Chapter 3: Consumer Behaviour

and Utility Maximization

Dr. S. Phakathi
[email protected]
To consult, send an email if I am not in my office

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 Learning objectives
 Define what economists mean by utility.

 Distinguish between the concepts of total utility and marginal utility.

 State the law of diminishing marginal utility and illustrate it graphically.

 Be able to explain the Equi-marginal principle (utility maximising rule) and use it to determine optimal consumer
choices.

 Know how the utility-maximization model helps highlight the income and substitution effects of a price change.

 Know how a demand curve can be derived by observing the outcomes of price changes in the utility-maximization
model.

 Be able to use the Ordinalist approach to analyse consumer behaviour.

 Know the characteristics of indifference curve.

 Know how a price change of one product shifts the budget line and be able determine a new equilibrium point.
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 UTILITY?
• Why are shopping baskets of consumers different? Why do you prefer Chicken vs Beef?

• Utility is the satisfaction or pleasure an individual gets from the consumption of a good or service.

 Utility has 3 characteristics:

1. Utility is a subjective concept. Why??

2. Utility and usefulness are Not Synonymous. Examples??

3. It can be measured in two different approaches.

Cardinal Approach Ordinal Approach

It can be measured quantitatively using numerical values in Can not be quantitatively measured but compared (ranked)
units called utils (units of utility). expressed in indifference curves.
Sihle derives 10 utils from having one slice of chicken pizza and e.g., Sihle prefers a burger to a slice of chicken pizza.
20 utils from the burger.
Have you been asked by a bank to rate their services on a scale Do you prefer Capitec Bank vs FNB or ABSA, or Standard?
of 1-10?
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 Total Utility and Marginal Utility?
• Total utility is the total amount of satisfaction or pleasure an individual derives from
consuming some specific quantity of goods or services.
• For example, from consuming 3 burgers, a consumer gets
10 utils 18 utils 24 utils = 52 utils
Total utility

• Marginal utility is the extra satisfaction a consumer gets from consuming an additional unit
of that product.
• Marginal utility is the change in total utility that results from the consumption of one more
unit of a product.
• Marginal U

• What is the marginal Utility after consuming 2 burgers

• 18-10/ 2-1 = 8 utils 4
 In graphics – Total & Marginal utility
Burge rs Totak margi nal
consume uti l i ty uti l i ty
TU
d pe r
me al
( TU)
( uti l s)
( MU)
( uti l s) TU = MAX
0 0 30
10
1 10 25
8
2 18 TU
20
6
3 24
4 15
4 28
2 10
5 30 5
0
6 30
-2 MU 1 2 3 4 5 6 7 Quantity of Burger (s)
7 28 10
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• Law of dimishing Marginal utility 6
• If you consume same good and service continuously over time, each unit will 4 Point of satiation
add less and less to the amount of total satisfaction.
2 MU=0
• TU increases at a diminishing rate, reaches maximum and then declines.
• Beyond a point of saturation, TU starts decreasing and marginal utility becomes 0
negative. 1 2 3 4 56 7 Quantity of Burger (s)
• The consumption should stop at the 5th unit, where TU is at max and marginal
-2
utility is zero. MU
• It’s rational to shift to something else which will give higher utility than a 5
burger.
How the Slope (MU) Explains Changes in TU
Slope (MU) Change in TU Graphical Behavior Interpretation

MU>0 TU increases TU curve slopes Additional units

upward increase satisfaction

TU curve flattens Consumer reaches

MU=0 TU is maximized (reaches a peak) maximum satisfaction

MU<0 TU decreases TU curve slopes Additional units reduce

downward satisfaction

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 Law of Diminishing Marginal Utility (DMU)
• Why is the first bite of your favourite chocolate far tastier than the last bite of the third of the same chocolate?

• The law of diminishing marginal utility states that satisfaction decreases as the consumer consumes additional
units of a given or the same product.

• The more of the product you obtain, the less you want.

