Chapter 5: Demand and Consumer Behavior

Utility Theory
‡ Utility: Utility means want satisfying Power. A good that gives you Utility is one that has the power to satisfy wants, or that gives you satisfaction. ‡ Example: A Pen has writing ability. ‡ Total Utility is the total satisfaction a person receives from consuming a particular quantity of good. ‡ Also, Total Utility is the summation of all individual utilities to be derived through the consumption of a commodity.

Marginal Utility
‡ Marginal Utility is the additional utility gained from consuming an additional unit of some good. ‡ Marginal Utility is the change in total utility due to a one-unit change in the quantity of a good or service consumed.
change in total utility Marginal utility = change in number of units consumed

Relationship between Total Utility and Marginal Utility Observations: ± Marginal utility falls as more is consumed ± Marginal utility equals zero when total utility is at its maximum .

Relationship between Total and Marginal Utility of Watching DVDs 20 18 Total Utility (utils per week) Total utility is maximized.. 5 14 12 10 8 6 4 2 0 2 3 4 5 6 7 DVDs Watched per Week DVDs Watched per Week . 16 Marginal Utility (utils per week) 10 8 6 4 2 0 1 -2 -4 1 2 3 4 5 6 7 «where marginal utility equals zero..

2. total utility tends to be rising but marginal utility tends to be falling. 3. Total utility tends to be falling when marginal utility is negative. Marginal utility is the additional utility to be derived through the consumption of last unit of a product. Total Utility is the summation of all individual utilities to be derived through the consumption of a commodity. . With the rise in consumption of a product. Total utility is maximum when marginal utility is zero. 4. With the rise in consumption total utility tends to be increasing but at a diminishing rate.Relationship Between Total Utility and Marginal Utility 1.

‡ Utilities are independent:-Marginal utility assumes that utility of different commodities are independent to each other.2 or 3. ‡ Constant Marginal utility of money:-Another important assumption is that the marginal utility of money remains constant.Basic assumptions of Marginal Utility Analysis ‡ Cardinal measurement of utility:.it is possible to draw inference about other person.It is assumed that utility can be measured and can be given definite quantity like 1.This means that a person can express the satisfaction derived from consumption of commodity in quantitative term. ‡ Introspection:-The Marginal utility also assumes that from one¶s experience . .

The law of diminishing marginal utility is based on the idea that if a good has a variety of uses but only one unit of the good is available. .Law of Diminishing Marginal Utility The law of Diminishing Marginal Utility states that for a given time period. the marginal utility gained by consuming equal successive units of a good will decline as the amount consumed increases. then the consumer will use the first unit to satisfy his or her most urgent want.

Diminishing marginal utility curve Assumptions: ‡ Goods are homogeneous. ‡ Consumers are rational. Preferences Fashions remain unchanged. ‡ No time gap between the consumption of the different units. . ‡ Taste. ‡ Income of the consumer is constant.

This can also be shown by graph Units of utility Units of commodity consumed .

For ex:. and if the consumer forced to take more the satisfaction may become zero.Law of Diminishing Marginal Utility It is generally accepted rule of consumption that total utility tends to be increasing and marginal utility tends to be gradually decreasing as with the rise of consumption. Therefore the relationship between rise in consumption of a product and gradual fall in marginal utility of that product is represented by the law often we called the diminishing marginal utility. the first toast gives him great pleasure.Suppose a person starts eating toast.the satisfaction of third is less than that of second and so on. Because with the rise in stock of anything marginal utility of a particular product gradually diminishes. . the additional satisfaction goes on decreasing with every successive toast till it drops down to zero. By the time he taking second he yield less satisfaction .

Further. Any change in income will falsify the law.The law of diminishing marginal utility applies to normal persons and not to eccentric or abnormal persons like misers.In case of rare collections . ‡ Constant income:-it is also essential that the income remains the same.the law does not hold good. ‡ Rare collections:. ‡ No change in consumer¶s tastes:-Another assumption is that the character of the consumers does not change. otherwise law will not apply. ‡ Fashion:. ‡ Normal persons:. ‡ Suitable time:-It is further assumed that the commodity is taken within a certain time. .It is assumed that the commodity is taken in suitable units. fashion utility depends on fashion too.LIMITATIONS OF THE LAW ‡ Suitable units:.

