ECON_WEEK3 1022210079

Week 3
The Theory of Consumer Behavior
• Consumer behavior theory describes how consumers allocate their income among
different goods and services to maximize their utility, given their budget constraints
and several factors influencing consumer behavior.

Utility
• Utility refers to the satisfaction or happiness of a consumer derived from consuming a
good or service.
• It is a measure of the benefit that the consumer gets from consuming a certain amount
of a good or service.
• Two measurements:
▪ The idea of one good being more useful or compelling than another is
known as "ordinal" utility.
• For example, we prefer a Benz car to a Toyota car, but we don't
say by how much.
▪ "Cardinal" utility is the notion that economic value can be quantified in
fictitious units called "utils."
▪ For example, People might be able to explain the utility that the
consumption of particular items provides.
• For example, if a Toyota car gives 4,000 units of utility, a Benz
car would give 8,000 units.
o The satisfaction level cannot be evaluated but can be leveled, according to the
ordinal utility, however, the cardinal utility believes it can be measured in utils.

Cardinal approach
• The Cardinal approach to measuring utility assigns numerical values to utility to
compare and rank different levels of satisfaction. It assumes that utility can be measured
precisely and quantified.

• Assumptions of Cardinal Approach,

o Utility of a commodity equals the money a consumer is willing to pay

for it

[Date] 1
 ECON_WEEK3 1022210079

o Marginal Utility of money remains constant

o One Utility = One unit of money
• Total Utility (TU) – the sum of the utility derived from all the units consumed of the
commodity.
TU = U1 + U2 + U3 + U4
The Marginal Utility (MU) – the addition to the total utility derived from consumption or
acquisition of one additional unit.

• Change in the total utility resulting from the consumption of one additional unit
MU = ∆TU/∆Q

Marginal Utility
• The marginal utility of a good or service is the additional satisfaction a consumer gets
from consuming an extra unit.
• As a consumer consumes more units of a good or service, the additional satisfaction
they get from consuming each additional unit decreases.

The Law of Equilibrium Marginal Utility

• The law of equilibrium marginal utility states that the marginal utility per dollar spent
on each good or service is equal.

• This law states that a consumer should spend their limited income on different
commodities to get maximum satisfaction from a limited income.

• There are several laws of diminishing marginal units, each of which are different but
tangentially related across the life cycle of a product.
• As a consumer consumes more than one commodity, the additional satisfaction they
get from consuming each additional unit decreases.

• Demand curves are downward sloping in microeconomic models, and salespeople use
this law to keep marginal utility high for products that they sell.

[Date] 2
ECON_WEEK3 1022210079

Sandwiches Total Utility Marginal Utility

1 40 40-0=40

2 70 70-40=30

3 90 90-70=20

4 100 100-90=10

5 100 100-100=0

6 90 100-90= -10

[Date] 3
 ECON_WEEK3 1022210079

Consumer Equilibrium
• Consumer equilibrium is reached when the marginal utility per dollar spent on each
good or service is equal.

• The consumer will be in the state of equilibrium when the following condition is
fulfilled:

• The marginal utility of commodity X in terms of rupees is equal to the price of

commodity X in rupees. [MUx (in ₹) = Px (in ₹)]

Or

• Mux (in utils) = Px (in ₹) or MU of Commodity X (in utils) = Px (in₹)

• MUm (in utils) MU of Money (₹)(in utils)

 A utility maximizing consumer exchanges his money income for the commodity as long as

𝑴𝑼𝒙 > 𝑴𝑼𝒎

Assumptions: - marginal utility of commodity X is subject to diminishing

- marginal utility of money income remains constant
Therefore,

The utility maximizing consumer reaches his equilibrium with the level of his maximum
satisfaction were

𝑴𝑼𝒙 = 𝑷𝒙 (𝑴𝑼𝒎 ).

For example:

(𝑴𝑼𝒎 ) MUx

Units of Price (Px) Marginal utility Remarks

X (Rs.) (utils)

1 10 20 MUX > Px>so

consumer will increase the
2 10 16 consumption

[Date] 4
ECON_WEEK3 1022210079

3 10 10 Consumer’s Equilibrium
(MUX=PX)

4 10 4 MUX < Px, so

consumer will decrease the
5 10 0 consumption

6 10 -6

The General Case

• In equilibrium, a consumer consumes more than one good and receives equal marginal
utility from each good.

• The law of maximum satisfaction states that a consumer should spend his limited
income on different commodities in such a way that the last rupee spent on each
commodity yield him equal marginal utility in order to get maximum satisfaction.