• E.g consider desire for a car when you have none is very strong. But the desire for the second car is less intense
etc..…

• As a rational consumer, you won’t use your money where you get less satisfaction because you consider the value
of money.

• The idea of DMU explains how consumers allocate their money income among many goods and services available
for purchase.

• Businesses also use this concept, for example, consider Newspaper vs soft drink and sweet Vending Machines
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and Marginal utility. What is the main difference? How are they using this concept?
 Assumptions of the law of DMU
to prevail
• Cardinality - measured in numerical values

• Homogeneity – consume identical products within a given period.

• Continuity in consumption – consumed within a specific time period.

• Rationality – aims to maximize total utility.

• Reasonable units – standard unit of measurement

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 Exercise
1. The first Pepsi yields Craig 18 units of utility and the second yields him an additional 12
units of utility. His total utility from three Pepsis is 38 units of utility. The marginal utility
of the third Pepsi is:
A. 26 units of utility. B. 6 units of utility. C. 8 units of utility. D. 38 units of
utility.

2. Where total utility is at a maximum, marginal utility is:

A. negative. B. positive and increasing. C. zero. D. positive but decreasing.

3. After eating four slices of pizza, you are offered a fifth slice. You turn down the firth slice.
Your refusal indicates that the:
A. marginal utility for pizza slices is negative.
B. total utility for pizza slices is negative.
C. marginal utility is positive for the fourth slice and negative for the fifth slice.
D. total utility was positive for the fourth slice and negative for the fifth slice.
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 Exercise
Units TU MU
Refer to the data given and fill-in the missing;
1. The value for Y is:
A) 25. (B) 30. (C) 40. (D) 45. 0 0

2. The value for X is: 1 W 20

B) 15. (B) 5. (C) 55. (D) 10.

2 35 X
3. The value for W is:
C) 15. (B) 20. (C)25. (D) 30.
3 Y 10
4. The value for Z is:
(A)-5. (B)+ 5. (C)-10. (D)0.
4 40 Z

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 Theory of Consumer Behaviour: Assumptions in
analysing consumer choices
1) Rational behaviour – the consumer wants to maximize
total utility.

2) Preferences- the consumer has clear-cut preferences for

goods and services.

3) Budget constraint – at a given point in time, the

consumer has a fixed money income, which implies
scarcity. The budget line marks the boundary between
affordable and unaffordable choices.

4) Budget management- In all cases, it is assumed that the

consumers will utilize their budget fully.

5) Prices - Every goods and services carries a price tag. We

are price takers.
 How will the consumer maximize utility and
reach Equi-marginal equilibrium ?
 A consumer’s TU is maximized by following the law of Equi-Marginal Principle (EMP) or Utility
maximizing rule
 To maximize satisfaction, the consumer should allocate his/her money income so that the last rand
spent on each product yields the same amount of extra (marginal) utility.
EMP
1. Spend all the available income:
• Pa*Qa + Pb*Qb +…….= Income
• Because more consumption brings more utility, only choices that exhaust income can maximize
utility.
2. Equalize the MU per rand spent:

3. Choose the combination that gives the highest level of utility

• If these conditions are met, then the household is in an equilibrium and
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• Have allocated limited resources efficiently (i.e. TU is maximized)
Decision making process:
Illustrating the equi-
marginal principle

1. Convert MU to MU per rand.

2. Then compare Mu/P for the two

goods where it is the same.

3. Check that the income is fully

exhausted by multiplying with its
price.
- Pa*Qa + Pb*Qb = Income

4. Buy the combination that gives the  Consumer is at equilibrium when consuming :2A + 4B = R10
same MU per rand spent, and that  MU from each good is equal and all income is exhausted.
exhaust all income.  Total utility derived from good A is 18 utils.
 Total utility derived from good B is 78 utils.
 Her R10, optimally spent, yields 96 utils of satisfaction. 13
 Income and
Substitution effect
SUBSTITUTION EFFECT
 Consumer shift away from goods that
become priced relatively higher in favor
of goods that are now priced relatively
low.
INCOME EFFECT
 When the price of a good decrease, real
income or purchasing power increases.

