The Theory of Consumer

Behaviour
Topic One
Outline

• Consumer Preferences

• Budget Constraints

• Consumer Choice

• Revealed Preference

• Marginal Utility and Consumer Choice

 CONSUMER BEHAVIOUR
Theory of consumer behavior Description of how consumers
allocate incomes among different goods and services to
maximize their well-being.

Consumer behavior is best understood in three distinct steps:

1.Consumer preferences
2.Budget constraints
3.Consumer choices
 CONSUMER PREFERENCES
Market Baskets
● Market basket (or bundle) List with specific quantities
of one or more goods.

TABLE Alternative Market Baskets

Market Basket Units of Food Units of Clothing

A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40

To explain the theory of consumer behavior, we will ask

whether consumers prefer one market basket to another.
Market baskets…
Some Basic Assumptions about Preferences
1. Completeness: Preferences are assumed to be complete.
In other words, consumers can compare and rank all possible baskets.
Thus, for any two market baskets A and B, a consumer will prefer A to
B, will prefer B to A, or will be indifferent between the two.
By indifferent we mean that a person will be equally satisfied with
either basket.
Note that these preferences ignore costs.
A consumer might prefer fresh juice to manufactured juice but buy
manufactured juice because it is cheaper.
Preferences by a binary relation: For all A and B basket of goods,
either 𝐴 ≿ 𝐵 or 𝐵 ≿ 𝐴
It says that, the consumer can examine any two distinct consumption
plans A and B and decide whether “A is at least as good as B” or “B is
at least as good as A”.
Market baskets…
2. Transitivity: Preferences are transitive.
Transitivity means that if a consumer prefers basket A to basket B and
basket B to basket C, then the consumer also prefers A to C.
Transitivity is normally regarded as necessary for consumer
consistency.
Preferences by a binary relation: For any three basket of goods A,B, and C,
if 𝐴≿𝐵 and 𝐵≿𝐴, then 𝐴≿C.
The assumptions (axioms) of completeness and transitivity describe a
consumer who can make consistent comparisons among alternatives.
These two assumptions together imply that the consumer can
completely rank any finite number of elements in the consumption set,
X, from best to worst, possibly with some ties.
Market baskets…
3. More is better than less (Local Non-satiation): Goods are
assumed to be desirable—i.e., to be good.
Consequently, consumers always prefer more of any good to less.
In addition, consumers are never satisfied or satiated; more is always
better, even if just a little better.
This assumption is made for pedagogic reasons; namely, it simplifies
the graphical analysis.
Of course, some goods, such as air pollution, may be undesirable, and
consumers will always prefer less.
 Indifference Curves
Indifference curve: Curve representing all combinations of
market baskets that provide a consumer with the same level
of satisfaction. An Indifference Curve
The indifference curve U1 that
passes through market basket
A shows all baskets that give
the consumer the same level
of satisfaction as does market
basket A; these include
baskets B and D.

Our consumer prefers

basket E, which lies
above U1, to A, but
prefers A to H or G,
which lie below U1.
Indifference Maps
Indifference map: Graph containing a set of indifference curves
showing the market baskets among which a consumer is indifferent.
An indifference map is a set An Indifference Map

of indifference curves that

describes a person's
preferences.

Any market basket on

indifference curve U3,
such as basket A, is
preferred to any basket
on curve U2 (e.g.,
basket B), which in turn
is preferred to any
basket on U1, such as
D.
Indifference Maps…

If indifference curves U1 Indifference Curves Cannot Intersect

and U2 intersect, one of

the assumptions of
consumer theory is
violated.

According to this
diagram, the consumer
should be indifferent
among market baskets
A, B, and D. Yet B
should be preferred to D
because B has more of
both goods.
 The Marginal Rate of Substitution
Marginal rate of substitution (MRS): Maximum amount of a good that a consumer is
willing to give up in order to obtain one additional unit of another good.

The magnitude of the slope of The Marginal Rate of Substitution

an indifference curve
measures the consumer’s
marginal rate of substitution
(MRS) between two goods.

In this figure, the MRS between clothing

(C) and food (F) falls from 6 (between A
and B) to 4 (between B and D) to 2
(between D and E) to 1 (between E and
G).
Convexity The decline in the MRS
reflects a diminishing marginal rate of
substitution. When the MRS diminishes
along an indifference curve, the curve is
convex.
 Perfect Substitutes and Perfect Complements

Perfect substitutes: Two goods for which the marginal rate of substitution of
one for the other is a constant.

