Chapter 4 Theory of Consumer Behaviour

Principles of Economics second edition All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T) 2010 Ch. 4: 1

CHAPTER 4
CONSUMER BEHAVIOUR

DEFINITION OF CONSUMER
BEHAVIOUR
Consumer behaviour refers to the study

of consumer while engaged in the process
of consumption.

UTILITY APPROACH
Definition
 ‘Utility’ means the satisfaction obtained from consuming
a commodity.
Two Types of Approach
1. Cardinal Approach
 The cardinal utility theory says that utility is measurable and by placing a
number of alternatives so that the utility can be added.
 The index used to measure utility is called utils.
2. Ordinal Approach
 The ordinal utility theory says that utility is not measurable but it can be
compared.
 Ordinal approach uses the ranking of alternatives as first, second, third
and so on.

TOTAL UTILITY AND MARGINAL
UTILITY
TOTAL UTILITY (TU)

The total satisfaction that a person gets from the
consumption of goods and service.
MARGINAL UTILITY (MU)

The additional to total utility as a result of consuming one
more units of the same good or services.
Marginal Utility (MU) = Change in Total Utility
Change in Total Quantity
MU =  TU/  Q

LAW OF DIMINISHING MARGINAL
UTILITY
 Definition
The additional benefit which a person derives from a
given increase of a stock of a thing diminishes, other
things being equal, with every increase in the stock
that he already has.
OR
Law of Diminishing Marginal Utility states that as
consumption increases more and more, marginal
utility will be less and less.

UTILITY (cont.)
TU increases from consumption of 1st unit of apple until the 5th unit of apples. After the
5th unit of apples, TU will decrease.
Units of Total Marginal

Apples Utility Utility
1 20 20
2 35 15
3 45 10 MU will decrease and
become zero at the 5th
4 50 5 unit of apples and further
consumption of apples
5 50 0 will not satisfy the
consumer as the MU
6 45 -5 shows negative signs.
7 35 -10
8 20 -15
UTILITY (cont.)
When TU is increasing, MU will be positive.
When TU is at its maximum, MU will be zero.
When TU is decreasing, MU will be negative.

LAW OF EQUI-MARGINAL UTILITY
(EMU)
 Definition
The Law of Equi-Marginal Utility (EMU) states
that other things being equal, a consumer gets
maximum satisfaction when he allocates his limited
income to the purchase of different goods, where
the marginal utility derived from the last unit of
money spent on each item of expenditure tends to
be equal.
 This is also known as conditions for maximum utility
or satisfaction.

(EMU) (cont.)
Conditions for Equilibrium
For consumer equilibrium, this condition must be fulfilled.
Condition 1: Every ringgit spent on every commodity must
yield the same marginal utility.
Marginal Utility of X = Marginal Utility of Y
Price of X Price of Y
MUx = MUy =… = MUn
Px Py Pn
Condition 2: Total expenditure of all goods must be equal to

the total budget allocated to maximize utility.
P1Q1 + P2Q2 + … + PnQn = Total budget

(EMU) (cont.)
EXAMPLE: Arwin has an income of RM37 and the prices of goods P, Q and R are RM5, RM1 and RM4 respectively.
Condition 1 : Every ringgit spent on every Fulfilling condition 1, two combination of goods are obtained:
commodity must yield the same marginal utility. Combination 1 : 2P, 4Q and 1R
Combination 2 : 4P, 5Q and 3R
Quantity Product P Product Q Product R

Total MUP/PP Total MUQ/PQ Total Utility MUR/PR
Utility Utility
1 21 4.2 7 7 16 4
2 41 4 13 6 30 3.5
3 59 3.6 18 5 42 3
4 74 3 22 4 50 2
5 85 2.2 25 3 55 1.25
6 91 1.2 27 2 58 0.75
7 91 0 28 1 60 0.5
Combination 1 : 2P, 4Q and 1R
Condition 2 : Total 2(5) + 4(1) + 1(4) = 18
expenditure of all goods must Combination 2 : 4P, 5Q and 3R
be equal to the total budget 4(5) + 5(1) + 3(4) = 37
allocated to maximize utility. So, 4 units of Product P, 5 units of Product Q and 3 units of Product R will be
purchased by Arwin.

INDIFFERENCE CURVE
Definition
 An indifference curve represents all the possible combinations
of two goods which will give the same level of satisfaction.
Assumptions
1. Scale of preferences
2. Consumers’ preferences are transitivity
3. Rationality
4. Diminishing marginal rate of substitution
5. Concept of ordinal utility

INDIFFERENCE CURVE (cont.)
An indifference schedule is a list of combination of two goods that give equal

satisfaction to the consumer.
Combinations Good Y Good X

A 12 2
B 6 4
C 4 6
D 3 8
E 2 12
The table above shows all the five combinations, which will give the equal level
of satisfaction.

INDIFFERENCE CURVE (cont.)
An indifference curve represents all those combinations of two goods; X and Y which
yield the same level of satisfaction to a consumer.

INDIFFERENCE MAP
An indifference map shows a set of indifference curve.
The higher the indifference curve from the origin, higher will be the utility. IC3
has the higher satisfaction.

