CHAPTER 4

CONSUMER BEHAVIOUR

1. Introduction

In this chapter we study human behaviour by reference to the concept of utility. The concept of
utility can help us understand two related aspects of consumer behaviour:

 It helps us predict how an individual will allocate his expenditure, given a fixed income
between goods and services available for consumption.
 It enables us to predict the effect of a price change on the quantity demanded of a good and
so confirms the law of demand

2. Total and Marginal Utility

Utility is the term used by economists to convey the pleasure and satisfaction derived from the
consumption of goods and services. Utility represents the fulfilment of a need or desire through the
activity of consumption

We must assume that it is possible to quantify and measure changes in utility or satisfaction. For this
purpose a ‘util’ will be used as a measure of utility. In reality utility is a psychological concept and its
subjective nature makes it unmeasurable. However we shall ignore this and proceed as if utility can
be measured in utils just like distance can be measured in meters or temperature in degrees. The
standard util is totally imaginary.

Total utility represents the satisfaction gained by a consumer as a result of his overall
consumption of goods.

Marginal utility represents the change in satisfaction resulting from the consumption of a further
unit of a good

Assuming that utility can be measured, we can say, for instance, a given individual enjoys 37 units of
satisfaction (utils) from drinking 3 pints of mahewu during an evening. This is a measure of total
utility. If one more pint increases his total utility to 42 utils, the marginal utility of his fourth pint
would be equal to 5 units of satisfaction. The marginal utility of the forth pint is equal to the total
utility derived from 4 pints minus total utility derived from 3 pints. Marginal utility is the increase in
total utility that results from the consumption of one more unit.

An Individual’s Utility Schedule

Pints drank in a day Total Utility Marginal Utility

O 0 -
1 17 17
2 29 12
3 37 8
4 42 5
 5 45 3
6 47 2
7 48 1
8 48 0
9 47 -1

The figures clearly reflect a crucial element of the utility theory: the law of Diminishing Marginal
Utility. The law states that the satisfaction derived from the consumption of an additional unit of a
good will decrease as more of the good is consumed, assuming that the consumption of all other
goods is held constant. The table above satisfies this law in that although each pint consumed until
the ninth pint adds to total satisfaction, it adds so by decreasing amounts. While the third pint adds
8 units of satisfaction, the 4th pint only adds 5 units. Neither of these can compare with the first pint
that resulted in 17 units of satisfaction. It is also interesting to note that MU can be negative. If the
individual were forced to drink the ninth pint, his total utility would actually be reduced. This is
sometimes called disutility.

It is important to appreciate fully the implications of the distinction between total and marginal
utility. If you were given the choice of giving up totally your consumption of either water or petrol,
you would choose to give up petrol. The implication is that water gives you more utility than petrol.

A man dying of thirst in the desert is faced with different conditions and therefore different marginal
utilities. He would definitely place more value on an additional gallon of water. From these examples
we can see that when a consumer makes a decision, he is concerned with the relative utilities of
different goods. Given the availability of resources, economic behaviour will be determined by
relative marginal utilities rather than by total utilities: shall I consume a few extra units of good A at
the expense of good B.

3. The Indifference Curve

An indifference curve is a line that shows all the possible combinations of two goods between
which a person is indifferent. In other words, it is a line that shows the consumption of
different combinations of two goods that will give the same utility (satisfaction) to the
person.

For instance, in Figure 1 the indifference curve is shown in colour. A person would receive
the same utility (satisfaction) from consuming 4 hours of work and 6 hours of leisure, as they
would if they consumed 7 hours of work and 3 hours of leisure

Figure 1: An indifference curve for work and leisure

An important point is to remember that the use of an indifference curve does not try to put a
physical measure onto how much utility a person receives.

The shape of the indifference curve

Figure 1 highlights that the shape of the indifference curve is not a straight line. It is
conventional to draw the curve as bowed. This is due to the concept of the diminishing
marginal rate of substitution between the two goods.

Marginal Rate of Substitution (MRS):

Definition and Explanation:
The concept ofmarginal rate of substitution (MRS) was introduced by Dr. J.R. Hicks and Prof. R.G.D. Allen to
take the place of the concept of diminishing marginal utility. Allen and Hicks are of the opinion that it is
unnecessary to measure the utility of a commodity. The necessity is to study the behaviour of the consumer as to
how he prefers one commodity to another and maintains the same level of satisfaction.
For example, there are two goods X and Y which are not perfect substitutes of each other. The consumer is
prepared to exchange goods X for Y. How many units of Y should be given for one unit of X to the consumer so
that his level of satisfaction remains the same?
The rate or ratio at which goods X and Y are to be exchanged is known as the marginal rate of substitution
(MRS). In the words of Hicks:
“The marginal rate of substitution of X for Y measures the number of units of Y that must be scarified for a unit
of X gained so as to maintain a constant level of satisfaction”.
Marginal rate of substitution (MRS) can also be defined as:
“The ratio of exchange between small units of two commodities, which are equally valued or preferred by a
consumer”.
Formula:
MRSxy = ∆Y
∆X

It may here be noted that the marginal rate of substitution (MRS) is the personal exchange rate of the consumer
in contrast to the market exchange rate.
Schedule:
The concept of MRS can be easily explained with the help of schedule given below:

Marginal Rate of Substitution

Combination Good X
1 1
2 2
3 3
4 4
5 5
Good Y MRS of X for Y
13 --
9 4:1
6 3:1
4 2:1
3 1:1

In the table given above, all the five combinations of good X and good Y give the same satisfaction to the
consumer. If he chooses first combination, he gets 1 unit of good X and 13 units of good Y.
In the second combination, he gets one more unit of good X and is prepared to give 4 units of good Y for him to
maintain the same level of satisfaction. The MRS is therefore, 4:1.
In the third combination, the consumer is willing to sacrifice only 3 units of good Y for getting another unit of
good X. The MRS is 3:1.
Likewise, when the consumer moves from 4th to 5th combination, the MRS of good X for good Y falls to one
(1:1). This illustrates the diminishing marginal rate of substitution.

