MANAGERIAL ECONOMICS

Consumer Behaviour

Dr. Subhasis Bera

Introduction

Micromax Canvas Samsung Galaxy S9 Iphone X

Top selling brands of Mobile

phone available in the Indian
market are shown at the left.
Rs. 13700 Rs. 67000 Rs. 95000

Which mobile you will buy and why?

How do consumers make decisions?

Depending on the number of consumer buying a particular Brand at a certain price we

can estimate the demand.
Best Interest of Consumer

Consumer act in their best interest.

Consumer will be interested in certain option if it matches

their own preference or in other words if they think it has
utility to them.

Therefore best interest is a situation where consumer will

get maximum utility.

To maximise utility, consumer usually consider the

subjective value of the product along with the return
he/she gets from the rupee spent.

Utility theory was designed to provide empirical measures of such values.

Utility

There are three different methods of representing a function: The Tabular, Graphical,
and Mathematical representation.

The selection of one method over another depends on the mathematical skill of the
decision-maker to understand and use it easily.

The three methods are evolutionary in their construction process, respectively;

therefore, one may proceed to the next method if needed.

The utility function is often used to predict the utility of the decision-maker for a given
monetary value.

The prediction scope and precision increases form the tabular method to the
mathematical method.
Utility Function: Tabular Representation

Suppose you are spending money for various goods and commodities represented by Mi .
You need to assign some utility (say 0 for smallest value and 100 for highest value)for each
time you purchase. Lets utility assigned are denoted as Ui.
Therefore we will get various combinations of (Mi, Ui).
Suppose we are having a combination represented in the table below

M 12 8 7 3 15 9 5 -2 7 7 7 7
U 58 28 20 13 100 30 18 0 20 20 20 20

The tabular representation is limited to the numerical values within the table. Suppose one
wishes to obtain the utility of a rupee value, say Rs10. One may apply an interpolation
method: however since the utility function is almost always non-linear; the interpolated
result does not represent the utility of the decision maker accurately

To overcome this difficulty, one may use the graphical method.

Utility Function: Graphical Representation

The combinations (Mi, Ui) that we have obtained in the earlier can be plotted as a
scatter diagram
U M 12 8 7 3 15 9 5 -2 7 7 7 7
U 58 28 20 13 100 30 18 0 20 20 20 20

Utility Function
Now if we want to know the utility
40 that can be obtained by spending
Rs.10, we can get the associated
level of utility from this diagram

M
0 10

Diagram drawn in this way normally represents a smooth curve, however this may not be true.
Utility Function: Mathematical Function

The combinations of (Mi, Ui) may represent varieties of relation between the two. If
we can conceptualise the relation we can simply express that with the help of
mathematical function.
Although there are various forms of utility function, normally a parabola shape
function fits well for relatively narrow domain of values for variable M.
Normally a quadratic function represents the parabola hence function form can be
represented as

U  a  bM  cM 2

How utility theory can be used to analyse consumer behaviour or demand for consumer?
Demand and Utility

Willingness and Ability to pay for particular commodity is called demand.

Therefore, the amount of a particular goods or services that a consumer is willing to buy at
a particular price is called demand.
Demand for a particular commodity depends on the behavior of the consumer.

Assumptions Regarding Behaviour of Consumer

1) Consumers are rational with an objective to maximize total utility.

2) More is better i.e., If bundle A has at least as much of every good as bundle B and more
of some good, bundle A is preferred to bundle B.
3) Marginal utility obtained from the successive units of a commodity diminishes.
Diminishing Marginal Utility

Unit of sweets (Gulab Total Utility Marginal Utility

Jamun)
1 10 10
2 19 9
3 27 8
4 34 7
5 40 6
6 45 5
7 59 4

Power of a commodity that satisfy the wants of consumer is known as utility.

Total utility is the sum utility derived from the conception of the bundle of commodity.
Marginal utility is the utility derived from the marginal unit i.e., rate of change of total utility
from one more unit of extra consumption. [i.e., MUn = TUn – Tun-1 or MU= ∂(TU)/∂Q]
Utility Theory: How it can help a manager

There are two types of utility approach

i) Cardinal Approach ( Jevons, Menger, Walras,
Marshall)
ii) Ordinal Approach (Slutsky, Pareto, Hicks)
In managerial economics we can use cardinal utility
approach to answer two important queries related
to Consumer’s decision regarding his purchase.
These are-
Which Product to buy?

How much of that a consumer will should buy?

