Chapter Three

Theory of Consumer
Behavior( Consumption Decision)
3.1 Utility and Preferences
3.1.1 Total and Marginal Utility
3.1.2 Law of Diminishing Marginal Utility
3.1.3 Consumer Equilibrium in Cardinal Approach
3.2 Indifference Curve
3.2.1 Properties of Indifference Curve
3.2.2 MRTS
3.2.3 Indifference Map
3.2.4 The Budget Constraint
3.2.5 Consumer Equilibrium in Ordinal Approach
3.4 Individual and Market Demand
3.4.1 Income and Substitution effects
3.4.2 Derived Demand curve
3.4.3 Consumer Surplus 1
 Theory of Consumer Behavior
What is meant by a consumer behavior?

A consumer is an individual or a household who uses/consumes final

goods and services with a primary objective of maximizing utility.

The theory of consumer behavior is a description of how consumers

allocate income among different goods and services to maximize their
well-being.

It is meant how consumers decide on the baskets of goods and

services they consume
Take Tea or coffee in the morning

Read in library or dorm

The consumer makes choices by comparing bundle of

goods.
3.1 Utility and Preferences
• A consumer's preferences are what he or she likes
or dislikes; a consumer's demands are what she or he
 Con’t……
Steps to understood a consumer behavior

Consumer preference: reasonable preference from one good over

the other

Budget constraint: preference need to consider the limited income

Consumer choice: make real decision based on both preference and

income constraint

Utility is the level of satisfaction/pleasure

that the consumer can derive from

consumption of goods and services or

by undertaking a certain activity.

It is a power of the good/service w/c enables

to satisfy our wants

It is feeling of pleasure or satisfaction on consumption

 Assumptions
The basic assumptions in analyzing consumer behavior
are
• The consumer has limited income.
• The consumer is a rational being.
• A consumer is a utility maximizing entity.
• A consumer has full information relevant to his
decision.
Consumption: is the act of using goods &
services to satisfy human wants.
The concept of utility is characterized with the following
properties:
– ‘Utility’ and ‘usefulness” are not synonymous. For
example, paintings by Picasso may be useless functionally
but offer great utility to art lovers.
 Approaches to measure Utility
There are two major approaches of measuring utility

Cardinal and

Ordinal approaches

1. Cardinal Approach:

In this case utility is quantitatively or cardinally

measurable feeling like height and weight and suggested the
measurement of utility in subjective units, called Utils.
• Thus, in a theory of cardinal utility, the size of the utility difference
between two bundles of goods and services is supposed to have some
sort of significance.
• In its attempt to reach at the equilibrium of the consumer, the cardinal
utility approach makes the following assumptions.
 Assumptions of Cardinal Utility theory
Rationality of Consumers
Utility is cardinally Measurable: the utility or satisfaction of each commodity
is measurable and Money is the most convenient measurement of utility.
Constant Marginal Utility of Money: A given unit of money deserves the
same value at any time or place it is to be spent
Limited Money Income.
Diminishing Marginal Utility (DMU): The additional benefit which a person
derives from a given increase of his stock of a thing diminishes with every
increase in the stock of what he already has.
Independence of utility: The total utility of a basket of goods depends on the
quantities of the individual commodities.
 Total utility , marginal utility and the LDMU

Total utility (TU) is the amount of satisfaction or pleasures a person

derives from consumption of some specific quantities of a commodity at a
particular time.
It refers to the total amount of satisfaction a consumer gets from consuming or
possessing some specific quantities of a commodity at a particular time.
Marginal Utility (MU): refers to the additional utility obtained from
consuming an additional unit of a commodity. Graphically, it is the slope of
total utility.
Mathematically, the formula for marginal utility is:
Alternatively, MU = ΔTU/ Δ Q,
where Δ TU is the change in Total Utility, and,
Δ Q is change in the amount of product consumed.
 Cont’d …

The relationship between TU & MU can be stated as:

When TU increases at an increasing rate MU will increase

When TU increase at a decreasing rate, MU will fall

When TU is constant (maximum), MU is zero; and

When TU decreases MU will be negative

 Laws of Diminishing MU

The 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.
Units of Quantity(x) consumed 0 1 2 3 4 5 6

TUX 0 10 16 20 22 22 20
MUX - 10 6 4 2 0 -2
 Equilibrium (Optimum) of the Consumer in
the Cardinal Utility theory

The objective of a rational consumer is to maximize the TU, or satisfaction derived

from spending his/her income.