 The combined effects ensure that the

quantity demanded of any normal good
will decrease when its money price
rises.

 By providing insights on the income

effect and substitution effects of a price
decline, the utility-maximization model
helps explain why demand curves are
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downward sloping
 Deriving a demand curve from income effect &
substitution effect

Price of B
•When the price of B was R2, the consumer spent all income by
buying 4 of B and 2 of A;
R2 •But after price of B falls to R1, the consumer for the same basket
(2A,4B) now spends R6 and has R4 as surplus income. So the
surplus is an increase in purchasing power due to price fall.

•Now 2 more units of B can be bought and 2 more of A, which is on

account of both an increase in income effect and also substitution
R1 effect.
Demand of B •The substitution effect implies that a lower price makes a product
relatively more attractive and, therefore, increases the consumer’s
willingness to substitute it for other products.

•The income effect implies that a decline in the price of a product

4 6 Quantity of B
increases the consumer’s real income and enables the consumer to
buy more of that product with a fixed money income.
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 Practice Exercise
1. A consumer with a fixed income will maximize utility when each good is purchased in amounts such that the:
A) total utility is the same for each good.
B) marginal utility of each good is maximized.
C) marginal utility per rand spent is the same for all goods.
D) marginal utility per rand spent is maximized for each good.

2. A consumer makes purchases of an existing product X such that the marginal utility is 10 and the price is R5. The consumer also tries a new
product Y and at the current level of consumption it has a marginal utility of 8 and a price of R1. The utility-maximizing rule suggests that this
consumer should:
A) increase consumption of product X and decrease consumption of product Y.
B) increase consumption of product X and increase consumption of product Y.
C) increase consumption of product Y and decrease consumption of product X.
D) decrease consumption of product Y and decrease consumption of product X.

3. Assume that a consumer purchases a combination of product A and product B such that the
MUa/Pa = 8 and MUb/Pb = 6. To maximize utility without spending more money, the consumer should:
A) purchase less of product A and more of product B.
B) purchase more of product A and less of product B.
C) purchase more of both product A and product B.
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D) make no change in purchases of products A and B.
 Does the ‘law of demand’ always hold ?

Possible exceptions exist.

 infinitely inelastic curves
• Perfectly inelastic demand means that the quantity
demanded remains the same when the price increases or
decreases.
• Consumers are completely unresponsive to changes in
price.
• Perfectly inelastic demand is an extreme case;
necessities with no close substitutes are likely to have
highly inelastic demand curves.
• This is the case with life-saving prescription drugs

 Conspicuous Consumption goods

• Veblen argued that some goods, such as expensive
jewellery, are purchased for their status.
• Thus, the higher the price the more would be purchased.
• No upward-sloping market D curve has ever been
observed for any goods purchased in significant
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quantities.
 Does the ‘law of demand’ always hold?
Possible exceptions exist.
An inferior good
• An inferior good is one whose demand drops when people's
incomes rise.

• Inferior goods are the opposite of normal goods.

• When incomes are low, or the economy contracts, inferior goods

become a more affordable substitute for a more expensive good.

• Inferior goods may refer to the brand of products purchased or

items purchased (i.e. buying a second car vs. a new car).

• However, even where some exceptions may be observed for

individual households.

• When the consumption behaviour of all households is observed,

the weight of evidence is that the ‘law of demand’ is confirmed.
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 Does the ‘law of demand’ always hold ?
 Giffen Goods
• A Giffen good is a low-income, non-luxury
product for which demand increases as the
price increases and vice versa.

• A Giffen good has an upward-sloping demand

curve which is contrary to the fundamental
laws of demand.

• Demand for Giffen goods is heavily influenced

by a lack of close substitutes and income
pressures.

• Examples of Giffen goods can include bread,

rice, and wheat. These goods are commonly
essentials with few near-dimensional
substitutes at the same price levels.

