THEORY OF CONSUMER BEHAVIOUR

Consumer behavior
The study of individuals, groups, or organizations and all the
activities associated with the purchase, use and disposal of goods
and services to satisfy their needs and wants.
The process whereby individuals decide whether, what, when,
where, how, and from whom to purchase goods and services.
The study of the buying units and the exchange processes
involved in acquiring, consuming, and disposing of goods,
services, experiences, and ideas.
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 THEORY OF UTILITY AND PREFERENCES
 Theory of utility: is the amount of satisfaction that you will get from
the consumption of a product or service
 Consumer preferences: is an individual / house holds who uses/
consumes final goods and service with a primary objective of
maximizing utility.
 The consumer preferences are divided into:

 Strict preference

 Weak preference

 Indifference preference

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 Cont.……
i. Strict preference
 Given any two consumption bundles X and Y, if X > Y or if he
chooses X when Y is available the consumer, definitely prefers the X-
bundle than Y.
ii. Weak preference
 Weak preference means either strict preference or indifference.

 Given any two consumption bundles X and Y, if the consumer is

indifferent between the two commodity bundles, the consumer
would be equally satisfied if he consumes X or Y,.

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 Cont.……
iii. More is better than less
 Consumers always prefer more of any good to less and they are never
satisfied.
 However, bad goods are not desirable and consumers will always
prefer less of them.
 In defining strict preference, the consumer preferred bundle X to
bundle Y if and only if the utility X is larger than the utility of Y.

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 Approaches to measure Utility
Two approaches:
a) Cardinal and
b) ordinal approaches.
The Cardinal Utility theory
Utility can be quantitatively measured like weight,
height, & temperature with a unit of measurement of
satisfaction called utils.
A util is a cardinal number like 1,2,3 etc simply attached to
utility.
It is a hypothetical satisfaction unit measuring .
 Assumptions of Cardinal Utility theory
A. Rationality of consumers

 It means that the consumers consume first a commodity which yields the

highest utility and the last which gives the least.

B. Utility is cardinally measurable

 The satisfaction of each commodity is measurable.

C. Constant marginal utility of money

 The MU of money remain constant with the level of income (wealth) of

the consumer.

 A given unit of money deserves the same value at any time or place it is to

be spent. 6
 Cont.….
D. Limited Money Income
 The consumer has limited money income to spend on the goods
and services, he/she chooses to consume.
E. Diminishing Marginal Utility (DMU)
 The marginal utility of a commodity diminishes as the
consumer consumes more quantities of the commodity.

F. 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, X1, X2,
… Xn, the total utility is given by:
TU = f (X1,X2,…Xn ) 7
 Total and Marginal Utility
Total Utility (TU)
Is the total amount of satisfaction a consumer gets from consuming
or possessing some specific quantities of a good at a particular time.

Is the aggregate satisfaction a person receives from the consumption of

all the units of the same good or service. 
Is derived from adding every marginal utility from each additional
unit.
The equation for total utility (TU) is: 
TU= MU-1+Mu-2+MU-3+………MU-N
 Where MU-N is the marginal utility from consuming the N-th unit of a
good.
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 Marginal Utility (MU)
It refers to the additional utility obtained from consuming an
additional unit of a commodity.

Is the change in TU resulting from the consumption of one more unit

of a product per unit of time.
Graphically, it is the slope of total utility.
Mathematically, the formula for MU is:
MU = ∆TU/∆Q
Where: TU is the change in Total Utility, and
Q is change in the amount of product consumed.
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 Table showing TU and MU of consuming apples (X)

Units of
Quantity
(x)
consumed 0 1st 2nd 3rd 4th 5th 6th
Unit Unit unit unit unit Unit Unit

TUX 0 util 10 16 utils 20 utils 22 utils 22 utils 20 utils

utils

MUX 0 10 6 4 2 0 -2

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Graphically, MU is the slope of total utility.

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 As the consumer consumes more of a goods;

 The total utility increases at an increasing rate (when

MU is increasing);
 Then increases at a decreasing rate (when MU
decrease);
 Reaches maximum (when MU is Zero).
 Decreases (when MU is negative)

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 Limitation of the Cardinalist approach

This approach involves 3 weaknesses:

It is doubtful because utility may not be quantified.

Utility cannot be measured absolutely (objectively).

The assumption of constant MU of money is

unrealistic b/c as income increases, the MU of money

changes.

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 2. The Ordinal Utility Theory
The ordinalist school postulates that utility cannot be
measured absolutely but different consumption
bundles are ranked according to preferences.

Consumer are assumed to be able to rank the various

baskets of goods and services according to the
satisfaction that each bundle gives him/her.

