Chapter Three

Theory of Consumer Behavior

 Consumer Behaviour

"A consumer is an individual who purchases, has the

capacity to purchase, goods and services offered for sale by
marketing institutions in order to satisfy personal or
household needs, wants, or desires." Walters

Behavior is a response of an individual to any given

situation.

Consumer behavior is defined as “the process whereby

individuals decide whether, what, when, where, how, and
from whom to purchase goods and services.“ Walters.
 Consumer preferences
• Consumer preference refers to how a
consumer values different commodities or
services.
 Symbols of preference
Symbols Written as Meaning Further meaning

∼ X~Y The consumer is indifferent

between two bundles of
X is at least as good as Y
and that Y is at least as
goods (X and Y) good as X
≻ X≻Y The consumer strictly prefers
one bundle of good to
if X ⪰ Y but we know that
it is not the case that X~ Y,
another (X and Y) we can conclude that X≻Y.
⪰ X⪰Y The consumer weakly prefers
one bundle of good to
another (X and Y)
 Cont…
A consumer makes choices by comparing
bundle of goods.
Assuming a consumer consumes any two
consumption bundles, the consumer either
decides that
 one of the consumption bundles is strictly better than the
other,
 or decides that he/she is indifferent between the two bundles.
 Cont…
 If a consumer always chooses X when Y is available,
then it is customary to say that this consumer prefers
X to Y.

And the symbol ≻ is used 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 the consumer
definitely wants the X-bundle rather than the Y-
bundle.
 Cont…
 If the consumer is indifferent between two
bundles of goods, the symbol ∼ and is written
X~Y.

 Indifference means that the consumer would

be just as satisfied, according to the consumer
own preferences, consuming the bundle X as
he/she would be consuming bundle Y.
 Cont…
 If the consumer prefers or is indifferent between the two bundles it is
said that he/she weakly prefers X to Y and write X ⪰ Y.

 If X ⪰ Y and Y ⪰ X, it can be concluded 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 the consumer must be indifferent between the two bundles of
goods.

 Similarly, if X ⪰ Y but we know that it is not the case that X~ Y, we can

conclude that X≻Y.

 This just says that if the consumer thinks that X is at least as good as Y,
and he/she is not indifferent between the two bundles, then he/she
thinks that X is strictly better than Y.
 The Concept of Utility

 Utility is the ability of a good or service to satisfy human wants.

 Utility is defined as the satisfaction which a consumer gets by having or

consuming goods or services.

 Utility is the satisfaction that someone receives from consuming

commodities and services.

It is the power of a commodity or service to satisfy human

wants i.e. to yield a consumer satisfaction.
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.
 Approaches of measuring utility

There are two approaches of utility

1. Cardinal utility approach-
utility is measurable by arbitrary unit of
measurement called utils and it is not
comparable.
Cardinal numbers are used (0,1,2,3,4,etc.)

For example, consumption of an orange gives
Munna 10 utils and a banana gives her 8 utils, and
so on.
2. Ordinal utility approach-
 utility is not measurable but
comparable.
Goods are ordered as 1st,2nd 3rd or 4th …
Cardinal utility approach (Theory)

Assumptions of cardinal utility theory

The cardinal approach is based on the following major assumptions.
1. Rationality of consumers. The main objective of the consumer is to maximize his/her
satisfaction given his/her limited budget or income. Thus, in order to maximize his/her
satisfaction, the consumer has to be rational.

2. Utility is cardinally measurable. According to the cardinal approach, the utility or

satisfaction of each commodity is measurable. Utility is measured in subjective units
called utils.

3. Constant marginal utility of money. A given unit of money deserves the same value at
any time or place it is to be spent. A person at the start of the month where he has received
monthly salary gives equal value to 1 birr with what he may give it after three weeks or so.

4. Diminishing marginal utility (DMU). The utility derived from each successive units of a
commodity diminishes. In other words, the marginal utility of a commodity diminishes as
the consumer acquires larger quantities of it.

5. The total utility of a basket of goods depends on the quantities of the individual
commodities. If there are n commodities in the bundle with quantities X , X ,...Xn 1 2 , the
total utility is given by TU = f ( n X , X ......X 1 2 ).
 1. Cardinal utility approach

There are two important utility concepts under cardinal utility.

A. Total Utility
B. Marginal Utility

I. TOTAL UTILITY(TU) = the total satisfaction received from

consuming goods or services and it depends on quantities of
goods consumed.

