Consumer

Behavior
 Contents
▪ Concept of Utility
▪ Measurement of Utility
❖ Cardinal Utility
� Law of diminishing Marginal utility
� Law of Equi Marginal Utility
� Consumer Surplus
❖ Ordinal Utility
� Indifference curves
� Consumer Equilibrium
Utility Analysis

▪ Utility
▪ Satisfaction derived from
consumption
▪ Subjective
▪ not Necessarily Equated with
Usefulness. Ex: A cigarette has
utility to the smoker but it is
injurious to his health
Utility…. Assumptions

▪ Maximization of Utility
▪ Tastes are given
▪ Tastes are
relatively stable
Approaches to Measurement of Utility

1. Cardinal Approach - by Alfred Marshall

- Utility or satisfaction can be measured in
cardinal numbers i.e., the quantitative
numbers such as 1, 2, 3, and so on. (units or
"utils“)

2. Ordinal Approach - by J. R.Hicks and R.

G. Allen.
�it is comparable in ranking
�shows the order of preference
� is a qualitative approach to measuring a
utility.
Theories of utility maximization

* Cardinal approach
–Law of diminishing Marginal Utility

–Law of equi-marginal utility

* Ordinal approach
–Indifference Curve Analysis
 Utility Concepts related to ‘cardinal utility approach’

▪ Total Utility (TU)

– The sum of the total satisfaction from the consumption of
specific goods or services. It increases as more goods are
consumed.
– Total Utility (T.U.) = U1 + U2 + … + Un

▪ Marginal Utility (MU)

– It is the additional satisfaction gained from each extra unit
of consumption.
– It decreases with each additional increase in the
consumption of a good.
– Marginal Utility (M.U.) = Change in T.U. / Change in Total
Quantity = Δ TU/ Δ Q or TUn – TUn-1
 Law of Diminishing Marginal Utility
▪ The Law Of Diminishing Marginal Utility states that all else
equal as consumption increases the marginal utility derived
from each additional unit declines.

Assumptions
▪ utility is measurable in units.
▪ Rational consumers wish to maximize their satisfaction with
limited income
▪ The marginal utility of money remains constant for the
consumer: This facilitates the measurement of the utility of
commodities in terms of money.
▪ The consumer’s tastes and preferences remain same during
the period of the consumption
▪ There must be continuity in the consumption.
 Utility Derived from Drinking
Water After Jogging Four Miles
 Total Utility and Marginal Utility You Derive from
Drinking Water after Jogging Four Miles
(a) Total utility (b) Marginal utility
80

Marginal utility
Total utility

60
40
40
20
20
0

0 1 2 3 4 5 1 2 3 4 5
Glasses (8-ounce) Glasses (8-ounce)

Total utility increases with each of the

first 4 glasses of water consumed but Marginal utility declines
by smaller and smaller amounts MU of the 5th glass is negative
The 5th glass causes TU to fall
 Law of Diminishing Marginal Utility (another
example)
• Assume that a consumer consumes 6 apples one after another.
• The first apple gives him 20 utils (units for measuring utility).
• When he consumes the second and third apple,
the marginal utility of each additional apple will be lesser.
• This is because with an increase in the consumption
of apples, his desire to consume more apples falls.
 The law of equi marginal utility

• The equi-marginal principle states that a

consumer will be maximizing his total
utility when he allocates his fixed money
income in such a way that the utility
derived from the last unit of money spent
on each good is equal.
 The law of equi marginal
utility….
Asuumptions
• Units of goods are homogenous.
• No time gap between the consumption of
the different units.
• Tastes, fashion, preferences, and priorities
remain unchanged.
• Consumer aims at maximum satisfaction.
• Consumer’s income is fixed and limited.
Total and Marginal Utilities from Pizza and Videos
(your income is Rs.40)
Total and Marginal Utilities from Pizza and Videos
(your income is Rs.40)
 Utility Maximization
With Scarcity