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 Assumptions of Ordinal Utility theory
1. The Consumers are rational
2. Utility is ordinal i.e. utility is not absolutely (cardinally)
measurable.
 Consumers are required only to order or rank their
preference
3. Diminishing Marginal Rate of Substitution (MRS):
 It is the rate at which a consumer is willing to substitute one commodity
(x) for another commodity (y) so that his total satisfaction remains the

same.
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 Assumptions of Ordinal Utility theory----------

4. The total utility of the consumer depends on the

quantities of the commodities consumed, i.e.,
U=f ( X1, X2,…Xn)
5. Preferences are transitive or consistent:
i.e. if the consumer prefers good X to good Y, and
prefers Y to Z, and then the consumer also prefers X to
Z.
The ordinal utility approach is explained with the help
of indifference curves to study the consumer’s
behavior.

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 Indifference Set, Curve and Map

Indifference Set/ Schedule

Shows the various combinations of

goods from which the consumer
derives the same level of utility.

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 Table2.4 Indifference Schedule

Bundle A B C D
(Combination)

Orange(X) 1 2 4 7

Banana (Y) 10 6 3 1

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 Indifference Curves:
 Is the locus of points shows the various
combinations of two goods that provide the
consumer the same level of satisfaction;
 so that the consumer is indifferent as to the
particular combination he/she consumes.

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By transforming the above indifference schedule
into graphical representation, we get an indifference
curve.
10 A

Banana Good B
(Y) Indifference
B
Curve (IC)
6

C
2 IC3
D IC2
1
IC1

1 2 4 7 Good A

OrangeX)) (X)

Indifference curve Indifference map

Fig2.4 indifference curves and indifference map. 21
 Indifference Map:
It is the entire set of ICs, which reflects the entire
set of tastes and preferences of the consumer.

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 Properties of ICs 
a) Are negatively sloped

b) Do not intersect to each other

 If they did, the point of their intersection would
mean two different levels of satisfaction, which
is impossible.

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C) A higher IC is always preferred to a lower
one.
 The further away from the origin an IC lies,
the higher the level of utility it satisfies:
D) Are convex to the origin
E) The slope of an indifference curve
decreases as we move along the curve from the
left downwards to the right.

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 Positively sloped and intersected ICs

Banana B
Banana
E
D IC2
C
A
IC1

Orange Orange X

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 Marginal rate of substitution (MRS)
Marginal rate of substitution is a rate at which
consumers are willing to substitute one
commodity for another in such a way that the
consumer remains on the same indifference
curve.
 It shows a consumer‘s willingness to substitute
one good for another while he/she is indifferent
between the bundles.

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MRS Cont.….

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 The Budget Line
Is a graph indicating d/t combinations of two goods that
a consumer can buy with a given income at a given
prices.

Assumptions to use budget line

 Only two goods, X and Y, bought in quantities X and Y;
 Two prices of goods (Px and Py) of good X and good Y
respectively;
 Fixed income; the consumer has a known and fixed money
income (M).

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 Budget Line Equation
We can express the budget constraint as:
M  PX X  PY Y
Where, PX = price of good X
PY = price of good Y
X = quantity of good X
Y= quantity of good Y
M= consumer’s money income
This means that consumer’s money income is the amount
of money spent on X plus the amount spent on Y.

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 Example:
Suppose a household with 30 Birr per day to
spend on banana(X) at 5 Birr each and Orange(Y)
at 2 Birr each.

o Given: Px = 5, Py = 2 and M = 30birr

o Therefore, our budget line equation will be:

5X + 2Y = 30
From this equation we can have d/t alternative
purchase possibilities of the two goods
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 5X + 2Y = 30
Consumption
A B C D E F
Alternatives
Kgs of banana (X) 0 1 2 3 4 6

Kgs of Orange(Y) 15 12.5 10 7.5 5 0

Total Expenditure 30 30 30 30 30 30

At pt A, the consumer is using all of his /her income for good Y.

Mathematically, it is the y-intercept (0, 15).

And at pt F, the consumer is spending all his income for good X.

It is the x-intercept (6, 0).
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Fig.2.7. Derivation of the Budget Line

M/PY


B

A 

M/PX

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 Factors Affecting the Budget Line
1. Changes in consumer income
If the income of the consumer changes (keeping the
prices of the commodities unchanged), the budget line
shifts (changes).
 upward shift of the budget line if increase in
income;
 downward shift of the budget line if decrease in
income; that leads the consumer to buy less quantity
of the two goods.
 but the slope of the budget line does not changes
when income changes.

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 Fig.2.8 Effects of change in income

M2/Py Where M2>M>M1

M/Py

B B2

M1/Py
B1

M1/PX M/PX M2/PX

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2. Changes in Price of the commodities

Y Y

B1 B1

B
B

X X

Fig.a Fig.b

Fig.2.9 Effects of change in price

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 Changes in the prices of X and Y ;
 shifts the budget line
 changes the intercept of budget
line
 changes slope of the budget
line

But, the proportional change in the

price of the two commodities do not
change the slope of the budget line
if it is in the same direction. 36
Equilibrium of the Consumer
A rational consumer seeks to maximize his
utility/satisfaction by spending his/her income.
This occurs where an IC is tangent to the budget
line so that the slope of the IC is equal to the
slope of the BL

( PX / PY ). =
MRS XY

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Figure2.14 Consumer equilibrium

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1

END!!

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