THEORIES OF CONSUMER

BEHAVIOUR

 The consumer is A central entity in the

business economics and environment.
 A consumer is an influential stakeholder who
spends part of his/her limited income on goods
and services to satisfy his/her needs.
 The major aim of this section is to provide
models that explain consumer choice given
that resources are scarce.
THEORIES Cont’d

In practice, there are two theories

that explain consumer behavior.
These include
1. The cardinal utility theory
2. The ordinal utility theory
The cardinal utility theory

 Utility simply refers to amount of

satisfaction a consumer obtains from
consumption /possession/use of a good
or a service.
 The challenge is to determine what
customers look for in the good/service.
 What satisfies the customer?????????
The cardinal utility theory

 Alfred Marshal believed that utility is

cardinally measured. It implies that utility
can be assigned a cardinal number like
1,2,3
 It was further assumed that one util
(measure of satisfaction) equals one unit
of money.
The assumptions of the theory

 Rationality
 The consumer derives utility from the
consumption of every commodity
consumed by him
 Utility is cardinal (measurable)
 The theory assumes diminishing marginal
utility
Relationship Between T.U& M.U

Qx TUx MUx
0 0 -
1 30 30
2 50 20
3 60 10
4 65 5
5 65 0
6 60 -5
7 45 -15
Graphical relationship
RELEVANCE OF THE APPROACH ON
MANAGERIAL DECISIONS

 ???????????????????????????????
THE ORDINAL APPROACH (I.C)

 This approach abandons the assumption

that utility is measurable in numerical
terms.
 Instead, the consumer is faced with a
number of baskets (goods) from which
he/ she can express preference by way
of ranking.
THE ORDINAL APPROACH (I.C)

 The basic tool of analysis is an

“indifference curve”. An indifference
curve refers to a locus of points showing
different combinations of two
commodities that yield the same level of
satisfaction to a consumer.
An indifference curve.

X
The complementary tool is the
indifference map

 An indifference map contains several ICs.

From which the consumer obtains
different levels of satisfaction.
Diagram ( Indifference Map)

 THE Indifference map.docx

Analysis of indifference map cont,d

 Commodity combinations that lie along

higher ICs. are said to contain
combinations from which the consumer
derives higher level of satisfaction.
 In practice, such combinations contain
at least more units of one commodity or
both commodities compared to those
that lie along lower ICs.
 The consumer budget-line

 This is a line, which shows attainable

combinations of two commodities X and Y
that exhaust the consumer’s income.
 Assume that the consumer’s income is
given as
B= 1000 Px = 200 Py­= 100
Budget schedule
THE B-L ILLUSTRATION
Explanation

Between B and L, the consumer can get

many combinations of X and Y that
exhaust his income. Below the budget-
line, the consumer’s income is not
exhausted while above; the
combinations are desirable but not
attainable due to budget constraint.
Equilibrium of the consumer

 A consumer is in equilibrium when he

maximizes his total utility given his
income and market prices for goods and
services he purchases.
 Under ordinal utility approach, the
consumer is in equilibrium when his
highest indifference curve is tangent to
his budget line.
Equilibrium (Illustration)
ANALYSIS OF EQUILIBRIUM

 Points a, b and c are affordable by the

consumer given his or her income
 However, b gives the consumer higher
satisfaction because it lies along a higher
Ic.
 Combination d is most desirable but not
affordable given the income constraint.
ANALYSIS OF EQUILIBRIUM

 The only point that is attainable while at

the same time exhausting his/her income
is b. Hence, the consumer equilibrium.
 The underlying condition of the
equilibrium is that the highest I.C must
make a tangency with the budget line
INCOME AND SUBSTITUTION
EFFECTS OF PRICE CHANGE

 ASSUMPTIONS
 Two commodities are assumed (x and y)
 Price of Y remains constant.
 Price x falls
 Consumer equilibrium is assumed
Explanation

 Initially the consumer is in equilibrium at

point e1
 A fall in the price of the commodity (X)
will lead to a rotation in the budget line
from BL to BL1
 The consumer will move to a higher Ic in
respect of the new equilibrium position e 2
.
Explanation cont’d

 The TPE can be broken down into its

components by introducing a
hypothetical budget line (HB).
 The hypothetical budget line prevents the
consumer from moving to a higher B.L
indicating that it is only the consumer’s
purchasing power that increased as a
result of a price fall of commodity X but
not his /her income in absolute terms.
Explanation cont’d

 The hypothetical HB must form a

tangency with the original IC1 and must
be parallel to budget line B-L1.
 e1 to e2 is the total price effect.
 A movement from e1 to e3 along the same
IC1 is referred to as the substitution effect
of price change.
 A movement from e3 to e2 is referred to
as the income effect of price change
THE APPLICATION OF I.C (Tools
of analysis)