Consumer Behaviour: Cardinal Utility Approach

According to this approach utility is measurable and can be measured in terms of money.
Later another unit “utile” is used to measure the level of utility obtained by a consumer.
Utility function is Ui  f (qx )

Unit of sweets (Gulab

Total Utility
Jamun)
1 10
2 19
3 27
4 34
5 40
6 45
7 59
Marginal Utility Price per unit Net Benefit per unit Total Benefit
10 6 4 4
9 6 3 7
8 6 2 9
7 6 1 10
6 6 0 10
5 6 -1 9
4 6 -2 7

For single commodity consumer max his utility at MU X  PX

Consumer Behaviour: Choice of a good

Now we need to know what does mean by MU X

PX
From the theoretical concept we understand that
MU X
 MU obtained from commodity X by spending rupee 1 for the commodity X
PX

Now using the utility approach consumer will choose to buy X between the product X
and Y if
MU X MUY

PX PY

Where , MUx = Marginal Utility of X =utility derived from a specific unit of the
commodity X
MUy = Marginal Utility of Y =utility derived from a specific unit of the commodity Y
Px = Price of X
Py = Price of Y
Consumer Behaviour: Choice of a good

Now if a consumer wants to spend his/her money income in such a way so that
he/she can maximise utility then consumer will spend money income in such a
way so that

MU X MUY

PX PY

i.e., MU obtained from commodity X by spending rupee 1 for the commodity X =

MU obtained from commodity Y by spending rupee 1 for the commodity Y
i.e,, consumer gets equal level of marginal utility from both the commodity.

This is known as Law of Equi-marginal Utility

Law of Equi-Marginal Utility
The law of E.M.U has a great practical importance in every field of eco-life. The importance of this law can
be proved with the help of the following facts.

1 application in consumption
We have unlimited wants and scares resources. The main objective of the consumer will be to achieve
maximum satisfaction. He can achieve maximum satisfaction when M.U of different goods consumes are
equal.

2 application in production
The main objective of a producer is to earn maximum profit. It will be possible only when the marginal
utilities of all factors of production are equal.

3 application in exchange
Exchange is nothing, but substituting one thing for another. Hence in this department the L.E.M.U has a
great importance. Different goods are exchanged in such a way that a sacrifice made by both persons is
equal.
4 application in distribution
In distribution shares of different factors of production are determined. These shares are determined
according to the principles of marginal productivity.

5 application in saving and Investment

As we know Y= C + S. If we feel that rupee save has a greater importance in future than consumption. We
shall save more. The substitution of spending for saving will go on till the MU of a rupee spent and rupee
saved is the same.
Consumer Behaviour: Ordinal Utility Approach

Assumptions-
1)Consumers are rational.
2)Consumer aims at maximising utility.
3)Utility can not be measured but be ordered according to the preferences.
4)Consumers are consistent in raking their preference.
5)Consumer prefer more to less of a good in the relevant range of choice.
6)Diminishing MU prevails

Utility function is U i  f (qx , q y )

Consumer Behaviour: Indifference Curve

Properties of IC
1) Downward slopping from left to right
y 2) Convex to origin
3) Higher IC represents higher level of
Utility

Y1 A
C
Y2
U ( x, y)  U 2
Y3
B U ( x, y)  U1
x
X1 X2 X3

The Locus of various combinations of two goods that represents the same level of utility is
called Indifference curve
Types of Indifference Curve
Take
Notes

Y Y Y

IC1 IC2

IC2 IC1
IC1

X X X

Perfect One good is

Complementary
Substitute not normal
goods
good
Rate of Substitution

Some consumers place a high value on obtaining an extra unit of a product; others place
low value on obtaining.
a consumer’s choice also requires understanding the measurement of relative importance
a consumer place on acquiring an additional unit of a particular product.
We need to look at the situation where consumer is willing to substitute the less valued
commodity with high valued commodity while remaining on the same level of satisfaction.

The rate at which consumer give away one commodity to get more of other commodity is known as
Marginal Rate of Substitutions (MRS).
Marginal Rate of Substitutions (MRS)

MRS indicates the rate at which a consumer is willing to substitute one good for another while
remaining at the same level of satisfaction.
consumer will remain on the same
y IC i.e., TU  0
 TU   TU 
ie.,TU x, y  Y    X   0
 Y   X 
C
y1 A
i.e., TU  Y .MU  X .MU  0
x, y Y X

y i.e., Y MU X
MRS x , y   
X MUY
y2 x B U ( x, y)  U1
( MRS for good X for good Y)
x
x1 x2

MRSxy = the volume of the commodity Y that a consumer is willing give away for an extra unit of X.
Marginal Rate of Substitutions (MRS)

Difference between MRSxy and MRSyx?