The equation Indifference curve can be written as : U = f(x. This curve is also known as Iso Utility curve and the different point on the curve represents the same level of satisfaction. is the locus of successive indifferent points or combinations which yield equal level of satisfaction. The I.C.Indifference Curve ‡ An Indifference curve is the locus of points indicating particular combinations of goods or the baskets of two commodities from which the consumer derives the same level of utility or satisfaction.y) ‡ ‡ .

Indifference Curves: An Example Market Basket A B D E G H Units of Food 20 10 40 30 10 10 Units of Clothing 30 50 20 40 20 40 ‡ Graph the points with one good on the x-axis and one good on the y-axis ‡ Plotting the points. we can make some immediate observations about preferences -More is better .

while all those in the pink box are preferred to A. G 10 10 20 30 40 Food .Indifference Curves: An Example Clothin 50 g B H A D E 40 30 20 The consumer prefers A to all combinations in the yellow box.

& D ‡E is preferred to points on U1 ‡Points on U1 are preferred to H&G U1 20 30 40 Food .Indifference Curves: An Example Clothin g 50 H 40 30 20 10 10 B E A D G ‡Indifferent between points B. A.

Indifference Curve Properties of Indifference Curve: 1. ‡ . 4. The utility function are dependent which can be written as U = f (x. Two Indifference curves never intersect each other. Higher Indifference curve represents higher level of satisfaction. Assumptions of Indifference Curve: ‡ Existence of two products X and Y in a commodity space where both the products are normal and the consumption combinations are positive definite. 3. It is Convex to the origin. 2. The collections of Indifference curves is known as indifferent Map. Indifference curve is down wards sloping. 5.C considers related product where both the products are substitute to each other.y) and I.

Indifference Curve X1 ((X1/ (X2) X1 Io X2 X1 I1 Io X2 X1 A B C X2 B>A B=C A= C X2 .

Indifference Curve Assumptions of Indifference Curve: ‡ The level of satisfaction is ordinarily measurable which means ranking of different combinations is possible according to the preference of the consumer.y) is defined as the no of units of good Y that must be given up in exchange for an extra unit of good X. ‡ The relation may be transitive.e. ‡ The relationship may be indifferent. (The marginal rate of substitution of X for Y (MRSx. ‡ Application of the diminishing marginal rate of substitution. so that the consumer maintains the same level of satisfaction. if the combinations on A & B or B & C is equally preferable then the combination of A & C must be equally preferable to the consumer. i.) .

we have a set of indifference curves ± an indifference map. D B A U3 U2 U1 Food . Market basket B is preferred to D. Clothing Market basket A is preferred to B.Indifference Map To describe preferences for all combinations of goods/services. Each indifference curve in the map shows the market baskets among which the person is indifferent.

Budget Constraints ‡ Preferences do not explain all of consumer behavior ‡ Budget constraints also limit an individual¶s ability to consume in light of the prices they must pay for various goods and services. ‡ The Budget Line ± Indicates all combinations of two commodities for which total money spent equals total income ± We assume only 2 goods are consumed. so we do not consider savings ‡ Let F equal the amount of food purchased. and PCC is the amount of money spent on clothing . and C is the amount of clothing ‡ Price of food = PF and price of clothing = PC ‡ Then PFF is the amount of money spent on food.

. ‡ Price of the products (Px and Py) are constant and market determined. These choices can be graphed as the budget line ‡ Example: Assume income of $80/week.The Budget Line ‡ The budget line then can be written: PF F  PC C ! I All income is allocated to food (F) and/or clothing (C) ‡ Different choices of food and clothing can be calculated that use all income. ³No savings´ and ³No Loan demand´. ‡ Total income spend on 2 products so. PF = $1 and PC = $2 Assumptions: ‡ Existence of 2 products which are close substitute and divisible in small nos. ‡ Income (M) of the Consumer is constant.

Budget Constraints Market Basket A B D E G Food PF = $1 0 20 40 60 80 Clothing PC = $2 40 30 20 10 0 Income I = P F F + P CC $80 $80 $80 $80 $80 .

