Principles Of Economics 3

Dr/ SAMIA SAMY

 Consumer behaviour Theory

 This module introduces you to:

 The Model of consumer behaviour:

o Preference: What the consumer wants? INDIFFERENCE CURVE.
o Utility: what the benefit the consumer gets?
o The law of Diminishing marginal utility.
o Budget Constraints: What the consumer can afford? BL (BUDGET LINE).
o Consumer equilibrium.
 Who is the consumer?

 Before understanding consumer behaviour let us first go through few more

terminologies:
 Who is a Consumer ?
 Any individual who purchases goods and services from the market for
his/her end-use is called a consumer.
 In simpler words a consumer is one who consumes goods and services
available in the market.
 Example - Tom might purchase a tricycle for his son or Mike might buy a
shirt for himself. In these examples, both Tom and Mike are consumers.
 Consumption Choices

 The choices you make as a buyer or consumer of goods and services are
influenced by many factors, which economists summarize as
Consumption Choices or Preferences.

 Consumption Choices
 Consumption Choices are all the things that you can afford to buy.
 Consumption Bundle
 An individual's consumption bundle is the collection of all the goods and
services consumed by that individual.
 Consumer Behaviour Model

 The Model of consumer behaviour is based on:

Preferences:
Individual tastes or preferences determine the amount of pleasure people
derive from the goods and services they consume .
Utility :
 Economists summarize a consumer's preferences using a utility function
,which assigns a numerical value to each possible set of goods, reflecting
the consumer's relative ranking of these bundles . The enjoyment or
satisfaction people receive from consuming goods and services.
 Budget constraint or line:
Consumers face constraints or limits on their choices( Prices ,income , and
government restrictions)
 limit a consumer's ability to make purchases by determining the rate at
which a consumer can trade one good for another
 Consumers maximize their pleasure from consumption ,subject to the
constraints they face. consumers will choose to buy the combination of
goods and services that makes them as well off as possible from among
all the combinations that their budgets allow them to buy.
Budget constraint or line
 The Theory of Consumer Behaviour

 The principle assumption upon which the theory of consumer behaviour

and demand is built is: a consumer attempts to allocate his/her limited
money income among available goods and services so as to maximize
his/her utility (satisfaction), so the consumer is rational.
 The theory of consumer behaviour assumes that buyers are completely
informed about:
 Range of products available
 Prices of all products
 Capacity of products to satisfy
 Their income
 Preference: What the
consumer wants

Indifference curve: is a line

showing all the combinations of
two goods which give a
consumer equal utility. In other
words, the consumer would be
indifferent to these different
combinations.
If the two bundles suit his tastes
equally well, we say that the
consumer is indifferent between
the two bundles.
 Indifference curve

 The consumer is equally happy at all points on any given indifference

curve, but he prefers some indifference curves to others.
 Because he prefers more consumption to less, higher indifference
curves are preferred to lower ones.

 The slope at any point on an indifference curve equals the rate at

which the consumer is willing to substitute one good for the other. This
rate is called the marginal rate of substitution (MRS).
 MRS: the rate at which a consumer is willing to trade one good for
another.
 Consumer Preferences (The
indifference Map of the consumer)
 The higher or the upper to right – the
indifference curve is the greatest utility
consumer receives.
 The higher level of satisfaction is (I4).
 An indifference map is a complete set of
indifference curves. It indicates the consumes
preferences among all combinations of
goods and services.
 The farther from the origin the indifference
curve is, the more the combinations of goods
along that curve are preferred
 • Four Properties of Indifference Curves

 Property 1: Higher indifference curves are preferred to lower ones.

 Property 2: Indifference curves are downward sloping.
 Property 3: Indifference curves do not cross.
 Property 4: Indifference curves are bowed inward.

 The bowed shape of the indifference curve reflects the consumer’s

greater willingness to give up a good that he already has in large
quantity.
 MRS
 MRS quantity of goods Y willing to substitute to obtain one unit of goods X
this substitution is to maintain its position at the same level of satisfaction.

 Marginal rate of substitution ( The rate at which a consumer would be

willing to trade off one good for another).

