utility.
4. Limited Money Income.
 Consumer has limited money income to spend on the
goods and services.
 Con’t
5. 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.
6. 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, the total utility is given by:
 TU=f (ᵡ₁, ᵡ ₂, ᵡ ₃…… ᵡ n )
 Total and Marginal Utility
  Total Utility (TU)
It refers to the total amount of satisfaction a
consumer gets from consuming 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.
 Marginal Utility (MU)

It refers to the additional utility obtained from
consuming an additional unit of a commodity.

In other words, marginal utility is the change in total
utility resulting from change in the consumption of
commodity.

Graphically, it is the slope of total utility.

Mathematically, the formula for marginal utility is:
 MU= TU/ Q
 
The Law of diminishing marginal Utility (LDMU)
Is the utility you get from consumption of the first
orange is the same as the second orange?
LDMU 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.
The LDMU is best explained by the MU curve that is
derived from the relationship between the TU and
total quantity consumed(Q).
Hypothetical table showing TU and MU of
consuming Oranges (X)
Units of
Quantity 4th
0 5th 6th
(x) Unit
1st Unit 2nd unit 3rd unit
unit Unit Unit
consume
d
TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils
MUX - 10 6 4 2 0 -2
T o t a l U t il it y

20 A
TUX
15

10

5
M a r g in a l U tilit y

Quantity X

10

Quantity X
1 2 3 4 5
MUX

Fig.2.1Derivation of marginal utility from total utility

 Con’t
As indicated in the above figures, total utility increase at
increasing rate
Total utility increase at decreasing rate when marginal
utility decline and
Then total utility reaches maximum when marginal utility
become zero.
The total utility curve reaches its pick point (Saturation
point) at point A.
 This Saturation point indicates that by consuming 5
oranges, the consumer attains its highest satisfaction of 11
utils.
However, Consumption beyond this point results in
dissatisfaction.
MU is inversely related to the quantity of the good
consumed.
Equilibrium of the consumer:
According to cardinal utility theory
A consumer reaches equilibrium position when he
maximizes his total utility given his income and prices
of commodities he consumes.
consumer’s equilibrium analysis how a consumer
allocates his money income among the various goods
and services he consumes.
Consumer equilibrium: - one commodity case
• With the simple model of a single commodity X, the
consumer can either buy X or retain his money
income.
• The consumer is in equilibrium when the marginal
utility of X is equated to its market price (PX).
• Symbolically , MUX= PX
 Con’t
If MUX >PX, the consumer can increase his well fare by
purchasing more units of X.
Similarly if MUX< PX, the consumer can increase his
total satisfaction by cutting down the quantity of X and
keeping more of his income unspent.
Therefore, he attains the maximization of his utility
when MUX =PX.
If there are more commodities, the condition for the
equilibrium of the consumer is the equality of the ratio
of the marginal utilities of the individual commodities
to their
MUX prices.
= MUY  ……………  MUN
PX PY PN

 Con’t
From MUX= PX MUY=PY MUN=PN

MUX
PX
1 , MUY
PY
1
MUN
PN
1

 MUX MUY
Px

PY
.............. 
MUN
PN

 The utility derived from spending on additional unit of money

must be the same for all commodities.
 If the consumer derives grater utility from any one commodity, he
can increase his welfare by spending more on that commodity and
less on the others, until the above equilibrium condition is
fulfilled.
 Utility schedule for a single commodity Marginal utility
Quantity of Marginal Marginal utility
  Total utility(TU) per Birr(price=2
Orange utility(MU) of money
birr)
0 0 - - 1
1 6 6 3 1
2 10 4 2 1
3 12 2 1 1
4 13 1 0.5 1
5 13 0 0 1
6 11 -2 -1 1

•For consumption level lower than three quantities of oranges,

since the marginal utility of orange is higher than the price, the
consumer can increase his/her utility by consuming more
quantities of oranges.
•On the other hand, for quantities higher than three, since the
marginal utility of orange is lower than the price, the consumer can
increase his/her utility by reducing its consumption of oranges.
Utility schedule for two commodity
 
Orange, Price=2birr Banana, Price=4birr
Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 3 1 6 6 1.5
2 10 4 2 2 22 16 4
3 12 2 1 3 32 10 2.5
4 13 1 0.5 4 40 8 2
5 13 0 0 5 45 5 1.85
6 11 -2 -1 6 48 3 0.75

