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Chapter Three: Theory of Consumer Behavior
Chapter Three: Theory of Consumer Behavior
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Total and Marginal Utility
Total Utility: refers to the total amount of satisfaction a consumer
gets from consuming or possessing some specific quantities of a
commodity at a particular time. TU is the summation of MU
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Marginal Utility (MU) :
• It is the change in the total utility resulting
from a unit change in commodity consumed
• It is the slope of total utility function
• Marginal Utility measures a marginal
change in total utility due to a unit change in
commodity consumed
• MU = TU/ Q or MUn = TUn – TUn-1
MU X PX
MUx
1
Px
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Note: In one commodity case:-
If MUx > Px, the consumer should
consume more of good X
If MUx <Px, the consumer should
consume less amount of X
If Mux= Px the consumer is at
equilibrium
Consumers Equilibrium: Two and more
commodity Case: (The law of equi-
marginal Utility)
• For n number of goods, he/she would
be in equilibrium or utility is
maximized if and only if:
MU X 1 MU X 2 MU X n
......... MU m
PX1 PX 2 PX n
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4.Diminishing Marginal Rate of Substitution
(MRS):
• The marginal rate of substitution is the rate
at which a consumer is willing to substitute
one commodity (x) for another commodity
(y) so that his total satisfaction remains the
same.
• MRS diminishes as substitution increases
5. Limited money income.
• The consumer is confronted/challenged with
limited money income, so that optimization is
mandatory.
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3.2.3.Indifference Curve, Set and Map
• IC : An indifference curve is an iso or equal utility
curve.
• The graphical representation of consumer’s
preference is called Indifference Curve (IC)
• Is the locus of different combinations of two
commodities, which are equally preferred
• or it is the locus of different combinations of
goods that yields the same level of satisfaction.
• Indifference set/ Schedule is a tabular presentation
of points or combinations which give same utility
• Indifference Map: It is a set of indifference curves
with different levels of satisfaction
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Properties of Indifference Curves:
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3.2.4.The Marginal Rate of Substitution
(MRS)
Marginal Rate of Substitution (MRS) is a rate at
which one commodity can be substituted for
another, without changing the level of satisfaction.
so that the consumer maintains the same level of
satisfaction
Marginal rate of substitution of X for Y is defined as: The
number of units of commodity Y that must be given up in
exchange for an extra unit of commodity of Xof Y given up
Number of units
MRS X ,Y
Number of units of X gained
• The slope of an indifference curve is called Marginal Rate
of Substitution
• A slope of an indifference curve =y MRS X ,Y
x 26
MRS decreases as a consumer continues to
substitute one commodity for another and MRS
is negative, Hence, usually we take the
absolute value of the slope
• Consider the following table; level of
consumption of good X and Y
Y 8
MRS X ,Y (between points A and B) 4
X 2
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3.3 The Budget Line or the
Price line
• A utility maximizing consumer would like to
reach the highest possible indifference curve
on his/her indifference map.
• But the consumer’s decision is constrained
by his/her
–money income and
– prices of the two commodities
• This limitation is called consumer’s budget
constraint.And is represented by the budget
line
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Budget Line (Cont…)
The budget line is a line representing different
combinations of two goods that a consumer can
buy with a given income at a given prices level
• Budget line is a graph that shows various
combinations of two commodities which can be
purchased with a given budget at given prices of
the two commodities.
Assumptions
A. There are only two goods, X and Y, bought in
quantities X and Y;
B. Each consumer is confronted/limited with
market determined prices, Px and Py, of good X
and good Y respectively
C. The consumer has a known and fixed income (I).
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Budget Line (Cont…)
M PX X PY Y
Where, PX=price of good X
PY=price of good Y
X=quantity of good X
Y=quantity of good
M=consumer’s money
income
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Budget Line (Cont…)
• Suppose a household has 60 Birr to spend
– on banana (X) at Birr 2 each and
– Orange (Y) at Birr 4 each. .
• Therefore, our budget line equation will be:
2 X 4Y 60
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Any combination of the two commodities on or
within the budget line is attainable, whereas any
combination above the budget line is not
attainable (because of the budget constraint).
Factors Affecting the Budget Line
• Budget line depends on the price of the two
goods and the income of the consumer
• A change in the income of the consumer results in
a shift in the budget line
• Where as a change in the price of a commodity
will rotate the budget line
Effect of change in income on BL
An increase in income, assuming that Px and Py
are constant, will increase the vertical intercept
and the horizontal intercept, and does not affect
the slope of the budget line.
Thus, an increase in income will result in a parallel
outward shift of the budget line.
Similarly, a decrease in income will reduce both
the vertical and the horizontal intercepts and as a
result it will cause a parallel inward shift of the
budget line
Effects of Changes in Price of the
commodities