Chapter Three. Introduction to economics ppt

The Theory of Consumer
Behavior

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Outline
 Why consumers buy goods
 Demand determinant
 Description of consumer preferences
 Assumptions of consumer preferences
 Utility
 Measuring Utility
 Utility in Cardinal approach
 Utility in ordinal approach

Why consumers buy goods and
Services?
 For example, a man is thirsty. He goes to
the market and satisfies his thirst by
purchasing coca cola instead of tea.
 The consumer buys a commodity because
it gives him satisfaction.

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Description of Consumer Preferences
 Consumer Preferences tell us how the consumer
would rank any two basket of goods, assuming these
allotments were available to the consumer at no cost.
 baskets or bundles is a collection of goods or
services that an individual might consume.
 Consumer Preference: is a practical means of explaining or
describing how consumers prefer one goods compared to the
other.
 The desire of a consumer with a limited income is unlimited but
not all desires have equal importance. This implies he/she must
prefer the most important and the urgent one first.

Preferences are Transitive: : It means that if a
consumer prefer market basket A to B, and prefer B to C
then the consumer prefers basket A to C.
Preferences are Consistent: It means if a consumer
prefer bundle A to B in one period, then he will not
consider bundle B to A in some other time period.
Preferences are Reflexive: It refers that any
consumption bundle is at least as good as itself. In other
words, it mean that the consumer weakly prefer or
indifferent between the two identical products.
No Satiation/ More is better: Good are desirable so
that consumers always prefer more of any good to less.
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It means that if a consumer prefer market basket A to
B, and prefer B to C then the consumer prefers basket
A to C

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3. No Satiation/ More is better:
Good are desirable so that
consumers always prefer more of
any good to less.

The Budget Line
 The budget line depicts the consumption
“bundles” that a consumer can afford.
 is a graph that shows various combinations of two goods consumer
can purchase given his/her limited income/budget and the prices
of the two goods.
 People consume less than they desire because their
spending is constrained, or limited, by their income.
 In order to draw a budget line, 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).

The Budget Line
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Note:
Any Points within the budget line (such as point A) attainable/feasible but
inefficient. Any points outside the budget line (such as point C) is
unattainable or unaffordable (because of the budget constraint). Any point
on the budget line (such as point B) is both attainable and efficient

The Budget Line; Income Change
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The Budget Line; Price Change
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The Budget Line; Price Change
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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.
Figure 3.3: Effects of Changes in Prices of Commodities on the budget line
Effects of
Proportional
Change in Price
Effects of Change
in Relative Price
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Concept of Utility:
 Jevon (1835 -1882) was the first economist who
introduces the concept of utility in economics.
According to him:
 "Utility is the basis on which the demand of an individual
for a commodity depends upon".
 Utility is thus the satisfaction which is derived by the
consumer by consuming the goods.
 Definition: Utility is the satisfaction that an individual
receives from consuming goods or services. In short,
utility refers the power of a product to satisfy human
want.

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Utility is strictly an ex-ante concept: That is, it measures the way
an individual feels about a commodity before the individual buys or
consumes it. In other words, utility does not mean realized
satisfaction rather it refers to expected satisfaction.
Utility is Subjective: The utility of a product will vary from person to
person. That means, the utility that two individuals derive from
consuming the same level of a product may not be the same. For
example, Cigarette has utility for a smoker but for a person who does
not smoke, cigarette has no utility.
Utility can be different at different places and time: For example,
the utility that we get from drinking coffee early in the morning may
be different from the utility we get during lunch time.

Approaches for Measuring Utility
♠ Once we understand what the concept of utility is all
about, the next question is how do consumers measure
the satisfaction level they derive from consumption of
goods and services.
♠ There are two major approaches for measuring
consumer‘s utility:
1.Cardinal Utility Approaches
2.Ordinal Utility Approaches
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Assumptions of Cardinal Utility
Analysis:
(I) Rationality. The consumer is rational. Consumer always
wants to maximize his satisfaction
(ii) Utility is cardinally measurable. The utility can be
measured in cardinal numbers such as 1, 3, 10, 15, etc.
(iii) Marginal utility of money remains constant.
(iv) Diminishing marginal utility.
(V)The total utility of a basket of goods depends on the
quantities of the individual commodities.

