ECONOMICS OF

CONSUMER
BEHAVIOUR
Dr.C S Shylajan
 Today’s Discussion
• Fundamental Economic Questions revisited

What?
• Consumer Preferences
Utility, Total Utility, Marginal Utility and
Law of Diminishing Marginal Utility

• Budget Constraints
• Consumer Choice/Consumer Equilibrium
 Consumer Behaviour
• Why people buy goods and services?

Primary goal of consumers is maximization of

satisfaction from consuming the goods

Economists call this satisfaction “Utility”

• But how do we measure satisfaction???

 Consumer Behaviour
• Can satisfaction you derive from consumption of a
good be measured in some units of measurement?

There are different opinions! Cardinal and Ordinal

Approaches

To Cardinal Economists, the motivation to consume

goods is to gain utility which is measurable in
some numerical value
 Consumer Behaviour
• There are three steps involved in the
study of consumer behavior.

1) To describe how and why people

prefer one good to another.
 Consumer Behaviour
2) Then we will turn to budget
constraints.
• People have limited incomes.

3) Finally, we will combine consumer

preferences and budget constraints
to determine consumer choices.
What combination of goods will
consumers buy to maximize their
satisfaction?
 Consumer Behaviour
It is assumed that consumers always
prefer more of any good to less. That is,
consumer is rational. This is called
economic rationality.
How can we determine the consumers
preference?

It is by looking at the Utility.

 Utility
Utility is the satisfaction or pleasure derived
from consumption of a good or service.

Utility received from consumption varies

from person to person. It is subjective.

Actual measurement of utility is impossible!

But to Cardinalists believe it is possible
 Utility
Ordinal Versus Cardinal Utility

The actual unit of measurement for utility

is not important- ordinal school of thought

Therefore, an ordinal ranking is

sufficient to explain how most individual
decisions are made.
 Total Utility

Total level of satisfaction derived from all

units of a good consumed.

Suppose Good X.

U = f (x1, x2, x3…)

U(x1, x2, x3),.. = U1 (x1) + U2 (x2)+…

 Marginal Utility

Marginal utility measures the additional

satisfaction obtained from consuming one
additional unit of a good.
U
MU=
Q
• Where  U is change in utility
 Q is change in quantity consumed
Total Utility and Marginal Utility-
A Hypothetical data
Units of Food Total Utility Marginal
Consumed Utility
0 0 -
1 40 40
2 60 20
3 70 10
4 75 5
 Total and Marginal Utility

• Example
– The marginal utility derived from increasing
from 0 to 1 units of food might be 40
– Increasing from 1 to 2 might be 20
– Increasing from 2 to 3 might be 10

Observation: Marginal utility is diminishing

 Law of Diminishing Marginal
Utility
• When more and more of a good is consumed,
consuming additional amounts will yield
smaller and smaller additions to utility.
• The extra satisfaction of a good declines as
people consume more and more.

This is a universal principle of human

consumption behavior
Utility Maximization in a world
of without Scarcity

• If a good is free, you increase

consumption as long as additional
units provide you positive utility.

• In our previous example, consumer

will consume 4 units. Thus his total
utility is maximixed (75 Utils)
 Utility Maximization in a
World of Scarcity
• But Goods are not free!

• In the real world, consumption

depends on tastes, Prices, and your
income.

• Now we will turn to Budget

Constraints.
 Budget Constraints

Preferences do not explain all of

consumer behavior.
• Budget constraints also limit an
individual’s ability to consume.

• Suppose you allocate your income for 2

goods, Food and Cloths
 The Budget Line
• Price of Food is Rs. 100 per unit
• Price of Cloths is Rs. 200 per unit
• You have disposable income of Rs.800
• Given the price and income, you have different
consumption possibilities.
• Budget Line shows all combinations of two
commodities for which total money spent equals total
income.
Pf. F + Pc. C = Total Income
Spending on food +Spending on Cloth =Total Budget
 Budget Constraints
Market Basket Food (F) Clothing (C) Total Spending
Pf = (Rs.100) Pc = (Rs.200) PfF + PcC = Income

A 0 4 Rs.800
B 2 3 Rs.800
C 4 2 Rs.800
D 6 1 Rs.800
F 8 0 Rs.800
 Budget Line-Graphically
Budget Line
Cloths
A
4

3 B

2 C

1 D

0 E Food (per
2 4 6 8 week)
 Shift in Budget Line
Due to Income Changes
An increase in income causes the budget
line to shift outward, parallel to the
original line (holding prices constant).

A decrease in income causes the budget

line to shift inward, parallel to the original
line (holding prices constant).
 80
New Budget Line
when income
Cloths
4
A increases

3 B

New 2 C
Budget
line when 1 D
income
decreases E
0
2 4 6 8 16
Food (per week)
 Shift in Budget Line
Due to Price Changes

If the price of one good increases, the budget line

shifts inward, pivoting from the other good’s
intercept.

