ManagerialEcon - Lecture01 - Part 7 Theory of Consumer Behavior PDF

DEPARTMENT OF
ECONOMICS
MANAGERIAL ECONOMICS
Mr. Jones Mendoza

The Theory of Individual Behavior
Department of Economics
50 Years of Excellence in Economics
The Theory of
Individual Behavior
The Theory of Individual
Behavior
• Utility Approach • Utility Maximization:

• The Concept of Marginal The Consumer
Utility Equilibrium Point
• Law of Diminishing • Concept of Derivative
Marginal Utility • A Change in Price
• Indifference Curves • A Change in Income and
Approach the Income
• Budget Constraints Consumption Line
The Consumer’s
Optimization Problem
• Individual consumption decisions are
made with the goal of maximizing total
satisfaction from consuming various
goods and services
• Subject to the constraint that spending
on goods exactly equals the individual’s
money income
Consumer Theory
• Assumes buyers are completely informed

about:
• Range of products available
• Prices of all products
• Capacity of products to satisfy
• Their income
• Requires that consumers can rank all
consumption bundles based on the level
of satisfaction they would receive from
consuming the various bundles
Typical Consumption Bundles for
Two Goods, X & Y (Figure 5.1)
Properties of Consumer
Preferences
• Completeness
• For every pair of consumption bundles, A
and B, the consumer can say one of the
following:
• A is preferred to B
• B is preferred to A
• The consumer is indifferent between A and B
• Transitivity
• If A is preferred to B, and B is preferred to C,
then A must be preferred to C
• Nonsatiation
• More of a good is always preferred to less
Utility
o Benefits consumers obtain from goods &

services they consume is utility
o A utility function shows an individual’s
perception of the utility level attained from
consuming each conceivable bundle of
goods
Behavior
Utility Approach
o The consumption of an individual for any preferred
goods and services is represented by utility
function which describes the relationship between
the number of goods or services consumed and
his/her level of satisfaction.
o The utility function measures the level of
satisfaction a consumer receives from any good or
service.
Behavior
The Concept of Marginal Utility
o While studying consumer behavior, we will
often want to know how the level of
satisfaction will change in response to a
change in the level of consumption.
o Economists refer to the rate at which total
utility changes as the level of consumption
rises as the marginal utility (MU).
Behavior
Law of Diminishing Marginal Utility
o The more of something we consume, whether it be
ice cream, candy bars, shoes or volleyball games,
the less additional satisfaction we get from
additional consumption.
o Marginal utility may not decline after the first unit,
the second unit, or even the third unit. But it will
normally fall after some level of consumption.
Behavior
Indifference Curves Approach
o A consumer is given a choice of basket of
goods with only 2 desirable
products/goods.
o The two goods are preferred by the
consumer.
o Goods are not perfect substitutes for one
another.
o One good is given up at the expense of
another.
Behavior
Budget Constraints
o Consumption of goods and services are
limited by income and by prices.
o A household has a given amount of income
to spend and cannot influence the price of
the goods and services it buys.
o A household’s budget constraints represent
all combinations of products that can be
purchased for a fixed amount.
Indifference Curves
o Locus of points representing different
bundles of goods, each of which yields the
same level of total utility
o Negatively sloped & convex
Typical Indifference Curve
(Figure 7.1)
Marginal Rate of Substitution
• MRS shows the rate at which one good
can be substituted for another while
keeping utility constant
• Negative of the slope of the indifference curve
• Diminishes along the indifference curve as X
increases & Y decreases
• Ratio of the marginal utilities of the goods
Y MU X
MRS  − =
X MUY
Slope of an Indifference Curve &
the MRS (Figure 7.2)
A
600
Quantity of good Y
C (360,320)
320
T’
0 360 800
Quantity of good X
Indifference Map
(Figure 7.3)
Quantity of Y
IV
III
II
Quantity of X
Marginal Utility
• Addition to total utility attributable to

the addition of one unit of a good to
the current rate of consumption,
holding constant the amounts of all
other goods consumed
MU = U X
Consumer’s Budget Line
• Shows all possible commodity bundles

that can be purchased at given prices
with a fixed money income
M = PX X + PY Y
or
M PX
Y= − X
PY PY
Consumer’s Budget Constraint
(Figure 7.4)
Typical Budget Line
(Figure 7.5)
M
PY
•A
M PX
Y= − X
Quantity of Y
PY PY
B
•M
Quantity of X PX
Shifting Budget Lines
(Figure 7.6)
R
120
A A
100 100
Quantity of Y
Quantity of Y
F
80
Z B N C B D
160 200 240 125 200 250
Quantity of X Quantity of X
Panel A – Changes in money income Panel B – Changes in price of X
Utility Maximization
• Utility maximization subject to a