This objective is reached (or said to be in equilibrium), when the consumer spends
his/her income in such a way that the utility or satisfaction of the dollar spent on the
various goods is the same. i.e.

the MU per unit of price for each commodity must be equal.

Mathematically,

Mux/Px = Muy/Py = … = Mun/Pn, subject to the constraint

PxQx + PyQy + …+QnPn = M ( M = individual's money income).

 Example
Suppose bread (B) & Butter (T) are the only two commodities
available, & PB = 2 & PT = 1, the individual income is 18 per time
period & is all spent. Given the above information & table below,
compute equilibrium quantities of B & T and TU obtained at
equilibrium.

MUB/PB = MUT/PT = 8 , at QB=4 and QT=10 (equilibrium quantities are: QB

= 4 & QT = 10).

TU at equilibrium=(18+16)B + (12+11+10+9+8)T = 84

NB: TU=Summation of MUs, i.e. TUi=MU1+MU2+---+MUn ; (i=1,2,---,n)

 Derivation of the Cardinalist Demand
• we discussed that marginal utility is the slope of the total utility
function.
• The derivation of demand curve is base don 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.

P1 a
Price b
P

P2 c
MUX
O Quantity

Price P1

P
Demand
P2
Curve
O Quantity
Figure - Derivation of Demand curve Q1 Q Q2
Critiques/Limitation of the Cardinal Utility Approach

• There are three basic weaknesses in the

cardinal utility approach.
a) The assumption of cardinal utility is
extremely doubtful.
b) The assumption of constant utility of money is
also unrealistic.
c) The additivity of utility is questionable since
there is no objective measure of utility.
 Ordinal Approach (Indifference Curve Analysis )

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, but it is
always possible for the consumers to express the utility in
relative terms
1st 2 nd 3rd
Ordinalists believes it is practically possible consumer prefers
can be measured via ordering, ranking, sorting out etc and
can be ranked as and so on.

The indifference curves theory is one of the theories which

 Con’t
The basic assumptions under the ordinal utility theory are:

A consumer is a rational being – they aim at maximizing their

satisfaction or utility given their income and market prices.

Utility is only measurable ordinally - Consumers are required only to

order or rank their preference for various bundles of commodities.

The Total Utility of the Consumer Depends on the Quantities of the

Commodity Consumed X , X ,...... X i.e., U=f (
1 2 n )

Transitivity and consistency of choice.

Transitivity - in the senses that if the consumer prefers market basket X to
market basket Y, and prefers Y to Z, and then the consumer also prefers X to
Z.

Consistency: If A>B, in one period, then B is not greater than/equal to A in

another period.

Diminishing marginal rate of substitution (DMRS) - The marginal

rate of substitution 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.

Limited Money Income.

 Indifference schedule, curve & Map
Indifference set/schedule: is a tabular list showing various
combinations of the commodities among which the consumer is
indifferent

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.
Bundle
(Combination) A B C D

Orange(X) 1 2 4 7

Banana (Y) 10 6 3 1

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: 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.
 Cont’d …

An indifference curve: is the locus of points, each representing a

different combinations of a pair of goods, which yield the same
utility or level of satisfaction to the consumer so that he/she is
indifferent between any two combinations of goods when it comes to
making a choice between them.

We can also call these curves as Iso-utility (or equal utility) curves.

