Professional Documents
Culture Documents
. 1
INTRODUCTION
• The theory of consumer behavior is the concern of
how consumers decide on the basket of goods and
services they consume in order to maximize their
satisfaction.
example, drug.
human wants. . 4
Cont…
It is the satisfaction or subjective pleasure that one
What is utility?
. 5
Cont..
Properties Of Utility
A.‘Utility’ and ‘Usefulness” are not synonymous.
– E.g. Paintings by Picasso may be useless
functionally but offer great utility to art lovers.
– Hence, usefulness is product centric whereas
utility is consumer centric.
B. Utility is subjective: The utility of a product will
vary from person to person.
. 6
Cont…
– For example, non-smokers do not derive any
utility from cigarettes
7
Major assumptions of TCB
1. The consumer is rational: - given his/her income and the
market price of the commodities, he/she plans the spending
of his/her income.
2. The goal of the consumer is to maximize his utility
3. The non-satiation assumption (more is better than less)…
Utility decreases as a consumer moves further away from
the best combination
4. The consumer has complete knowledge of all the
information relevant to his/her
.
decision; price, income
Approaches to consumer optimum
B. Cardinal Utility: The utility of each commodity is measurable and the most
D. Limited money income of the consumer and all is income is spent in the
consumption process.
G. Utility is also additive, i.e., Total Utility (TU) = U (X1) + U (X2) +U (X3) ……+U ( Xn )
• Then TU = U1+U2+U3+U4. . 11
Cardinal Utility (cont…)
• Marginal Utility (MU) : Total utility derived from, the last
unit of a commodity consumed.
• It is the change in the total utility resulting from a unit
change in commodity consumed
• It is the slope of total utility function,
• MU = TU/ Q
– TU = Change in Total Utility
– Q = Change in quantity consumed
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Cardinal Utility (cont…)
• Utility Schedule for banana
Quantity of 0 1 2 3 4 5
Banana
Consumed
Total 0 3 8 10 11 11
Utility (TU)
Marginal Utility - 3 5 2 1 0
(MU)
. 13
Graphical representation of total utility
TU
1
2 0
11
8 3
6 5
4
2
O 1 2 3 4 5
.
Quantity 14
Graphical representation of total utility
TU
11
8
TU
6
4
2
O 1 2 3 4 5
.
Quantity 15
Marginal Utility (cont…)
Utility
Marginal utility
0 5
Quantity
. 16
The Law Diminishing Marginal Utility:
Utility
Px (Mum)
E
MUx
X Quantity of X
. 20
• If MUx > Px, the consumer can increase his/her
welfare by purchasing more unit of X, and
• if the MUx < Px, welfare can be increased by
reducing the consumption of X.
. 21
Consumers Equilibrium: More Than Two Commodities
MU X 1 MU X 2 MU X n
......... MU m
PX1 PX 2 PX n
And Total expenditure = total income
22
cont.…
. 25
Ordinal Utility Approach
a) Strict preference
B) Weak preference
C) Indifference
28
Other Properties of preference
• Completeness: any two bundles can be compared by
a consumer
Orange (X) 1 3 5 7
Banana (Y) 23 15 9 6
Banana (Y)
10 A
Indifference
6 B Curve (IC)
2 C
D
1
1 2 4 7 Orange(X)
Good B
Indifference map
IC3
IC2
IC1
Good A
Indifference Map: It is a set of indifference curves with different levels of
satisfaction
Properties of Indifference Curves:
C
B IC2
IC1
Orange
Orange (X) 1 3 5 7
Banana (Y) 23 15 9 6
Y 8
MRS X ,Y (b / n points A and B) 4
X 2
. 39
Marginal Utility and Marginal rate of Substitution
• MRS is also equals to the ratio of MU of
commodities involved in the utility function.
MU X
MRS X ,Y
MU Y
Proof:
Suppose the utility function for two commodities X and Y is defined as:
U f ( X ,Y )
MRS ( Cont…)
• Since utility is constant on the same indifference curve:
U f ( X ,Y ) C
• The total differential of the utility function is
U U
dU dX dY 0
X Y
MU X dX MU Y dY 0
• Since there is no change in utility for any movement along
the same indifference curve , dU=0
The relationship b/n MRS and MU
MU X dY
MRS X ,Y
MU Y dX
Exceptional Indifference Curves
• indifference curves are convex to the origin and
downward sloping
• However, the shape of the indifference curve reflects the
degree of substitution between the two commodity
• The shape of an indifference curve might be different if the
relationship between two commodities is unique
• Perfect substitutes: perfect substitutes are goods which can
be replaced for one another at a constant rate.
. 42
Exceptional IC (Cont …)
• Perfect substitutes: the indifference curve is a
straight line with negative slope, as shown in
Figure 41 because the MRSXY is constant.
Total
IC3
IC2
IC1
Mobile
. 43
Exceptional IC (Cont …)
• Perfect complements: perfect complements are
goods which are to be consumed jointly at a
constant rate
• If two commodities are perfect complements the
indifference curve takes the shape of a right angle (L
–shape)
• Graphically it is shown as follows.