• Theoretically feasible, provided the good is both

an inferior good and constitutes a large 19
proportion of total household expenditure.
 MU/Pa
Some applications
• DVDs and DVD players vs. VC players and VCs
- MUdvd /Pdvd > MUvc /Pvc , hence by more DVDs & players
relative to VCs & players.

• DVDs provide higher- quality audio than videocassettes

• DVD are much easier to store
• DVD and VC are substitute goods for playing movies, hence
• The improved audio and video experience of DVDs – the greater consumer satisfaction,
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which has produced a substitution away from VCs and toward DVDs
 Application cont….
• Water-diamond paradox
 The ‘puzzle’: why do some goods essential to life (e.g. water) have a low ‘value’ (mkt price) while non-
essential goods (e.g. diamonds) are highly valued?
-Role of scarcity (Demand vs Supply)
-Value in use vs Value in exchange
- Goods are priced according to marginal value , not total value

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 Application: Value of time and Full Price

• High labour productivity, means high value of time

• Full price takes into account opportunity cost of time
 e.g. You can buy a game of golf, which takes 4hours of your time, at R150, but you can also buy a music
concert ticket, which takes 2 hours of your time, at R180. If your hourly wage rate is R100.

WHAT IS THE FULL PRICE OF EACH CHOICE?

• Full price of golf = R150 + cost of time (= 4 hrs x R100) = R550
• Full price of concert = R180 + cost of time (=2hrs x R100) = R380
• Conclusion: Full price helps us take into account the TRUE COST of our decisions.
• Market prices do not reflect the true opportunity cost (full price of our decisions). If we had focused on ticket
prices, golf would have been chosen as the cheapest, but if we consider opportunity cost of time, concert is
economically preferable

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 Ordinal Approach to utility theory
• The ordinal approach theory suggests that utility is only
relatively ranked based on preferences but not quantifiable.

• It is the level of satisfaction than an amount of satisfaction.

• The model has two main elements;
- Indifference curves
- Budget line

 An Indifference curve is the locus of points representing all the

different combinations of two goods (say A and B) which yield
equal utility or satisfaction to the consumer.

 A whole set of indifference curves is called an indifference map.

 All points on the same curve give equal level of satisfaction, but
each point on higher curve gives higher level of satisfaction.
 Characteristics of Indifference Curve

 1. IC to the northeast are preferred

• Indifference curve further from the origin
represents higher utility.

• Because we assume that for human beings

more is better (non-satiation, i.e., the
consume always prefers more quantities of
goods to lesser quantities).

• Point O is preferred to point K and N because

it has more quantity of A and B

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 2. IC do not touch horizontal or vertical axis
- One of the assumptions of
IC is that the consumer
purchases combinations of
different commodities.

- Hence, if it touches either

axis, this assumption will
be violated.
3. Indifference curves slope down from left to right
 Consider 2 points, J & M on the
same indifference curve.

 At point m, you have more of Qty B

than at point J.

 So you have less of Qty A at M,

which means than M lies below J
and the indifference curve slopes
downward.

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 4. Indifference curves are convex to the origin
 The slope or steepness of indifference curves is determined by
consumer preferences.

 It reflects the amount of one good that a consumer must give up to

get an additional unit of the other good while remaining equally
satisfied.

 This relationship changes according to diminishing marginal utility—the

more a consumer has of a good, the less the consumer values an
additional value of that good.

 Convexity implies a diminishing slope of the indifference curve.

 The slopes of IC’s fall as we move from left to right, or we have a

diminishing marginal rate of substitution (MRS); A for B.
 When we have lots of A & not much B (as near J & K), we are willing to
give up a lot of A to get a little more B.

 When we have lots of B & not much A (as near L & M), we are willing
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to give up very little A to get a little more B.
 5. IC cannot intersect or cross each other
 Suppose indifference curves could intersect.

 Let the intersection of IC1 & IC2 be C.

