CHAPTER 5: CONSUMER BEHAVIOR THEORY

CHAPTER 5: CONSUMER BEHAVIOR THEORY

LEARNING OBJECTIVES After completing this topic, students should be able to: explain the concept of utility, total utility, marginal utility and law of diminishing marginal utility describe the consumer equilibrium position by maximizing utility depends on the price of the goods and services and budget constraint. Derive demand curve Explain the concept of consumer surplus

Theory of Consumer Behavior

Cardinal Utility Approach

Measuring utility in term of quantity

Ordinal Utility Approach

Measuring utility based on preference

I. CARDINAL UTILITY APPROACH A. Concepts Utility refers to the degree of satisfaction acquired as a result of consuming goods and services. It is impossible to measure utility, and it is impossible to compare the utilities of different people. However, we can use the concept to better understand the process of choice. Total utility (TU) refers to the total satisfaction as a result of consuming goods and services. Marginal utility (MU) refer to the additional satisfaction derived as a result of consuming an additional unit of good or service

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The law of diminishing marginal utility refers to the more of any one good consumed in a given period, the less satisfaction (utility) generated by consuming each additional (marginal) unit of the same good.

The law of diminishing marginal utility states that as consumption

increases, marginal utility will always fall. Total utility will increase initially; reach a maximum and finally fall. The rational consumer will only consume up to the point where marginal utility is at zero or when total utility is at its maximum. As the marginal utility falls, consumers do not want to buy as much. Even if the product were free, consumers would eventually get so sick of it that there would be a limit to the amount consumed. Table: Total Utility and Marginal Utility Quantity 0 1 2 3 4 5 6 Total Utility 0 22 40 50 50 40 20 Marginal Utility 22 18 10 0 -10 -20

Figure: Relationship between Total Utility and Marginal Utility

Utils

The relationship between MU and TU When TU increase, MU is

TU 4 Quantity

positive When TU is at maximum, MU is zero When TU falls, MU is negative

Utils

MU

Quantity

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A. Utility Maximizing Rule A rational consumer will always try to maximize his/her satisfaction given his/her limited income so as to reach consumer equilibrium. For single product,

Condition for equilibrium is MUx = Px

Consumer will equate marginal utility with the price of the product to reach equilibrium For multiple products,

condition for equilibrium is MUx/Px = MUy/Py = MUz/Pz

The utility derived per RM spent on the last unit bought must be equal to the utility derived per RM spent on last unit consumed of all other goods.

If the condition is not fulfilled, consumer does not achieve

equilibrium position.

If MUx/Px > MUy/Py , consumer will increase consuming good x

in order to achieve equilibrium

If MUx/Px < MUy/Py , consumer will decrease consuming good x

in order to achieve equilibrium

Maximizing utility depend on budget constraint.

B. Derivation of Demand Curve The law of diminishing marginal utility theory can explain why the demand curve is downward sloping. The rational consumer will always try to be in equilibrium condition. Example: Original equilibrium position of consuming 2 goods MUx/Px = MUy/Py 10 / 2 = 40 / 8 If the price of good x increases from RM2 to RM4, the consumer will be in a state of disequilibrium. In order to achieve equilibrium, the consumer will buy

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less of good x such that marginal utility of good x rises to 20. Only then he is in equilibrium again. MUx/Px = MUy/Py 20 / 4 = 40 / 8 This explains why the demand for good x falls as price increases and vise versa. Refer question 3 for illustration

Examples: Question 1 Given quantity and total utility of good x and good y, if the price of x is RM2.00, price of y is RM3.00, and total budget is RM20.00, determine which combination of good x and good y yields the greatest utility? Answer: Quantity 0 1 2 3 4 5 6 TUx 0 10 18 24 28 30 31 TUy 0 24 45 63 78 90 99 MUx 0 10 8 6 4 2 1 MUy 0 24 21 18 *** 15 12 9 2 1 0.5 5* 4 ** 3 *** MUx/Px 0 5* 4 ** 3 MUy/Py 0 8 7 6

Combination of good x and y which yields maximum utility Combinatio n * ** *** Good x 1 2 3 Good y 4 5 6 MU/P 5 4 3 Total spending ( 1 X RM2) + ( 4 X RM3) = RM14 ( 2 X RM2) + ( 5 X RM3) = RM 19 ( 3 X RM2) + ( 6 X RM3) = RM 24

Given the budget equal to RM 20, the best combination will be 2 units of good x and 5 units of good y.