The set of indifference curves which rank the preferences of the consumer are called
indifference map. Indifference
Indifferenc
Map
e
Curve (IC)
 Characteristics (Features) of (Well – Behaved) ICs

1. ICs are downward sloping: implies scarcity/trade off and

possibility of substitution

2. ICs are convex to the origin – due to diminishing MRS

3. ICs do not intersect (cross} one another. If they do, their point
of intersection exhibits the same level of utility, which is
impossible.

4. As an indifference curve becomes far from the origin, it

represents a higher utility.

5. Utility is the same for any moment along an IC

 MRS
MRSxy (marginal rate of substitution of X for Y): refers to the amount
of Y that a consumer is willing to sacrifices in order to gain an
extra unit of X, if he/she wants to maintain the same level of
satisfaction.

MRSx,y = - ΔY/ΔX, ----(slope of IC)

Or MRSyx refers to the amount of X that a consumer is willing to

sacrifices in order to gain an extra unit of Y, if he/she wants to
maintain the same level of satisfaction.

MRSyx = - ΔX/ΔY
X4
U 5  2
Y
MRSX ,Y .
Example: Suppose a consumer’s utility function MU
is given by
X
MRS X ,Y 
MU Y
Compute the
Example

20
 Budget line/constraint
The budget line (BL): shows all the various combinations of any
two products, which can be purchased, given the prices of the
products & the consumer's money income.

The budget line can be defined as the locus of points of all the
combinations of the two commodities that cost exactly the consumer
income. The budget line includes the bundles of goods that just
exhaust the consumer’s income.

Assuming a two-commodity model, the income constraint may be

expressed as:

PxQx +PyQy = I ---- Budget constraint model

Solving for Qy from the above equation we get a budget line equation:

Qy = I/ Py – (Px/ Py )Qx --- Budget line equation

22
 Cont’d …
Applying intercept concept:

The slope of the budget line is the ratio of the two prices: Px/Py.

The slope of the budget line has a nice economic interpretation. It

measures the rate at which the market is willing to substitute
commodity X for commodity Y. The negative sign is there since the
change in X and change in Y must always have opposite signs. If you
consume more of commodity X, you have to consume less of
commodity Y and vice versa if you continue to satisfy the budget
constraint.
 Determinants of BL

Basic determinates of BL are Income and Price

When income increases the budget line will shift to upward; and
decrease in income will shift the budget line to the left but remains
parallel to the original one.

And the effect of change in price is to rotate the budget line to

the left or the right.
 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?
• From our previous discussion the budget line for two commodities was
PX X  PY Y as:
expressed M
3 X  5Y 100
5Y 100  3 X
100 3
Y  X
5 5
3
Y  20  X
5
– When the person spends all of his income only on the consumption of good
Y,we can get the Y intercept that is(0,20).
– However, when the consumer spends all of his income on the consumption of
only good X,then we get the X intercept that is (33.33,0).
– Using these two points we can draw the budget line. Thus, the budget line will
25
be:
 Con’t….

• If the budget decreases by 25%, then the budget will be reduced to 75.
– As a result the budget line will be shifted in-ward that is indicated by (A’B’).This forces
the person to buy less quantity of the two goods.
– The equation for the new budget line can be solved as follows:

3 X  5Y 75
5Y 75  3 X
75 3
Y  X
5 5
3
Y 15  X
5

26
 Consumer Equilibrium in Ordinal Approach
• A rational consumer seeks to maximize his utility or satisfaction by
spending his or her income. It maximizes the utility by trying to attain
the highest possible indifference curve, given the budget line. This
MRS XYis tangent to the budget line so (that
occurs where an indifference curve PX / PY ).
the slope of the indifference curve ( ) is equal to the slope of the
budget line
• Thus, the condition for utility maximization, consumer optimization, or
consumer equilibrium occurs where the consumer spends all income (i.e.
he/she is on the budget line) and the slope of the indifference curve
MRS
equals the
XY to PX slope
/ PY of the budget line
 Mathematical derivation of Consumer
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.
– In utility maximization, the function that represents the objective that the
consumer tries too achieve is called the objective function and the constraint
that the consumer faces is represented by the constraint function.
• The maximization problem will be formulated as follows:

