Session 05

THEORY OF CONSUMER
BEHAVIOUR AND APPLICATIONS

Managerial Economics (MAN 3119)

HNDM 2019
Visiting Lecturer (SLIATE): Susanga Hasithani
 Passion
+
Consistency
=
Success
 Lecture Outline
• Introduction
• Description of consumer preferences
• The Utility functions
• Marginal utility and diminishing marginal utility
• Indifference curves
• Budget line
• Marginal rate of substitution
 Introduction
The purpose of the theory of demand is to determine the
various factors that affect demand.

Determinants
1. The price of the commodity
2. Other prices
3. Income
4. Tastes
5. Income distribution
6. Total population
7. Wealth
8. Government policy
 Consumer Preference
Consumer Preferences tell us how the consumer would
rank any two basket of goods, assuming these
allotments were available to the consumer at no
cost.

Baskets or bundles is a collection of goods or services

that an individual might consume.
 Properties of Consumer Preferences
1. Complete: Preferences are complete if the consumer can rank
any two baskets of goods

i. A strictly preferred to B (A  B )
ii. B strictly preferred to A (B  A )
iii. indifferent between A and B (A ≈ B)

2. Transitive: Preferences are transitive if a consumer who

prefers basket A to basket B, and basket B to basket C also
prefers basket A to basket C (No illogical behavior)
A  B and B  C → A  C NOT C  A
Cont…
3. Monotonic (more is better) Preferences: if a basket with
more of at least one good and no less of any good is
preferred to the original basket.

• The more is better assumption is also known as the

property of non-satiation.
• It assumes are looking at what economists call a ‘good’.
Something we want more of
• We are not looking at a ‘bad’ i.e. pollution
• We can relax this assumption it is the first two that are
crucial for the analysis
Example
• Which bundles are better because more is
better?
 Cardinal Utility Approach
• Nineteenth century economists, such as Jevons, Menger and
Walras, assumed that utility was measurable in a cardinal
sense, which means that the difference between two
measurement is itself numerically significant.

UX = f (X), UY = f (Y), …..

Cont…
• To introduce the theory of consumer behavior, it helps to
think for a moment about your own behavior as a consumer.
Imagine you have $100 to spend this week:
In the table below, identify
• 5 goods or services you would spend your money on.
• The approximate price of each product, and
• The quantity you would buy

Item Price Quantity Questions:

1. How did you decide which items to put in
your “basket”?
2. Is your basket identical to your classmates?
Why or why not?
3. How would a change in the price of one of
the items affect the quantity you buy?
4. How would a change in your budget affect
the composition of your basket?
 Utility, Marginal Utility and Total
Utility
• Utility:
Utility is wants satisfying power of a commodity which varies from person to
person. The value-in-use of a commodity is the satisfaction which we get from
the consumption of the commodity.
• Marginal Utility:
The additional utility derived from additional unit of a commodity. It refers to
net addition made to the total utility by the consumption of an extra unit of a
commodity
• Total Utility:
The sum of the utility derived from the different units of the commodity
consumed by a consumer. The amount of utility derived from the
consumption of all units of a commodity which are at the disposal of the
consumer.
 The law of Diminishing Marginal
Utility
• The greater the level of consumption of a particular good, the
less utility consumers derive from each additional unit of the
good.
Consider the total and marginal utility one derives
from consuming ice cream. Notice the following:
• The first scoop provides you with 5 utils, so TU = 5
at Q=1
• Additional scoops of ice cream provide you with
less and less additional happiness. Nothing tastes
quite as good as that first scoop! MU declines
beyond the first scoop, but TU continues to
increase, until…
• The fourth scoop: At four scoops your TU is
maximized, but the 4th scoop provided you with
no additional utility.
• Beyond four scoops, you’ve “had too much”. TU
begins decreasing while MU becomes negative.
 Ordinal Utility Approach
• This approach gives us information on how a consumer ranks
different baskets of goods. But it does not say by how much
(i.e. 2 times as much)
– This is how we view preferences.
• It needed for the consumer to rank the various commodities.
• The main ordinal theories are the,
1. Indifference curve approach
2. Revealed preference hypotheses
 Indifference Curve Analysis
• Indifference curve shows consumption bundles that
give the consumer the same level of satisfaction.
• In other words, an IC is a graph showing combination
of two goods that give the consumer equal
satisfaction and utility. Each point on an IC indicates
that the consumer is indifferent between two and all
points give him the same utility
U = f(X,Y) = K
 Assumptions of an IC
• Rationale consumers
• Two commodities
• Utility is ordinal
• Diminishing marginal rate of substitution
• Total utility of the consumer depends on the
quantities of commodities consumed
• Consistency and transitivity of choice
 Properties of IC
• Negative downward slope
• Higher IC represent higher level of satisfaction
• Does not intersect each other
• Convex to the origin
 Graphical Illustration

Combination Food Clothing

A 1 12
B 2 6
C 3 4
D 4 3
 IC Map
• Map shows ICs which ranks the preference of
the consumer.
Combinations of good
situated on and IC yield
higher level of
satisfaction and
preferred.
Combinations on the
lower IC yield the lower
satisfaction
 Marginal rate of substitution
• A consumer’s willingness to substitute one good for
another while maintaining the same level of
satisfaction (i.e. slope of indifference curve remains
the same).

• The marginal rate of substitution of x for y (MRSx,y)

is the rate at while the consumer is willing to give up
y in order to get more of x, holding utility constant.
– This assumes y is on the vertical axis and x the horizontal.
Graphical Illustration
• If you like both goods
then both goods will
have positive marginal
utilities
• Then indifference
curve must be
negatively sloped,
because if you give up
one good need more
of the other.
Marginal Rate of Substitution
Mathematically
 The Budget Line
• The budget line shows all those combinations of two goods.
• The consumer can buy spending has given money income at
their given price
• All those combinations which are within the reach of the
consumer will lie on the budget line.
Consumer budget states
the real income or
purchasing power from
which he can purchase
certain quantitative
bundles of two goods at
given price
Example
Ravi’s income: $1200
Prices: PF = $4 per fish, PM = $1 per mango
A. If Ravi spends all his income on fish,
how many fish does he buy?
B. If Ravi spends all his income on mangos,
how many mangos does he buy?
C. If Ravi buys 100 fish, how many mangos can he buy?
D. Plot each of the bundles from parts A – C on a graph
that measures fish on the horizontal axis and mangos
on the vertical, connect the dots.
 Consumer Equilibrium/ Optimum
choice of consumer
• A consumer derives maximum possible satisfaction from the
goods at equilibrium position.

Assumptions
1. The consumer has given indifference map which shows his
scale of preference for various combinations of two goods x
and y.
2. He has fixed money income.
3. The given prices of good x and y are fixed.
Graphical Illustration
 Mathematical formula
• Utility maximization rule:
𝑴𝑼𝒙 𝑴𝑼𝒚
=
𝑷𝒙 𝑷𝒚

𝑴𝑼𝒙 𝑴𝑼𝒚
If > buy more of ‘X’
𝑷𝒙 𝑷𝒚

𝑴𝑼𝒙 𝑴𝑼𝒚
If < buy more of ‘Y’
𝑷𝒙 𝑷𝒚
Example