•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 .
 Con’t
 MU i.e. MUP 1
1

MU 2
P2

 Thus, the consumer will be at equilibrium when he consumes

2 quantities of Orange and 4 quantities of banana, because
MU orange
Porange

MU banana 4 8
Pbanana
  2
2 4
or one orange and

 Derivation of Demand curve: using Cardinal utility theory

 The derivation of demand curve is based on the concept of diminishing
marginal utility.
 If the marginal utility is measured using monetary units the demand curve
for a commodity is the same as the positive segment of the marginal utility curve.
 con’t
To explicitly derive the demand curve from consumer’s
equilibrium condition for a single commodity case, say X, as
MUx=PX (Mum).
Suppose that the consumer is in equilibrium at point E1 where
MUx=Px .
Now, if price of good X falls toP2 , the equilibrium will be
disturbed making MUx>Px(Mum).
Since Mum is constant, the only way to attain the equilibrium
is reducing MUx, by buying and consuming more of
commodity X.
Thus by consuming additional units of X he reduces his MUx
to E2Q2 and thereby, restores equilibrium condition at
MUx=Px.
Similarly, if price falls further to P3, equilibrium points shift to
E3, where equilibrium quantity is OQ3.
A graph showing derivation of
cardinals‘t demand
E1
P1

E2
P2

Price
E3
P3
MUX

O Quantity

P1

P2
Price

P3

O Quantity

Q1 Q2 Q3
 con’t
The above fact indicates that as price decreases, the
quantity demanded increases.
This price and equiliburum quantity relationship is
presented in part (b) in the above figure.
 The price-quantity combination corresponding to
equilibrium point, E1 is shown at point E1’.
similarly the price-quantity combinations
corresponding to equilibrium points E2 and E3 have
been shown to point E2’ and E3’ respectively.
By joining point E1’, E2’ and E3’ we get the demand
curve for commodity X.
 Critiques of cardinal approach
 The assumption of cardinal approach that utility is
cardinally or objectively measurable is unrealistic.
Utility is a subjective concept, which cannot be measured
objectively.
 The assumption of constant utility of money and serves as a
measure of utility assumption is unrealistic.
 Because marginal utility of money, like that of all other
goods is subject to change and therefore it cannot serve as a
measure of utility derived from goods and services.
 The psychological law of diminishing marginal utility has
been established from introspection.
The law is accepted as an axiom without empirical
verification.
The Ordinal (indifference curve) Utility
Theory
States that utility being a subjective and abstract
concept can’t be measured.
i.e it may not possible for a consumer to express the
utility of a good in cardinal number.
It can be measured only in ordinal terms, that is in
terms of greater than(>),less than(<) or equal to(=).
it implies that a consumer can list all the commodities
he consumes in the order of his preference.
Assumptions of Ordinal Utility theory
 Consumers are rational- aims to maximizing their
satisfaction or utility given their income and market prices.
 Utility is ordinal, i.e. 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 (MRS):
 MRS is the rate at which a consumer is willing to substitute
one commodity (x) for another commodity (y) so that his
total satisfaction remains the same.
When a consumer continues to substitute X for Y the rate
goes decreasing and it is the slope of the Indifference curve.
 Con’t
 The total utility of the consumer depends on the quantities
of the commodities consumed.
i.e TU=f(X1,X2,X3……..Xn).
 Preferences are transitive and consistent:
It is transitive in the senses that if the consumer prefers
market basket A to market basket B , and prefers B to C,
then the consumer must also prefers A to C.
When we say consistent it means that if market basket A is
greater than market basket B (A>B) in a certain period
then B must not greater than A in another period (B not
>A).
 All goods are “are good” (i.e desirable) rather than “bad”.
So that living costs aside consumers always prefer more of
any good to less.
Indifference Set, Curve and Map
Indifference Set/ Schedule: It is a combination of
goods for which the consumer is indifferent, preferring
none of any others.
 It shows the various combinations of goods from
which the consumer derives the same level of utility.
Indifference Schedule
Bundle A B C D
(Combinati
on)
orange (X) 1 2 4 7

Banana (Y) 10 6 3 1
 Con’t
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 Curves(IC): an indifference curve
shows the various combinations of two goods that
provide the consumer the same level of utility or
satisfaction.
It is the locus of points (particular combinations or
bundles of good), which yield the same utility (level of
satisfaction) to the consumer, so that the consumer is
indifferent as to the particular combination he/she
consumes.
By transforming the above indifference schedule into
graphical representation, we get an indifference curve.
 Indifference map
10 A

Indifference
B
6 curve
Banana (Y)

Good B
Indifference Map
C
2 IC3
1
D IC2
IC1

1 2 4 7
Orange
(X)

 Indifference Map: it is the entire set of indifference curves.

