Today’s Discussion
• Fundamental Economic Questions revisited What? • Consumer Preferences Utility, Total Utility, Marginal Utility and Law of Diminishing Marginal Utility • Budget Constraints • Consumer Choice/Consumer Equilibrium

Consumer Behaviour
• Why people buy goods and services? Primary goal of consumers is maximization of satisfaction from consuming the goods Economists call this satisfaction “Utility” • But how do we measure satisfaction???

Consumer Behaviour
• Can satisfaction you derive from consumption of a good be measured in some units of measurement?

There are different opinions! Cardinal and Ordinal Approaches To Cardinal Economists, the motivation to consume goods is to gain utility which is measurable in some numerical value

Consumer Behaviour
• There are three steps involved in the study of consumer behavior.

1) To describe how and why people prefer one good to another.

3) Finally. • People have limited incomes. What combination of goods will consumers buy to maximize their satisfaction? .Consumer Behaviour 2) Then we will turn to budget constraints. we will combine consumer preferences and budget constraints to determine consumer choices.

This is called economic rationality. That is. . consumer is rational.Consumer Behaviour It is assumed that consumers always prefer more of any good to less. How can we determine the consumers preference? It is by looking at the Utility.

Utility Utility is the satisfaction or pleasure derived from consumption of a good or service. It is subjective. Utility received from consumption varies from person to person. Actual measurement of utility is impossible! But to Cardinalists believe it is possible .

. an ordinal ranking is sufficient to explain how most individual decisions are made.ordinal school of thought Therefore.Utility Ordinal Versus Cardinal Utility The actual unit of measurement for utility is not important.

Total level of satisfaction derived from all U = f (x1. x3…) U(x1. Suppose Good X.Total Utility units of a good consumed.. x3). x2. x2. = U1 (x1) + U2 (x2)+… ..

∂U MU= ∂Q • Where ∂ U is change in utility ∂ Q is change in quantity consumed .Marginal Utility Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good.

Total Utility and Marginal UtilityA Hypothetical data Units of Food Total Utility Consumed 0 1 2 3 4 0 40 60 70 75 Marginal Utility 40 20 10 5 .

Total and Marginal Utility • Example – The marginal utility derived from increasing from 0 to 1 units of food might be 40 – – Increasing from 1 to 2 might be 20 Increasing from 2 to 3 might be 10 Observation: Marginal utility is diminishing .

consuming additional amounts will yield smaller and smaller additions to utility. This is a universal principle of human consumption behavior . • The extra satisfaction of a good declines as people consume more and more.Law of Diminishing Marginal Utility • When more and more of a good is consumed.

• In our previous example. you increase consumption as long as additional units provide you positive utility. consumer will consume 4 units.Utility Maximization in a world of without Scarcity • If a good is free. Thus his total utility is maximixed (75 Utils) .

.Utility Maximization in a World of Scarcity • But Goods are not free! • In the real world. Prices. • Now we will turn to Budget Constraints. and your income. consumption depends on tastes.

• Suppose you allocate your income for 2 goods.Budget Constraints Preferences do not explain all of consumer behavior. • Budget constraints also limit an individual’s ability to consume. Food and Cloths .

• Budget Line shows all combinations of two commodities for which total money spent equals total income. F + Pc. C = Total Income Spending on food +Spending on Cloth =Total Budget .The Budget Line • Price of Food is Rs. Pf.800 • Given the price and income. you have different consumption possibilities. 200 per unit • You have disposable income of Rs. 100 per unit • Price of Cloths is Rs.

800 .800 Rs.Budget Constraints Market Basket Food (F) Clothing (C) Total Spending Pf = (Rs.800 Rs.100) Pc = (Rs.200) PfF + PcC = Income A B C D F 0 2 4 6 8 4 3 2 1 0 Rs.800 Rs.800 Rs.

Budget Line-Graphically Budget Line Cloths 4 3 2 1 0 2 4 6 8 A B C D E Food (per week) .

A decrease in income causes the budget line to shift inward.Shift in Budget Line Due to Income Changes An increase in income causes the budget line to shift outward. . parallel to the original line (holding prices constant). parallel to the original line (holding prices constant).

80 Cloths 4 3 New Budget line when income decreases 2 1 0 A B C D New Budget Line when income increases E 2 4 6 8 16 Food (per week) .

pivoting from the other good’s intercept. the budget line shifts inward.Shift in Budget Line Due to Price Changes If the price of one good increases. If the price of one good decreases. pivoting from the other good’s intercept. the budget line shifts outward. .

Cloths 4 3 2 1 0 2 4 6 8 16 Food (per week) Due to decrease in the price of Food .

50) Pc = (Rs.800 Rs.200) PfF + PcC = Income A B C D F 0 4 8 12 16 4 3 2 1 0 Rs.800 Rs.800 Rs.800 Rs.800 .Price of Food Decreases Market Basket Food (F) Clothing (C) Total Spending Pf = (Rs.

Cloths 4 3 Due to increase in the price of food 2 1 0 2 4 6 8 Food (per week) .

given the limited budget available to them. • Consumers will consider their Preferences (utility) Market prices.Consumer Choice • How do you allocate our disposable income between the two goods to maximize utility? Consumers choose a combination of goods that will maximize the satisfaction they can achieve. and their Income .

Marginal Utility and Consumer Choice Total utility is maximized when the total budget is spent and the marginal utility for the final unit consumed divided by that good’s price is identical for each good .

