Chapter Three

Theory of Consumer Behavior

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3.1. Consumer Preferences & Utility

 People choose the best things they can

afford from consumption bundle.
 Consumption bundle is a complete list of
the goods and services that are involved in
the choice problem.
 Given any two consumption bundles,
X = (X1, X2) and Y = (Y1,Y2), the consumer
can rank them as to their desirability:
◦ X > Y  Strict preference
◦ X ~ Y  Indifference
◦ X ≥ Y  Weak preference
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Assumptions about Preferences
 Complete
We assume that any two bundles can be compared.
That is, given any X-bundle and any Y-bundle, we
assume that (X1, X2) ≥ (Y1 ,Y2), or (Y1 ,Y2) ≥(X1,
X2) , or both, in which case the consumer is
indifferent between the two bundles.
 Reflexive
We assume that any bundle is at least as good as itself:
(X1, X2) ≥ (X1, X2 )
 Transitive
If (X1, X2 ) ≥ (Yl ,Y2) and (Yl ,Y2) ≥ (Zl , Z2) then
we assume that (X1, X2 ) ≥ (Zl , Z2).

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Utility
 Satisfaction or pleasure consumers derive
from the consumption of consumer goods
is called “utility”
 The concept of utility is characterized with
the following properties:
◦ „Utility‟ and „Usefulness” are not synonymous.
◦ Utility is subjective
◦ The utility of a product can be different at
different places and time.

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 A Consumer considers the following
points to get maximum utility:
◦ How much satisfaction he gets from buying
and then consuming an extra unit of a good
or service.
◦ The price he pays to get the good.
◦ The satisfaction he gets from consuming
alternative products.
◦ The prices of alternative goods and services.
 Approaches to measure Utility
◦ Cardinalist approach
◦ Ordinalist approach.
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3.2.The Cardinal Utility Approach
 Utility could be measured by the amount
of money the consumer is willing to pay
for another unit of commodity and its
measuring unit is called „utils‟.
Assumptions of Cardinal Utility theory:
◦ Rationality of Consumers
◦ Utility is Cardinally Measurable
◦ Constant Marginal Utility of Money
◦ Diminishing Marginal Utility (DMU)
◦ Utility is additive

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Total and Marginal Utility
 Total Utility (TU) - total amount of
satisfaction a consumer gets from
consuming or possessing some specific
quantities of a commodity at a particular
time.
 Marginal Utility (MU) - additional utility
obtained from consuming an additional
unit of a commodity.
◦ Mathematically

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 Total And Marginal Utility
Utils 70
60 Total Utility
50
40 1. The change in total utility from one
30 more ice cream cone . . .
20
10

1 2 3 4 5 6
Ice Cream Cones per Week
2. is called the marginal utility of 3. Marginal utility falls
Utils an additional cone. as more cones are
30
20 consumed.
10
Marginal Utility
1 2 3 4 5 6
Ice Cream Cones per Week

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Law of diminishing marginal Utility (LDMU)
 As the quantity consumed of a commodity
increases per unit of time, the utility
derived from each successive unit
decreases, consumption of all other
commodities remaining constant.
Equilibrium of a consumer
 For a Single commodity case

 For n commodities case

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Example
 Consider that Marta has Birr 10 and she
consumes two goods, X and Y. Px = 1Birr
and Py = 2Birr. Based on TU given below
identify the optimal combinations.

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Answer
 Candidates: (1x,2y), (2x,4y).(4x,5y)
 But(2x,4y) is the correct answer, why?

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Critique of the cardinal approach
i. Satisfaction cannot be measured objectively
ii. The assumption of constant marginal utility
of money is unrealistic.
iii. The LDMU has been established from
introspection. The law accepted as axiom
without empirical verification.
iv. This theory ignores substitution and
income effects.
v. It considers that effect of price changes on
demand curve is exclusively price effect.

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3.3. Budget Constraint and the
Budget Line
 Given income (M) of the consumer and
price of the two products (PX, PY), budget
constraint of the consumer requires:
Px X + Py Y ≤ M
 Budget line - it is a set of the commodity
bundles that can be purchased if the entire
money income is spent.
Px X + Py Y = M

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 The Budget Constraint
Number of With $150 per month, Max
Movies per
Month can afford 15 movies and no
concerts, . . .
15 A
12 movies and 1 concert or any other
B combination on the budget line.
12
Points below the line are
9 C
H also affordable.