Total utility of N goods is a function of quantities consumed:

TU=f(Q1,Q2,…,Qi,…,QN), i=1,2,..,N
TU –total utility,
Qi–quantity consumed of good i, i–good.
II. Marginal utility- is extra satisfaction a
consumer derives from consuming one
more unit of a product.

 It is the level of utility obtained from the

consumption of each additional
consumption of

Mu = dTu/dQ = ∆Tu/ ∆Q
 II Marginal Utility(MU)
It is the change in TU caused by changing
consumption of a good by one unit, holding
consumption of all other goods fixed.

Marginal utility measures the additional

satisfaction obtained from consuming one
additional unit of a good.
Total and Marginal Utility
MU
• In this example, the marginal utility of the first
glass of water is greater than that of the third
glass.

• As each glass of water is consumed, the

marginal utility (desire for one more)
diminishes.
 Relationship between Total Utility and
Marginal Utility
Number of slices of pizza Total Utility Marginal Utility

0 0 --
1 10 10
2 15 5
3 19 4
4 21 2
5 22 1
6 22 0
7 20 -2
• Total Utility = Sum of all Marginal Utilities

1. Draw graph (TU and MU curves) referring

the previous table.
 Relation between TU &MU
 TU increases as long as marginal utility is
positive .
  TU is maximum when MU is zero.
  TU starts declining when MU becomes
negative.
Law of Diminishing Marginal Utility (LDMU)

This low states that each additional unit of a

good eventually gives less and less extra utility
than the previous additional unit.
It means a decrease in enjoyment with
increased consumption.
Each successive increase in consumption of a
product or service provides less additional
enjoyment than the previous increase.
Assumption of the Law of Diminishing Marginal Utility

1. Various units of the goods are homogeneous.

2. There is no time gap between the
consumption of different units.
3. Consumer is rational (Maximizing utility)
4. Test , preference and fashion remain
constant.
No of Bread TU MU
1 5 5
2 9 4
3 12 3
4 14 2
5 15 1
6 15 0
7 14 -1
 Exercise Fill the boxes of TU
Q TU MU
0 --
1 6
2 3
3 1
4 0
5 -1
 Equilibrium of a Consumer
• Assume- A world of one commodity
A consumer has two choices in a market
regarding his limited income
1. He buys a commodity and consumes
2. Not to buy and put aside his money
If he buys, the satisfaction gained by each
additionally bought quantities must be equal
to the pain felt in paying the price.
 Cont…
 Mux = Px → Mux - Px = 0 or Mux/Px = Px/Px
• → Mux/Px = 1
Mux/Px = Px/Px
 If Mux > Px → ↑satisfaction by purchasing more
units of X.
 If Mux < Px → ↑satisfaction by cutting down the
quantity of X and by keeping more of his money
unspent.
 Thus, the consumer attains the maximum of his
utility when Mux = Px .
 A world of two commodities
If we assume that the consumer consumes only two products, say, X
and Y, then the following condition should fulfill in equilibrium:

MU x = MU y or MU=x Px
Px Py MU y Py
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.
 
 Cont…
 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.
 The law of equi - marginal utility
• The law of equi - marginal utility states that a customer gets
maximum satisfaction when the ratio of MU of all
commodities and their prices is equal.

• Mathematically , the conditions of equilibrium as follows:

MU x/P x = MU y/P y = ……= MU n/P n
Where ,MU x = Marginal utility of commodity x
MU y = Marginal utility of commodity y
MU n = Marginal utility of commodity n
P x = price of x
p y = price of y
p n = price of n
 Income and Expenditure
Expenditure on x + Expenditure on y + ... + Expenditure on n = Consumer’s Income
or
Px× Qx+ Py× Qy+ ... + Pn× Qn= I
Where,
 Qx, Qy and Qn are quantities of commodities x, y
and n, respectively
 I = consumer’s income
 Exercise 1
Given
 Suppose there are two commodities x and y.
 Px = Birr 3 per unit; Py= Birr 2 per unit;
 I= consumer’s income = Birr 29.
 Marginal utilities of x and y are given in coming Table A.
Questions
i. Fill the Mu and Mu/P for good x and good y
ii. Find the best combination of x and y that maximizes utility
iii. Find the total utility that the consumer derives from the of
combination
 Table A
UNITS TUX MUX MUX /Px
TUY MUY MUY /PY

Px = 3 PY = 2

1 24 24 8 20 20 10
2 45 21 7 38 18 9
3 63 18 6 54 16 8
4 78 15 5 68 14 7
5 90 12 4 80 12 6
6 99 9 3 90 10 5
7 105 6 2 98 8 4
 Solution
MU y
MU x = OR MU x = Px
Px Py MU y Py
 A consumer reaches his/her equilibrium position when he/she has maximized the
level of his/her satisfaction, given budget constraints(birr 29).