 Then you must be indifferent between C & and point A

on IC1.

 Similarly, you must be indifferent between C & point B

on IC2.

 At the point of tangency, the higher curve ( IC2) will

give as much of the commodity as given by the lower
(IC1), and this is logically impossible and violates
transitivity.
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 Illustrating changes in the budget constraint

The Budget line

• The budget line shows all combinations of
two products that the consumer can
purchase, given product prices and his or
her money income.

 It shifts in parallel fashion outwards

when money income increases (Graph
A), and inwards when it decreases

 It shifts in parallel fashion outwards,

if the prices of both goods fall by the
same magnitude (Graph B), and
inwards if they increase by same
magnitude.

 If the price of one good changes while

that of another remains the same, the
budget line pivots in favour of the
good whose price fell (Graph C) 29
 Budget line in maths
PA PB Expenditure

Quantity of A PA x Quantity of A - PAA

Quantity of B - PB x Quantity of B PBB

Income (M) - - PAA + PBB = M

If PAA + PBB = M
Then PBB = M – PAA
Divide by PB : B = M/PB - (PA/PB) A

So the slope of the budget line is –(PA/PB)

It is a relative price e.g. if PA = 20 and PB = 10 then -PA/PB = -20/10 = -2

Interpretation: the opportunity cost of consuming one more unit of

good A is 2 units of B forgone 30
 Marginal rate of substitution
•The marginal rate of substitution is given by the ratio of the marginal utilities i.e. ratio of subjective
valuations of the relative worth of the two goods.:

•Notice that the MRS can be obtained from the equi-marginal principal.

Objective valuation
Subjective valuation (psychological fact/data) - (market data) – from budget line
from indifference curve

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 Putting psychological and market
data together
Good B

100/10 =10 W
Utility increases in this direction
X

Y V
6

U3 = 400 utils
Z U2 = 300 utils
U1 = 200 utils
U0 =100 utils
2 100/20=5
Good A
Budget line

Is utility at W = X = Y = Z?
Is utility at W > V?
Where is MRS = MUA/MUB =relative prices (PA/PB)?

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 Putting psychological and market
data
Good B together
100/10 =10
Where is MRS = MUA/MUB =relative prices (PA/PB)?

6 E

U1 = 300 utils

2 100/20=5
Good A

At E, MRSA,B = PA/PB
E consumer is in equilibrium and utility is
maximise and last rand spend on A equals last
rand spend on B
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 The consumer’s equilibrium position
• At equilibrium MRS = Pb/Pa
-The slope of IC equals the slope of the budget line because the slope of IC reflects
the marginal rate of substitution.
- For example, the table below indicates combination of product A and B
purchased by a consumer at given price and income. (Page 52-53)
Product A = R1.50 Product B= R1
Y 6 3
X 4 6
Z 1 10.5
W 7 5
Income = R 12

1. Draw the consumer indifference curve (s) and indicates the equilibrium position?
2. What combination of A and B will this consumer purchase? Does your answer meet the MRS
= PB/PA rule for equilibrium?
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 Indifference curve analysis
• Equilibrium position at tangency (x)
• Combination lying on the highest attainable indifference curve

• Slope Marginal rate of substitution (MRS): rate at which the consumer who possesses the combination will substitute
one good for the other to remain equally satisfied.

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10 PB
MRS =
PA
8
Quantity of A

Preferred –
6 W but requires
more income
4 X

At X: slope of I4
indifference curve = 2 I3
slope of budget line I2
0 I1
2 4 6 8 10 12
Quantity of B
 Key terms
• End of chapter 3
You must be familiar with these key terms
• Law of diminishing marginal utility
• Utility
• Total utility
• Marginal utility
• Rational behavior
• Budget constraint
• Utility-maximizing rule
• Budget line
• Indifference curve
• Marginal rate of substitution (MRS)
• Equilibrium position
 Any Questions ???
• Email: [email protected]
Or come to my office
• Room E16, Economics Department

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