Properties of MRS
- MRSxy diminishes along with the IC curve
- From the MRS we can identify whether the commodities available in the bundle are
complementary of substitute. If MRSxy = MRSyx= 0 then goods are perfect complements

Moving from a to b → Y1

 Y 
MRS xy     X 1
Y  X 
Moving from b to c → Y1
A X 2
a Y1 Y1
b Here X 1  X 2  
X 1 X 2
c  Y 
B MRS xy    0
 X 

X
MRS in the Real World

Consumer can have a choice between Interior space and handling or can have in between
Horsepower and Mileage
More desirable the attribute, more will be the willingness to pay for car by the customer.

Company should collect Information regarding customer’s choice through survey.

Automobile design and performance are two important factors in determining the demand for car.
Since cost is involved in improving both the attributes as a manager you need to decide how much
of each attribute should be included in the car.
Although answer depends part on the cost of production, but it is also depends on consumer
preferences for automobile attributes.

A study shows that during 1977-91 in America, consumers preferred styling over performance of
the car. The importance of styling helps explain the growing share of Japanese imports in the United
States.
Example of MRS

Value (in $) of the MRS derived from the new Human Development Index proposed by Herrero et al
(2012)

Country Health Education Income MRS-Income-Health

Sudan 61.5 4.4 1894 30.79675
Mauritania 58.6 8.1 1859 31.7235
Austria 80.9 15.3 35719 441.5204
Andorra 80.9 11.5 36095 446.1681

Country Health Education Income MRS-Income-Education

Panama 76.1 13.2 12335 934.4697
Gabon 62.7 13.1 12249 935.0381
Luxembourg 80 13.3 50557 3801.278
Kuwait 874.6 12.3 47926 3896.423

Details are available here

Budget Line

When a consumer buys a product or services he/she needs to consider his/her own budget.
Budget lines shows the combination of two goods that a consumer can purchase at given prices and
income.
For two commodity world Equation of the budget line is M= PX. QX + PY .QY

Qy

Y2 Change in
Income

Y1
Change in
Price

Qx
X2 X1 X3
Consumer’s Equilibrium

y
Equilibrium condition is
Slope of IC = Slope of Budget Line
C
M1
As price of X increases budget line
y2 B moves to M1M2 and new
A
y1 IC3 equilibrium attains at point B

IC2
IC1
x
x2 x1 M2 M1
Consumer’s Equilibrium: Mathematical Approach

Therefore we can write

max U ( x, y)
x  0, y  0 L( x, y)  U ( x, y)   (M  px x  p y y)
subject to px x  p y y  M d d
F. O. C is L( x, y)  U ( x, y)   px  0
We wish to maximize utility function subject to a dx dx
budget constraint. if U(x,y) is continuously Or, MU x   Px A
differentiable then we can use the Kuhn-Tucker
(necessary) conditions. and
d
L ( x, y ) 
d
U ( x, y )   p y  0
We can do that with the help of Lagrangian dy dy
equation.
Or, MU y   Py B
The generic Lagrangian equation is
L = objective function + λ ( Constraint =0) MU x MU y
Now from (A) and (B) we get =
Px Py
λ = Lagrange Multiplier
Marginal utility obtained by spending one unit of money for each good will be same. This law
also known as law of equimarginal utility.
Consumer’s Equilibrium: Walrasian Demand

Normally to find the optimum value we need to check the second order
condition(SOC).
However, If the utility function is quasi-concave and monotone, then first order
conditions are sufficient. However to be sure it is always better to check SOC.

The solution to the Utility Maximisation problem gives you the Walrasian Demand
Function or uncompensated demand function x(w,p ). where W is the wealth and
P is the price. Walrashian demand also known as Marshalian demand curve. The
original Marshallian analysis ignored wealth effects.
Demonstration Problem

Problem 1: Tarun goes to the market with Rs. 5000 and finds that the price of commodity X and Y
are Rs. 100 and Rs. 200 respectively. If his utility function is represented by U = 2X2 + 3Y2 what will
be his equilibrium purchase?

Solution: budget line is 5000 = 100.x + 200.y

Now our problem is max U  2 x 2  3 y 2
s.to 5000  100 x  200 y
Now Lagrange equation is L  (objective function)   (constraint  0)

i.e., L   2 x 2  3 y 2     5000  100 x  200 y 

Now F.O.C is L
 4 x   .100  0...................(i )
x
L
and  6 y   .200  0..................(ii )
y
4x 6y
Now calculating λ from equation (i) and (ii) and equating them we get 
x 3 100 200
or ,  ..............( A)
y 4
Demonstration Problem
3
Now substituting the value of y in the budget equation we get 5000  100.   y  200. y
4
 200 
solving we get y   
 11 
Similarly get the value of x.