Perfect complements: Two goods for which the MRS is zero or infinite; the indifference
curves are shaped as right angles.

Bads

Bad: Good for which less is preferred rather than more.

Perfect Substitutes and Perfect Complements…

Perfect Substitutes and Perfect Complements

In (a), Bob views orange juice and
apple juice as perfect substitutes:
He is always indifferent between a
glass of one and a glass of the
other.
In (b), Jane views left shoes and
right shoes as perfect complements:
An additional left shoe gives her no
extra satisfaction unless she also
obtains the matching right shoe.
 Utility and Utility Functions
Utility: Numerical score representing the satisfaction that a consumer gets from
a given market basket.
Utility function: Formula that assigns a level of utility to individual market baskets
or a function that describes consumer’s preference relations. E.g. u(𝐹, 𝐶) = 𝐹𝐶
A utility function can be Utility Functions and Indifference Curves

represented by a set of
indifference curves,
each with a numerical
indicator.
This figure shows three
indifference curves
(with utility levels of 25,
50, and 100,
respectively)
associated with the
utility function FC.
Utility and Utility Functions…
Some examples of utility functions
Perfect Substitutes
Here a and b are some positive numbers that measure
Perfect Complements the “value” of goods 1 and 2 to the consumer.

Perfect Complements
a and b are positive numbers that indicate the
proportions in which the goods are consumed.

Cobb-Douglas
Where c and d are positive numbers that describe the preferences
of the consumer
 Constant Elasticity of Substitution (CES)
Elasticity of substitution for a utility function is defined as the elasticity
of the ratio of consumption of two goods to the MRS.
Therefore it is a measure of how easily the two goods are substitutable
along an indifference curve.
For a class of utility functions this value is constant for all (𝑥1 , 𝑥2 ).
These utility functions are called Constant Elasticity of Substitution
(CES) utility functions.
The following utility functions are special cases of the general CES
utility function:
Linear Utility: Linear Utility is of the form of Perfect Substitutes
Leontief Utility: Leontief utility is of the form of Perfect Complements
 BUDGET CONSTRAINTS
Budget constraints: Constraints that consumers face as a result of limited incomes or is
the set of all the bundles a consumer can afford given that consumer's income.
𝑃𝐹 𝐹 + 𝑃𝐶 𝐶 ≤ 𝐼
Budget line: All combinations (set) of goods for which the total amount of money
spent is equal to income.
PF F  PC C  I

TABLE Market Baskets and the Budget Line

Market Basket Food (F) Clothing (C) Total Spending

A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
The table shows market baskets associated with the budget line
F + 2C = $80
BUDGET CONSTRAINTS…

• The Budget Line A Budget Line

A budget line describes the

combinations of goods that
can be purchased given the
consumer’s income and the
prices of the goods.
Line AG (which passes
through points B, D, and E)
shows the budget
associated with an income
of $80, a price of food of PF
= $1 per unit, and a price of
clothing of PC = $2 per unit.
The slope of the budget line
(measured between points
B and D) is −PF/PC = −10/20 C  ( I / PC )  ( PF / PC ) F
= −1/2.
BUDGET CONSTRAINTS…
The Effects of Changes in Income and Prices Effects of a Change in Income on the
Budget Line

Income Changes A
change in income (with
prices unchanged) causes
the budget line to shift
parallel to the original line
(L1).
When the income of $80
(on L1) is increased to
$160, the budget line shifts
outward to L2.
If the income falls to $40,
the line shifts inward to L3.
 BUDGET CONSTRAINTS…
The Effects of Changes in Income and Prices Effects of a Change in Price on the
Budget Line

Price Changes A
change in the price of
one good (with income
unchanged) causes the
budget line to rotate
about one intercept.
When the price of food
falls from $1.00 to $0.50,
the budget line rotates
outward from L1 to L2.
However, when the price
increases from $1.00 to
$2.00, the line rotates
inward from L1 to L3.
 CONSUMER CHOICE
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.
2. It must give the consumer the most preferred combination
of goods and services.
Maximizing Consumer Satisfaction

A consumer maximizes
satisfaction by choosing market
basket A. At this point, the
budget line and indifference
curve U2 are tangent.
No higher level of satisfaction
(e.g., market basket D) can be
attained.
At A, the point of maximization,
the MRS between the two
goods equals the price ratio. At
B, however, because the MRS
[− (−10/10) = 1] is greater than
the price ratio (1/2), satisfaction
is not maximized.
 CONSUMER CHOICE

Satisfaction is maximized (given the budget constraint) at the

point where

MRS  PF / PC (3)

● marginal benefit Benefit from the consumption of one

additional unit of a good.
● marginal cost Cost of one additional unit of a good.