▪ Goods – not free

▪ Tastes, preferences
▪ Limited income
▪ Maximize utility
▪ Equilibrium
▪ Any affordable
change will reduce
utility
 Law of Equi Marginal Utility –
Utility Maximizing Conditions
▪ Equilibrium
▪ There is no way to increase utility by
reallocating the budget
▪ Last $ spent on each good yields the same
marginal utility
▪ Higher-priced goods must yield more
marginal utility than lower-price goods
 Water, Water, Everywhere
◆ Diamonds
Case Study
◆ Not a necessity; expensive;
relatively scarce
◆ Water
◆ Necessity; cheap; abundant
◆ Diamonds-Water paradox
◆ TUwater >TUdiamonds
◆ Pdiamond > Pwater
 Total and Marginal Utilities from
Pizza and Videos After the Price of
Pizza Decreases from $8 to $6
 Marginal Utility and law of Demand

• The Law of Diminishing Marginal Utility directly relates to the concept of

diminishing prices.
• As the utility of a product decreases as its consumption increases,
consumers are willing to pay smaller dollar amounts for more of the product.
• For example, assume an individual pays $100 for a vacuum cleaner.
Because he has little value for a second vacuum cleaner, the same
individual is willing to pay only $20 for a second vacuum cleaner.
• The law of diminishing marginal utility directly impacts a company’s pricing
because the price charged for an item must correspond to the consumer’s
marginal utility and willingness to consume or utilize the good.
D = f (p)
P=f (MU) therefore D = f (DMU)
 Marginal Utility and
the Law of Demand

▪ Obj. - Max U;
▪ budget = $40
▪ Qpizza = 3; Pp = $8; one point on D curve
▪ (Qv = 4 ; Pv = $4)
▪ Price of pizza drops to $6, other things constant
▪ Max U; budget = $40
▪ Qp = 4; Pp = $6; second point on D curve
▪ (Qv = 4 ; Pv = $4)
 Demand for Pizza Generated from
Marginal Utility

$8 a
P=$8, consumer equilibrium at Q=3
MU per $ is the same for all goods
b
Price per pizza

6 consumed

4 P=$6, consumer equilibrium at Q=4

2 D

0 1 2 3 4 Pizzas per week

 Consumer surplus

• Proposed by Alfred Marshall

• The concept of consumer surplus is derived from the law of diminishing
marginal utility.
• As per the law, as we purchase more of a commodity, its marginal utility
reduces.
• Since the price is fixed, for all units of the goods we purchase, we get extra
utility. This extra utility is consumer surplus.
Consumer’s Surplus = The price a consumer is ready to pay – The price
he actually pays

• The consumer is in equilibrium when the marginal utility is equal to the

price. That is, he purchases those many numbers of units of a good at
which the marginal utility is equal to the price.
 Consumer Surplus

– Value of a good purchased must at least

equal the P
▪ D curve
– Marginal valuation
▪ Consumer surplus
– Consumer bonus
– Value of total utility minus total spending
– Area under D, above P
Consumer Surplus from Sub Sandwiches
$8 At P=$4:
• 1st sub valued at $7
7
Price per subs

• 2nd sub valued at $6

6
• 3rd sub valued at $5
5 • 4th sub valued at $4
4 • Willing to pay $22 for 4
3 subs
• Pays only $16 for 4 subs
2
• Consumer surplus
1
D $22-$16 = $6

0 1 2 3 4 5 6 7 8 Subs per
month
When P drops to $3, consumer surplus increases by $4
 Market D and
Consumer Surplus
▪ Market D curve
– Horizontal sum of individual D curves
– Total quantity demanded, per period, by
all consumers, at various prices
▪ Consumer surplus for the market
– Amount consumers are willing to pay
minus amount they pay
– Net benefit for consumers
– Economic welfare
 Summing Individual Demand Curves to Derive
Market Demand for Sub Sandwiches
(a) You (b) Brittany (c) (d) Market demand
Chris for subs
$6 $6 $6 $6
Price

4 4 4 4 dY+dB+dC=D

2 2 2 2

dY dB dC

0 2 4 6 0 2 4 0 2 0 2 6 12
Subs per month

Market demand curve is the horizontal sum of individual demand curves

 Market Demand and
Consumers Surplus

Consumer surplus at a price of $2

is shown by the blue area.
Price per unit

If the price falls to $1, consumer

surplus increases to include the
green area.