Diminishing Marginal Rate of Substitution:

In the above schedule, we have seen that as the consumer moves from combination first to fifth, the rate of
substitution of good X for good Y goes down. In other words, as the consumer has more and more units of good
X, he is prepared to forego less and less of good Y.
For instance, in the 2nd combination, the consumer is willing to give 4 units of good Y in exchange for one unit
of good X, in the fifth combination only one unit of Y is offered for obtaining one unit of X.
This behaviour showing falling MRS of good X for good Y and yet to remain at the same level of satisfaction is
known as diminishing marginal rate of substitution.
Diagram/Figure:
The concept of marginal rate of substitution (MRS) can also be illustrated with the help of the diagram.

In the fig. 3.3 above as the consumer moves down from combination 1 to combination 2, the consumer is
willing to give up 4 units of good Y (∆Y) to get an additional unit of good X (∆X).
When the consumer slides down from combinations 2, 3 and 4, the length of ∆Y becomes smaller and smaller,
while the length of ∆X remains the same. This shows that as the stock of the consumer for good X increases, his
stock of good Y decreases.
He, therefore, is willing to give less units of Y to obtain an additional unit of good X. In other words, the MRS
of good X for good Y falls as the consumer has more of good X and less of good Y. The indifference curve IC
slopes downward from left to the right. This means a negative and diminishing rate of substitution of one
commodity for the other

It is possible to draw more than one indifference curve on the same diagram. If this occurs
then it is termed an indifference curve map (Figure 2).

Figure 2: An indifference map

The general rule is that indifference curves further to the right (I4 and I5) show combinations
of the two goods that yield a higher utility, while curves to the left (I2 and I1) show
combinations that yield lower levels of utility.

4. A Budget Line (budget constraints)

The budget line is an important component when analysing consumer behaviour. The budget
line illustrates all the possible combinations of two goods that can be purchased at given
prices and for a given consumer budget. Remember, that the amount of a good that a person
can buy will depend upon their income and the price of the good.

This discussion outlines the construction of a budget line and how the change in the
determinants will affect the budget line.
Figure 3 constructs a budget line for a given budget of £60, £2 per unit of x and £1 per unit of
y.

With a limited budget the consumer can only consume a limited combination of x and y (the
maximum combinations are on the actual budget line).

A change in consumer income and the budget line

If consumer income increases then the consumer will be able to purchase higher
combinations of goods. Hence an increase in consumer income will result in a shift in the
budget line. This is illustrated in Figure 4. Note that the prices of the two goods have
remained the same; therefore, the increase in income will result in a parallel shift in the
budget line.

Assume consumer income increased to £90.

Figure 4: An increase in consumer income

If consumer income fell then there would be a corresponding parallel shift to the left to
represent a fall in the potential combinations of the two goods that can be purchased.

A change in the price of a good and the budget line

If income is held constant, and the price of one of the goods changes then the slope of the
curve will change. In other words, the curve will pivot. This is illustrated in Figure 5.

Figure 5: A change in price

The reduction of the price of good x from £2 to £1 means that on a fixed budget of £60, the
consumer could purchase a maximum of 60 units, as opposed to 30. Note that the price of
good y has remained fixed, hence the maximum point for good y will remain fixed.

Indifference analysis combines two concepts; indifference curves and budget lines
(constraints)

The first stage is to impose the indifference curve and the budget line to identify the
consumption point between two goods that a rational consumer with a given budget would
purchase.

The optimum consumption point is illustrated on Figure 6.

Figure 6: The optimum consumption point

A rational, maximising consumer would prefer to be on the highest possible indifference
curve given their budget constraint. This point occurs where the indifference curve touches
(is tangential to) the budget line. In the case of Figure 6, the optimum consumption point
occurs at point A on indifference curve I3.

Indifference analysis can be used to analyse how a consumer would change the combination
of two goods for a given change in their income or the price of the good.

The next section looks at the income and substitution effects of a change in price.

If we assume that the good is normal, then the increase in price will result in a fall in the
quantity demanded. This is for two reasons; the income effect (have a limited budget,
therefore can purchase lower quantities of the good) and the substitution effect (swap with
alternative goods that are cheaper).

These two processes can be visualised using indifference analysis (see Figure 7).

Figure 7: An increase in the price of good x (a normal good)

Due to the price of good x increasing, the budget line has pivoted from B1 to B2 and the
consumption point has moved.

The decrease in the quantity demanded can be divided into two effects;

The substitution effect

 The substitution effect is when the consumer switches consumption patterns due to
the price change alone but remains on the same indifference curve. To identify the
substitution effect a new budget line needs to be constructed. The budget line B1* is
added, this budget line needs to be parallel with the budget line B2 and tangential to
I1.

Therefore, the movement from Q1 to Q2 is purely due to the substitution effect.

The income effect

 The income effect highlights how consumption will change due to the consumer
having a change in purchasing power as a result of the price change. The higher price
means the budget line is B2, hence the optimum consumption point is Q3. This point
is on a lower indifference curve (I2).

Therefore, in the case of a normal good, the income and substitution effects work to reinforce
each other.