CHAPTER 3

THE THEORY OF
CONSUMER
BEHAVIOUR
 LEARNING OUTCOME

At the end of this chapter, student will be able to:

Explain total utility and marginal utility.

 Define and explain the law of diminishing marginal utility.
Define the indifference curve and its properties.
Define the budget line.
 Explain how consumer equilibrium is achieved.
 DEFINITION OF CONSUMER
BEHAVIOUR

Consumer behaviour refers to

the study of consumer while
engaged in the process of
consumption.
 UTILITY APPROACH

 Definition
– ‘Utility’ means the satisfaction obtained from consuming a
commodity.
 Two Types of Approach
– Cardinal Approach
• The cardinal utility theory says that utility is measurable and by
placing a number of alternatives so that the utility can be added.
• The index used to measure utility is called utils.
– Ordinal Approach
• The ordinal utility theory says that utility is not measurable but it
can be compared.
• Ordinal approach uses the ranking of alternatives as first, second,
third and so on.
 TOTAL UTILITY AND MARGINAL
UTILITY
TOTAL UTILITY (TU)
The total satisfaction that a person gets from the
consumption of goods and service.

MARGINAL UTILITY (MU)

The additional to total utility as a result of consuming one more units
of the same good or services.

Marginal Utility (MU) = Change in Total Utility

Change in Total Quantity

MU =  TU/  Q
 LAW OF DIMINISHING
MARGINAL UTILITY

 Definition
The additional benefit which a person derives from a
given increase of a stock of a thing diminishes, other
things being equal, with every increase in the stock that
he already has.
OR
Law of Diminishing Marginal Utility states that as
consumption increases more and more, marginal utility
will be less and less.
 LAW OF DIMINISHING MARGINAL
UTILITY (cont.)
TU increases from consumption of 1st unit of apple until the 5th
unit of apples. After the 5th unit of apples, TU will decrease.
Units of Total Utility Marginal Utility
Apples
1 20 20
2 35 15
MU will decrease
3 45 10 and become zero at
the 5th unit of apples
4 50 5
and further
5 50 0 consumption of
6 45 -5 apples will not
satisfy the consumer
7 35 -10 as the MU shows
8 20 -15 negative signs.
 LAW OF DIMINISHING
MARGINAL UTILITY (cont.)
When TU is increasing, MU will be positive.
When TU is at its maximum, MU will be zero.
When TU is decreasing, MU will be negative.
 LAW OF EQUI-MARGINAL
UTILITY (EMU)
 Definition
The Law of Equi-Marginal Utility (EMU) states that
other things being equal, a consumer gets maximum
satisfaction when he allocates his limited income to the
purchase of different goods, where the marginal utility
derived from the last unit of money spent on each item
of expenditure tends to be equal.
– This is also known as conditions for maximum utility
or satisfaction.
 LAW OF EQUI-MARGINAL UTILITY
(EMU) (cont.)

 Conditions for Equilibrium

For consumer equilibrium, this condition must be fulfilled.

Condition 1: Every ringgit spent on every commodity must yield

the same marginal utility.

Marginal Utility of X = Marginal Utility of Y

Price of X Price of Y

Condition 2: Total expenditure of all goods must be equal to

the total budget allocated to maximize utility.

P1Q1 + P2Q2 + … + PnQn = Total budget

 LAW OF EQUI-MARGINAL
UTILITY (EMU) (cont.)
EXAMPLE:
EXAMPLE: Arwin
Arwin has
has an
an income
income of
of RM37
RM37 and
and the
the prices
prices of
of goods
goods P,
P, Q
Q and
and R
R are
are RM5,
RM5, RM1
RM1 and
and RM4
RM4 respectively.
respectively.