At a zero price, consumer surplus

increases to the entire area under
the D curve.
$2
1 D

0 Quantity per period

 The Marginal Value of Free Medical Care
◆ Free medical care
Case Study
◆ Consumed until
marginal utility = 0
◆ High marginal cost to
taxpayers
◆ Waste, fraud, abuse
◆ Less incentive for
healthy behavior
◆ Charge $1 per doctor
visit
◆ Reduce cost to
taxpayers
• https://www.facebook.com/TEDEducation/
?hc_ref=NEWSFEED
• https://www.facebook.com/TEDEducation/
videos/1272510129428857/
Indifference Curves – Ordinal
Utility

▪ Indifference curve
– Combinations of goods
– Same total utility
– Slope downward to right
– Convex to origin
 An Indifference Curve

An indifference curve (I) shows all

Video rentals per week

combinations of two goods that

10
provide a particular consumer with
8 a the same total utility.

Indifference curve:
5 • negative slope
4 b • convex to origin
3 c
2 d
I

0 1 2 3 4 5 10
Pizzas per week
Indifference curves can not be
like this
Indifference Curves and
Utility Maximization

▪ Marginal rate of substitution MRS

– Willingness to trade
– Slope of indifference curve
▪ Law of diminishing MRS
– Diminishing slope of I curve
Indifference Curves and
Utility Maximization

▪ Indifference map
– Graphical representation of consumer’s
tastes
– Each I: different utility levels
– The further indifference curve from origin
• The higher the utility
• More of both goods
 An Indifference Map
Indifference curves I1 through
I4 are examples from a
10 consumer’s particular
Video rentals per

indifference map.

Indifference curves farther

5 from origin depict higher
week

I4 levels of utility.
I3
I2
I1
A line intersects each higher
indifference curve, reflecting
more of both goods.
0 5 10
Pizzas per week
Indifference Curves Do Not Intersect
Video rentals per week

If indifference curves crossed (i)

every point on I and every point on
I’ would have to reflect the same
k level of utility as i.

j k: more pizzas and videos

i
than j; higher utility than j
I’
I

0 Pizzas per week

Indifference curves cannot intersect
Indifference Curves and
Utility Maximization

▪ The budget line

– Combinations of goods
– Able to buy
– Consumption possibilities frontier
▪ Slope of budget line:
LO4
A Budget Line
Budget line: all combinations of pizza and videos that
Video rentals per week

10 can be purchased at fixed prices with a given

income of rs.40.
Slope = -pp / pv = -$8/$4 = -2

5
Slope = -2: the price of 1 pizza is 2 videos.

0 5 10
Pizzas per week
LO4
A Budget Line
Budget line: when price of pizza decreases from
Video rentals per week

10 Rs. 8 to Rs.6 and no change in income and price of

video, the slope of budget line now 6.67 pizzas .

Slope = -pp / pv = -$6/$4 = -1.5

5
Slope = -1.50: the price of 1 pizza is 1.5videos.

0 5 10
Pizzas per week
Indifference Curves and
Utility Maximization

▪ Consumer equilibrium at the tangency

– Maximize utility
– Indifference curve tangent to budget line
LO4
Utility Maximization
Video rentals per week

10 A consumer’s utility is maximized at

point e, where indifference curve I2 is
a
tangent to the budget line.

5
e
4
I3
I2
I1

0 3 5 10
Pizzas per week
Indifference Curves and
Utility Maximization

▪ Effects of a change in price

– Derive the D curve
▪ Income effect
▪ Substitution effect
LO4
Effect of a Drop in the Price of Pizza
(a) (b)
10
Video rentals per week

Price per pizza

5 e
e” $8
4 e”
e 6
I I” D

0 3 4 5 6.67 0 3 4
Pizzas per week Pizzas per week

A reduction in the price of pizza to A drop in price of pizza increases

Rs.6 rotates the budget line quantity demanded.
rightward.
The consumer is back in equilibrium
at point e” along the new budget line.
LO4
Substitution and Income Effects of a Drop in the
Price of Pizza from $8 to $4
Video rentals per week

10
A reduction in the price of pizza moves the
consumer from e to e*.

C Substitution effect: e to e’; consumer’s reaction

e*
5 to a change in relative prices along the
e
4 original indifference curve.
I*
e’
Income effect: e’ to e*; moves the
I
consumer to a higher indifference
curve at the new relative price ratio.
0 3 4 5 F 10
Pizzas per week
Substitution Income
effect effect