 The combination of the two goods must correspond to the maximum

budget that the consumer has.
 PxQx+ PyQy = M(29)
 At equilibrium, the consumer spends birr 29
 The maximum units that the consumer consumes are 5 units of X
and 7 units of Y. Because 5 * 3 + 7 * 2 = birr 29
• The total utility that the consumer derives from this combination is:
• TU= TUx + TUy
• TU= 90 + 98
• TU= 188
 Exercise 2
Given
 Suppose there are two commodities x and y.
 Px = Birr 2 per unit; Py= Birr 3 per unit;
 I= consumer’s income = Birr 17.
 Marginal utilities of x and y are given in coming Table B .
Questions
i. Fill the Tu and Mu/P for good x and good y
ii. Find the best combination of x and y that maximizes utility
iii. Find the maximum utility that the consumer derives from the
combinations of the two goods.
 Table B
UNITS TUX MUX MUX /Px
TUY MUY MUY /PY

Px =2 Px =3

1 16 36
2 14 33
3 12 30
4 6 27
5 4 24
6 3 21
 Ordinal utility approach/Theory
The ordinal theory suggests that utility is only
relatively discernible but not quantifiable, not
measurable
 Utility can only be ranked by an order or a scale
of preference to show the degree of willingness
of a consumer
Since it uses indifference curves to study the
consumer behavior, the ordinal utility theory is
also known as the indifference curve approach.
Assumptions of Ordinal Utility Theory
1. Rationality: A consumer aims to maximize her/his
utility (subject to income and prices) under
conditions of certainty.
2. Complete Ordering: All possible combinations of
goods can be ordered into preferred, indifferent or
inferior combinations when compared to a given
combination of the good.

3. Consistency: This condition requires that if a

consumer prefers bundle A to bundle B, he/she does
not, at the same time, prefer bundle B to bundle A.
 Cont…
4. Transitivity: If consumer prefers bundle A to B and B to C, she/he
prefers A to bundle C.
5. Non-satiation: A bigger bundle is preferred to a smaller bundle.

Example: If 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.

6. Diminishing Marginal Rate of Substitution: This means that as the

consumer substitutes more and more of one commodity (say X) for
another commodity (say Y), he will be prepared to give up lesser
units of the later (Y) for each additional unit of the former (X).
 Indifference Set, Curve, and Map
An indifference set (iso-utility set)
• It refers to a table that shows various
combinations of two goods which give equal
level of satisfaction (utility) to the consumer.
 Cont…
Indifference Curve
 graphical expression combination of goods
for which the consumer has equal level of
utility
Indifference Map
 is a set of indifference curves
 Each successive curve to the right represents
higher level of utility.
 An indifference set (iso-utility set)

Combination Good X (units) Good Y (units)

A 1 10
B 2 7
C 3 5
D 4 4
 Cont…
The consumer gets equal satisfaction from all the four
combinations, namely A, B, C and D of good X and
good Y.
Thus the consumer is indifferent whether she/he
consumes combination A, B, C or D
At combination ‘A’, he has 1 unit of good X and 10
units of good Y; at combination ‘B’ he has 2 units of
good X and 7 units of good Y and so on.

 In order to have one more unit of good X he has to

sacrifice some amount of the good Y in such a way
that there is no change in the level of his satisfaction
from each of these combinations.
 Indifference Curve(Iso-utility 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.
 Cont…
• It is the locus (the set of all points on a curve
satisfying given conditions) of points, each
point representing a different combination of
two goods, which yield the same level of
satisfaction to the consumer so that he/she is
indifferent between these combinations.
 Indifference Curve(Iso-utility curve)

Good Y

10

5
•
• 4

1 2 3 4 5

Good X
Different points A, B, C and D on indifference
curve IC show the combinations of good X and
good Y which give equal satisfaction to the
consumer.
An indifference curve is also known as
Iso-Utility Curve or Equal-Utility Curve.
 Indifference Map
An indifference map is a group or set of indifference
curves, each one of which represents a given level
of satisfaction.

Each indifference curve represents a different level

of satisfaction.

