Session 8: Consumer Behaviour

The consumers have to believe that they derive benefit from consuming the product, till then no profits for the producer. Hence understanding the consumer becomes of utmost importance for a manager. Few consumers have incomes sufficient to buy as much as they desire of a product, they are constrained by their incomes, and hence they try to maximize their satisfaction from the goods and services they purchase given the income constraint. Consumer preference and utility Preference pattern: 1. Ranking order of bundle of goods 2. Compares all pairs of bundles that give him the same satisfaction. 3. Consumers prefer more of a good to less of the good. The utility function: benefit that the consumers derive from consumption of a good. Utility can be measured in units of utility. Utility Function is U = f(X, Y), combination of the two goods. The utility function may be expressed with n number of goods and services.

Indifference curves:
Consumers are willing to make trade-offs or substitute among different goods from the utility function. Fundamental tool to analyze consumer behavior is the indifference curve. We use only two goods in order to be able to represent it by a graph. Properties of Indifference curve: 1. Downward sloping: some has to be taken away from good X to add to good Y in order to get the same utility. 2. Convex: giving up fewer and fewer of one good for the other: represents marginal rate of substitution. Marginal Rate of Substitution: No. of units of Y that must be given up to have X. Change in y/Change in x. 60-40/10-200=-2 Further it is 20-15/40-50=5/10=1/2 only half a units of Y for additional unit of X.

MRS diminishes along an indifference curve. At a particular point we can use the slope of the line to estimate the MRS: change in Y/ change in X MRS = -slope of tangent drawn to the point on the curve. Indifference maps: two or more indifference curves. Above and to the right represents a higher level of utility. Higher indifference curves are preferred to lower ones. Marginal Utility is addition to total utility by consuming an additional unit (25 X 2) + (10 X -1) = 40 so by consuming 2 more of X and 1 less of Y 40 units of units of utility were added to total utility. On a curve all the combinations give the same level of utility. Budget constraint: Demand function is what the consumer is willing and able to buy at various price points. Indifference curves give no indication of ability as in income of consumer or price of the product. Budget lines: Consumers generally have limited income and goods are not free. Problem is to use the income in such a manner so as to get maximum utility. 5X + 10Y = 1000 Y = 1000 1/2X Budget line has combinations of spending on two goods with the entire income. Slope of the budget line = Price ratio = -Price of good X/price of good Y= -1/2 Shifting of budget line: income increases or decreases One intercept point fixed: price ratio changes Utility maximization: Since a higher indifference curve gives more utility than a lower one, all points that intersect the budget line but are lower IC curves are not points of utility maximization.

Demand for Wheat and Rice

Illustration of demand theory Lily's demand for wheat and rice depends upon the prices for these goods, her income, and her preferences. Wheat costs Rs.4/kg.

Rice costs Rs.2/kg. Li has Rs.40 of income.

The table shows the combinations of wheat and rice that Li can buy with her income.

Liliys Budget Constraint

The mathematical expression for Liliys budget constraint is: Income = Price Wheat x Wheat + Price Rice x Rice In symbols: I = PW W + PR R

Points on Liliys Budget Constraint

So, all the points on Liliys budget constraint satisfy the equation: 40 = 4 Wheat + 2 Rice Which can be re-written: Rice = (40 - 4 Wheat)/2 Slope of the budget constraint is -PW/PR = -4/2 = -2