• Price of Orange is Rs. • Then.A hypothetical example • Suppose you want to consume Apple and Orange • Price of Apple is Rs.Consumer Choice.8 per one. how do you allocate your limited budget to maximize your total utility given the prices and preferences? . 4 per one • You have Rs. 40 with you.

8 56 32 7 4 0 1 2 0 40 68 88 108 114 40 28 20 8 6 10 7 5 0 1 2 0 56 88 3 4 5 6 112 130 142 150 24 18 12 8 3 2 1/4 1 1/2 1 3 4 5 6 100 12 3 2 1 1/2 .Consumer Equilibrium.Example Units of TU Apple MU MU/P Units of TU MU MU/P Orange P= P=4 Rs.

Food and Cloths M UFood / PFood = M UCloth / PCloth This is referred to as the equal marginal principle. .Marginal Utility and Consumer Choice Condition for Consumer equilibrium if we choose two goods.

Summary • People behave rationally in an attempt to maximize satisfaction from a particular combination of goods and services. • Consumers maximize satisfaction subject to budget constraints . • Consumers make choices by comparing bundles of commodities. • Consumer choice has two related parts: the consumer’s preferences and the budget line.

Topics of Discussion WHAT? • • • • • • What is behind the Law of Demand? Income Effect Substitution Effect Ordinal Approach to Consumer Behavior Consumer Surplus Types of Demand .

What is behind the Law of Demand? Price Any logic from consumer behavior point of view? Quantity demanded .

It causes an increase/decrease in the consumer’s willingness and ability to purchase a good. This income effect is one of the reasons for law of demand. Recent rise in Petroleum price.Why do you purchase less at higher price and more at lower price? Price changes alter your real income Money Income Vs eal Income A rise in prices decreases purchasing power. . and a fall in prices increases purchasing power.

Any other explanation? Suppose the price of a good rises. then you will consume less of that good. This is substitution effect. consumers may switch to more affordable substitutes. This is second reason behind the law of demand . Why? When the price of a good rises.

Ordinal Approach to Consumer Behavior WHAT? • • • • Ordinal approach to Consumer Behaviour Indifference curves Properties of ICs Consumer equilibrium using IC analysis .

• If A is preferred to B.Ordinal Approach • Economic rationality is assumed • Consumers are able to rank their preferences for various combinations of goods • A is preferred to combination B or both combinations A and B are equally preferred. then A gives him more utility/satisfaction .

• Numerical measure of utility is not required . or the same utility.Indifference Curve • Ordinal approach use indifference curves to analyze consumer preferences • An indifference curve shows all combinations of goods that provide the consumer with the same satisfaction.

. • Total utility is same at all combinations on an IC • So consumer is indifferent about which combination to choose.Indifference Curve • All combinations on an IC are equally preferred.

Properties of IC • IC slope downward • Higher IC represent higher levels of utility • IC will not intersect .

Indifference Map • An indifference map is a graphical representation of a consumer’s tastes for two goods • Each curve in the map reflects a different level of utility • Then how we will decide given a consumer’s indifferent map. how much of each good will be consumed? This is a consumer choice problem .

Consumer Choice/Equilibrium We need to consider • the relative prices of the goods and • the consumer’s income .

Consumer Equilibrium • The indifference curve indicates what you are willing to buy • The budget line shows what you are able to buy • Now find out what quantities of each good you are both willing and able to buy. .

MUFood / PFood = MUCloth / PCloth .that is.the last rupee spent on each good (Food and Cloth for instance) yields the same marginal utility.Consumer Equilibrium • In equilibrium . when the consumer maximizes utility.

• Consumer Surplus is the difference between what a person is wiling to pay for a commodity and the amount that he actually is required to pay .The Concept of Consumer Surplus • The demand curve can be viewed as a willingness-topay curve. • It shows the value that consumers place on extra units of the good.

Consumer Surplus • Consumer surplus = total willingness to pay for a good the total amount consumers actually do pay. • Consumer enjoys consumer surplus if he pays the same amount of money for each unit of good he buys. .

Consumer Surplus (CS) • It is a measure of the net benefits received by the consumer. They enjoy more utility than they had to pay for. . • CS occurs when people are able to buy a good for less than they would be willing to pay.

Application of Consumer Surplus • This concept has more public policy relevance. government can estimate the loss or increase in consumer welfare due to any policy change. . • Since it is a measure of the net benefits received by the consumer.

Types of demand • • • • Individual and Market Demand Direct and Derived Demand Total Market and Segmented Market Demand Domestic and Industrial Demand .

Types of demand • • • • • • Company and Industry Demand Final and Intermediate Demand Perishable and Durable goods demand New and replaceable Demand Autonomous and Induced Demand Short run and Long run Demand .

this contributes to the law of demand. . B. The income effect. For normal goods. one effect of this price increase is that consumers of that good experience a decline in their purchasing power that is like a decline in income. What is this effect called? Quiz Time A.When the price of a good increases. The substitution effect.

total utility becomes smaller and smaller. True. False.TRUE OR FALSE: The law of diminishing marginal utility states that as more and more units of a good or service are consumed. Quiz Time . a. b.

The total utility derived from consuming all the units of each good is equal. The price of each unit consumed is equal. . d. which of the following is true? a. b. The marginal utility per rupee spent is equal for the last unit of each good consumed. The marginal utility from the last unit of each good consumed is equal.In a consumer equilibrium. c.