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Question 2 Assuming the price of good x decrease from RM2 to RM1 with the price of good y and given budget remaining the same, determine the combination of good x and y which yields maximum utility. Answer: Quantity 0 1 2 3 4 5 6 TUx 0 10 18 24 28 30 31 TUy 0 24 45 63 78 90 99 MUx 0 10 8 6 4 2 1 MUy 0 24 21 18 15 * 12 9 2 1 4*** 3 MUx/Px 0 10 8* 6** 4** MUy/Py 0 8* 7 6** 5

Combination of good x and y which yields maximum utility Combinatio n * ** *** Good x 2 3 4 Good y 1 3 5 MU/P 5 4 3 Total spending ( 2 X RM1) + ( 1 X RM3) = RM 5 ( 3 X RM1) + ( 3 X RM3) = RM 12 ( 4 X RM1) + ( 5 X RM3) = RM 19

Given the budget equal to RM 20, the best combination will be 4 units of good x and 5 units of good y.

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Question 3 Derive the demand curve for good x based on the answer from question 1 and question 2
Price x

Answer: When price of x =RM2.00, Qd = 2 units When price of x =RM1.00, Qd = 4 units

2.00 1.00

Quantity of good x

Question 4 Aminah spends her disposable income on food and clothing. When her weekly income is RM200, she buys 10 units of food at a price of RM2. Her marginal utility from food consumption is 20. If the price of a clothing unit is RM4, Aminahs marginal utility from clothing is: Answer: Condition for equilibrium: MU food / Price food = MU clothing / Price clothing 20 / 2 = MU clothing / 4 MU clothing = 40 utils

Question 5 If MUx = 20 utils, Px = RM2.00, MUy = 12 utils and Py = RM4.00, which good should be consumed more? Answer:

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Condition for equilibrium: MUx / Px = MUy / Py MUx / Px = 20 / 2 = 10 Since MUx / Px > MUy / Py ; MUy/Py = 12 / 4 = 3

the consumer will then consume more of good x and less of good y

II. ORDINAL UTILITY APPROACH

A.

Indifference Curve (IC)

An indifference curve (IC) is a set of points, each point representing a combination of two goods, all of which yield the same level of satisfaction Characteristics of Indifference Curve (IC) IC is downward sloping from left to right (negatively sloped) The points along the curve represent the combination of 2 goods which will give the same level of satisfaction. Example: consuming 14Y and 5X yield the same satisfaction as consuming 9Y and 7X. Point a, b and c represents the same level of satisfaction
Figure: Indifference Map Good Y Good Y

a 14 9 4 5 7 15 Good X b c IC IC3 IC2 IC1 Good X

IC that lie farther from the origin represent higher levels of satisfaction
IC3 represents the highest level of satisfaction relative to IC2 IC cannot intersect another IC, due to the principle of transitivity. B, and B to C, then the consumer prefers A to C (rationality).

Example: If A, B, and C are bundles of goods, and a consumer prefers A to Marginal rate of substitution (MRS) represents the slope of IC
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MRSxy = Y / X = - MUx / MUy IC convex to origin due to the principle of diminishing marginal rate
of substitution.

As the point move to the right, quantity of good y falls, hence marginal
utility for y increases; while quantity of x increase, hence marginal utility for x decrease.

Because the slope is MUx/MUy, the slope must therefore be decreasing as

the point move to the right along the curve. the curve from left to right.) B. Budget Line

(Convex to the origin means that the slope decreases as we move down

A line that shows the combinations of any two goods, given the level of income and the price of both goods. Given : Price of x = RM10; Price of y = RM5; The slope of budget line = - Px / Py
Figure: Budget Line

Income = RM100

Good y 20

The equation of the budget line: 10x + 5y = 100 5y = -10x + 100 y = -2x + 20

10

BL 5 10 Good x

Possible combination: 5 good x and 10 good y, 10 good x and 0 good y, and 0 good x and 20 good y

Change in the budget line If price of good x falls to RM5.00 while price of y is RM5 and income is RM100 5x + 5y = 100 5y = -5x + 100 y = -x + 20
BLo 5 10 BLn 20 Good x 10 Good y 20 Figure: Budget line- Change in price

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If income increase to RM140 while 10x + 5y = 140 5y = -10x + 140 y = - 2x + 28

Good y Figure: Budget line- Change in income

price of x is RM10 and price of y is RM5 28

20

10 BLo 10 BLn 14 Good x

C.