Condition Fulfilling condition 1, two combination of goods are obtained:

Condition 1
1 :: Every
Every ringgit
ringgit spent
spent on
on every
every
commodity Combination 1 : 2P, 4Q and 1R
commodity must yield the same marginal utility.
must yield the same marginal utility.
Combination 2 : 4P, 5Q and 3R

Condition Combination 1 : 2P, 4Q and 1R

Condition 2 2 :: Total
Total 2(5) + 4(1) + 1(4) = 18
expenditure
expenditure of of all
all goods
goods must
must
be equal to the total budget Combination 2 : 4P, 5Q and 3R
be equal to the total budget 4(5) + 5(1) + 3(4) = 37
allocated
allocated to
to maximize
maximize utility.
utility. So, 4 units of Product P, 5 units of Product Q and 3 units of Product R will be purchased by
Arwin.
 INDIFFERENCE CURVE

 Definition
– An indifference curve represents all the possible
combinations of two goods which will give the same
level of satisfaction.
 Assumptions
1. Scale of preferences
2. Consumers’ preferences are transitivity
3. Rationality
4. Diminishing marginal rate of substitution
5. Concept of ordinal utility
 INDIFFERENCE CURVE (cont.)

An indifference schedule is a list of combination of two

goods that give equal satisfaction to the consumer.

Combinations Good Y Good X

A 12 2
B 6 4
C 4 6
D 3 8
E 2 12

The table above shows all the five combinations,

which will give the equal level of satisfaction.
 INDIFFERENCE CURVE (cont.)

An indifference curve represents all those combinations of two goods;

X and Y which yield the same level of satisfaction to a consumer.
 INDIFFERENCE MAP

An indifference map shows a set of indifference curve.

The higher the indifference curve from the origin, higher will be the utility.
IC33 has the higher satisfaction.
 INDIFFERENCE CURVE

 Marginal Rate of Technical Substitution

– Refers to the rate at which one good is substituted for another
good.

 Characteristics of Indifference Curve

1. Indifference curve slopes downward from left to right.
2. Indifference curve are convex to the origin.
3. Higher indifference curves represent higher level of satisfaction.
4. Indifference curve never intersect each other.
5. Indifference curve does not touch the Y axis or X axis.
 BUDGET LINE

A budget line represents various combinations of two goods, which can be

purchased with a given amount of money at the given price of each unit.
 CHANGES IN BUDGET LINE

1. Change in Consumer’s Income

An
An increase
increase in
in consumer’s
consumer’s income
income will
will lead
lead to
to a
a shift
shift of
of the
the budget
budget line
line to
to the
the right,
right, A1B1.
A1B1.
A
A decrease
decrease in
in consumer’s
consumer’s income
income will
will shift
shift the
the budget
budget line
line to
to the
the left
left as
as represented
represented by
by A
A 22B
B2.2.
 CHANGES IN BUDGET LINE
(cont.)
2. Change in Price of Good X

Budget Line Budget Line

30 30

25

20 20
Good Y

15 AB

Good Y
A1B1 AB
10 10

5
A1B1
0 0
2 4 6 8 10 12 14 2 4 6 8 10 12 14 16 18 20 22 24

Good X Good X
Good
Good X
X

Price
Price of
of good
good X
X increase
increase from
from RM1
RM1 toto Price
Price of
of good
good X
X decrease
decrease from
from RM1
RM1 to
to
RM2
RM2 and
and price
price of
of good
good Y
Y constant.
constant. RM0.50
RM0.50 and
and price
price of
of good
good YY constant.
constant.
 CHANGES IN BUDGET LINE
(cont.)
3. Change in Price of Good Y

Budget Line Budget Line

30 30

25 25

20 20
Good Y

Good Y
15 AB 15 AB
AB1 AB1
10 10

5 5

0 0
2 4 6 8 10 12 14 2 4 6 8 10 12 14

Good X Good X

Price of good Y increase from RM0.50 Price of good Y decrease from RM0.50
to RM1 and price of good X constant. to RM0.40 and price of good X constant.
 CONSUMER EQUILIBRIUM
A consumer is in equilibrium when he or she is consuming the best possible
combination of two goods with the given amount of income.

At point b, and e, the consumer will

have a lesser satisfaction at IC 3
with the same amount of income

Consumer equilibrium is reached when

indifference curve tangent with budget
Line which represents best combination
of two goods with limited income
as point C.