Introduction to Economics

(Econ. 101)

By Eyasu kumera

April, 2010

1
2.2. THE THEORY OF CONSUMER BEHAVIOR
Consumer Choice and the Concept of Utility
2.2.1.Cardinal Utility
 Total and Marginal Utility
 Consumer’s Equilibrium
2.2.2. The Budget Line
 Shift and Rotation of the Budget Line
2.2.3. Ordinal Utility
 The Indifference Curve
 Marginal Rate of Substitution
 Consumer’s Equilibrium Using Ordinal
2
Approach
• Consumer Choice and the Concept of Utility
 the theory of consumer behavior :
 is to determine the various factors that
affect demand.
 examines and verifies the postulate of
preference and consistency of choice.
 Utility is the satisfaction or pleasure
obtained from consuming good or
service.
 is a want satisfying power of a product to
satisfy human needs.
3
2.2.1.Cardinal Utility
 Some 19th century economists thought that utility might be measurable
as if it were a physical commodity. These economists have become
known as cardinalists, because they believed that cardinal numbers (i.e.
1, 2, 3 …) could be used to express the utility derived from the
consumption of a commodity. Some economists suggested that utility
could be measured in monetary units while others (in the same school)
suggested the measurement of utility in subjective units, called utils.

 Example: a consumer may obtain 10 utils, of utility from a

consumption of good A, but only 5 utils from the consumption of
good B. The cardinalists would conclude from this that the consumer
obtains twice as much utility from A as from B, and the absolute
difference between the utility derived from A and that obtained from
B is 10 utils.

 However, utility is an abstract, subjective concept and there are two

major problems involved in trying to measure it: It is difficult to find an
appropriate unit of measurement. If we call the unit a util, what is a util?
Are 5 utils enjoyed by one individual equivalent to 5 utils enjoyed by
another? Stated differently, can we make interpersonal comparison of
utility? 4
2.2.1.1. Total and Marginal Utility
 Total utility = the total satisfaction obtained
from the consumption of a good or bundle of
goods in a given time period.
TU = f (q1, q2, ... qn)

Marginal (or incremental) utility = the

satisfaction added by the consumption of the
last unit.
is the EXTRA satisfaction a consumer
realizes from an additional unit of that
product
Mux = ΔTu/Δx 5
Table: Total and marginal utility (hypothetical data)

Units of a Total utility of commodity Marginal utility of

commodity X X commodity X
(TUx) (MUx)
0 0 _
1 40 40
2 75 35
3 105 30
4 130 25
5 150 20
6 165 15
7 175 10
8 180 5
9 180 0
10 175 -5
6
 Total and marginal utility
T
o Saturation point
t
al
u
ti
li
t
y

M
a
r
g
i
n
al
u
ti
li
t
7
y
Explanations of the Law of Demand

8
Explanations of the Law of Demand
1. The Income and Substitution Effect:
combine to make a consumer able and willing
to buy more of a specific good at a low price
than at a high price.

2. Law of Diminishing Marginal Utility: can be

stated as the more a specific product consumer
obtain, the less they will want more units of the
same product. The fact that marginal utility will
decline as the consumer acquires additional
units of a specific product is known as the law
of diminishing marginal utility.
9
Derivation of demand curve from marginal utility curve
As indicated in fig. below, If the marginal utility is measured in monetary units, the
demand curve for X is identical to the positive segment of the marginal utility curve. At
quantity X1 the marginal utility is MU1, and this is equal to P1, by definition. Hence at
P1 the consumer demands X1 quantity of commodity X. Similarly at X2 the marginal
utility is MU2, which is equal to P2. Hence at P2 the consumers will buy X2 units of X,
and so on. The negative section of the MU curve does not form part of the demand
curve, since negative quantities do not make sense in economics.

10
2.2.1.2 Consumer's Equilibrium
A consumer is said to have reached his/her equilibrium position
when he/she has maximized the level of his/her satisfaction, given
budget constraints and other conditions. At equilibrium, the consumer
is supposed to have spent his/her entire income on the goods and
services he/she consumes. If we assume that the consumer
consumes only two products, say, X and Y, then the following
condition should fulfill in equilibrium:

MU x Px MU x MU y
= or =
MU y Py Px Py

The utility derived from spending an additional unit of money must

be the same for all commodities. If the consumer derives greater
utility from any one commodity, he can increase his welfare by
spending more on that commodity and less on the others, until the
above equilibrium condition is fulfilled.