[Date] 5
ECON_WEEK3 1022210079

Assumptions of the Law

• A consumer has many wants, a fixed income, perfect knowledge of utility, and tries to
have maximum satisfaction.

Limitation of the Law

• There are some limitations to this law, including that it is not applicable in case of
knowledge, fashion and customs, very low income, and frequent price change.

Importance of the Law

• This law is helpful in the field of production, exchange, public finance, allocating time
between work and rest, saving and spending, and looking for substitution in case of
price rise.

The Law of Equilibrium Marginal Utility

• The law of equilibrium marginal utility is a statement that states that in equilibrium, the
marginal utility per dollar spent on each good or service is equal.

• It is based on the principle of obtaining maximum satisfaction from a limited income

and states that a consumer should spend their limited income on different commodities
in such a way that the last rupee spent on each commodity yields equal marginal utility.

• Suppose there are different commodities like A, B, …, N. A consumer will get the
maximum satisfaction in the case of equilibrium i.e.,

• MUA / PA = MUB / PB = … = MUN / PN

• Where MU’s are the marginal utilities for the commodities and P’s are the prices of the
commodities.

▪ The consumer reaches his equilibrium when the marginal utility derived
from each rupee spent on two commodities X and Y is the same.
MUX MUY
▪ =
PX PY

[Date] 6
ECON_WEEK3 1022210079

Drawbacks of Cardinal Utility

• Drawbacks of cardinal utility include the fact that it is difficult to measure utility
quantitatively and the assumption that utility can be measured in numerical terms may
not be realistic.
• It also does not consider interpersonal utility comparisons, making it difficult to
compare utility across different individuals.
• Additionally, it may not fully explain consumer behavior as consumers may not always
make decisions based solely on maximizing utility.

[Date] 7
 ECON_WEEK3 1022210079

Week 4

Demand and supply elasticity

Elasticity

■ Elasticity in microeconomics refers to how responsive a demand or supply of a product is

to changes in price, income, or other factors.

■ Elasticity influences decisions such as pricing strategies, production levels, and tax
policies.

■ Elastic demand means that the quantity demanded for a good or service is highly
responsive to changes in price. Inelastic demand means that the quantity demanded for a
good or service is not very responsive to changes in price.

• Measure of the degree of responsiveness (or sensitivity) of a dependent variable

to changes in an independent variable
• How changes in product demand and supply relate to changes in the product’s
price
• Price elasticity of demand
• Price elasticity of supply
■ There are several types of elasticity including price elasticity of demand, price elasticity of
supply, income elasticity of demand, and cross-price elasticity of demand.

• Each type of elasticity measures the responsiveness of either the demand or supply
to changes in specific factors.
o For example, the price elasticity of demand measures the responsiveness of the
quantity demanded of a product to a change in its price.
o If the price elasticity of demand is high, then a small
increase in price will cause a large decrease in the quantity
demanded.
o On the other hand, if the price elasticity of demand is low,
then a price change will have little effect on the quantity
demanded.

[Date] 8
 ECON_WEEK3 1022210079

o Overall, elasticity plays a crucial role in microeconomics by

helping firms and policymakers make informed decisions
about pricing, production, and other economic factors.

Price Elasticity of Demand

• Price elasticity of demand measures how much the demand for a product changes when the
price of that product changes.

 Elastic demand: If the demand for a good or service is elastic, it means that the
quantity demanded is highly responsive to changes in price.
o A small change in price results in a proportionally larger change in quantity
demanded. The elasticity of demand is greater than 1 in absolute value.
 Inelastic demand: If the demand for a good or service is inelastic, it means that the
quantity demanded is not very responsive to changes in price.
o Even if there is a significant change in price, the quantity demanded changes
proportionally by a smaller amount. The elasticity of demand is less than 1 in
absolute value.

A Negative Price Elasticity of Demand

[Date] 9
 ECON_WEEK3 1022210079

A positive price elasticity of demand

Computing price elasticity of demand

% change in quantity demanded___

% change in the price of the product

 The answer is negative if the demand curve is downward sloping.

 The answer is positive if the demand curve is upward sloping

Interpretation of the elasticity

 The sign (positive/ negative)

 Relationship between quantity demanded and Price
 The value (greater or less than 1)
 Elastic or inelastic demand
 Elastic demand – (E >1)
 Inelastic demand – (E<1)
 Unit elastic demand – (E=1)

[Date] 10
 ECON_WEEK3 1022210079

Determinants of price elasticity of demand

1. Availability of Close Substitutes

2. Necessities versus Luxuries
3. The cost of switching between different products
4. The % of a consumer’s income allocated to spending on the good
5. The time period allowed following a price change
6. Whether the good is subject to habitual consumption
7. The definition of a good or service

Price Elasticity of Demand

• Price elasticity of demand is a measure of the responsiveness of the quantity of a good or

service demanded in response to changes in the price of that good or service.
• In other words, it measures how much the demand for a product change when there is a
change in the price of that product.
o If the price of a product changes and the demand for the product changes
significantly, then the product is said to have a high price elasticity of
demand.
o If the price of a product changes and the demand for the product changes
only slightly, then the product is said to have a low-price elasticity of
demand.