28
Con’t….

29
Example 1

30
 Con’t….

• The maximum utility at y=14, x=8

• U  XY  2 X =
(14x8)+2(8)=128
• At this maximum utility the budget
constraint is met –i.e. 60 =4X+2Y
60=(4x8)+(2x14) 60=32+28
60=60 31
 Example 2
• Suppose a consumer spends his/ her entire
income on food (x1) and clothing (x2) and
25% of the total income is spend on food. If
price of x1 = 2, prices of X2=3, m = 200,
estimate function & determine the optimum
quantity of x1 & x2 given U(x1. x2) = X1¼ X2 ¾

32
Effects of Changes in Income and Prices on Consumer equilibrium

A. Changes in Income: Income Consumption/expansion/offer/Curve

and the Engel Curve
 Income consumption curve (ICC) or Income
expansion curve (IEC) is a curve joining the points of
consumer optimum (equilibrium) as income changes
(ceteris paribus). Or, it is the locus of consumer
equilibrium points resulting when only the consumer’s
income varies.
 If we connect all of the points representing equilibrium
market baskets corresponding to all possible levels of
01/17/20
25
01/17/20
25
 Engle Curve
 From the ICC we can derive the Engle Curve.
 The Engle curve is named after Ernest Engel, the
German Statistician who pioneered studies of
family budgets and expenditure positions
 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; (ceteries
paribus) per unit of time.

01/17/20
25
01/17/20
 Changes in Price: Price Consumption Curve (PCC) and Individual Demand
Curve

• The price-consumption curve 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.
Below is an illustration of deriving the demand
curve when price of commodity X decreases from .
Fig.1.17 the PCC &derivation of the
demand curve
Com
modi
ty Y
PCC

Commodity X

Px1
Price
of X
Px2
Individual

demand curve
Px3

X1 X2 X3 Commodity X
Derivation of Individual's Demand Curve form Indifference Curve
analysis
 Substitution & Income Effects of a Change in
•
Price
In our previous discussion we have noted that there are two effects of a
price change.
• If price falls (rises), the good becomes cheaper (more expensive) relative
to other goods; and consumers substitute toward (away from) the good.
This is the substitution effect.
• Also, as price falls (rises), the consumer’s purchasing power increases
(decreases).
– Since the set of consumption opportunities increases (decreases) as price changes,
the consumer changes the mix of his or her consumption bundle.
– This effect is called the income effect.
• Let us analyse each effect in turn, and then combine the two in order to
see why demand is assumed to be downward sloping.
• A fall in the price of a good has two effects:
A. The consumer will tend to buy more of a good that has become cheaper and
less of those goods that are now relatively expensive. This response to the
change in relative prices of goods is called the substitution
effect(compensating variation)
B. Because one of the goods is now cheaper, the consumer enjoys an increase
in real purchasing power. The consumer is better off because he/she can buy
the same amount of the good for less money and thus money left over for
additional purchases.
– The change in demand resulting from this change in real purchasing power is called the
income effect. The combined effect of the two is known as the total effect (net
 Income and Substitution effect for a normal good
I1
• Suppose initially the income of the consumer is , price
Py1 of
I I
good Y is Px1, and Price of good X is , we have
Py 1
the budget Pxline
1

with y-intercept and X-intercept . The consumer’s

equilibrium is point A that IC
indicates
1 the point of tangency
I I
Px1 the
between Px2 budget line and indifference curve Py . As a resultPx2
1
of a decrease in the price of X from to the budget line
shifts outward with y-intercept & X-Intercept . The
consumer’s new equilibrium will be on point B.