limited money income occurs at the
combination of goods for which the
indifference curve is just tangent to
the budget line
Y MU X PX
MRS = − = =
X MUY PY
Behavior
Utility Maximization: The Consumer
Equilibrium Point
o Given the consumer’s preferences
(representing the indifference curves) and
budget constraint information, it is possible
to determine the optimal consumption or
the utility maximization level of good X and
Y.
o This is called the consumer equilibrium
point or CEP.
Behavior
Concept of Derivative
o The CEP may be determined with an aid of simple
rule on derivative in calculus.
o The concept of derivative is similar to the concept
of slope in algebra and marginal concept in
economics.
o The bottom line of all of these is that they measure
CHANGES. Because economic phenomenon is not
static, understanding changes and its implications
are very relevant in any managerial and business
decisions.
Utility Maximization
• Consumer allocates income so that

the marginal utility per dollar spent
on each good is the same for all
commodities purchased
MU X MUY
=
PX PY
Constrained Utility Maximization
(Figure 7.7)
50
45 •A
40 •B •D
Quantity of pizzas
E
30
R
• IV
III
20
C
15 • II
T
10
I
0 10 20 30 40 50 60 70 80 90 100
Quantity of burgers
Individual Consumer Demand
• An individual’s demand curve for a

specific commodity relates utility-
maximizing quantities purchased to
market prices
• Money income & prices held constant
• Slope of demand curve illustrates law of
demand—quantity demanded varies
inversely with price
Deriving a Demand Curve
(Figure 7.8)
100
Quantity of Y
Px=$10
Px=$8
Px=$5
0
50 65 90 100 125 200
Quantity of X
10
Price of X ($)
Demand for X
0 50 65 90
Quantity of X
Market Demand & Marginal
Benefit
• List of prices & quantities consumers are
willing & able to purchase at each price,
all else constant
• Derived by horizontally summing
demand curves for all individuals in
market
• Because prices along market demand
measure the economic value of each unit
of the good, it can be interpreted as the
marginal benefit curve for a good
Derivation of Market Demand
(Table 7.9)
Quantity demanded
Market
Price Consumer 1 Consumer 2 Consumer 3
demand
$6 3 0 0 3
5 5 1 0 6
4 8 3 1 12
3 10 5 4 19
2 12 7 6 25
1 13 10 8 31
Derivation of Market Demand
Figure (7.10)
Behavior
A Change in Price
o The effect of a change in the price of one
good on the quantity of the good
consumed is called the price effect.
Behavior
A Change in Income and the Income
Consumption Line
o The effect of a change in income on buying
plans is called the income effect. We will
use the same problem above to work out
the effect of an increase in income of an
individual.
Substitution & Income Effects
• When price changes, total change in

quantity demanded is composed of
two parts
• Substitution effect
• Income effect
• Substitution effect
• Change in consumption of a good after a
change in its price, when the consumer
is forced by a change in money income
to consume at some point on the
original indifference curve
• Income effect
• Change in consumption of a good
resulting strictly from a change in
purchasing power
Income & Substitution Effects:
A Decrease in Px (Figure 7.11)
Total effect of Total effect of = Substitution + Income
= Substitution + Incom
price price decrease effect effect
effect e
decrease 3 = 5 + (-2)
9 = 5 + effect
4
• Consider the substitution effect

alone:
• Amount of good consumed must vary
inversely with price
• Income effect reinforces the
substitution effect for a normal good
& offsets it for an inferior good
Summary of Substitution &
Income Effects (Table 7.12)
Substitution Effect Income Effect
Price of X decreases:
Normal Good X rises X rises

Inferior Good X rises X falls
Price of X increases:
Normal Good X falls X falls

Inferior Good X falls X rises

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DEPARTMENT OF

Mr. Jones Mendoza

• Utility Approach • Utility Maximization:

• Assumes buyers are completely informed

o Benefits consumers obtain from goods &

• Addition to total utility attributable to

• Shows all possible commodity bundles

Panel A – Changes in money income Panel B – Changes in price of X

• Utility maximization subject to a

• Consumer allocates income so that

• An individual’s demand curve for a

• When price changes, total change in

• Consider the substitution effect

Substitution Effect Income Effect

Normal Good X rises X rises

Normal Good X falls X falls

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