Chapter Three

Theory of Consumer Behaviour

Introduction
• Consumer theory is based on what people like, so it
begins with something that we can‘t directly
measure, but must infer.
• i.e., consumer theory is based on the premise that
we can infer what people like from their choices.
• Three steps to best understand consumer behaviour:
1. Examining consumer’s preference, we need a
practical way to describe how people prefer one
good to another.
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 2. We must take into account that consumers face
budget constraints – they have limited incomes
that restrict the quantities of goods they can buy.
3. We will put consumer preference and budget
constraint together to determine consumer choice.

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 Chapter objectives
After successful completion of this chapter, you will
be able to:
• explain consumer preferences and utility
• differentiate between cardinal and ordinal utility
approach
• define indifference curve and discuss its properties
• derive and explain the budget line
• describe the equilibrium condition of a consumer

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 Consumer preferences
• A consumer makes choices by comparing bundle of
goods.
• Given any two consumption bundles, the consumer
decides that:
 one of the consumption bundles is strictly better than
the other,
 or he/she is indifferent b/n the two bundles.
• In order to tell whether one bundle is preferred to
another, we see how the consumer behaves in choice
situations involving the two bundles.

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• If he/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 he/she definitely wants the X-
bundle rather than the Y-bundle.
• If the consumer is indifferent b/n the two bundles of
goods, we use the symbol∼ and write X~Y.
• Indifference means that the consumer would be just as
satisfied consuming the bundle X as she would be
consuming bundle Y.

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• If the consumer prefers or is indifferent b/n the two
bundles we say that he/she weakly prefers X to Y and
write X ⪰ Y.
• Strict preference, weak preference, and indifference
relations are not independent concepts; the relations
are themselves related.
• e.g., if X ⪰ Y and Y ⪰ X, we can conclude that X ~ Y.
• i.e., if the consumer thinks that X is at least as good as
Y and that Y is at least as good as X, then he/she must
be indifferent b/n 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.
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 The concept of utility
• Economists use the term utility to describe the
satisfaction or pleasure derived from the consumption
of a good or service.
• i.e., 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.

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• In defining utility, it is important to bear in mind that:
• ‘Utility’ and ‘Usefulness’ are not synonymous. Because
usefulness is product centric whereas utility is consumer
centric.
• Utility is subjective. The utility of a product will vary
from person to person. i.e., the utility that two
individuals derive from consuming the same level of a
product may not be the same. e,g., non-smokers do not
derive any utility from cigarettes.
• Utility can be different at different places and time. e.g.,
the utility that we get from drinking coffee early in the
morning may be different from the utility we get during
lunch time.
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 Approaches of measuring utility
• Two major approaches to measure or compare
consumer‘s utility: cardinal and ordinal approaches.
• The cardinalist school postulated that utility can be
measured objectively.
• According to ordinal, utility is not measurable in
cardinal numbers rather the consumer can rank/order
the utility he derives from different goods and services.

The cardinal utility theory

• According to this theory, utility is measurable with an
arbitrary unit of measurement called utils, as 1, 2, 3 etc.
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 Assumptions of cardinal utility theory
1. Rationality of consumers. The main objective of the
consumer is to maximize his/her satisfaction given
his/her limited budget or income. Thus, to maximize
his/her satisfaction, the consumer has to be rational.
2. Utility is cardinally measurable. According to cardinal
approach, the utility 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 who received monthly salary at
the start of the month gives equal value to 1 birr with
what he may give it after three or more weeks.
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4. Diminishing marginal utility (DMU). The utility derived
from each successive units of a commodity diminishes.
i.e., the marginal utility of a commodity diminishes as
the consumer consumes 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
X1 , X2 , ..., Xn ,
the total utility is given by
TU = f (X1 , X2 ,… , Xn).

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 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.

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 Marginal Utility (MU) is the extra satisfaction a
consumer realizes from an additional unit of the
product.
• In other words, MU is the change in TU that results
from the consumption of one more unit of a product.
• Graphically, it is the slope of total utility.
• Mathematically, marginal utility is:
MU = ∆TU/∆Q
where, ∆TU = the change in total utility, and
∆Q = the change in the amount of product
consumed.

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To explain the relationship between TU and MU, let us
consider the following hypothetical example.
Table 3.1: Total and marginal utility

Quantity Total utility (TU) Marginal utility (MU)

0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2
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Q (birr) TU (birr) MU
0 0
1 40 40
2 85 45
3 120 35
4 140 20
5 150 10
6 157 7
7 160 3
8 160 0
9 155 -5
10 145 -10
145

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• 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.
• Graphically, the above data can be depicted as
follows.

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 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.

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 Law of diminishing marginal utility (LDMU)
• The LDMU states that as the quantity consumed
of a commodity increases per unit of time, the
utility derived from each successive unit
decreases, ceteris paribus.
• 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
of time.

