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 Consumer behaviour can be best understood
CHAPTER THREE
THEORY OF CONSUMER
BEHAVIOR
3.1 Consumer Preferences
 Consumer preferences are defined as the
subjective (individual) tastes, as measured by
utility, of various bundles of goods.
 Preferences are independent of income and
prices.
 If a consumer is provided with two bundles of
goods (A & B), then the consumer may prefer
• A to B, i.e., u(A) > u(B)
• B to A, i.e., u(A) < u(B)
• indifferent, i.e., u(A) = u(B)
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3.3 Approaches of Measuring Utility
We have two theories of utility
 Cardinal utility approach- utility is
measurable and comparable
 Ordinal utility approach- utility is not
measurable but comparable
1. Cardinal utility approach
 Says utility is measurable by subjective and
arbitrary unit of measurement called utils
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in three steps.
First, by examining consumer’s preference.
Second, we must take into account that
consumers face budget constraints.
Third, we will put consumer preference and
budget constraint together to determine
consumer choice.
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3.2 The Concept of Utility
 Utility describes the satisfaction or pleasure
derived from the consumption of a good or
service.
 It is the power of the product to satisfy human
wants.
 Utility is subjective. The utility of a product
will vary from person to person.
 Utility can be different at different places and
time.
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Assumptions of cardinal utility theory
 Rationality of consumers
 Utility is cardinally measurable
 Constant marginal utility of money
 Diminishing marginal utility
 The total utility depends on the quantities of
the individual commodities in the basket
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Total utility and marginal utility
Total utility (TU) –is total satisfaction a
consumer derives from consuming some
specific quantity of a product at particular
time.
 As the consumer consumes more of a good
per time period, his/her total utility increases.
However, there is a saturation point for TU.
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The relationship between TU and MU
• When TU is increasing, MU is positive.
• When TU is maximized, MU is zero.
• When TU is decreasing, MU is negative.
Example
 TU can be derived from MU.
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Budget Constraint
 The most important factors the consumer
faces in TU maximization are the consumer's
income and the prices of the goods.
 The consumer has fixed income I and has to
pay the prices of the goods to consume them.
 A consumer with income I, consuming two
commodities X and Y, the budget constraint is
P ∗X+P ∗Y≤ I
 The consumer’s total expenditure must not
exceed his total income.
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Marginal utility (MU) is the extra satisfaction
a consumer realizes from consuming one more
unit of the product.
 Marginal utility is the change in total
utility that results from the consumption of
an additional unit of a product.
 Graphically, MU is the slope of total utility.
∆𝑇𝑈
 Thus, MU = = , where ∆Q is
∆𝑄
change in the amount of product consumed.
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Law of Diminishing Marginal Utility (LDMU)
It says as the quantity consumed of a
commodity increases per unit of time, the
utility derived from each successive unit
decreases, consumption of all other
commodities remaining constant.
Assumptions for LDMU
 rational consumer
 identical product is consumed
 there is no time gap
 taste remain unchanged
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Budget line - graph that shows the various
combinations of two goods that a consumer
can buy if the entire income is spent, ceteris
paribus.
 Budget line equation P ∗ X + P ∗ Y = I
The slope of the budget line
= = -PX / PY .
The slope of the line is the ratio of the prices of the
two goods.
 It tells the amount of Y the consumer must give up
in order to buy one more unit of X.
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Drawing Budget line Cont…

i. Place good X on the x-axis and good Y on the y-
axis.
ii. Find x-intercept (𝑋 = , 0) and y-intercept (0, Y =
).
iii. Join x-intercept and y-intercept using straight line.
Example: A consumer has $100 to spend on two
goods X and Y with prices $3 and $5 respectively.
a. Derive the equation of the budget line
b. Sketch the graph.
c. Find the slope of the budget line.

𝑑𝑌 3
=−
𝑑𝑋 5

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Factors shifting the budget line Factors shifting the budget line
1. Change in income while price is constant
2. Change in price while income is constant
 Increase in income causes an upward/
 Change in price could be proportional or
outward shift in the budget line that allows the
relative.
consumer to buy more goods and services.
Proportional rise in the prices of both goods
 The slope of the budget line does not change
cause a parallel shift in the budget line to the
when income changes.
left (inward).

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Proportional rise in the prices of both goods Cardinalist Equilibrium of a Consumer

cause a parallel shift in the budget line to the
left (inward).
 A change in relative price can occur because
of changes in only one of the prices or changes
in both prices in different proportions.
 Consumer equilibrium occurs when the
consumer maximizes his total utility.
 The consumer has to choose how much of
each commodities to consume given the
budget constraint.
i. Single commodity case
 The equilibrium condition of a consumer that
consumes a single good X occurs when the
marginal utility of X is equal to its market
price.

