Teaching PowerPoint Slides - Chapter 4

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T), 2013 4– 1

CHAPTER 4
THEORY OF CONSUMER
BEHAVIOUR

DEFINITION OF CONSUMER
BEHAVIOUR
Consumer behaviour refers to

the study of consumer while
engaged in the process of
consumption.

UTILITY APPROACH
 Definition
– ‘Utility’ means the satisfaction obtained from consuming a
commodity.
 Two Types of Approach
– Cardinal Approach
• The cardinal utility theory says that utility is measurable and by
placing a number of alternatives so that the utility can be added.
• The index used to measure utility is called utils.
– Ordinal Approach
• The ordinal utility theory says that utility is not measurable but it
can be compared.
• Ordinal approach uses the ranking of alternatives as first, second,
third and so on.

TOTAL UTILITY AND MARGINAL
UTILITY
TOTAL UTILITY (TU)
The total satisfaction that a person gets from the
consumption of goods and service.
MARGINAL UTILITY (MU)

The additional to total utility as a result of consuming one more units
of the same good or services.
Marginal Utility (MU) = Change in Total Utility
Change in Total Quantity
MU = TU/ Q


LAW OF DIMINISHING
MARGINAL UTILITY
 Definition
The additional benefit which a person derives from a
given increase of a stock of a thing diminishes, other
things being equal, with every increase in the stock that
he already has.
OR
Law of Diminishing Marginal Utility states that as
consumption increases more and more, marginal utility
will be less and less.

LAW OF DIMINISHING MARGINAL
UTILITY (cont.)
TU increases from consumption of 1st unit of apple until the 5th
unit of apples. After the 5th unit of apples, TU will decrease.
Units of Total Utility Marginal Utility
Apples
1 20 20
2 35 15
MU will decrease
3 45 10 and become zero at
the 5th unit of apples
4 50 5
and further
5 50 0 consumption of
6 45 -5 apples will not
satisfy the consumer
7 35 -10 as the MU shows
8 20 -15 negative signs.

LAW OF DIMINISHING
MARGINAL UTILITY (cont.)
When TU is increasing, MU will be positive.
When TU is at its maximum, MU will be zero.
When TU is decreasing, MU will be negative.

LAW OF EQUI-MARGINAL
UTILITY (EMU)
 Definition
The Law of Equi-Marginal Utility (EMU) states that
other things being equal, a consumer gets maximum
satisfaction when he allocates his limited income to the
purchase of different goods, where the marginal utility
derived from the last unit of money spent on each item
of expenditure tends to be equal.
– This is also known as conditions for maximum utility
or satisfaction.

LAW OF EQUI-MARGINAL UTILITY
(EMU) (cont.)
 Conditions for Equilibrium

For consumer equilibrium, this condition must be fulfilled.
Condition 1: Every ringgit spent on every commodity must

yield the same marginal utility.
Marginal Utility of X = Marginal Utility of Y

Price of X Price of Y
Condition 2: Total expenditure of all goods must be equal to

the total budget allocated to maximize utility.
P1Q1 + P2Q2 + … + PnQn = Total budget

LAW OF EQUI-MARGINAL
UTILITY (EMU) (cont.)
EXAMPLE: Arwin has an income of RM37 and the prices of goods P, Q and R are RM5, RM1 and RM4 respectively.
Condition 1 : Every ringgit spent on every Fulfilling condition 1, two combination of goods are obtained:
commodity must yield the same marginal utility. Combination 1 : 2P, 4Q and 1R
Combination 2 : 4P, 5Q and 3R
Condition 2 : Total Combination 1 : 2P, 4Q and 1R

expenditure of all goods must 2(5) + 4(1) + 1(4) = 18
be equal to the total budget Combination 2 : 4P, 5Q and 3R
allocated to maximize utility. 4(5) + 5(1) + 3(4) = 37
So, 4 units of Product P, 5 units of Product Q and 3 units of Product R will be purchased by
Arwin.

INDIFFERENCE CURVE
 Definition
– An indifference curve represents all the possible
combinations of two goods which will give the same
level of satisfaction.
 Assumptions
1. Scale of preferences
2. Consumers’ preferences are transitivity
3. Rationality
4. Diminishing marginal rate of substitution
5. Concept of ordinal utility

INDIFFERENCE CURVE (cont.)
An indifference schedule is a list of combination of two

goods that give equal satisfaction to the consumer.
Combinations Good Y Good X

A 12 2
B 6 4
C 4 6
D 3 8
E 2 12
The table above shows all the five combinations,

which will give the equal level of satisfaction.

INDIFFERENCE CURVE (cont.)
An indifference curve represents all those combinations of two goods;

X and Y which yield the same level of satisfaction to a consumer.