Consumer Equilibrium

Consumer equilibrium is at the tangential point of the budget line and indifference curve. The conditions to achieve consumer equilibrium: fully spend the income given achieve maximum satisfaction the slope of indifference curve (MRS) equal with the slope of budget line (Px/Py) MRSxy = - Px/Py

Consumer equilibrium single indifference curves with multiple budget lines Point a, b, c, d and e c a and e Good y f Description Same level of satisfaction Consumer is in equilibrium position: maximum satisfaction with minimum budget High level of satisfaction but consumer need to spend more than budget Though cheaper, the satisfaction level is low.

a b c d
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f
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IC BL4
Good x

BL1

BL2 BL3

CHAPTER 5: CONSUMER BEHAVIOR THEORY

Consumer equilibrium single budget line with multiple indifference curve Point e a and b c d Description Consumer is in equilibrium position: maximum satisfaction with minimum budget Lower level of satisfaction compared to IC2 Lower level of satisfaction and not fully used the budget given High satisfaction but not attainable given the budget line.

Good y

a d c e IC3 b BL IC2 IC1 Good x

EXERCISES Structure
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1. If a rational consumer is in equilibrium, then, A. marginal utility obtained from one product is equal to the marginal utility obtained from any other product. B. a reallocation of income would increase the consumers total utility. C. marginal utility per last ringgit spent is the same for all goods consumed. D. total utility becomes zero. 2. If Mux/Px < Muy/Py, a consumer who spend all of his income on these two goods A. can never maximize utility B. has maximized their total utility C. can increase utility by buying more of good y and less of good x D. can increase utility by buying more of good x and less of good y 3. Lia spends RM150 on movie tickets and pizza. The price of a pizza is RM10 and a movie ticket is RM7.50. If Lia buys 9 movie tickets, how many pizzas can he afford? A. 7 B. 10 C. 9 D. 8

4.

Sue consumes apples and bananas. Suppose Sues income doubles and the prices of apples and bananas do not change. Sues budget line will: A. shift rightward and its slope will not change B. remain unchanged C. shift rightward and become steeper D. shift leftward and its slope will not change

Apples (number per month)

10 5

0
100

20
80

40

oranges (number per month)

5.

The figure above shows Sallysast budget line and one of her indifference 60 E curves. At point a, Sallys marginal rate substitution is ______ Wes t 40 A. B. 40 North C. 10 D. 4
20

0 6. The marginal rate of Qtr 4thQtr substitution is defined as the 1s Qtr 2ndQtr 3rd t A. relative price of the two goods B. magnitude of the slope of the indifference curve C. inverse of the slope of the budget line D. marginal cost of each slope

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7. An indifference curve shows combinations of goods ____ A. that are inside or on the budget line B. that are affordable C. which the consumer prefers equally D. that have the same relative price 8. All points above a given indifference cure are A. definitely affordable B. preferred to any point on the indifference curve C. definitely not affordable D. inferior to any point on the indifference curve

Structure questions 1. The following is the price of two goods, A and B and the total utility for consumer Z. Price of good A = RM30 ; Price of good B = RM20 Quantity TU A TU B 1 29 20 2 50 35 3 68 49 4 83 61 5 93 71 6 101 78

a. If the budget given is RM170, calculate how many of good A and good B will be bought by consumer Z to maximize utility from both goods.

b. Calculate the total utility gained by consumer Z

2. The schedule below shows the marginal utility of shoes and cloth bought by Alina. Quantity Marginal utility for shoes Marginal utility for cloth 1 20 40 2 18 30 3 14 25 4 10 20 5 6 15 6 2 5

a. If the price of shoes is RM40 and the price of cloth is RM60 and Alinas income is RM460, calculate how many shoes and cloth will be bought by Alina to maximize her utility. b. Calculate the total utility gained by Alina.
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c. If the price of shoes is reduce to RM20 and Alinas income increase to

RM480, calculate how many shoes and cloth will she bought to maximize her utility.

d. Based on question c, calculate the total utility gained by Alina.

3. The diagram below shows the equilibrium position of a consumer who has
spent RM600 on good Y and good X. The budget line and indifference curves are shown in the diagram. BLo is the original budget line and BLn is the new budget line.

Good X

60 A Qx 33 B E D I2 I1 C BLo Qy 20 40 BLn 75 Good Y I3

a. Calculate the original price of good Y and good X b. Determine the value of Qy. c. What is the new price of the good Y? d. Determine the value of Qx.
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e. Referring to a new budget line (BLn), which combination will give the
highest possible utility to the consumer? Why? f. Is utility maximum at combination C g. State the condition for maximizing utility from the ordinal approach.

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