11
Let’s illustrate this using a three - commodity model.

Table: Marginal utility and units of a good

Unit Marginal Utility

Good A Good B Good C
1 60 36 16
2 50 30 14
3 40 18 10
4 30 12 8

The price of commodity A (PA) = birr 5, commodity B(PB) = birr 3, and

commodity C(PC) = birr 1. The total income of the consumer is birr 19.
Now, would the consumer purchase the first unit of A, B or C? The answer
is the consumer would purchase the first unit of commodity C. Why?
Because, the highest level of marginal utility per birr is obtained from the first
unit of C That is:
Commodity A will have 60/5 = birr 12
Commodity B will have 36/3 = birr 12
Commodity C will have 16/ 1= birr 16
12
Now that consumer is left with birr 18. Which unit of commodity will he buy next?
Again by the same logic, he will purchase the 2nd unit of C. This time is having 17
birr.
The consumer's next choice will be either the first unit of A or B since both have
the same level of utility per birr, which is greater than that from the 3rd unit of C.
Assuming that his 3rd purchase is commodity x, the first unit of commodity B will
then be his 4th purchase (choice). Now he is left with 9 birr, after he purchases 2
units of commodity C and one unit each from A and B. Next, the consumer can
purchase either the 2nd unit of A or the 2nd unit of B or the 3rd unit of C. Let us
say the consumers fifth, sixth and seventh choices are the 2nd unit of commodity
A, the 3rd unit of B and the 3rd unit of C, respectively. At this level of purchase (i.e.
2 units of A, 2 units of B and 3 units of C), the consumer has exhausted all his
income and is in a position to purchase nothing.
Note here that the last units of expenditure spent on each commodity consumed
bring about the same level of utility. When this condition is satisfied no shifting of
expenditure between goods can serve to increase total utility, and hence
consumer equilibrium is said to exist. As we can clearly see from and example, the
last birr spent on A, B and C yields the same amount of utility, that is:
MUA /PA = 50/5 = 10 Birr
MUB/PB= 30/3 = 10 Birr
MUC/PC= 10/1 = 10 Birr
13
 MU x Px MU x MU y
MU y
= Py
or Px
=
Py

Unit Good A Good B Good C

1 12 12 16 MUA /PA = 50/5 = 10 Birr
2 10 10 14 MUB/PB= 30/3 = 10 Birr
MUC/PC= 10/1 = 10 Birr
3 8 6 10
4 6 4 8

At 2 units of A, 2 units of B and 3 units of C purchase , the

consumer has exhausted all his income and is in a position to
purchase nothing.

As long as the objective of the consumer is to maximize total utility,

expenditure switching between goods will take place until the
marginal utility of a Birr's worth of each good consumed is equal to
the marginal utility of Birr's worth of any other goods consumed.
14
2.2.2 The Budget Line
The budget line is, the locus of combinations or bundle of goods that can be
purchased if the entire money income is spent. It shows all combinations of
commodities that are available to the household given its money income and the
prices of the goods that it purchases, if it spends all of its income on them. In
order to draw the budget line facing the consumer, let us assume that there are
only two goods, X and Y, bought in quantities X and Y. Each consumer is
confronted with market determined prices, Px and Py, of X and Y respectively.
Finally, the consumer in question has a known and fixed money income (M). M
is the maximum amount the consumer can spend, and we assume that it is all
spent on X and Y. Algebraically :

M = XPx + YPy M = the maximum amount the consumer can spend

.X.Px= The amount spent on X
YPy = The amount spent on Y
In equation form:

If X = 0, Y=M If Y = 0, Y=M
M - Px
Y= X Py Px
Py Py If we join the two points(M/Py & M/Px,
it will give us the budget line. 15
 The Budget Line

The negative sign

in the price ratio
indicates that the
budget line slopes
downward from left
to the right.

M
(-) , Mathematically speaking, is the Y - intercept.
Py
Slope = OA = M / Py = Py
OB M / Px Px 16
2.2.2.1.Shift and Rotation of the Budget Line

A. Shift of the Budget Line

When M increases, Rightward Parallel Shift of the budget line

(since prices are constant , the budget line slope doesn’t change).
When M decreases, leftward Parallel Shift of the budget line.
17
B. Rotation of the Budget Line

Happens when price ratio changes with money income held constant
If the price of X(Px) increases, Px/Py increases also. The budget line
becomes stepper, in this case the line AB!
Since the Y-intercept (M/Py) is constant, the consumer can purchase the
same amount of Y by spending the entire money income on Y regardless of the
price of X. We can see from above figure that an increase in the price of X
rotates the budget line back ward, the Y - intercept remaining fixed. Similarly, in
decrease in the price of X, money income and price of Y held constant, pivots
the budget line out-ward in the above fig. from AB' to AB.
18
2.2.3 Ordinal Utility
By the 1930's many economists were coming to the view that utility could not
be measured cardinally and that cardinally measurement was not essential for a
theory of consumer behavior. These economists have become known as
ordinalists. This is because they claimed that an individual can only rank
bundles of goods in order of his/her preference. And the consumer can say that
he/she obtains more utility from one bundle than from another, or the consumer
derives equal utility from two or more bundles. It is impossible, though to
measure by how much one bundle is preferred to another. Only ordinal numbers
(first, second, … so on) can be used to "measure" utility, and these say nothing
about the absolute difference of any other relationship between utilities.