If the price of one good decreases, the budget line

shifts outward, pivoting from the other good’s
intercept.
Cloths
4
Due to decrease
3 in the price of
Food
2

0
2 4 6 8 16
Food (per week)
 Price of Food Decreases
Market Basket Food (F) Clothing (C) Total Spending
Pf = (Rs.50) Pc = (Rs.200) PfF + PcC = Income

A 0 4 Rs.800
B 4 3 Rs.800
C 8 2 Rs.800
D 12 1 Rs.800
F 16 0 Rs.800
Cloths
4

3
Due to
increase 2
in the
price 1
of food
0
2 4 6 8
Food (per week)
 Consumer Choice
• How do you allocate our disposable
income between the two goods to
maximize utility?
Consumers choose a combination of goods that will
maximize the satisfaction they can achieve, given the
limited budget available to them.
• Consumers will consider their
Preferences (utility)
Market prices, and their Income
 Marginal Utility and
Consumer Choice

Total utility is maximized when the total

budget is spent and the marginal utility
for the final unit consumed divided by
that good’s price is identical for each good
 Consumer Choice- A
hypothetical example

• Suppose you want to consume Apple and

Orange
• Price of Apple is Rs.8 per one.
• Price of Orange is Rs. 4 per one
• You have Rs. 40 with you.
• Then, how do you allocate your limited
budget to maximize your total utility
given the prices and preferences?
 Consumer Equilibrium- Example
Units TU MU MU/P Units of TU MU MU/P
of P= Orange P=4
Apple Rs.8

0 0 - - 0 0 - -
1 56 56 7 1 40 40 10
2 88 32 4 2 68 28 7
3 112 24 3 3 88 20 5
4 130 18 2 1/4 4 100 12 3
5 142 12 1 1/2 5 108 8 2
6 150 8 1 6 114 6 1 1/2
 Marginal Utility and
Consumer Choice
Condition for Consumer equilibrium if we choose
two goods, Food and Cloths

MU Food / PFood  MU Cloth / PCloth

This is referred to as the equal marginal
principle.
 Summary
• People behave rationally in an attempt to
maximize satisfaction from a particular
combination of goods and services.
• Consumer choice has two related parts: the
consumer’s preferences and the budget line.
• Consumers make choices by comparing
bundles of commodities.
• Consumers maximize satisfaction subject to
budget constraints
 Topics of Discussion
WHAT?

• What is behind the Law of Demand?

• Income Effect
• Substitution Effect
• Ordinal Approach to Consumer Behavior
• Consumer Surplus
• Types of Demand
 What is behind the Law of Demand?
Price
Any logic from
consumer
behavior point of
view?

Quantity
demanded
 Why do you purchase less at higher
price and more at lower price?
Price changes alter your real income
Money Income Vs eal Income
A rise in prices decreases purchasing power, and a fall in
prices increases purchasing power.

Recent rise in Petroleum

price.
It causes an increase/decrease in the consumer’s
willingness and ability to purchase a good.
This income effect is one of the reasons for law of demand.
Any other explanation?

Suppose the price of a good rises, then you will

consume less of that good. Why?

When the price of a good rises, consumers may

switch to more affordable substitutes. This is
substitution effect.

This is second reason behind the law of demand

 Ordinal Approach to
Consumer Behavior
WHAT?

• Ordinal approach to Consumer

Behaviour
• Indifference curves
• Properties of ICs
• Consumer equilibrium using IC analysis
 Ordinal Approach
• Economic rationality is assumed

• Consumers are able to rank their preferences for

various combinations of goods

• A is preferred to combination B or both

combinations A and B are equally preferred.
• If A is preferred to B, then A gives him more
utility/satisfaction
 Indifference Curve
• Ordinal approach use indifference curves to
analyze consumer preferences

• An indifference curve shows all combinations

of goods that provide the consumer with the
same satisfaction, or the same utility.

• Numerical measure of utility is not required

 Indifference Curve

• All combinations on an IC are equally

preferred.

• Total utility is same at all combinations

on an IC

• So consumer is indifferent about which

combination to choose.
 Properties of IC
• IC slope downward

• Higher IC represent higher levels of

utility

• IC will not intersect

 Indifference Map
• An indifference map is a graphical
representation of a consumer’s tastes for two
goods

• Each curve in the map reflects a different level

of utility

• Then how we will decide given a consumer’s

indifferent map, how much of each good will be
consumed? This is a consumer choice problem
 Consumer Choice/Equilibrium
We need to consider

• the relative prices of the goods and

• the consumer’s income

 Consumer Equilibrium
• The indifference curve indicates what you
are willing to buy

• The budget line shows what you are able

to buy

• Now find out what quantities of each good

you are both willing and able to buy.
 The Concept of Consumer
Surplus
• The demand curve can be viewed as a
willingness-to-pay curve.

• It shows the value that consumers place on

extra units of the good.

• Consumer Surplus is the difference

between what a person is wiling to pay for a
commodity and the amount that he actually
is required to pay
 Consumer Surplus
• Consumer surplus = total willingness
to pay for a good - the total amount
consumers actually do pay.

• Consumer enjoys consumer surplus if

he pays the same amount of money for
each unit of good he buys.
 Consumer Surplus (CS)
• It is a measure of the net benefits
received by the consumer.

• CS occurs when people are able

to buy a good for less than they
would be willing to pay. They
enjoy more utility than they had
to pay for.
 Application of Consumer
Surplus
• This concept has more public policy
relevance.

• Since it is a measure of the net benefits

received by the consumer, government
can estimate the loss or increase in
consumer welfare due to any policy
change.
When the price of a good increases, one Quiz Time
effect of this price increase is that
consumers of that good experience a
decline in their purchasing power that
is like a decline in income. For normal
goods, this contributes to the law of
demand. What is this effect called?

A. The substitution effect.

B. The income effect.

TRUE OR FALSE: Quiz Time
The law of diminishing
marginal utility states that as
more and more units of a good
or service are consumed, total
utility becomes smaller and
smaller.

a. True.

b. False.
In a consumer equilibrium, which of the following
is true?

a. The marginal utility from the last unit of each good

consumed is equal.

b. The price of each unit consumed is equal.

c. The total utility derived from consuming all the units of

each good is equal.

d. The marginal utility per rupee spent is equal for the last
unit of each good consumed.
Thank you