6 D
G But not points
E above the line.
3
F
1 2 3 4 5 Number of
Concerts
per Month

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 Budget line - Example
Clothing
Pc = $2 Pf = $1 I = $80
(units
per week)
A Budget Line F + 2C = $80
(I/PC) = 40

B 1
30 Slope  C/F  -  - PF/PC
2
10
D
20
20
E
10

G
Food
0 20 40 60 80 = (I/PF) (units per week)

Chapter 3: Consumer Behavior Slide 15

Factors that influence the budget line to change
Case 1: Changes in Income and Prices
Clothing
(units An increase in
per week) income shifts
80 the budget line
outward (holding
prices constant)
60
A decrease in
income shifts
40 the budget line
inward

20 L3
(I = L1 L2
$40) (I = $80) (I = $160)
Food
0 40 80 120 160 (units per week)

Chapter 3: Consumer Behavior Slide 16

Case 2: Changes in Prices

Clothing
(units An increase in PF
per week) to $2.00 changes
the slope of the
budget line and
rotates it inward
pivoting from the
other good’s intercept. A decrease in the
40 price of food to
$.50 changes
the slope of the
budget line and
rotates it outward.
L3 L1 L2
(PF = 1) (PF = 1/2)
(PF = 2) Food
40 80 120 160 (units per week)

Chapter 3: Consumer Behavior Slide 17

Case 3: Taxes, Subsidies, and Rationing
 Economic policy often uses tools that
affect a consumer's budget constraint:
 Tax
◦ Quantity tax of t dollars  New P‟ = P + t
◦ Value tax of t%  New P‟ = P(1 + t )
◦ Lump sum tax  M‟ = M - t
 Subsidy (opposite of tax)
◦ Quantity subsidy of s dollars  P‟ = P - s
◦ Value subsidy of s%  P‟ = P(1 - s)
◦ Lump sum subsidy  M‟ = M + s
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 Rationing - the level of consumption of
some good is fixed to be no larger than
some amount.

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Numerical Example
 A person has $ 100 to spend on two
goods(X,Y) whose respective prices are $3
and $5.
◦ Draw the budget line.
◦ What happens to the original budget line if the
budget falls by 25%?
◦ What happens to the original budget line if the
price of X doubles?
◦ What happens to the original budget line if the
price of Y falls to 4?
◦ What happens to original budget line if the
government levied a per unit tax of 50 cents on
good X?
◦ What happens to original budget line if the
government gives a lump sum subsidy of birr 10?
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3.4. Ordinal Utility Approach
Assumptions of Ordinal Utility theory
◦ The Consumers are rational
◦ Utility is ordinal
◦ Diminishing Marginal Rate of Substitution
(MRS)
◦ The total utility of the consumer depends on
the quantities of the commodities consumed
◦ Preferences are transitive and consistent
 The ordinal utility approach is expressed
with the help of ICs.
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Indifference set, curve, and map
 Indifference Set - A combination of goods
for which the consumer is indifferent.
Combinations Quantity of Good X Quantity of Good Y
A 10 2
B 6 4
C 3 6
D 2 8

 When the indifference set is expressed

graphically, it called an indifference curve.
◦ An indifference curve contains equally preferred
bundles.
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 Preferences: What the Consumer Wants

Indifference curve: Quantity One of Hurley‟s

shows consumption of Mangos indifference curves
bundles that give the
consumer the same
level of satisfaction
B
A, B, and all other
bundles on I1 make A
Hurley equally happy –
I1
he is indifferent between
them.
Quantity
of Fish
THE THEORY OF
CONSUMER CHOICE 23
 Indifference map: it is a set of
indifference curves. Each successive curve
to the right represents better bundles.

