ARSI UNIVERSITY

COLLEGE BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS
INTRODUCTION TO ECONOMICS

CHAPTER THREE

THE THEORY OF
CONSUMER
BEHAVIOR AND
LECTURE NOTES
DEMAND COMPILED BY: ASSEFA D.
2024
 Introduction
• In chapter two, we have learned demand for a
single commodity only.
• In reality, of course, consumers have to
choose from the many thousands of different
goods available on the market.
• In other words, consumers are faced with the
problem of choice.
• In examining the shape of a demand curve for
a single good, therefore, we must closely look
at the behavior of the consumers when faced
with this problem of choice.
 The Theory of Consumer Behavior
• The principle assumption upon which the
theory of consumer behavior and demand
is built is:
• a consumer attempts to allocate his/her
limited money income among available
goods and services so as to maximize
his/her utility (satisfaction).
• Useful for understanding the demand side
of the market.
• Utility - amount of satisfaction derived
from the consumption of a commodity
Characteristics of utility
• ‘Utility’ and ‘Usefulness” are not synonymous.
– For example, paintings by Picasso may be useless
functionally but offer great utility to art lovers.
• Utility is subjective. The utility of a product will
vary from person to person.
– For example, no-smokers do not derive any utility
from cigarettes.
• The utility of a product can be different at
different places and time.
– For example, the utility that we get from wearing
thicker clothes during summer is not the same as
any time else.
 Approaches of Measuring Utility
• The Cardinal Utility Theory (CUT)
• Utility is measurable in a cardinal sense
• cardinal utility - assumes that we can
assign values for utility
• E.g., derive 100 utils from eating a slice of
bread
• The Ordinal Utility Theory (OUT)
• Utility is measurable in an ordinal sense
• ordinal utility approach - does not assign
values, instead works with a ranking of
preferences.
 The Cardinal Approach
• Nineteenth century economists, such as
Jevons, Menger and Walras, assumed that
utility was measurable in a cardinal sense,
• Utility is measurable by arbitrary unit of
measurement called utils in the form of 1, 2,
3 etc.
Assumptions of Cardinal Utility theory
• 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.
• Utility is Cardinally Measurable. According to this
approach, the utility or satisfaction of each
commodity is measurable with utils
• Constant marginal utility of money. A given unit
of money deserves the same value at any time or
place it is to be spent.
Assumptions…
• Limited Money Income. The consumer has limited
money income to spend on the goods and services
he/she chooses to consume.
• Diminishing Marginal Utility (DMU).The utility
derived from each of successive units of a
commodity diminishes.
• 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)
 The Cardinal Approach
• Total utility (TU) - the overall level of
satisfaction derived from consuming a good
or service
• Marginal utility (MU)-additional satisfaction
that an individual derives from consuming an
additional unit of a good or service.
Formula :
MU = Change in total utility
Change in quantity

= ∆ TU
∆Q
 The Cardinal Approach
• Law of Diminishing Marginal Utility
(LDMU) = As more and more of a good are
consumed, the process of consumption will
(at some point) yield smaller and smaller
additions to utility
• When TU is increasing, MU is positive.
• When TU is maximized, MU is zero.
• When TU is decreasing, MU is negative.
 EXAMPLE
Number
Purchased TU MU

0 0 0
1 4 4
2 7 3
3 8 1
4 8 0
5 7 -1
 The Cardinal Approach
• TU, in general, increases
with Q
• At some point, TU can start
falling with Q
• If TU is increasing, MU > 0
• From Q = 1 onwards, MU is
declining  principle of
diminishing marginal utility
 As more and more of a
good are consumed, the
process of consumption
will (at some point) yield
smaller and smaller
additions to utility
 Assumptions of Law of Diminishing
Marginal Utility
• 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
 Consumer Equilibrium
• So far, we have assumed that any amount
of goods and services are always available
for consumption
• In reality, consumers face constraints
(income and prices):
– Limited consumers income or budget
– Goods can be obtained at a price

• Consumer equilibrium refers to the level of

consumption of commodities that
maximize utility given income constraint.
 The Case of One Commodity
• If A consumer consume only one commodity (X)
with price (Px) the equilibrium determined at:
MUx=Px
Consumer Equilibrium for Two or more
Commodities Case
• 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 available
money income
Consumer Equilibrium: Two Good Case

• Optimizing condition:
MU X MU Y

PX PY

• If MU X MU Y

PX PY

 spend more on good X and less of Y

until equilibrium position restored
Simple Illustration

• Suppose: X = Milk
Y = Bread

• Assume: PX = 2
PY = 10
Numerical Illustration
Qx TUX MUX MUx QY TUY MUY MUy
Px Py
Px=2 Py=10

1 30 30 15 1 50 50 5
2 39 9 4.5 2 105 55 5.5
3 45 6 3 3 148 43 4.3
4 50 5 2.5 4 178 30 3
5 54 4 2 5 198 20 2
6 56 2 1 6 213 15 1.5
 Cont.
• 2 potential optimum positions
• Combination A:  X = 3 and Y = 4
– TU = TUX + TUY = 45 + 178 = 223