All points on a particular indifference curve indicate

alternative combinations of good X and good Y that
give the consumer an equal level of satisfaction.
• The farther the curve is from the origin, the
higher is the level of satisfaction it represents.
 Indifference Map

Good Y

IC4
IC3
IC2
IC1

Good X
 For example, IC3 is a higher indifference curve
than IC2 , which means that all points on IC3
yield a higher level of satisfaction than the
points on IC2.
 Note that an indifference map represents the
preference pattern of the consumer.
 Exercise
1. Identify and explain properties of Indifference
Curve
 Properties of Indifference Curve
1. Indifference curves slope downwards form left
to right.
2. Indifference curves are convex to the origin.

3. Indifference curves cannot intersect each other.

4. A higher indifference curve represents higher

level of satisfaction than the indifference curve
at the lower level.
 Indifference set (Schedule)

Schedule –I Schedule –II

Goods ‘X’ Goods ‘Y’ Goods ‘X’ Goods ‘Y’
1 15 1 17
2 11 2 14
3 8 3 11
4 6 4 8
5 5 5 6
 Indifference curves slope downwards from left to right

  This property implies that an indifference

curve has a negative slope which means that
when the amount of one piece of goods in the
combination is increased, the amount of the
other good is reduced.
 So that the loss of satisfaction by giving up
the first good is compensated for the gain the
satisfaction by additional unit of the other
good.
 Indifference curves are convex to the origin

The property of indifference curve being

convex to the origin follows from the
assumption of diminishing marginal rate of
substitution.
According to the principles of diminishing
marginal rate of substitution, it is assumed
that the consumer will be prepared to give up
less and less of goods Y for each additional
unit of X.
Marginal rate of substitution(MRS)
MRS – is rate by which the consumer is willing
to give up a good so as to obtain more of
another good, holding total utility constant
 MRSxy =  Y /  X =
 The number of a good Y that had to be given
up for each unit of good X to maintain the
same level of utility declines, along the
indifference curve.
Combinations Good X Good Y MRSXY

A 2 20

B 4 10 5

C 6 6 2

D 8 4 1
 Y 20  10 10
• MRS = X = 24
= 2
=5
• As the consumer moves from A to B, he is willing to
sacrifice 10 units of good Y to get 2 units of
good X.
 In the beginning the consumer gives up 10 units of Y for 2
units of X or 5 units of Y for the gain in one additional unit of
X.

 It follows that he gives up 4 units of Y for 2 units of X or 2

units of Y for an additional unit of X.
 Later on 2Y for 2X OR 1Y for 1X and so on.

MRS xy diminishes as more and more of X is

substituted for Y.
• Thus the convex indifference curves are
consistent with the principle of diminishing
MRS xy.

• What if indifference curve was concave to the

origin.
• Marginal rate of substitution is the rate at
which a consumer is willing to substitute one
commodity for another in consumption.
 The Budget Line or Iso-Expenditure Line

A good is demanded by the consumer if he/she has:

 a preference for that good --indifference curves
 purchasing power to buy the good --money income
and market prices of the goods.

 His preference pattern is represented by a set of

indifference curves (indifference map), while his
purchasing power depends upon his money income
and market prices of the goods.
 Assume that the consumer has allocated some
money to be spent on goods X and Y, whose
prices are Px and Py

 Then his/her purchasing power can be

represented in terms of a budget equation:

• E = Qx · Px + Qy · Py
 The budget equation gives us a budget line.
 Let a consumer have
 E = Birr 2,000,
 PX = Birr 50 and
 PY = Birr 40.

The maximum amount of X which he can buy can be found

from his budget equation:
2000 = 50(QX) + 40(0) or QX = 40
• Similarly, we find that the maximum amount of QY= 50.
B (0,E/Py)

Budget line

A ( E/Px, 0)
• The vertical intercept, E/Py, illustrates the
maximum amount of Y that can be purchased
with income E

• The horizontal intercept, E/Px, illustrates the

maximum amount of X that can be purchased
with income E
 Definition of Budget Line
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.

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).
 Slope of the Budget Line
The slope of the budget line AB
• The slope indicates the rate at which the two
goods can be substituted without changing
the amount of money spent
Effect of Change in Income/Price of Goods

The Effects of Changes in Income

 An increase in income causes the budget line
to shift outward, parallel to the original line
(holding prices constant).

