Chapter three

Theory of consumer behavior

 3. INTRODUCTION
 In our day –to- day life, we buy different goods and services for
consumption.
 As consumer, we act to derive satisfaction by using goods and
services
3.1 Consumer preferences
 A consumer makes choices by comparing bundle of goods.
 Given any two consumption bundles, the consumer either
decides that one of the consumption bundles is strictly better
than the other, or decides that she/he is indifferent between
the two bundles
 Cont.….
 In order to tell whether one bundle is preferred to another, we
see how the consumer behaves in choice situations involving
two bundles. If she/he always chooses X when Y is available,
then it is natural to say that this consumer prefers X to Y.
 We use the symbol ≻ to mean that one bundle is strictly
preferred to another, so that X ≻Y should be interpreted as
saying that the consumer strictly prefers X to Y, in the
sense that she/he definitely wants the X-bundle rather than
the Y-bundle.
 If the consumer is indifferent between two bundles of
goods, we use the symbol ∼ and write X~Y.
 Indifference means that the consumer would be just as
satisfied, according to her/his own preferences, consuming
the bundle X as she would be consuming bundle Y.
 If the consumer prefers or is indifferent between the two
bundles we say that she weakly prefers X to Y and write X
⪰ Y.
 The relations of strict preference, weak preference,
and indifference are not independent concepts; the
relations are themselves related.
 For example, if X ⪰ Y and Y ⪰ X, we can conclude
that X ~Y. That is, if the consumer thinks that X is at least as
good as Y and that Y is at least as good as X, then she must
be indifferent between the two bundles of goods.
 3.1.1 THE CONCEPT OF UTILITY:
-developed by Germy Bentham
 Economists use the term utility to describe the satisfaction
or pleasure derived from the consumption of a good or service.
 In other words, utility is the power of the product to satisfy
human wants. Given any two consumption bundles X and Y, the
consumer definitely wants the X-bundle than the Y-bundle if and
only if the utility of X is better than the utility of Y
In defining utility, it is important to bear in mind
the following Properties of utility:-
 Properties of utility
 Utility’ and ‘Usefulness’ are not synonymous. Hence,
usefulness is product centric whereas utility is consumer
centric.
 Utility is subjective. The utility of a product will vary
from person to person..
 Utility can be different at different places and time. For
example, the utility that we get from drinking coffee early
in the morning may be different from the utility we get
during lunch time
3.2 THE APPROACHES OF UTILITY ANALYSIS
3.2.1. Cardinal Utility Approach; by Marshall
 This school postulates that utility can be measured in
absolute terms
 What is the measurement unit?
– Monetary unit and By a subjective unit called util
ASSUMPTIONS:-
A. Rationality of consumers- The main objective of the
consumer is to maximize his/her satisfaction given
his/her limited budget or income.
B. Cardinal Utility: The utility of each commodity is
measurable and the most convenient unit of
measurement is money.
C. Constant Marginal Utility of Money-The essential
feature of a standard unit of measurement(money) is that
it is consistent/constant.
8
 Cardinal Utility (cont…)
D. Limited money income of the
consumer and all income is spent in
the consumption process.
– That is, saving gives no positive
utility to the consumer.
E. Diminishing Marginal Utility (DMU).
– The utility derived from each
successive units of a commodity
diminishes. .
9
 Cardinal Utility (cont…)
F. Total utility depends on the quantity of the
commodities consumed.
– If there are n commodities in the bundle with
quantities X1, X2, X3 …… Xn the total utility is
then
TU = f (X1, X2, X3 ……. Xn).
G. Utility is also additive, i.e., Total Utility
(TU) = U (X1) + U (X2) +U (X3) ……+U ( Xn )

10
 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

• Marginal Utility: Marginal utility refers to the extra or

additional utility derived from the consumption of an additional
unit of a commodity
• It is total utility derived from, the last unit of a commodity
consumed

11
 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

TU = Change in Total Utility

Q = Change in quantity consumed
12
Tot TU Graphs of Total Utility &
al X1 is where Marginal Utility
Utili marginal utility
ty
reaches its maximum.
This is where we
diminishing marginal
encounter
utility.
The slope of TU has
X1 X reached its maximum;
Margi TU has an inflection
Utili
nal
X2 X2 is where
point here. total utility
ty reaches its maximum,
M MU is zero.
U
This is the saturation
point or satiation point
of TU
After that point, TU
X X2 X
1 MU
falls and MU is
The following are relationship between
Total Utility (TU) and Marginal Utility
(MU):-
TU increases at decreasing rate as long as
marginal utility is positive
 MU decrease as TU increases
TU is maximum when MU is zero
TU starts declining when MU becomes
negative.
 THE LAW DIMINISHING MARGINAL
UTILITY
• States that as the quantity consumed of a commodity
increases, the utility derived by the consumer from the
successive units is decreases, ceteris paribus.
• As more and more quantity of a commodity is consumed,
the intensity of desire decreases and therefore, the utility
derived at the margin decrease
• ASSUMPTIONS OF THE LAW OF DIMINISHING MARGINAL UTILITY

• Various units of the good are homogeneous,

• There is no time gap between consumption of the
different units,
15
 Consumer’s Equilibrium: One
Commodity Case
U asf (X )
Suppose the consumer’s utility function is given

and his/her total income spent (expenditure) on commodity X –

total expenditure would
TE be:
Q PX X

• Where Qx is amount of commodity x and Px is price of good

X.

• The consumer would like to maximize the difference

between the utility (satisfaction) and expenditure (sacrifice).

• The problem is a simple maximization of the function.

16
 Cardinal Utility (cont…)
• Max (U – TE) or (U – PxQx)

• The necessary condition (First Order

Condition) for maximum, require that
the derivative of the function with
respect to independent variable (Qx)
must be equal to zero.
17
dU d (Q X PX )
 0
dQX dQX
 MUx -
Px =0

 MU X  PX
MUx
1
Px
18
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

•And Total expenditure = total income

20
 3.2.2.Ordinal Utility Approach; by
J.R.Hicks & R.J.D. Allen

This approach states that utility is not

cardinally measurable, It is ordinal in
magnitude.
• The consumer may not know the specific
unit of utility derived from different
commodity.
• The consumer can able to rank or order
different basket of goods. It is The modern
theory of utility analysis approach
• Therefore it also called Indifference
curve (IC) approach 21
Assumptions of ordinal utility approach :-

1.Rationality: The consumer is assumed to be

rational aiming at maximizing his utility
2. Utility is Ordinal: The consumer can rank or
order his preferences
3. Consistence of Choice:
– If he/she preferred bundle A to B, he will not
choice bundle B over A another time.
– If consumer prefers bundle A to B and B to C,
she/he prefers A to bundle C, This property is
called axiom of transitivity

22
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.
23
 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
24
 Properties of Indifference Curves:

a) Indifference curves have a negative slope

b) Indifference curves are convex to the Origin /U-shape
c) A higher Indifference curve is always
preferred to a lower .
d) Indifference curves do not intersect each
other

25
 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
27
 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
28
 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).
29
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
30
 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

31
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

 If we consider the effect of decline in Px while

holding Py and I constant, the vertical intercept
remains constant but the slope becomes flatter
and the horizontal intercept increases and
shift outward, as a result the budget line rotates
outward with a
constant vertical intercept and a flatter slope,
so this can affect the slope of the budget line