• Combination B:  X = 5 and Y =
5
– TU = TUX + TUY = 54 + 198 = 252
 Cont.
• Presence of 2 potential equilibrium
positions suggests that we need to
consider income.
• To do so let us examine how much each
consumer spends for each combination.
• Expenditure per combination
– Total expenditure = PX X + PY Y
– Combination A: 3(2) + 4(10) = 46
– Combination B: 5(2) + 5(10) = 60
 Cont.
• Scenarios:
– If consumer’s income = 46,
– then the optimum is given by combination
A. .…Combination B is not affordable
– If the consumer’s income = 60,
– then the optimum is given by
Combination B….Combination A is
affordable but it yields a lower level of
utility
Limitation of the Cardinalist approach
• The assumption of cardinal utility is
doubtful because utility may not be
quantified.
• It is difficult to find an appropriate unit of
measurement. By the way, if we define a
unit of utility as a "util", what is a util?
• The assumption of constant MU of money
is unrealistic because as income
increases, the marginal utility of money
changes.
THE ORDINAL UTILITY APPROACH
• Economists following the lead of Hicks,
Slutsky and Pareto believe that utility is
measurable in an ordinal sense--the utility
derived from consuming a good, such as
X, is a function of the quantities of X and Y
consumed by a consumer.
U = f ( X, Y )
• The consumers can rank commodities in
the order of their preferences as 1st, 2nd,
3rd and so on.
The Ordinal Approach
• In the ordinal utility approach, utility
cannot be measured absolutely but
different consumption bundles are ranked
according to preferences.
• The concept is based on the fact that it
may not be possible for consumers to
express the utility of various commodities
they consume in absolute terms, like, 1 util,
2 util, or 3 util
Assumptions of Ordinal Utility theory
• The Consumers are rational-they aim at
maximizing their satisfaction or utility given
their income and market prices.
• Utility is ordinal, i.e. utility is not absolutely
(cardinally) measurable.
• Diminishing Marginal Rate of Substitution
(MRS):When a consumer continues to
substitute X for Y the rate goes decreasing
and it is the slope of the Indifference curve.
Assumptions

• The total utility of the consumer depends

on the quantities of the commodities
i.e., U=f (X1, X2......Xn) consumed,
• Preferences are transitive or
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.
 INDIFFERENCE CURVE (IC)
• Helps to Illustrate Ordinal Utility Theory
• Curve where the points represent a combination
of items when the consumer at indifference
situation (satisfaction).
• It shows the various combinations of two goods
from which the consumer derives the same level
of satisfaction.
• Axes: both axes refer to the quantity of goods
• For the combination that produces a higher level
of satisfaction, the curves shift to the right (IC2)
from the first curve (IC1)
• In contrast, the curves shift to the left (IC-1)
Indifference schedule
Indifference Curve and Map
PROPERTIES OF INDIFFERENCE CURVE
• Downward sloping: from left to right
• Convex to the origin: Because the
marginal rate of substitution (MRS) decrease
as more of one commodity consumed
• Do not cross (intersect): consumer
preferences transitive
• Different ICs show different level of
satisfaction. Far from the origin, the higher
the satisfaction.
Marginal rate of Substitution
• 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
EXAMPLE
 BUDGET LINE (BL)
• 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.
 Budget line (BL)
• Line showing all combinations of items can be
purchased for a particular level of income (M) ;
M =PxQx + PyQy
• The slope depends on the prices of
goods X and Y, the slope = Px/Py
• Slope-Ve: to use more goods X, Y should reduce
& vice versa
• In the X-axis, when the quantity Y = 0, all M used
to purchase X; M = PxQx Qx =M/Px
• At the Y axis, when the quantity X = 0, all M used
to purchase Y; M = PyQy Qy =M/Py
 Example
• Suppose that the consumer’s money
income is, 1000 Birr, price of commodity X
is 100 Birr, and the price of commodity Y
is 200 Birr.
– Indicate the quantity of X the consumer could
purchase if she spent all her income on
commodity X
– Indicate the quantity of Y the consumer could
purchase if she spent all her income on
commodity Y
– What is the equation for the budget line?
– Find the slope of the budget line.
FACTORS THAT SHIFT A BUDGET LINE
• Change in income: If the income of the
consumer changes (keeping the prices of
the commodities unchanged), the budget
line also shifts (changes).
FACTORS THAT SHIFT A BUDGET LINE
• Change in prices: An equal increase in the
prices of the two goods shifts the budget
line inward, and the reverse is true
FACTORS THAT SHIFT A BUDGET LINE
• 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.
FACTORS THAT SHIFT A BUDGET LINE
• 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 either of X or Y
 CONSUMER EQUILIBRIUM
• A rational consumer tries to attain the highest
possible indifference curve, given the budget
line (For a given income and prices of goods).
• This occurs at the point where the indifference
curve is tangent to the budget line
• So that, the slope of the indifference curve
(MRSxy ) is equal to the slope of the budget
line (Px/Py)
CONSUMER EQUILIBRIUM
(Point E)
CONSUMER EQUILIBRIUM