19
2.2.3.1.The Indifference Curve (iso-utility curve)
Basic Assumptions of the indifference curve
1. Rational consumers: Maximize utility
2. The consumer can rank his/her preferences according to the satisfaction
of each basket of goods (preferences based on Marginal Utility)
3. Diminishing marginal rate of substitution: the slope of the indifference
curve, which depicts the rate at which the consumer is willing to substitute one
good for another, declines
4. U = f (q1, q2, ... qn) quantities of the commodities consumed
5. Consistency and transitivity of choice
 Consistency : If A > B then B < A (if in one period the consumer
chooses bundle A over B he will not choose B over A in another period
if both bundles are available to him )
 Transitivity : If A > B, and B > C, then A > C (if bundle A is preferred to
B, and B is preferred to C, then bundle A is preferred to )
6. The non- satiety assumption: the consumer always prefers the bundle with at
least one more commodity in it
 Example: The first bundle consists of 8 units of X and 6 units of Y while the second
bundle consists 10 units of X and 6 of Y. According to the above assumption, the
consumer prefers the second bundle to the first one.
20
7. The consumer is assumed to have all relevant information
 Indifference Curve (Iso-curve)
An indifference curve shows all combinations of two products, which will
yield the same level of total utility to the consumer. The consumer is
therefore indifferent (equally happy) among the bundles (combinations)
represented by the points on the curve. In order to draw the indifference curves,
which depict the consumer's preferences, let us assume there are only two goods,
say X and Y, available for consumption.
Every point on the graph represents
some combination of X and Y

The consumer is said to be indifferent

between combinations A, B, C, D, and E.
All combinations yield the same utility to
the consumer. In other words, all
combinations yield the same utility to the
consumer.

21
Basic properties of the indifference curve
1. Has a negative slope downward from left to right
 If the quantity of one commodity, say Y decreases, and the quantity of the
other (x) must increase, if the consumer is to stay on the same level of
satisfaction.
2. The further away from the origin an indifference
curve lies, the higher the level of utility it denotes
 Bundle of goods on a higher indifference curve are preferred by the
rational consumer. This property holds true, only assuming non-satiety
assumption.
3. Indifference curves do not intersect each other. If they
did, the point of intersection would imply consumer would obtain two different
levels of satisfaction consuming one combination of the two goods at the same
time, which is impossible.

22
4. The indifference curves are convex to the origin
 The curve is convex to the origin due to imperfect substitution of the goods in
question. In other words, as more and more units of one good, say Y, are
given up, successively bigger quantities of X must be obtained to compensate
the consumer for the loss and leave him/her at the same level of utility.
Indifference Map
 An indifference map consists of a set of indifference
curves. The further away any indifference curve is from the
origin, the higher is the level of satisfaction given by any of
the combinations of goods indicated by points on the curve

I4 > I3 > I2 > I1

Indifference map23
2.2.3.2 Marginal Rate of Substitution
 It is the rate at which a consumer is willing to
substitute one commodity for another in
consumption.
At point P, the consumer is willing to
give up 5 units of X for 10 more units
of Y. At point R, the consumer is
willing to give up 10 units of Y for 5
more units of X. The rate at which the
consumer is willing, on average, to
substitute X and Y is therefore:

MRS =
Y
= RS = 14  4 = 10 = 2
X SP 27 5
The ratio measures the average number of units of Y the consumer is willing
to forego (sacrifice) in order to obtain one additional unit of X (over the range
of consumption pairs under consideration, i.e. over the range of RP).
24
2.2.3.3 Consumer's Equilibrium using
ordinal approach
 Theory of consumer behavior assumes that : the
consumer aims at the MAXIMIZATION OF UTILITY,
given his/her INCOME and MARKET PRICES of the
commodities available for consumption.
 In order to determine the equilibrium position we need:
 The indifference Map
 The budget line
 Recall that
 The slope of the budget line is the negative of the
price ratio, the ratio of the price of X to the price of Y

 The slope of an indifference curve at any point is

called MRS of X for Y
25
 Px
MRSx for y =
Py

MU x
MRSx for y =
MU y
Consumer's Equilibrium
MU x Px
MRSx for y = =
MU y Py
E

The position of maximum satisfaction or the point of

consumer optimization is attained at E, where an
indifference curve is just tangent to the budget line. 26
 The consumer cannot purchase any bundle lying above and to the right of the
budget line and, therefore, cannot consume any combination lying on
indifference curves is. However, some points on indifference curves I1, I2 and
I3 are attainable. The question then arises as to which combinations of X and
Y the rational consumer will purchase.
 If a consumer were situated at a point such as C, experimentation would lead
him to substitute Y for X, there by moving the consumer in the direction of E.
The consumer would not stop short of E, because each successive
substitution of Y for X brings him/her to a higher indifference curve.
Therefore, the position of maximum satisfaction or the point of consumer
optimization is attained at E, where an indifference curve is just tangent to the
budget line.
 It will be recalled that the slope of the budget line is the negative of the price
ratio, the ratio of the price of X to the price of Y. It is also stated earlier that
the slope of an indifference curve at any point is called MRS of X for Y.
Therefore, the point of consumer equilibrium is defined by the condition that
the marginal rate of substitution of X for Y must equal the price ratio.
 The MRS shows the rate at which the consumer is willing to substitute X for
Y. The price ratio shows the rate at which market prices permit substitution of
X for Y. Unless these rates are equal, it is possible to change the combination
of X and Y purchased to attain a higher level of satisfaction.
27