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 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

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 Equilibrium of a consumer
• The objective of a rational consumer is to
maximize total utility.
• As long as the additional unit consumed brings a
positive marginal utility, the consumer wants to
consumer more of the product because total
utility increases.
• However, given his limited income and the price
level of goods and services, what combination of
goods and services should he consume so as to
get the maximum total utility?
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a) the case of one commodity
• The equilibrium condition of a consumer that
consumes a single good X occurs when the
marginal utility of X is equal to its market price.
Mux = Px
Proof
Given the utility function
U = f (X)
• If the consumer buys commodity X, then his
expenditure will be QXPX.
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b) the case of two or more commodities
• For the case of two or more goods, the consumer‘s
equilibrium is achieved when the marginal utility per
money spent is equal for each good purchased and
his money income available for the purchase of the
goods is exhausted. That is,

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Recall that 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.

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• The total utility that Saron derives from this
combination can be given by:
TU= TU1 + TU2 = 14 + 12 = 26
• Given her fixed income and the price level of the two
goods, no combination of the two goods will give her
higher TU than this level of utility.
Limitation of the cardinal approach
1. The assumption of cardinal utility is doubtful because
utility may not be quantified. Utility cannot be
measured absolutely (objectively).
2. The assumption of constant MU of money is
unrealistic because as income increases, the marginal
utility of money changes.
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 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.
• 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.
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 Assumptions of ordinal utility theory
The ordinal approach is based on these assumptions.
• Consumers are rational - they maximize their utility
or satisfaction 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 goods.
• 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.

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• 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.
• The 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. e.g., 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. The ordinal utility theory is also
known as the indifference curve approach.
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 Indifference set, curve and map
• Indifference set/schedule is a combination of goods
for which the consumer is indifferent.
• It shows the various combinations of goods from
which the consumer derives the same level of utility.
• Consider a consumer who consumes two goods X
and Y (table 3.3).
Table 3.3: Indifference schedule
Bundle A B C D
Orange 1 2 4 7
Banana 10 6 3 1
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• In table 3.3 above, 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 curve: When the indifference
set/schedule is expressed graphically, it is called an
indifference curve.
• An indifference curve shows different combinations
of two goods-yield same utility to the consumer.
• A set of indifference curves is called indifference
map.
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 Properties of indifference curves
1. Indifference curves (ICs) have negative slope.
ICs are negatively sloped as consumption level of one
good can be increased only by reducing the consumption
level of the other. i.e., to keep utility of the consumer
constant, as the quantity of one good is increased the
quantity of the other must be decreased.
2. Indifference curves are convex to the origin.
→ the slope of an IC decreases as we move along the
curve from left to right. The convexity of ICs is reflection
of the diminishing marginal rate of substitution. This
assumption → the goods can substitute one another at
any point on an IC but are not perfect substitutes.
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3. A higher IC is always preferred to a lower one.
The further away from the origin an IC lies, the
higher the level of utility it denotes. Baskets of
goods on higher ICs are preferred by the rational
consumer since they contain more of the two
commodities than the lower ones.
4. ICs never cross each other (cannot intersect).
The assumptions of consistency and transitivity
will rule out the intersection of ICs. Figure 3.4
shows the violations of the assumptions of
preferences due to the intersection of ICs.
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• In the above figure, the consumer prefers bundle B to
bundle C.
• In contrast, following indifference curve 1 (IC1), the
consumer is indifferent b/n bundle A and C, and along
indifference curve 2 (IC2) the consumer is indifferent
b/n bundle A and B.
• According to the principle of transitivity, this implies
that the consumer is indifferent b/n bundle B and C
which is contradictory or inconsistent with the initial
statement where the consumer prefers bundle B to C.
• Thus, indifference curves never cross each other.

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 Marginal rate of substitution (MRS)
• Marginal rate of substitution is a rate at which
consumers are willing to substitute one good
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 b/n the bundles.

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• 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 on 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.

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• 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.
• i.e., 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 MRS is reflected by the convex
shape of the IC and is called diminishing MRS.
• It is also possible to derive MRS using the concept
of marginal utility.
• MRSX ,Y is related to MUX and MUY as follows.
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 The budget line or the price line
• ICs only tell us about consumer preferences for any
two goods
• 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.

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• It is a graph which shows the various combinations of
two goods that a consumer can purchase given
his/her limited income and prices of the two goods.
• To draw a budget line facing a consumer, we
consider the following assumptions.
 There are only two goods bought in quantities, say, X
and Y.
 Each consumer is confronted with market
determined prices, PX and PY.
 The consumer has a known and fixed money income
(M).

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• Assuming that the consumer spends all his/her
income on the two goods (X and Y), we can express
the budget constraint as:
M = PX X + PYY
• By rearranging the above equation, we can derive
the following general equation of a budget line.