. 44
Exceptional IC (Cont …)
• Perfect complements
Right shoe
IC3
(3,3)
IC2
(2,2)
IC1
(1,1)
Left shoe
. 45
Exceptional IC (Cont …)
• A useless good: This shows the relationship between
useless good and another normal good.
• A good example is outdated book and food.
• since the outdated books are totally useless, increasing their
purchases does not increase utility.
• The person enjoys a higher level of utility only by getting
additional food consumption
• The indifference curve in this case will have a vertical one
. 46
Exceptional IC (Cont …)
• IC involving a useless good(Y axis)
Food
. 47
Indifference curve of a bad and good commodity
•Bad and good Commodity IC( Y-axis):IC a consumer prefer less of bad commodity and more of
good commodity
Bad Good(Y)
IC
Y2
Y1
X1 X2 Good Commodity(X)
price?
optimization approach
consumption point . 50
Budget Line (Cont…)
• This limitation is called budget constraint
Assumptions
2 X 4Y 60 . 52
Three areas of a budget line
• The Budget Line
Three areas of a budget line
• Inside…feasible but
inefficient
M/PY
B • On the line… feasible and
efficient
• Outside…..not feasible
A
M/PX
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Factors Affecting the Budget Line
M2/Py
Mo/Py
M1/Py Bo B2
B1
Where M2>Mo>M1
Effects of Changes in Price of the commodities
M/Px1 M/Px2 X
Effects of Changes in Price of the commodities
Y
M/Py2
M/Py1
X
M/Py
Optimum of the Consumer
• A consumer reach at optimum when he chooses the quantity
that maximizes his utility given his income and market
prices of commodities
• This occurs when an IC is tangent to the budget line
• At the point of tangency the slope of the indifference curve
(MRSxy) is equal to the slope of the budget line
MRS X ,Y PX / PY
. 58
Consumer’s Optimum (Cont…)
Consumer optimum
Y
E
Y*
IC4
IC3
IC1 IC2
X* X
Mathematical derivation of equilibrium
( PX X PY Y M ) 0
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Consumer’s Optimum (Cont…)
C) Form a composite function or the Lagrange function:
U ( X , Y ) ( M PX X PY Y )
U ( X , Y ) ( PX X PY Y M )
D) The first order condition for maximum requires that
the partial derivatives of the Lagrange function with
respect to the two goods and the Lagrangian constraint
be equals to zero.
U U
PX 0 ; PY 0 and ( PX X PY Y M ) 0
X X Y Y
From the above equations
we obtain: U U
PX and PY
X Y
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Consumer’s Optimum (Cont…)
MU X MU Y
PX PY
MU X PX
By rearranging we get:
MU Y PY
. 63
Consumer’s Optimum (Cont…)
E) The second order condition for maximum requires
that the second order partial derivatives of the
Lagrange function with respect to the two goods
must be negative.
2 2 2 2
U U
2
2
0 and 2
2
0
X X Y Y
. 64
Consumer’s Optimum (Cont…)
Example 1: A consumer consuming two commodities X
and Y has the following utility function. U =X2Y2 and the
price of the two commodities are Birr 1 and 4
respectively and his/her budget is birr 10.
i. Find the quantities of good X and Y which will maximize
utility.
ii. Total utility at optimum point
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Since both X and Y increased as income increase this shows the case of normal goods
Commodity Y
ICC
E3
Y3
E2
Y1 E1
X1 X3 Commodity X
Effects of Income Changes (Cont …)
. 70
the income –consumption curve when good X is inferior
Y
ICC
Y3
Y2
Y1
X
X1 X1 X3
the income –consumption curve when good y is inferior good
Y3
Y1
ICC
X1 X3 X
Effects of Income Changes (Cont …)
PCC
E3
E2
E1
M M’ M’’ X
PCC
Commodity X
Price of
X Px1
Px2
Individual
Px3
demand curve
X1 X2 X3
Commodity X
Income and Substitution effects of a price change
. 79
Suppose the consumer is at equilibrium at point A consuming X1 unit of X
C
P R IC2
Point Q represents imaginary
equilibrium
Q IC1 The movement from P to Q and a
resulting increase in demand by X1 to X2
is due to substitution effect.
SE change
The TE can be split into SE and IE by drawing imaginary budget line CC’
Where:
X1X3= NE=Net effect Point Q represents imaginary equilibrium
X1X2= SE=Substitution effect
X2 X3= IE=Income effect The movement from P to Q2 and a
Y resulting increase in demand by X1X3
is substitution effect.
A
X1 X2 X3 X
IE
NE
SE
• In this case we observe that,
demanded
of a commodity decreases.
The f/f graph shows the substitution .and income effect of Giffen goods
87
Suppose the consumer is at equilibrium at point P
consuming X1 unit of X
Y
A
R When price of X falls while other
IC2 things remain unchanged
C The budget line will shift from AB
P to AB’
Q •A consumer move to a new
IC1 equilibrium point at point R
B’
B C’ consuming X3 units
X3 X1 X 2 X •The movement from P to R is
SE
NE Total Effect or Net effect of price
change
IE
The TE can be split into SE and IE by drawing imaginary budget line CC’
. 90
The End!!!
. 91