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ii. Multiple commodity case

 The consumer‘s equilibrium is achieved when
the marginal utility per money spent is equal
for each good purchased and his money
income available for the purchase of the goods
is exhausted. That is
If MUx > Px, the consumer should consume = =⋯= and
more of good X P X +P Y +⋯+P N = I
If MUx < Px, the consumer should consume  If > , buy more of X.
less amount of X
If MUx= Px the consumer is at equilibrium If < , buy more of Y.
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Example: Suppose there are two commodities x Find

and y. Px = Birr 4 per unit; Py = Birr 2 per unit; i. utility maximizing quantity of X and Y.
consumer’s money income = Birr 30. Marginal ii. the maximum utility at equilibrium
utilities of x and y are given in below.
Ans: X=4, Y=7
TU=TUx +TUy
= 272 + 238
=510

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Limitation of the cardinal approach

• The assumption of cardinal utility is doubtful
because utility may not be quantified. Utility
cannot be measured absolutely (objectively).
• The assumption of constant MU of money is
unrealistic because as income increases, the
marginal utility of money changes.
Exercise: Consider that Mr. Tulu has birr 12 and
he consumes two goods X and Y, the Px=2 birr
and Py= 1 birr. The TU he gets from the
consumption of the goods are given below.
i. Fill the MU and MU/P for good X and good Y
ii. Find the best combination of X and Y that
maximizes utility
iii. Find the maximum utility

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Cont… 2. Ordinal Utility Approach/Theory

Qty TUx MUx MUx/Px Qty TUy MUy MUy/Py
• The consumers can rank commodities in the
0 0 0 0
order of their preferences as 1st, 2nd, 3rd and
1 16 1 11
so forth.
2 30 2 21
• The consumer need not know in specific units
3 42 3 30
the utility of various commodities to make his
4 52 4 38
choice.
5 60 5 45
6 66 6 51
• Uses of indifference curves to study consumer
7 70 7 56
behaviour → Indifference curve approach
8 72 8 60

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Assumptions of ordinal utility theory Indifference schedule, curve and map

• Consumers are rational • A consumer is indifferent between two
• Utility is ordinal choices if he gets the same satisfaction from
• Preferences are consistent both choices.
• Preferences are transitive • Indifference set/ schedule shows the various
combinations of goods from which the
• Diminishing marginal rate of substitution consumer derives the equal level of utility.
(MRS)
• An indifference curve (IC) is a graph that
• The total utility of a consumer is measured by shows various combinations of two goods
the amount of all items he/she consumes which give equal satisfaction to the consumer.

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Cont … Cont …
• An indifference map is a group of ICs, each • Example
representing a given level of satisfaction.
• An indifference map represents the rank of
consumer preference.
• The farther the curve is from the origin, the
higher is the level of satisfaction it represents.

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Properties of indifference curves Cont …

i. ICs have negative slope (downward sloping iii. Indifference curves never cross each other
to the right): to keep the utility of the (cannot intersect) in indifference map. The
consumer constant, as the quantity of one assumptions of consistency and transitivity
commodity is increased the quantity of the will rule out the intersection of indifference
other must be decreased. curves.
ii. ICs are convex to the origin. IC slope
declines as we from left to right. The
convexity of ICs is the reflection of the
diminishing MRS.

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Marginal rate of substitution (MRS) Cont …

• MRS – is rate by which the consumer is willing to • Example
give up a good so as to obtain more of another good,
holding total utility constant.
• MRS of X for Y (MRSx,y) is defined as the number
of units of good Y that must be given up in exchange
for an extra unit of good X so that the consumer
maintains the same level of satisfaction.
∆
• 𝑀𝑅𝑆 , = = =
∆
Good Y Good X Movement MRSx,y
• MRS measures slope of an IC. 30 5
• MRSx,y can be rewritten as: MUx/MUy 20 10 A to B -2
• To keep utility constant, utility lost=utility gained. 12 15 B to C -1.6
8 20 C to D -0.8
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Ordinalist Consumer Equilibrium Cont

 Consumer equilibrium occurs where the  MRS shows consumers willingness to
budget line is tangent to the highest possible exchange one good for another.
indifference curve.  Px/Py shows market willingness to trade one
At equilibrium point, slope of BL= slope of IC commodity for another.
 When MRSx,y > Px/Py, the consumer buys
more of X.
 When MRSx,y < Px/Py, the consumer buys
less of X.
 When MRSx,y= Px/Py, the consumer is at
equilibrium.
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