 Reflects the entire set of tastes and preferences of the
consumer.
 A higher indifference curve refers to a higher level of
satisfaction and a lower indifference curve shows lesser
satisfaction.
 Properties of Indifference Curves
 Indifference curves have negative slope.
 Indifference curves are convex to the origin.
 A higher Indifference curve is always preferred to a lower one.
Indifference curves cannot intersect each other. If they did, the
consumer would be indifferent between C and E, since both are on
indifference curve one (IC1).

B
B an ana
Ba nana

E

D IC2
C
A
IC1

Orange Orange

Similarly, the consumer would be indifferent between points D and

E, since they are on the same indifference curve, IC2.
By transitivity, the consumer must also be indifferent between C
and D.
 
Marginal rate of substitution(MRS)

MRS refers to the amount of one commodity that an

individual is willing to give up to get an additional unit of
another good while maintaining the same level of
satisfaction or remaining on the same indifference curve.
MRSxy is defined as the number of units of commodity
Y that must be given up in exchange for an extra unit of
commodity of X so that the consumer maintains on the
same level of satisfaction.
It is the negative of the slope of an indifference curve at
any point of any two commodities such as X and Y.
i.e., Slope of indifference curve y
 MRS
X ,Y
x
 Level of consumption of good X and Y

Bundle A B C D
(Combinatio
n)
ORANGE 1 2 4 7
(X)
Banana (Y) 10 6 3 1

Y 4
MRS X ,Y (between point s A and B   4
X 1

•In the above case the consumer is willing to forgo 4 units of Banana to
obtain 1 more unit of Orange.
•If the consumer moves from point B to point C, he is willing to give up only
2 units of Banana(Y) to obtain 1 unit of Orange (X), so the MRS is 2(∆Y/∆X
=4/2).
• In general, as the amount of Y increases, the marginal utility of additional
units of Y decreases.
• Similarly, as the quantity of X decreases, its marginal utility increases.
• In addition, the MRS decreases as one move downwards to the right.
 Marginal utility and marginal rate of substitution

It is also possible to show the derivation of the MRS using

MU concepts. This is related to the MUx and the MUy as:
MU X
MRS XY 
MU Y
Proof:

Suppose the utility function for two commodities X and Y is

defined as:

U  f ( X ,Y )

Since utility is constant on the same indifference curve:

U  f ( X ,Y )  C

The total differential of the utility function is:

U U
dU  dX  dY  0
X Y

MU X dX  MU Y dY  0

MU X dY
  MRS X ,Y
MU Y dX

OR MU Y
MU X

dX
dY
 MRS Y , X
 Example
X4
Suppose a consumer’s utility function is given by U 5 .Compute the
Y 2
MRSX ,Y .
MU X
MRS X ,Y 
MU Y
dU dU
MU X  and MU Y 
dX dY

Therefore, MU X  4( X 41Y 2 )  4( X 3Y 2 ) and MU Y  2( X 4Y 2 1 )  2 X 4Y

MU X 4 X 3Y 2 Y
MRS X ,Y   4
2
MU Y 2X Y X
Special Indifference Curves
In convexity or down ward sloping indifference curve, we
assume that two commodities such as x and y can
substitute one another to a certain extent but are not
perfect substitutes.
However, the shape of the indifference curve will be
different if commodities have some other unique
relationship such as perfect substitution or
complementary.
Here, are some of the ways in which indifference
curves/maps might be used to reflect preferences for
three special cases.
Perfect substitutes
If two commodities are perfect substitutes (if they are
essentially the same), the indifference curve becomes a
straight line with a negative slope.
MRS for perfect substitutes is constant.
Y

IC2
IC1 IC3
X
 Perfect complements
If two commodities are perfect complements the
indifference curve takes the shape of a right angle.
MRS for perfect complements is zero (both and is the
same, i.e. zero).
Y IC1 IC2 IC3