Problem 2: Budget line is 360=10x +30y and your utility function is U  U ( x, y)  x3/4 y1/4
Calculate the optimum purchase.

Solution: do it yourself.
Mathematical Problem

Problem 3: Aman’s Income is Rs. 5000. He finds that the price of commodity X and Y are Rs. 100 and
Rs. 200 respectively. If his utility function is represented by U = 2X2 + 3Y2 what will be his
equilibrium purchase?
a) Now if Aman’s Income goes up by Rs. 5000, what changes in the equilibrium purchase will you
observe in his equilibrium purchase?
b) If Price of X falls to Rs. 50 and income remain same as initial, what changes will you observe in
his equilibrium purchase?

Solution:
Do it yourself
Applications of IC: Analysis of Subsidy

f
Let the price of food is pf . A typical consumer
has income M and normal preferences, (quasi- M C
concave indifference curves with DMRS). The Pf  s
budget constraint is pxx + pf f = M.
M B
E2
Pf
Suppose now that a subsidy of $s per unit is
introduced on food.
E1 IC2
The budget constraint becomes pxx + (pf − s)f = M.
IC1
Therefore slope of budget line will change and
hence the equilibrium point ( purchase).
X
M A
Px
Applications of IC: Consumer Price Index (CPI)

The CPI is a measure of how much it costs today (in today's dollars) to buy a fixed
bundle of commodities.

We currently use 1982-84 as our reference period, which means the CPI is
calculated by finding the cost of the bundle relative to its cost in 1982-84, $100.

Suppose the CPI is 177.5, (which it was in July 2001). That means it now costs 1.775
times as much to purchase the standard bundle as it did on average in 1982-84. If
someone earns 1.78 times as much as he did in the early 80s, then he is at least as
well of as he was then.
Applications of IC: Consumer Price Index (CPI)

Does your nominal income necessarily have to rise in proportion with the CPI?
Suppose that in 1983 you purchased (xO,f O) at prices (PxO, PfO). Your income was M
and therefore your budget line is
x 0 px0  f 0 p 0f  M 0


Now in the current year if prices are px (1   1 ), p f (1   2 )
0 0


In this case prices increased at the rate of π1 and π2.

How much would your income have to increase in order to off set the increase in prices?
Applications of IC: Consumer Price Index (CPI)

f
The increase in the cost of living is represented by Budget line if the
the increase in the cost of the reference bundle income increases by a
function of π1 and π2
(xO,f O) i.e.,

 px0 (1  1 ) x 0  p0f (1   2 ) f 0    px0 x 0  p 0y f 0 

M
Pf
  1 px0 x 0   2 p 0f f 0 M
Pf (1   1 ) A
  n .M x0 ,f 0

Therefore to be better off your income must B

increase at a proportion greater than πn . Where is
πn a function of π1 and π2
X
M M / Px
Px (1   2 )
Applications of IC: Income-Leisure Choice

This may help to construct efficient

employment contract. Income
Workers normally looks at income and (per day)
Worker
leisure as substitute at a diminishing rate Opportunities
along an indifference curve.
$240
Worker
Firms need to compensate to induce worker Equilibrium
to give up Leisure ( say $10 per hour)

Workers behavior may be examined in $80

much the same way we analyzed consumer (8 hrs X $10)
behavior. Workers attempts to achieve a
higher IC curve until he maximizes his Leisure
per day
utility. 16 24
Estimation of Utility Function

Biggest problem with the utility approach is its measurement.

Difficulty in direct measure of utility hence determine the choice of goods and thereafter
the demand for goods/services is difficult task as preference pattern of consumer not only
depends on the quantity of the commodity but also on other factor such as Income and
Price.

This calls us for an alternative approach for

determining the demand
Indirect Utility Function: Definition

We have observed that change in income also changes the equilibrium purchase of
consumer hence his total utility.

Therefore utility can also be represented as a function of Income and Prices of the
commodity. A consumer's indirect utility function u ( M,P) gives the consumer's
maximal utility when faced with a price level P and an amount of income M . It
represents the consumer's preferences over market conditions.