 Income leisure curve

 The income - leisure curve shows how
much time of leisure an individual must give up
if he/she wants to earn an extra income.
 Illustration and explanation
Explanation

 The maximum time available for either leisure

or work is OZ HRS a day .An individual can
either use all the Oz hrs for leisure, in which
case he/she earns zero income or
 He/she can choose to work for all Oz hrs and
earn maximum money income OM.
Explanation

 Under normal circumstances, an individual

allocates part of the available time to leisure
(OA) and the rest to work (AZ).
 Hence, he/she would earn OM1 income for
(AZ) hours worked and lose income equivalent
to M1-M for the leisure time enjoyed (OA).
THE APPLICATION OF I.C (Tools
of analysis)

 Income leisure trade off

 The income leisure trade off shows various
combinations of income and leisure that will lead
to the same level of satisfaction for an individual.
 Illustration and explanation
 Along the income leisure trade off, an individual
obtains the same level of satisfaction
 By combining both tools, we obtain an equilibrium
point. Illustration & explanation
Why employers need to pay over
time rates higher than the
normal wage rate
 Employee equilibrium is an important
tool for analyzing work effort (behavior)
by employees in respect of different wage
rates; and to explain why firms must pay
higher rates for overtime work.
 illustration
Explanation

 The point of tangency between the income

leisure curve and the highest possible income
leisure trade off is the equilibrium of the
individual.
 Given the wage rate w1, the individual
maximizes his utility by working A-z hrs,
earning income OM1 and using the remaining
time O-A for leisure.
Explanation

 If firms wish to induce employees to reduce on

their leisure time and dedicate extra hrs to
work, they will have to pay a higher hourly rate
w2 than the normal w1
 An increase in overtime rate is depicted by
income leisure line which is steeper and to the
left of e1 ie (Y1-e1) .
Explanation

 The individual will be induced to give up some

of his/her leisure time because, in this way,
he/she will reach a higher income leisure trade
off (indifference curve)
 The new equilibrium of the individual is at e2
along a higher income leisure trade off
(indifference curve) IT2 showing that an
individual increases his/her working hours by A-
A1 and earn extra income M1 – M2
ICs and alternative welfare policies
Food subsidy and supplementary
income policy

The underlying objectives by government are

To improve the welfare of the
disadvantaged persons (IDPs, pensioners
etc) at minimum cost through provision of
either supplementary income or food
subsidy
 To minimize/ mitigate the negative effects
of such policies of the economy.
ICs and alternative welfare policies
cont’d

 The effect of food subsidy on welfare

Assumptions
   The consumer buys only one type of a given
commodity (X) to meet his/her welfare needs.
 The law of demand operates (prevails)
 Consumer equilibrium is assumed
Illustration
Explanation

 Initially, an individual is at equilibrium at point e1

consuming x1 units of food and paying B-B1
amount of money.
 When government allows individuals to buy food
at half price, the budget line rotates outwards to
B-L1 from B-L.
 The individual’s welfare improves and a new
equilibrium is created at e2
 Explanation ctd

 At e2, the individual consumes x2 units of

food and would be expected to pay B-B3
but only pays B-B2.
 Therefore, B2-B3 is the cost of subsidy
paid by government and x1-x2 is the extra
food.
Explanation ctd
 In the case of supplementary income, the budget
line will shift upward to B4-L2. The new budget
line must be parallel to the original budge line
(B-L) and must make a tangency with IC2.
 A new equilibrium point is at e3 along IC2
indicating that an individual consumes a mount
of food equivalent to o-x3 (x1-x3) increase in
food consumption as a result of supplementary
income received from Government (B-B4).
Explanation ctd

 It is important to note that the food subsidy

policy is more expensive to the tax payers
although welfare achieved is higher due to
more food consumed.
 However, the supplementary income policy is
less expensive although relatively less food is
consumed.
 Nevertheless both intervention policies lead to
improvement in welfare if well administered
 ICs and alternative welfare policies
cont’d

 Note: the alternative policy intervention

will depend upon other factors prevailing at
a time.
 For example, in the case of surplus food
production, the more costly food
subsidization policy would be adopted.
 Besides improving the welfare of the
beneficiaries, it would help the producers
to eliminate the surplus.
ICs and alternative welfare policies
cont’d

 If there were scarcity of food, the less

expensive supplementary income would be
adopted.
 This would regulate the food consumption rate
while meeting the objective of improvement in
welfare.
 It would also regulate prices to avoid
inflationary tendencies.
ICs and alternative welfare policies
cont’d

 In effect, analysis of indifference curves helps

in selecting an optimal welfare policy for
implementation.
END OF LECTURE.

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