Total Utility and Marginal Utility:
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Total Utility and Marginal Utility:
 For example, a person consumes eggs and gains 50
units of total utility. This total utility is the sum of utilities
from the successive units (30 units from the first egg, 15
units from the second and 5 units from the third egg).
 Summing up total utility is the amount of satisfaction
(utility) obtained from consuming a particular quantity of
a good or service within a given time period. It is the sum
of marginal utilities of each successive unit of
consumption.
Formula:
 TUx = ∑MUx

Marginal Utility (MU):
 "Marginal utility means an additional or incremental utility. It
is the change in the total utility that results from unit one unit
change in consumption of the commodity within a given
period of time".
 For example: when a person increases the consumption of
eggs from one egg to two eggs, the total utility increases from
30 units to 45 units. The marginal utility here would be the15
units of the 2nd egg consumed.
 Marginal utility, thus, can also be described as difference
between total utility derived from one level of consumption
and total utility derived from another level of consumption.
Formula:
 MU = ∆TU
∆Q

Marginal Utility (MU):
 It may here be noted that as a person consumes more
and more units of a commodity, the marginal utility of the
additional units begins to diminish but the total utility
goes on increasing at a diminishing rate.
 The slope of Total utility give us the marginal utility
 The relationship between total utility and marginal
utility is now explained with the help of following
schedule and a graph.

Graphically
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TU and MU
 TU first increases, reaches the maximum
(when the consumer consumes 6 units),
and then declines as the quantity
consumed increases.
 MU continuously declines (even becomes
zero or negative) as quantity consumed
increases.
 When MU decrease but remains positive,
TU is increasing
 hen MU is zero , TU is said to be at a
maximum
 When MU negative , TU starts to decline.

X
X
Total
Utility
Marginal
Utility
TU
MU
X1 X2
X1 X2
Graphs of Total Utility
& Marginal Utility
X2 is where total utility reaches
its maximum.
MU is zero.
This is the saturation point or
satiation point.
After that point, TU falls and
MU is negative.
X1 is where marginal utility
reaches its maximum.
This is where we encounter
diminishing marginal utility.
The slope of TU has reached its
maximum; TU has an inflection
point here.

What happens at Equilibrium ?(in Cardinal
approach) (For one commodity case)
35

y.
M a r g i n a l U t i l i t y : is the change in total utility that
results from the consumption of one more unit of a product.
M a r g i n a l U t i l i t y (MU): is the extra satisfaction or pleasure
a consumer derives from consuming one more additional unit
of the commodity. In short, the increment of your utility per
unit of item consumed is called M a r g i n a l u t i l i t
Graphically, marginal utility is the slope of total utility.
Mathematically, marginal utility is:
MU 
Change in Total
Utility Change in Quantity Consumed
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Consumer in consumption of single commodity (say, x) will be at
equilibrium when:
i. If MUX > Px , then consumer is not at equilibrium and he goes on
buying because benefit is greater than cost. As he buys more, MU falls
because of operation of the law of diminishing marginal utility. When
MU becomes equal to price, consumer gets the maximum benefits and
is in equilibrium.
ii. If MUX < Px, then also consumer is not at equilibrium as he will have
to reduce consumption of commodity x to raise his total satisfaction till
MU becomes equal to price.
 Rlationship Between TU and MU
 When MU decrease but remains positive, TU is increasing
♠ When MU is zero , TU is said to be at a maximum
♠ When MU negative , TU starts to decline.