 The slope of the indifference curve is presented by the marginal rate of

substitution
 Calculating the MRS

 The marginal rate of substitution

(MRS) of good x for good y
 MRS xy= change in y/ change in x
 (which is just the slope of the
indifference curve)
 Utility

 A consumer’s preferences determine the benefits or satisfaction a

person receives consuming a good or service.
 Or The benefit or satisfaction from consuming a good or service is
called utility.
 Total Utility
 Total utility is the total benefit a person gets from the consumption of
goods. (TU): The overall level of satisfaction derived from consuming
a good or service
 Marginal Utility

 Marginal utility(MU):
 is the change in total utility that results from a one-unit increase in the
quantity of a good consumed.
MU = Change in total utility
Change in quantity
 As the quantity consumed of a good increases, the marginal utility from
consuming it decreases.
 We call this decrease in marginal utility as the quantity of the good
consumed increases the principle of diminishing marginal utility.
Marginal utility &Total utility
Total utility increases with the
consumption of a good.
Diminishing marginal utility.
 Law of Diminishing Marginal Utility

 Law of Diminishing Marginal Utility (Return) = As more and more of a good

are consumed, the process of consumption will (at some point) yield
smaller and smaller additions to utility.
 The principle that consumers experience diminishing additional
satisfaction as they consume more of a good or service during a given
period of time.

 When the total utility maximum, marginal utility = 0.

 When the total utility begins to decrease, the marginal utility = negative.
 Calculate Slices of Total Marginal Marginal
pizza utility in utility/ cost
Marginal Utility dollars benefit
0 0 0 2$
1 8 8 2$
How many pizzas 2 14 6 2$
would you buy if the 3 19 5 2$
price per slice was 4 23 4 2$
$2? 5 25 2 2$
You will continue to 6 26 1 2$
consume until 7 26 0 2$
Marginal Benefit = 8 24 -2 2$
Marginal Cost
 Budget constraint

 Budget constraint: A household’s consumption possibilities are constrained by its budget

and the prices of the goods and services it buys. (the limit on the consumption bundles that
a consumer can afford).
 People consume less than they desire because their spending is constrained, or limited, by
their income. The budget line describes the limits to the household’s consumption choices.
 The Budget Equation: We can describe the budget line by using a budget equation
 The budget equation states that : Expenditure = Income
 Call the price of product 1P1, the quantity Q1, the price of a product 2 P2, the quantity Q2,
and income Y.
 • The budget equation is: P1Q1 + P2Q2 = Y.
 Budget constraint or line BL

 All the points on the line from A to F are possible.

This line, called budget constraint, shows the
consumption bundles that the consumer can
afford.
 It also shows the trade off between two goods
that the consumer faces.
 The slope of the budget constraint measures the
rate at which the consumer can trade one good
for the other.
 The slope of the budget constraint equals the
relative price of the two goods-the price of one
good compared with the price of the other.
 Factors that affect the budget line

 1-Change in income :The increase in income leads to the shift of the

budget line to the right and the decrease of income leads to the shift of
the budget line towards the left .

 2-Change in prices :The change in the prices of one good or both

goods leads to the shift of the budget line towards the right or the left .
The shifts of the budget line
 Consumer Equilibrium

 The indifference map in combination with the budget line allows us to

determine the one combination of goods and services that the consumer
most wants and is able to purchase. This is the consumer equilibrium.
 With income (M) some combination of goods that consumers choose the
highest satisfaction.
 The point where the curve IC and BL tangent.
 Therefore, the consumer equilibrium is reached when the slope of the
budget line equals the slope of the indifference curve .
Consumer Equilibrium
(PX/PY=𝑴𝑹𝑺𝒐𝒇𝑿𝒇𝒐𝒓𝒀)
 EXAMPLE; given the following data on
different combinations of two goods

 1-Calculate the MRS Group X Y

 2-Draw the indifference curve A 1 10

If a consumer’s income is
B 2 6
20$,Px=4$,Py=2$
 3-Draw the budget line C 3 4

 4 -Determine the case of D 4 3

consumer equilibrium
1-Calculate the MRS

Group X Y MRS

A 1 10 ----------

B 2 6 4

C 3 4 2

D 4 3 1
2-Draw the indifference curve IC
 3-Draw the budget line

 In order to draw the budget line,

we calculate the maximum value
of X and Y by assuming that each
variable equals zero in the
previous formula:
 When X=0,Y=10
 When Y=0,X=5
 And then draw the budget line by
matching both points.
 4 -Determine the case of consumer
equilibrium

 According to the previous figure, the consumer is considered in the

equilibrium state at point (C) since both the budget line and the
indifference curve are tangent.
 Another way to determine the equilibrium state is by applying the
equilibrium law:
 PX/PY= 𝑴𝑹𝑺 𝒐𝒇 𝑿 𝒇𝒐𝒓 𝒀 PX/PY= -4/2= -2
 By looking at the combinations of both goods in the previous table, we
can easily determine that the MRS at point (C) equals 2, which is equal to
the slope of the budget line. Note that the negative sign of the slope refers
to the inverse relationship between the consumption of both goods.