The condition given in equation (3) illustrates the kind of

optimization conditions that arise in economics. In this instance,
satisfaction is maximized when the marginal benefit—the
benefit associated with the consumption of one additional unit of
food—is equal to the marginal cost—the cost of the additional
unit of food. The marginal benefit is measured by the MRS.
 CONSUMER CHOICE
• Corner Solutions
● corner solution Situation in which the marginal rate of
substitution of one good for another in a chosen market
basket is not equal to the slope of the budget line.
Figure

A Corner Solution

When the consumer’s marginal

rate of substitution is not equal to
the price ratio for all levels of
consumption, a corner solution
arises. The consumer
maximizes satisfaction by
consuming only one of the two
goods.
Given budget line AB, the highest
level of satisfaction is achieved at
B on indifference curve U1, where
the MRS (of ice cream for frozen
yogurt) is greater than the ratio of
the price of ice cream to the price
of frozen yogurt.
 MARGINAL UTILITY AND CONSUMER CHOICE

● marginal utility (MU) Additional satisfaction obtained

from consuming one additional unit of a good.
● diminishing marginal utility Principle that as more of a good is
consumed, the consumption of additional amounts will yield
smaller additions to utility.
0  MU (F )  MU (C)
F C
(C / F )  MU / MU
F C
MRS  MU /MU (5)
F C
MRS  P / P (6)
F C
MU / MU  P / P
F C F C
MU / P  MU / P (7)
F F C C

The MRS is thus obtained by solving for the (negative) slope of

the indifference curve.
MARGINAL UTILITY AND CONSUMER CHOICE
Example: Find the MRS for a Cobb-Douglas utility function. Suppose
that the utility function from consuming goods 1 and 2 is
 Consumer Demand
The optimal choice of goods 1 and 2 at some set of prices and income is
called the consumer’s demanded bundle.
In general when prices and income change, the consumer’s optimal
choice will change.
The demand function is the function that relates the optimal choice—
the quantities demanded—to the different values of prices and incomes.
We will write the demand functions as depending on both prices and
income: and
For each different set of prices and income, there will be a different
combination of goods that is the optimal choice of the consumer.
Different preferences will lead to different demand functions
Consumer Demand…
Perfect Substitutes: We have three possible cases.
If 𝑝2 > 𝑝1 , then the slope of the budget line is flatter than the slope of
the indifference curves.
The optimal bundle is where the consumer spends all of his or her
money on good 1.
If 𝑝1 > 𝑝2 , then the consumer purchases only good 2.
Finally, if 𝑝1 = 𝑝2 , there is a whole range of optimal choices—any
amount of goods 1 and 2 that satisfies the budget constraint is optimal
in this case. Thus the demand function for good 1 will be
Optimal choice with perfect substitutes
If the goods are perfect substitutes, the optimal choice will usually be
on the boundary.
Consumer Demand…
Perfect Complements
Note that the optimal choice must always lie on the diagonal, where the
consumer is purchasing equal amounts of both goods, no matter what
the prices are.
We know that the consumer is purchasing the same amount of good 1
and good 2, no matter what the prices.
If this amount is denoted by x, then we have to satisfy the budget
constraint

Solving for x gives us the optimal choices of goods 1 and 2:

Optimal choice with perfect complements
If the goods are perfect complements, the quantities demanded
will always lie on the diagonal since the optimal choice occurs
where x1 equals x2.
Consumer Demand…
Cobb-Douglas Preferences
Suppose that the utility function is of the Cobb-Douglas form
These demand functions will look like:

Thus the Cobb-Douglas consumer always spends a fixed fraction of his

income on each good.
 The size of the fraction is determined by the exponent in the Cobb-Douglas
function.
Consumer Demand…
uncompensated and compensated demand
What we have been calling demand up to now is Marshallian (uncompensated) or
ordinary demand which maximizes utility u given prices p1 and p2 and income m, so
is a function of p1, p2, m.
Notation 𝑥1 (𝑝1 , 𝑝2 , 𝑚) and 𝑥2 (𝑝1 , 𝑝2 , 𝑚).
Compensated (Hicksian) demand minimizes the expenditure (cost) of obtaining
utility u at prices p1 and p2 and is a function of utility u, p1 , p2.
Notation 𝑥1ℎ (𝑝1 , 𝑝2 , 𝑢) and 𝑥1ℎ (𝑝1 , 𝑝2 , 𝑢).
The Hicksian demand curve—the one with utility held constant—is sometimes called
the compensated demand curve.
This terminology arises naturally if you think of constructing the Hicksian demand
curve by adjusting income as the price changes so as to keep the consumer’s utility
constant.
Hence the consumer is “compensated” for the price changes, and his utility is the
same at every point on the Hicksian demand curve.
This is in contrast to the situation with an ordinary demand curve.
In this case the consumer is worse off facing higher prices than lower prices since his
income is constant.
 Optimization of Utility Functions
Optimization is a procedure which aims to find the optimal solutions to the
objective function or functions under constraints.
There are two approaches for optimizing a utility function
Substitution approach
Lagrange multipliers approach
While substitution approach is simple enough, there are situations where it will be
difficult to apply.
The procedure requires that, as we know, before the calculation, the budget
constraint actually binds.
In many situations there may be other constraints and we may not know whether
they bind before demands are calculated.
In this course, Lagrange multipliers will be used as a more general approach.
Consider the (two good) problem of
 Examples
Examples 1: A consumer has a utility function
𝑢(𝑥1 , 𝑥2 ) = min(𝑥1 𝑥2 )
a) What type of utility function is that?
b) Find the consumer demand functions
Example 2: You are given the following utility function
𝑢 𝑥1 , 𝑥2 = 𝑥1 + 𝑥2
a) State what type of utility function is that?
b) Find consumer demand functions
Example 3: The consumer want to maximize the following utility
𝑢(𝑥1 , 𝑥2 ) = 𝑥1 𝑥2
Find consumer demand functions
Example 4: Suppose that the utility function is of the form

a) State what type of utility function is that?

b) Find consumer demand functions
Example 5: Leah spends all of her food budget on chips and eggs. Leah’s
utility function is:
𝑈(𝑥1 , 𝑥2 ) = 𝑥1 𝑥2
Where x1 is the quantity of chips and x2 is the quantity of eggs. Her
monthly food budget is TSh 120,000, the price of chips (p1) is 3,000, and
the price of egg (p2) is 2,000. Find Leah’s utility-maximizing choice of chips
and eggs.
Example 6: Mansoor has a utility function 3750 = 𝑥1 𝑥2 . Where x1 is the
quantity of beef and x2 is the quantity of rice. His monthly food budget is
TSh 120,000, the price of beef (p1) is 3,000, and the price of rice (p2) is
2,000. He aims to find the minimum amount of money that he needs to
spend to reach that utility level of 3750.
a) Find Mansoor’s demand functions
b) Find the minimum amount of money that he needs to spend to reach a
utility level of 3750
c) Find Mansoor’s expenditure function.
 The Slutsky equation
Generally, if the price of something goes down, we buy more of it.
This is down to two effects:
Income effect: because it’s less expensive, we have more purchasing power
because it is a smaller drain on our personal finances.
Substitution effect: because it offers more utility per unit of money, other
alternatives become less attractive.
Eugen Slutsky managed to find an equation that decomposes this
effect based on Hicksian and Marshallian demand curves.
The Slutsky equation…
Mathematically, it is based on the derivatives of Marshallian and Hickisan
demands:

The left hand side of the equation is the total effect- that is, the derivative of x
(quantity) respect p (price).
It shows us how much the total quantity of x that we consume varies when we change
price.
The next part is the substitution effect- how much the variation is due to us
finding similar options.
It is obtained from the derivative of the Hicksian demand with regards price.
The right hand side is the income effect, how much changes in our purchasing
power affect the amount we consume of a certain good.
It is the derivative of the Marshallian demand with regards wealth (multiplied by the
quantity).