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Properties of Indifference Curves:
◦ Indifference curves have negative slope
◦ Indifference curves do not intersect each
other
◦ A higher Indifference curve is always
preferred to a lower one
◦ Indifference curves are convex to the origin

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Four Properties of Indifference Curves

Quantity One of Hurley‟s

1. Indifference curves of Mangos indifference curves
are downward-sloping.

If the quantity of
fish is reduced, B

the quantity of mangos

A
must be increased to
I1
keep Hurley equally
happy.
Quantity
of Fish
THE THEORY OF
CONSUMER CHOICE 26
Four Properties of Indifference Curves

Quantity A few of Hurley‟s

2. Higher indifference of Mangos indifference curves
curves are preferred
to lower ones.

Hurley prefers every

bundle on I2 (like C) C
to every bundle on I1 D
A I2
(like A).
I1
He prefers every bundle
on I1 (like A) I0
to every bundle on I0 Quantity
(like D). of Fish
THE THEORY OF
CONSUMER CHOICE 27
Four Properties of Indifference Curves

Quantity Hurley‟s indifference

3. Indifference curves of Mangos curves
cannot cross.
Suppose they did.
Hurley should prefer
B to C, since B has B
more of both goods.
Yet, Hurley is indifferent C A
between B and C: I1 I4
He likes C as much as A
(both are on I4).
He likes A as much as B Quantity
of Fish
(both are on I1).
THE THEORY OF
CONSUMER CHOICE 28
Four Properties of Indifference Curves

Quantity
4. Indifference curves of Mangos
are bowed inward.

A
Hurley is willing to give
up more mangos for a 6
fish if he has few fish (A)
1
than if he has many (B).
B
2
1 I1

Quantity
of Fish
THE THEORY OF
CONSUMER CHOICE 29
Marginal Rate of Substitution
 It is a rate at which consumers are willing
to substitute one commodity for another
in such a way that the consumer remains
on the same indifference curve.
 Marginal rate of substitution is reflected
by the slope of the indifference curve.
 Mathematically,

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The Marginal Rate of Substitution

Quantity MRS = slope of

of Mangos indifference curve

Hurley‟s MRS is the A

amount of mangos he
MRS = 6
would substitute for
another fish. 1
B
MRS falls as you move down MRS = 2
along an indifference curve. 1 I1

Quantity
of Fish
THE THEORY OF
CONSUMER CHOICE 31
 Marginal Utility and Marginal rate of
Substitution:

How?
Example
◦ Suppose a consumer‟s utility function is given
by:

◦ Compute the
 Convexity of Indifference Curves
and Diminishing Marginal Utilities
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Optimum of the Consumer
(Ordinal Approach)
 The consumer maximizes utility by trying
to attain the highest possible indifference
curve, given the budget line. This occurs:

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 Consumer Choice
Clothing Pc = $2 Pf = $1 I = $80
(units per
week) Point B does not
maximize satisfaction
40 because the
MRS (-(-10/10) = 1
is greater than the
B
30 price ratio (1/2).

-10C
Budget Line
20

U1
+10F

0 20 40 80 Food (units per week)

Chapter 3: Consumer Behavior Slide 34

 Consumer Choice
Clothing Pc = $2 Pf = $1 I = $80
(units per
week)

40

D Market basket D
30 cannot be attained
given the current
budget constraint.
20
U3

Budget Line

0 20 40 80 Food (units per week)

Chapter 3: Consumer Behavior Slide 35

 Consumer Choice
Clothing Pc = $2 Pf = $1 I = $80
(units per
week) At market basket A
the budget line and the
40 indifference curve are
tangent and no higher
level of satisfaction
30 can be attained.

A
20 At A:
MRS =Pf/Pc = .5

U2
Budget Line
0 20 40 80 Food (units per week)

Chapter 3: Consumer Behavior Slide 36

Example 1
 Mr X faces a Cobb–Douglas utility function0.4 0.6
on two goods (x and y ) given by: U ( x, y)  20x y
Suppose that x and y are purchased in the
market at a constant unit price of birr 200
and birr 400 respectively and the consumer
has a money income of birr 6,000, which he
spend on the two goods.
a.Formulate the consumer maximization
problem
b.Compute and interpret MRSx,y at x = 2 and
y=8
Example 2
 Assume the utility function from two goods
(x and y ) given by: U(x,y)= 2x + xy +4y
Suppose that x and y are purchased in the
market at a constant unit price of birr 3 and
birr 2 respectively and the consumer has a
money income of birr 104, which he spend
on the two goods.
a. Formulate the consumer maximization
problem
b. Compute and interpret MRSx,y at x = 2 and
y=8
Exercise
1. Maximize U(x,y) = xy + x + 2y subjected
to Px = 2, Py = 5, and M = 51
2. Maximize U(x,y) = xy subjected to Px =
2, Py = 8, and M = 160
3. Max U ( x, y )  x 0.4 0.6
y subjected to Px
= 6, Py = 8, and M = 60
-----End of Chapter Three-----

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