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 Note that:
• The slope of the budget line is given is by – P X/PY (the
ratio of the prices of the two goods).
• Any combination of the two goods within the budget
line (such as point A) or along the budget line is
attainable.
• Any combination of the two goods outside the
budget line (such as point B) is unattainable
(unaffordable).
• Example: A consumer has Birr 120 to spend on two
goods X and Y with prices Birr 4 and 6, respectively.
Derive the equation of the budget line and sketch the
graph.
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Solution: The equation of the budget line can be
derived as follows.
PXX + PYY = M Y
4X + 6Y = 120
6Y = 120 – 4X 20
Y = 120/6 – 4X/6
Y = 20 – 2X/3
X=0 Y = 20
X
Y=0 X = 30 30

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• When the consumer spends all of his/her income on
good Y, we get the Y- intercept (0, 20).
• Similarly, when the consumer spends all of her
income on good X, we obtain the X- intercept (30, 0).
• Using these two points we can sketch the graph of
the budget line.
• Recall that a budget is drawn for given prices and
fixed consumer‘s income.
• Hence, the changes in prices or income will affect the
budget line.

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 Change in income: If the income of the consumer
changes (keeping the prices of the commodities
unchanged), the budget line also shifts (changes).
• Increase in income causes an upward/outward shift
in the budget line that allows the consumer to buy
more goods and services
• Decrease in income causes a downward/inward shift
in the budget line that leads the consumer to buy
less quantity of the two goods.
• It is important to note that the slope of the budget
line (the ratio of the two prices) does not change
when income rises or falls.

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 Change in prices: An equal increase in the prices of
the two goods shifts the budget line inward.
• Since the two goods become expensive, the
consumer can purchase lesser amount of the goods.
• An equal decrease in the prices of the two goods,
one the other hand, shifts the budget line out ward.
• Since the two goods become cheaper, the consumer
can purchase more amounts of the two goods.
• Any increase/decrease in the price of one of the two
goods, keeping the price of the other good and
income constant, changes the slope of the budget
line by affecting only the intercept of the commodity
that records the change in the price.
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• e.g., if the price of good X decreases while both the
price of good Y and consumer‘s income remain
unchanged, the horizontal intercept moves outward
and makes the budget line flatter.
• The reverse is true if the price of good X increases.
• On the other hand, if the price of good Y decreases
while both the price of good X and consumer‘s
income remain unchanged, the vertical intercept
moves upward and makes the budget line steeper.
• The reverse is true for an increase in the price of
good Y.

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 Equilibrium of the consumer
• Preferences of a consumer are indicated by the IC.
• The budget line specifies different combinations of two
goods (X and Y) the consumer can purchase with the
limited income.
• So, a rational consumer tries to attain the highest possible
IC, given the budget line.
• This occurs at the point where the IC is tangent to the
budget line so that the slope of the IC (MRSX,Y) 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
IC (IC2).
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Mathematically, consumer optimum (equilibrium) is
attained at the point where:
Slope of indifference curve = Slope of the budget line

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 Example: A consumer consuming two
commodities X and Y has the utility function
U(X, Y) = XY + 2X . The prices of the two
commodities are 4 Birr and 2 Birr, respectively.
The consumer has a total income of 60 birr to
be spent on the two goods.
a) Find the utility maximizing quantities of good
X and Y.
b) Find the MRSX ,Y at equilibrium.

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 Chapter summary
• A consumer makes choices by comparing bundle of
goods.
• Given any two consumption bundles, the consumer
either decides that
 one of the consumption bundles is strictly better than the
other, or
 he/she 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.
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• 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/she derives from different goods.

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

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 Review questions
Part I: Discussion questions
1. Explain briefly the following concepts.
A) Utility
B) Indifference curve
C) Law of diminishing marginal utility
D) Budget line
E) Consumer preference
F) Marginal rate of substitution
2. What is the basic difference between cardinal
and ordinal approaches of utility?
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3. Elaborate the justifications for the negative slope and
convexity of indifference curve.
4. Standard indifference curves cannot intersect each
other. Why?
5. Does the change in income affect the slope of the
budget line? Explain.
Part II: Workout
1. A person has $ 100 to spend on two goods X and 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%?
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 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?
2. A rational consumer spends all of her income on two
goods: Apple and Banana. Suppose the last dollar
spent on Apple increased her total utility from 60
utils to 68 utils and the last dollar spent on Banana
increased her total utility from 25 utils to 29 utils. If
the price of a unit of Apple is 2 Birr, what is the price
of a unit of Banana at equilibrium?

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3. Given utility function U = X0.5Y0.5 where PX = 12 Birr,
PY = 4 Birr and income of the consumer is, M = 240 Birr.
A. Find the utility maximizing combinations of X and Y.
B. Calculate marginal rate of substitution of X for Y
(MRSX,Y) at equilibrium and interpret your result.
4. Suppose a particular consumer has 8 Birr to be spent on
two goods, A and B. The unit price of good A is 2 Birr
and the unit price of B is 1 Birr. The marginal utility
(MU) she gets from consumption of the goods is given
below.

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