This function is called indirect because consumers usually think about their
preferences in terms of what they consume rather than prices. A consumer's
indirect utility u ( M,P) can be computed from its utility function u(x)by first
computing the most preferred bundle x(M,P)by solving the utility maximization
problem; and second, computing the utility u(x(M,P)) the consumer derives from
that bundle. The indirect utility function for consumers is analogous to the profit
function for firms.
Indirect Utility Function: Derivation

We characterized the solution to the problem max U ( x, y) subject to px x  p y y  M

x  0, y  0

Suppose as an optimal pair (xo, y0) that satisfies the first order conditions (tangency,
budget constraint). Note that (xo, y0) varies with (px, py, M).
We call the optimal choices at a given level of prices and income the demand functions
and write: x  x 0  px , p y , M 
y  y 0  px , p y , M 
Note that px x0 (px , py , M)+ px y0 (px , py , M) = M, so the demand functions satisfy the
budget constraint by definition, even as prices vary. This gives rise to restrictions on the
demand functions. The highest level of utility that can be achieved under (px, py, M) is
u(x0(px, py, M), y0(px, py, M)), which is the utility of the optimal choices under the budget
parameters. We define the indirect utility function to be
v  px , p y , M   max u  x, y  s.to px x  p y y  M
x ,y

 
 u x 0  px , p y , M  , y 0  p x , p y , M 
Expenditure Function

Instead of maximizing utility subject to a budget constraint, one could minimize

spending, subject to a utility constraint.
we can solve the same using Khun Tucker Conditions and can have

x  x c  px , p y , u 0 
y  y c  px , p y , u 0 

This Demand function is known as Hicksian Demand

Effect on Demand due to change in Price
Changes in the price changes consumer’s real income while nominal
income remain same. Changes in the real income may alter the demand for
commodity

Again changes in the price of one commodity changes the relative price of
that product compare to the other products. Changes in the relative price
may change the demand for the concerned commodity

Therefore it is important to know types of effect on demand as a result of

change in price
Price Effect

Changes in the price changes the quantity of commodities purchased at equilibrium.

This is known as price effect. Price effect can be decomposed as
Price effect (P.E.) = Income effect (I.E.) + Substitution effect (S.E.).
As price of X decreases budget line moves to
m1m3 and new equilibrium attains at b
Y Decline in price increases the consumer’s real
income. To offset the income effect we can reduce
his money income and the budget line shifts to
m1
m4m5. new equilibrium is at c
m4 Movement from a to b is price effect.
a Movement from c to b( or from b to c) is income
b effect.
c
Movement from a to c is substitution effect.

m2 m5 m3
X
Price Effect

Substitution effect is always negative.

Income effect can be positive or negative.
Price effect will depend on the relative strength of I.E. and S.E.

For normal goods S.E. > I.E. → P.E < 0

Inferior goods I.E. < 0 → P.E. > 0 or P.E. < 0
For Giffen goods P.E. > 0 → All the Giffen goods are Inferior Goods but not all the Inferior goods
are Giffen goods
Derivation of Demand Curve from IC

Law of Demand -Relation between Price and

A B C Quantity demanded is negative.

Why Demand Curve has Negative Slope?

X
1. As price increases consumer’s capability
Px to purchase also increases.
2. More numbers of consumer will be able to
purchase the commodity

Qx1 Qx2 Qx3

Qx
Exception to the law of Demand

Sometimes, the law of demand may not hold true.

1. Giffen goods: In case of such goods, the income effect is negative and it is stronger than
positive substitution effect. Examples of such goods are coarse grain like jowar, bajra and
coarse cloth.
2.Articles of Distinction/Snob appeal: They satisfy aristocratic desire to preserve
exclusiveness for unique goods- such goods are purchased only by few highly rich people
for snob appeal. For instance, very costly diamonds, rare paintings, Rolls-Royce- cars and
antique items.
3.Consumers psychological bias or illusion about the quality of commodity with price
change. They feel that high priced goods are better quality goods and low price goods are
inferior goods. This is known as Veblon effect.
4. The law of demand does not apply in case of life saving essential goods and also in
times of extraordinary circumstances like inflation, deflation, war and other natural
calamities. The law also does not hold true in case of speculative demand. Stock markets
are the fine examples of speculative demand.
Thank You!
What to do with Lagrange multiplier?

The Lagrange multiplier tells us the increase in utility when we get an extra dollar of income. This
has two interpretations.

We could see it in the literal sense of the value of increasing our income.
Alternatively, we could view it more generally as the value of relaxing our constraint. In
other words, how much can we increase our objective function by making our constraint less
restrictive? This interpretation can be used for any Lagrange Function.

It is also known as shadow price, the value (or price) of the budget constraint relaxed (
i.e., increased) by dollar.