INDIFFERENCE CURVE
 Marginal Rate of Technical Substitution

- Refers to the rate at which one good is substituted for another good.
Combinations Good Y Good X Marginal Rate of
Substitution
A 12 1 -
B 8 2 4Y : 1X
C 5 3 3Y : IX
D 3 4 2Y : 1X
E 1 5 1Y : 1X
 Characteristics of Indifference Curve

1. Indifference curve slopes downward from left to right.
2. Indifference curve are convex to the origin.
3. Higher indifference curves represent higher level of satisfaction.
4. Indifference curve never intersect each other.
5. Indifference curve does not touch the Y axis or X axis.
BUDGET LINE
A budget line represents various combinations of two goods, which can be purchased
with a given amount of money at the given price of each unit.

CHANGES IN BUDGET LINE
1. Change in Consumer’s Income
An increase in consumer’s income will lead to a shift of the budget line to the right, A1B1
A decrease in consumer’s income will shift the budget line to the left as represented by A2B2

2. Change in Price of Good X
Budget Line Budget Line
30 30
25
20 20
Good Y
AB
Good Y
15
A1B1 AB
Good Y 10 10
5 A1B1
0 0
2 4 6 8 10 12 14 16 18 20 22 24
2 4 6 8 10 12 14
Good X Good X
Good X
Price of good X increase from RM1 to RM2 Price of good X decrease from RM1 to RM0.50
and price of good Y constant and price of good Y constant

3. Change in Price of Good Y
Budget Line Budget Line
30 30
25 25
20 20
Good Y
Good Y
15 AB 15 AB
AB1 AB1
Good Y 10 Good Y 10
5 5
0 0
2 4 6 8 10 12 14 2 4 6 8 10 12 14
Good X Good X
Price of good Y increase from RM0.50 to Price of good Y decrease from RM0.50 to
RM1 and price of good X constant RM0.40 and price of good X constant

CONSUMER EQUILIBRIUM
A consumer is in equilibrium when he or she is consuming the best possible

combination of two goods with the given amount of income.
At point b, and e, the consumer will

have a lesser satisfaction at IC3
with the same amount of income
Consumer equilibrium is reached when

indifference curve tangent with budget
Line which represents best combination
of two goods with limited income
as point C.

INCOME, PRICE AND SUBSTITUTION
EFFECT
 INCOME EFFECT
The income effect is defined as the effect on the purchases of the
consumer caused by changes in income with prices of goods remaining
constant.
 PRICE EFFECT
Price effect explains what happens to the consumers’ equilibrium
position when the price of one good changes while the price of another
good and other factors remains constant.
 SUBSTITUTION EFFECT
Substitution effect explains what happens to the consumers’
equilibrium position when the price of both good changes – price of one
rises and price of another falls while other factors remains constant.

CONSUMER SURPLUS
Consumer surplus is defined as the excess of what a consumer is
willing to pay and what he/she actually pays.
Example : Suppose Sally who is fond of

chocolates is ready to pay for each successive Bars of
bar of chocolate as shown in table below. 1 2 3 4 5
chocolate
Assume that Sally is willing to pay lower price for
the successive bar of chocolates. Assume the Price (RM) 2.50 2.00 1.50 1.00 0.80
market price of one bar of chocolate is RM1.00.
CONSUMER SURPLUS = TOTAL VALUE – (MARKET PRICE x NUMBER OF UNITS CONSUMED)
Price (RM)
2.50
CONSUMER SURPLUS
1.00 Consumer surplus = (2.50 + 2 + 1.50 + 1) – (1 x 4)

= RM3.00
DD
Quantity
0
4


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Principles of Economics second edition All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T) 2010 Ch. 4: 1

Principles of Economics second edition All Rights Reserved

Consumer behaviour refers to the study

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

TOTAL UTILITY (TU)

MARGINAL UTILITY (MU)

Marginal Utility (MU) = Change in Total Utility

Change in Total Quantity

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

Units of Total Marginal

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

Condition 2: Total expenditure of all goods must be equal to

Principles of Economics second edition All Rights Reserved

Quantity Product P Product Q Product R

Principles of Economics second edition All Rights Reserved

2. Consumers’ preferences are transitivity

4. Diminishing marginal rate of substitution

5. Concept of ordinal utility

Principles of Economics second edition All Rights Reserved

An indifference schedule is a list of combination of two goods that give equal

Combinations Good Y Good X

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

An indifference map shows a set of indifference curve.

Principles of Economics second edition All Rights Reserved

 Marginal Rate of Technical Substitution

 Characteristics of Indifference Curve

Principles of Economics second edition All Rights Reserved

1. Change in Consumer’s Income

Principles of Economics second edition All Rights Reserved

2. Change in Price of Good X

Budget Line Budget Line

Principles of Economics second edition All Rights Reserved

3. Change in Price of Good Y

Budget Line Budget Line

Principles of Economics second edition All Rights Reserved

A consumer is in equilibrium when he or she is consuming the best possible

At point b, and e, the consumer will

Consumer equilibrium is reached when

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

Example : Suppose Sally who is fond of

CONSUMER SURPLUS = TOTAL VALUE – (MARKET PRICE x NUMBER OF UNITS CONSUMED)

1.00 Consumer surplus = (2.50 + 2 + 1.50 + 1) – (1 x 4)

Principles of Economics second edition All Rights Reserved

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