• Demand is perfectly inelastic if the elasticity of demand is 0 – when the quantity

demanded remains constant when the price changes
• Demand is inelastic if the elasticity of demand is between 0 and 1 – when the %
change in quantity demanded is less than the % change in price
• Demand is elastic if the elasticity of demand exceeds 1 – when the % change in
quantity demanded is more than the % change in price
• Demand is perfectly elastic if the elasticity of demand is infinite – when the
quantity demand changes by an infinitely large % in response to a tiny price change
or the price barely changes

[Date] 11
ECON_WEEK3 1022210079

Income Elasticity of Demand

• Income elasticity of demand measures how sensitive consumer behavior is to

changes in income.

• A positive income elasticity of demand indicates that the quantity demanded a

good or service increases as income increases, and vice versa.

• A negative income elasticity of demand indicates that the quantity demanded a

good or service decreases as income increases, and vice versa.

• A good or service with zero income elasticity of demand has a relatively stable
demand regardless of changes in income.

• Measures how much the quantity demanded of a good responds to a change in

consumers’ income.

% change in the quantity demanded

% change in income
• Higher income raises the quantity demanded for normal goods but lowers
the quantity demanded for inferior goods.
• When income elasticity of demand is:
> 1 – luxury product
< 1 – necessity product

Cross price elasticity of demand

• The cross-price elasticity of demand measures the degree to which demand for one
good is affected by the price of another good.

 Measures how much quantity demanded for good X changes when price
of good Y changes
% change in quantity demanded of Product X
% change in price of Product Y
 If the cross-price elasticity is positive (>0) then two products are
substitutes. The greater the elasticity the more similar are the products.

[Date] 12
 ECON_WEEK3 1022210079

 If the cross-price elasticity is negative (<0) then two products are

complements.

• Businesses need to understand cross price elasticity of demand to make decisions

regarding pricing and product positioning.

• For example, if two goods have a positive cross price elasticity of demand, a business
might decide to lower the price of their goods to increase the quantity demanded and
gain market share.

Price Elasticity of Supply

• Supply elasticity measures how responsive the quantity supplied of a good or service is to
changes in its price.

• It can be classified into three types: elastic, inelastic, and rigid.

o Elastic supply: If the supply of a good or service is elastic, it means that the
quantity supplied is highly responsive to changes in price. A small change in
price results in a proportionally larger change in quantity supplied. The
elasticity of supply is greater than 1 in absolute value.

[Date] 13
 ECON_WEEK3 1022210079

o Inelastic supply: If the supply of a good or service is inelastic, it means that the
quantity supplied is not very responsive to changes in price. Even if there is a
significant change in price, the quantity supplied changes proportionally by a
smaller amount. The elasticity of supply is less than 1 in absolute value.

Determinants of price elasticity of supply:

1. The amount that costs rise as output rises

2. The number of firms in the industry
3. Spare production capacity
4. Stocks of raw materials
5. The time period price reduces the quantity supplied

o The additional cost of producing output- higher- inelastic lower- elastic

o Number of firms – many- elastic few-inelastic
o Spare production – plenty capacity – elastic
o Raw materials- if they can readily get raw materials at low cost – elastic
o Time period – immediate - inelastic

Computing price elasticity of supply

% change in quantity supplied

% change in price
o Positive sign: upward sloping supply curve; an increase in price increases the
quantity supplied
o Negative sign: downward sloping supply curve; an increase in price reduces the
quantity supplied

[Date] 14
ECON_WEEK3 1022210079

Supply Over Time

o Over time supply

usually becomes more
price elastic as more
resources can move
into an industry

Price Elasticity of Supply (cont’d)

• Supply is perfectly inelastic if the elasticity of supply is 0 – when the quantity

supplied remains constant when the price changes
• Supply is inelastic if the elasticity of supply is between 0 and 1 – when the %
change in quantity supplied is less than the % change in price
• Supply is elastic if the elasticity of supply exceeds 1 – when the % change in
quantity supplied is more than the % change in price
• Supply is perfectly elastic if the elasticity of supply is infinite – when the
quantity supplied changes by an infinitely large % in response to a tiny price
change

[Date] 15