Equilibrium Utility In Cardinal Approach
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His expenditure
Equilibrium point for
“N” commodities
Equilibrium point for
“2 commodities

In economics, a consumer is said to be i n e q u i l i b r i u m
when he/she maximizes his/her utility, given his/her income
and the commodity prices. This is sometimes also referred as
Utility Maximizing Rule
Equilibrium point is the combination of goods and services
maximize total utility of the consumer given his limited income
and the price level of goods and services, Mathematically, the conditions
of equilibrium are as follows: Mux/Px = Muy/Py

approach) (For two or more commodity case)
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approach) (For two or more commodity case)
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Limitations of Cardinal Approach
1. Utility cannot be measured absolutely (objectively).
2. The assumption of constant MU of money is
unrealistic.
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Utility in Ordinal approach
 It is not possible for consumers to express the utility in
Magnitude
 But it is possible to express the utility in relative terms
 Unlike the cardinalist approach, the ordinal utility theory states that
utility is not measurable in the form of 1, 2, 3, etc. According to this
theory, it is meaningless to attach numbers to utility/satisfaction we
derive from consumption of a product.
 Rather the ordinalist says that the consumer can rank or order the
utility he/she drives from different goods. The consumers can rank
commodities in the order of their preferences as 1st, 2nd , 3rd and so on.
 .
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Assumptions of ordinal utility theory
1. Consumers are rational
2. Utility is ordinal
3. Diminishing marginal rate of substitution
4. total utility from bundles of commodities
 Since this theory uses another method of studying the consumer`s
behavior. i.e., indifference curve, the ordinal theory of utility is also
known as the i indifference curve Approach
Example:
Table 3.4 Comparison between Cardinalist and Ordinalist Approach
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 A consumer’s preference among consumption
bundles may be illustrated with indifference
curves.
An indifference curve showsvarious combinations
of two goods which give equal level of satisfaction
(utility) to the consumer. Since each of these
combinations gives equal satisfaction, the consumer is
indifferent among them

The Consumer’s Preferences...
Quantity
of Pizza
Quantity
of Pepsi
0
C
B
A
Indifference
curve, I1
D
I2
The consumer is indifferent, or equally happy,
with the combinations shown at points A, B,
and C because they are all on the same curve.

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Example: Utility and a single indifference curve
10 = xy
20 = xy
x
y
Preference direction
2
0 5
2
5

PROPERTIES OF INDIFFERENCE CURVE
 All points on the same IC shows the same level of satisfaction.
 Downward sloping: consumption level of one commodity can
be increased only by reducing the consumption level of the
other commodity
 Convex to the origin: commodities can substitute one
another at any point on an indifference curve but are not
perfect substitutes.
 A higher indifference curve is always preferred to a lower
one: the More is the better
 Do not cross (intersect): consumer preferences transitive
 Eg : Quantities X and Y for the combination of A> a
combination of B;  utility A> B *
When cross = C, so the utility A = C & B = C; 
utility A = B = C. This is not transitive as above *

The Marginal Rate of Substitution
 The slope at any point on an indifference curve is
the marginal rate of substitution.
 It is the rate at which a consumer is willing to
substitute one good for another.
 It is the amount of one good that a consumer
requires as compensation to give up one unit of
the other good.
 Since one good is scarified to obtain more units of the
other good, the value of MRS is negative. Hence,
usually we take absolute value of the slope.

 Let’s practise calculating partial derivatives:
Rules of partial/total differentiation
  2 3
, 2 3 1
f x y x xy y
   
 
 
,
, 4 3
x
f x y
f x y x y
x


  

y is treated like a constant
 
  2
,
, 3 3
y
f x y
f x y x y
y


  

x is treated like a constant

 Given the partial derivatives, the total derivative
is obtained as follows:
 The general definition of the total derivative is:
 Let’s replace these to get the total derivative
Rules of partial/total differentiation
 
   
, ,
,
f x y f x y
df x y dx dy
x y
 
 
 
     
2
, 4 3 3 3
df x y x y dx x y dy
    

Equilibrium of the consumer under
Oridinal approach
 The utility maximizing market basket must
satisfy two conditions:
1. It must be located on the budget line.
2. It must give the consumer the most
preferred combination of goods and
services
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The Consumer’s Optimum...
Quantity
of Pizza
Quantity
of Pepsi
0
I1
I2
I3
Budget constraint
A
B
Optimum
A consumer maximizes
satisfaction by choosing
market basket where the
budget line and indifference
curve are tangent

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 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 commodities.
a) Find the utility maximizing quantities of good X and Y.
b) Find the MRSXY, at equilibrium.
Answer: 1. Y = 14 , X = 8

Chapter Three. Introduction to economics ppt

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