X
 useless good
the following figure shows an individual’s indifference
curve for food (on the horizontal axis) and an out-dated
book, a useless good, (on the vertical axis).
Since they are totally useless, increasing purchases of
out-dated books does not increase utility.
This person enjoys a higher level of utility only by getting
additional food consumption.
Outdated IC1 IC2 IC3
book

food
 The Budget Line or the Price line
 
The budget line is a line or graph indicating different
combinations of two goods that a consumer can buy with
a given income at a given prices.
It shows the market basket that the consumer can
purchase, given the consumer’s income and prevailing
market prices.
 Assumptions for the use of the budget line
 there are only two goods, X and Y, bought in quantities X
and Y.
Each consumer is confronted with market determined
prices.
The consumer has a known and fixed money income (M).
 Con’t
Assume that the consumer spends all his/her income on two goods
(X and Y), the budget constraint express as;
M  PX X  PY Y
Where, PX=price of good X
PY=price of good Y
X=quantity of good X
Y=quantity of good Y
M=consumer’s money income
This means that the amount of money spent on X plus the amount
spent on Y equals the consumer’s money income.
Suppose for example a household with 30 Birr per day to spend on
banana(X) at 5 Birr
PX each
5, PY and
2, M Orange(Y)
 30birr at 2 Birr each. That is,

Therefore, our budget line equation will be: 5 X  2Y  30

 By rearranging the above equation we can derive the
general equation of a budget line,
M  PX X  PY Y
M  XPX  YPY

M P
Y   X X
PY PY

M
= Vertical Intercept (Y-intercept), when X=0.
PY

PX
 = slope of the budget line (the ratio of the prices of the two goods)
PY

The horizontal intercept (i.e., the maximum amount of X the individual can consume or
purchase given his income) is given b M PX M P M
 X 0  X X X 
PY PY PY PY PX
M/PY

B

A


M/PX
Factors Affecting the Budget Line
 Effects of changes in income
keeping the prices of the commodities unchanged, if
the income of the consumer changes the budget line
also shifts.
Increase in income causes an upward shift of the
budget line .
While decreases in income causes a downward shift of
the budget line.
But the slope of the budget line (the ratio of the two
prices) does not change when income rises or falls.
The budget line shifts from B to B1 when income
decreases and to B2 when income rises
 Con’t
M2/Py

M/Py

M1/Py Where M2>M>M1

B B2

B1

M1/PX M/PX M2/PX

Effects of change in income

 Effect of change in price of the
commodity
Changes in the prices of X and Y is reflected in the shift of
the budget lines.
Y Y

B1 B1
B
B
X X
Fig a fig b

•In the above figures (fig.a) a price decline of good

X results in the shift from B to B1.
•A fall in the price of good Y in figure (b) is
reflected by the shift of the budget line from B to
B1.
 Cont’d
Note that changes in the prices of the commodities change the
position and the slope of the budget line.
 But, proportional increases or decreases in the price of the two
commodities (keeping income unchanged) do not change the slope
of the budget line if it is in the same direction.
 Numerical Example
A person has $ 100 to spend on two goods(X,Y) whose respective prices
are $3 and $5.
A. Draw the budget line.
B. What happens to the original budget line if the budget falls by
25%?
C. What happens to the original budget line if the price of X doubles?
D. What happens to the original budget line if the price of Y falls to 4?
Equilibrium of the consumer: The ordinal utility approach
 
Consumer equilibrium is the point where a consumer
maximizes his total utility, given his income and the
market price of goods.
Two conditions must be satisfied for the consumer to
be in equilibrium.
 Foc is the slope of the IC must be equal to the slope
of the budget line (BL).i.e Mux/Muy=Px/Py
 Soc requires that the necessary condition must be full
field at the highest attainable convex IC.
Graphical presentation of the equilibrium of
the consumer.
Given the indifference map of the consumer and his
budget line, the equilibrium is defined by the point of
tangency of the budget line with the highest attainable
IC.
Y
A

B
E
IC4

C IC3

IC2
D
IC1

•At Point ‘E’ the consumer obtains the greatest level

of satisfaction (IC3) relative to other indifference
curves.
Mathematically, consumer optimum (equilibrium) is
attained at the point where
PX MU X MU Y MU X P
MRS XY  , But we know   .......MU X PY  MU Y PX ...,  X
PY PX PY MU Y PY
 Con’t
Mathematically, consumer optimum (equilibrium) is
attained at the point where
PX MU X MU Y MU X P
MRS XY  , But we know   .......MU X PY  MU Y PX ...,  X
PY PX PY MU Y PY

Mathematical derivation of equilibrium

Suppose that the consumer consumes two commodities X
and Y given their prices by spending level of money income
M.
Thus, the objective of the consumer is maximizing his
utility function subject to his limited income and market
prices.
•The maximization problem will be formulated as follows:
  MaximizeU  f ( X , Y )