41
 Income, Substitution, and Net effect for an inferior commodity
• the following diagram shows the income,
substitution and net effect for an inferior
commodity in the case of a decline in the price
of good X.
• For an inferior good, a decrease in the price of
the commodity causes the consumer to buy more
of it (the substitution effect), but at the same
time the higher real income of the consumer
tends to cause him to reduce consumption of the
commodity (the income effect).
• We usually observe that the substitution effect
still is the more powerful of the two; even though
the income effect works counter to the
substitution effect, it does not override it. Hence,
the demand curve for inferior goods is still
42
negatively sloped.
 Con’t……

• In short in the case of normal goods, the income effect and the
substitution effect operate in the same direction –they reinforce each
other.
• But not all goods are normal. Some goods are called inferior goods
because the income effect is the opposite (of that of a normal good)
43
for them-they operate in opposite direction.
Decomposition of price change into income and substitution effects
• As we have noted above that a fall in the price of
commodity X leads to an increase in its quantity
demanded.
– The total increase in the quantity demanded of X is,
however the result of combined action of substitution
and income effect of a given price change.
• As we know, when the price of X falls (the money
income of the consumer remaining the same), the
real income of the consumer increases.
– In other words, with the same money income, the
consumer can now purchase larger quantities of both the
goods X and Y.
• Two approaches have been developed in economics
so far to define the level of constant real income o
income effect.
1. Slutsky’s approach 2. Hick’s
approach
 The first approach has been developed by the well-
known Russian economist Prof Fugen Slutsky.
 Slutsky states that to keep the real income of the
consumer constant, we should reduce his money
income to the extent that he should be just able to
purchase the original combination of the two
commodities (if he desires).
 This can be done by drawing a line parallel to the new price
line which passes through the original combination of the
two commodities X and Y(same quantity)
 The second approach has been developed by the
well-known British economist, J.R. Hicks.
 According to this approach, in order to keep the real
income of the consumer constant, we should reduce
his money income to the extent that he should be just
able to enjoy the original indifference curve.
 This can be done by drawing a line parallel to the new price
line which at some point touches the original indifference
curve(same level of satisfaction).
Summary of Substitution and Income Effects of a fall
in the Price of X
 Numerical Example
• Suppose that the consumer has a demand function
2
for goodXXis 20given
 MPX by . Originally
his income is $ 200 per month and the price of the
200
good is 5 per 20 killogram.
28 Therefore, his demand for
52
good X will be per month.
200
• Suppose that the price of the good 20  falls
2
32.to
5 4 per
4
kilogram. Therefore, the new demand at the new
price will be: per month.
• Thus, the total change in demand is 4.5 that is 32.5-
28.
• When 1 ' the price falls the purchasing power of the
M  P1 X  P2Y
consumer
M  P1 X  P2Y
changes. Hence, in order to make the
Subtracting the second equation from the
original consumption of good X, the consumer
first gives:
1 '
M  M  Xhis
adjusts [ P1 income.
P1 ] This new
Therefore, canincome
be calculated
to make the as follows:
M  XP1 original consumption affordable
when
M  Xprice
P1 falls to 4 is:
M 28 * [4  5]  28
• Hence, the level of income necessary to keep
purchasing power
M 1 M  constant
M 200 is28 172
• The consumers new demand at the new price and
income will beX (:4,172) 20  172 30.75
42

• Or Find IE and SE of price change.

 The Consumer Surplus
• While consumers purchase goods and services, they
often pay less than what they are willing to pay.
Thus, the difference between what they are willing to
pay and what they actually paid is considered as
their surplus.
• Therefore, consumer surplus is the difference
between what a consumer is willing to pay and what
he actually pays. Graphically, it is measured by the
area below the demand curve and above the price
level.

01/17/2025 51
 Numerical Example
• Q 15
Suppose the demand function of a consumer is given  p
by:
a. Compute the consumer surplus when the price of the
good is 2
b. Compute the consumer surplus when the price of the
good is 4
c. Compute the change in consumer surplus when the price
changes
When Pricefrom
is zero2the
to demand
4. for
quantity purchased will be 15 and
• Solution
when the demand for quantity is put
to zero then the price level will be
15.And finally, when we insert the
given price level 2 in the demand
equation we get the level of quantity
demanded that is 13. Hence, we can
easily compute the area of the
triangle that is found above the given
price level that is 2.

52