 Can buy more of both goods with more

income
• How about when an income tax is raised?
Changes in Income

E=br100 E= br200 E=br300

 The Effects of Changes in Prices

If the price of one good increases, the budget line

shifts inward, pivoting from the other good’s
intercept.
If the price of good X increases and you buy
only good X (x-intercept), then you can’t buy as
much good Y. The x-intercept shifts in.
If you buy only good Y (y-intercept), you can
buy the same amount.
No change in y intercept.
Px= 4 Px= 2 Px= 1
A consumer shall be in equilibrium where
she/he can maximize her/his utility, subject to
her/his budget constraint.

In other words, where the indifference curve

and the budget line are tangent to each other
(that is, their slopes are equal) the consumer
will attain equilibrium.
We have established the two components of choices:

 Budget constraints (represented by budget line)

 Preferences (represented by indifference curves).

 The individual needs to choose a consumption bundle:

 the amount of x1 and y1 that a buyer most prefers, given budget constraint.

Since higher indifference curves are more preferable, she will choose the
highest indifference curve possible.

Typically, the individual's choice of consumption bundle is where the

indifference curve is tangent to the budget line, as illustrated on the next side.
 Consumer equilibrium under indifference curve approach

Y1 A

Buyer’s choice of Y B

C
Indifference Curve C

Buyer’s choice of X X1
• The maximizing market basket must satisfy
two conditions:
1. It must be located on the budget line
They spend all their income – more is better
2. It must give the consumer the most preferred
combination of goods and services
 Graphically, we can see different indifference curves
of a consumer choosing between good Y and good X.

 Remember that indifference curve B > A > C.

 B is the highest utility but not affordable.

 Consumer wants to choose highest utility within their

budget; that is, indifference curve A.
Any consumption bundle on indifference curve B is
not attainable.

The consumer does not have enough money.

Any indifference curve below A is not preferred

because people like more stuff.

Point A and C are not preferred because they lie on

lower indifference curve than (where point B lies).
Point of Tangency: When the budget
constraint and the indifference curve are
tangent, this by definition means their slopes
are the same.
 So,

Slope of budget line(Y1X1) = Slope of indifference curve(at point B)

 Graphically, we can see different indifference curves
of a consumer choosing between good Y and good X.

 Remember that indifference curve B > A > C.

 B is the highest utility but not affordable.

 Consumer wants to choose highest utility within their

budget; that is, indifference curve A.
Any consumption bundle on indifference curve B is
not attainable.

The consumer does not have enough money.

Any indifference curve below A is not preferred

because people like more stuff.

Point A and C are not preferred because they lie on

lower indifference curve than (where point B lies).
 Point of Tangency: When the budget constraint and
the indifference curve are tangent, this by definition
means their slopes are the same.
 So,

Slope of budget line(Y1X1) = Slope of indifference curve(at point B)

Slope of budget line = (price ratio of X and Y)

Slope of indifference curve = MRS =

At equilibrium point E, =
Therefore, it can be said at consumer’s
optimal consumption point,
 Cont…
It can be said that satisfaction is maximized
when marginal rate of substitution is equal to
the ratio of the prices of X and Y.

Note this is ONLY true at the optimal

consumption point
 Optimum (equilibrium)
• Mathematically, consumer optimum
(equilibrium) is attained at the point where:
• Slope of indifference curve = Slope of the budget line
• That is at point of tangency

• MRSXY =

MU x Px
• =
MU y Py
 Exercise
Example 1.
Assume that a consumer consumes two goods X and Y and
has the utility function
U(X,Y) = XY + 4X
• The prices of the two goods are birr 8 and birr 4
respectively.
• The consumer has a total income of birr 40 to be spent on
the two goods.
Questions
a) Find the utility maximizing quantities of good X and good Y.
b) Find the X Y MRS , at equilibrium.
Given
PX = birr 8
PY = birr 4
Income (M) = birr 40
Solution for a
a. The budget constraint of the consumer is
given by:
• PX .X+ PY.Y = M
• 8X+4Y= 40 …………….…………. (i)
MU x Px
=
MU y Py
U
MUX 
X
U
MUY 
Y

= = 4/2 = 2

= 2

Y = 2X – 4 ………….………… (ii)
Substituting equation (ii) into (i), we obtain Y = 3 and X = 3.5
 U/¶X

• Utility maximizing quantities of good X and

good Y are 3.5 units of X and 3 units of Y.
Solution for b
MU x
MRSXY = = = = 2
=MU
y

At the equilibrium, MRS can also be calculated as the ratio of the prices of the two goods
Px
MRSXY = =
Py