INDIFFERENCE MAP
An indifference map shows a set of indifference curve.
The higher the indifference curve from the origin, higher will be the utility.
IC3 has the higher satisfaction.

INDIFFERENCE CURVE
 Marginal Rate of Technical Substitution

– Refers to the rate at which one good is substituted for another
good.
 Characteristics of Indifference Curve

1. Indifference curve slopes downward from left to right.
2. Indifference curve are convex to the origin.
3. Higher indifference curves represent higher level of satisfaction.
4. Indifference curve never intersect each other.
5. Indifference curve does not touch the Y axis or X axis.

BUDGET LINE
A budget line represents various combinations of two goods, which can be

purchased with a given amount of money at the given price of each unit.

CHANGES IN BUDGET LINE
1. Change in Consumer’s Income
An increase in consumer’s income will lead to a shift of the budget line to the right, A1B1.
A decrease in consumer’s income will shift the budget line to the left as represented by A 2B2.

(cont.)
2. Change in Price of Good X
Budget Line Budget Line
30 30
25
20 20
Good Y
15 AB
Good Y
A 1 B1 AB
10 10
5
A1B1
0 0
2 4 6 8 10 12 14 2 4 6 8 10 12 14 16 18 20 22 24
Good X Good X
Good X
Price of good X increase from RM1 to Price of good X decrease from RM1 to
RM2 and price of good Y constant. RM0.50 and price of good Y constant.

(cont.)
3. Change in Price of Good Y
Budget Line Budget Line
30 30
25 25
20 20
Good Y
Good Y
15 AB 15 AB
AB1 AB1
10 10
5 5
0 0
2 4 6 8 10 12 14 2 4 6 8 10 12 14
Good X Good X
Price of good Y increase from RM0.50 Price of good Y decrease from RM0.50
to RM1 and price of good X constant. to RM0.40 and price of good X constant.

CONSUMER EQUILIBRIUM
A consumer is in equilibrium when he or she is consuming the best possible
combination of two goods with the given amount of income.
At point b, and e, the consumer will

have a lesser satisfaction at IC 3
with the same amount of income
Consumer equilibrium is reached when

indifference curve tangent with budget
Line which represents best combination
of two goods with limited income
as point C.

INCOME, PRICE AND
SUBSTITUTION EFFECT
 INCOME EFFECT
– The income effect is defined as the effect on the purchases of
the consumer caused by changes in income with prices of goods
remaining constant.
 PRICE EFFECT
– Price effect explains what happens to the consumers’
equilibrium position when the price of one good changes while
the price of another good and other factors remains constant.
 SUBSTITUTION EFFECT
– Substitution effect explains what happens to the consumers’
equilibrium position when the price of both good changes—price of one
rises and price of another falls while other factors remains constant.

CONSUMER SURPLUS
Consumer surplus is defined as the excess of what

a consumer is willing to pay and what he/she actually pays.
Example : Suppose Sally who is fond of chocolates is ready to pay for each successive bar
of chocolate as shown in table below. Assume that Sally is willing to pay lower price for the
successive bar of chocolates. Assume the market price of one bar of chocolate is RM1.00.
CONSUMER SURPLUS = TOTAL VALUE – (MARKET PRICE x NUMBER OF UNITS CONSUMED)
Price (RM)
Bars of
1 2 3 4 5
chocolate
2.50
CONSUMER SURPLUS Price (RM) 2.50 2.00 1.50 1.00 0.80
Consumer surplus = (2.50 + 2 + 1.50 + 1) – (1 x 4)

1.00
= RM3.00
DD
Quantity
0
4


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PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 4– 1

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Consumer behaviour refers to

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

MARGINAL UTILITY (MU)

Marginal Utility (MU) = Change in Total Utility

Change in Total Quantity

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

 Conditions for Equilibrium

Condition 1: Every ringgit spent on every commodity must

Marginal Utility of X = Marginal Utility of Y

Condition 2: Total expenditure of all goods must be equal to

P1Q1 + P2Q2 + … + PnQn = Total budget

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Condition 2 : Total Combination 1 : 2P, 4Q and 1R

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

An indifference schedule is a list of combination of two

Combinations Good Y Good X

The table above shows all the five combinations,

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

An indifference curve represents all those combinations of two goods;

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

An indifference map shows a set of indifference curve.

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

 Marginal Rate of Technical Substitution

 Characteristics of Indifference Curve

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

A budget line represents various combinations of two goods, which can be

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

1. Change in Consumer’s Income

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Budget Line Budget Line

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Budget Line Budget Line

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

At point b, and e, the consumer will

Consumer equilibrium is reached when

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Consumer surplus is defined as the excess of what

Consumer surplus = (2.50 + 2 + 1.50 + 1) – (1 x 4)

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

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