Subject to PX X  PY Y  M
 Con’t
We can rewrite the constraint as follows:

PX X  PY Y  M  0

Multiplying the constraint by Lagrange multiplier

 ( PX X  PY Y  M )  0
 
Forming a composite function gives as the Lagrange
function:   U ( X , Y )   ( PX X  PY Y  M )

•FOC requires that the partial derivatives of the Lagrange

function with respect to the two goods and the langrage
multiplier be zero.
 U  U 
  PX  0 ;   PY  0 and  ( PX X  PY Y  M )  0
X X Y Y 
 Con’t
From the above equations we obtain:
U U
 PX and  PY
X Y

U U
 MU X and  MU Y
X Y
Therefore, substituting and solving for we get the
equilibrium condition:
MU X MU Y
 
PX PY

•By rearranging we get: MU

MU

P
P
X X

•SOC for maximum requires that the second order partial derivatives of the
Y Y

Lagrange function with respect to the two goods must be negative.

 
2 U 2 2 U 2
  0 and  0
X 2 X 2 Y 2 Y 2
 Example
A consumer consuming two commodities X and Y has
the following utility function .U  XY  2 X
If the price of the two commodities are 4 and 2
respectively and his/her budget is birr 60.
A. Find the quantities of good X and Y which will
maximize utility.
B. Find the MRSx,y at optimum.
 Solution
The Lagrange equation will be written as follows:
  XY  2 X   ( 4 X  2Y  60)
 Con’t

=y+2-4  =0……………. (1)
X


 X   2  0 ……….(2)
Y


 4 X  2Y  60  0 …….…..(3)


From equation (1) we get Y  2  4 and from equation (2) we get

Y 2
X  2 .Thus, we can get that X  and equation (2) gives as   1 X .
2 2

Y 2
By substituting X  in to equation (2) we get Y  14 and X  8.
2

MU X Y 2
MRS X ,Y  
MU Y X

After inserting the optimum value of Y=14 and X=8 we get 2 which equals

to the price ratio of the two goods ( PX 

4
 2)
PY 2
 Effects of Changes in Income and Prices on
Consumer behavior
 Changes In Income: Income Consumption Curve and the
Engel Curve
 Note that an increase in the consumer’s income (all other
things held constant) results in an upward parallel shift of the
budget line.
 This allows the consumer to buy more of the two goods.
And when the consumer’s income falls, ceteris paribus, the
budget line shifts downward, remaining parallel to the original
one.
If we connect all of the points representing equilibrium
market baskets corresponding to all possible levels of money
income, the resulting curve is called the Income
consumption curve (ICC) or Income expansion curve
 Income consumption curve (ICC)
is a curve joining the points of consumer optimum as
income changes (ceteris paribus).
Or, it is the locus of consumer equilibrium points
resulting when only the consumer’s income varies
Commodity

ICC
Y

Commodity X

Engle Curve
M3
M2
M1

X1 X2 X3 Commodity X
 Con’t
From the Income Consumption Curve we can derive the Engle
Curve.
 The Engle Curve is the relationship between the equilibrium
quantity purchased of a good and the level of income.
It shows the equilibrium (utility maximizing) quantities of a
commodity, which a consumer will purchase at various levels of
income; (celeries paribus) per unit of time.
 In relation to the shape of the income-consumption and Engle
curves goods can be categorized as normal (superior) and
inferior goods.
Thus, commodities are said to be normal, when the income
consumption curve and its Engle curve are positively sloped.
On the other hand, commodities are said to be inferior when
the income consumption curve and Engle curve is negatively
sloped
Changes in Price: Price Consumption Curve (PCC) and Individual DD-
Curve
The second factor that affects the equilibrium of the
  consumer is price of the goods.
The effect of price on the consumption of good is even
more important to economists than the effect of
changes in income.
The change in the price of x will result in out ward/in
ward shift of the budget.
If we connect all the points representing equilibrium
market baskets corresponding to each price of good X
we get a curve called price-consumption curve(PCC).
 price-consumption curve(PCC)
is the locus of the utility-maximizing combinations of
products that result from variations in the price of one
commodity when other product prices, the money
income and other factors are held constant.
We can derive the demand curve of an individual for a
commodity from the price consumption curve(PCC).
 deriving the demand curve when price of commodity
X decreases from Px1 to Px2 to Px3.
 Con’t
Commodity Y

PCC

Commodity X

Px1
Price of X

Px2
Individual
Px3
Demand curve

X1 X2 X3 Commodity X