The Budget Line Clothing (I/PC) = 40 A B (C 1 PF Slope ! ! .!(F 2 PC D 20 E 30 10 20 10 G 0 20 40 60 80 = (I/PF) Food .

the consumer spends less on one item and more on the other ‡ The slope of the line measures the relative cost of food and clothing ‡ The slope is the negative of the ratio of the prices of the two goods ‡ The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent ‡ We can rearrange the budget line equation to make this more clear I ! PX X  P Y Y I  PX X ! P Y Y I PX  X !Y P P Y Y .The Budget Line ‡ As consumption moves along a budget line from the intercept.

I/PF. I/PC. illustrates the maximum amount of C that can be purchased with income I ± The horizontal intercept. illustrates the maximum amount of F that can be purchased with income I ‡ As we know. income and prices can change ‡ As incomes and prices change. there are changes in budget lines ‡ We can show the effects of these changes on budget lines and consumer choices .Budget Constraints ‡ The Budget Line ± The vertical intercept.

The Budget Line . Can buy more of both goods with more income Clothing (units per week) 80 An increase in income shifts the budget line outward 60 A decrease in income shifts the budget line inward L3 (I = $40) L1 (I = $80) L2 (I = $160) 40 20 0 Food (units per week) 40 80 120 160 .Changes 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).

50 changes the slope of the budget line and rotates it outward.Changes Clothing (units per week) A decrease in the price of food to $. (PF = 1/2) Food (units per week) .The Budget Line . 40 L3 (PF = 2) 40 L1 (PF = 1) 80 L2 120 160 An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward.

± If the two goods increase in price.Changes ‡ The Effects of Changes in Prices ± If the price of one good increases. ± If the price of food increases and you buy only food (x-intercept). the slope will not change ± However. pivoting from the other good¶s intercept. the budget line shifts inward. the slope will not change ± However. but the ratio of the two prices is unchanged. ± If you buy only clothing (y-intercept). you can buy the same amount. No change in y-intercept. then you can¶t buy as much food. The x-intercept shifts in. the budget line will shift outward parallel to the original budget line .The Budget Line . but the ratio of the two prices is unchanged. the budget line will shift inward parallel to the original budget line ± If the two goods decrease in price.

Slope of I. ‡ This equilibrium considers 3 basic problems of the consumer behaviour: ± Equilibrium satisfaction level.e. MUx / Px = MUy/Py Sufficient Condition: ‡ At equilibrium I.Consumer¶s Equilibrium ‡ Consumer shall be in equilibrium where he / she can maximize his / her utility subject to his budget constraint. ± Equilibrium commodity combination. . ‡ Occurs when the consumer has spent all income and the marginal utilities per dollar spent on each good purchased are equal.C must be convex to the origin. = Slope of B.C.L. ± Distribution of income between two products. Conditions: Necessary Condition: ‡ At the equilibrium point. i.

C on budget line ‡D highest utility but not affordable ‡C highest affordable utility ‡Consumer chooses C 20 U3 B 0 20 40 80 U1 Food (units per week) .Consumer¶s Equilibrium: Consumer Choice Clothing (units per week) 40 A 30 D C ‡A. B.

‡ Consumers taste and preference is constant.Consumer¶s Equilibrium Assumptions: ‡ Existence of the 2 products in the commodity space say X and Y. ‡ Consumer spends his entire income for the 2 products represents the Income ± Expenditure equality.Y ) ‡ Level of income (M) and prices of the products (Px and Py) are constant. divisible in small units and consumption combinations are positive definite. U = f ( X.e. . where both the products are normal. ‡ Utility levels are ordinarily measurable and ranking of the different combinations are possible where the utility functions are dependent. i. ‡ The relationship or the choice of the product combinations may be indifferent or transitive. ‡ Application of diminishing marginal rate of substitution and principle of substitution. close substitutes.

Consumer¶s Surplus ‡ Consumer¶s surplus is the difference between the total amount of money the consumer would be willing to pay for a quantity of a commodity and the amount he /she actually had to pay for it and this concept is based on DMU. Unit MU MP CS s 1 70 20 50 2 60 20 40 3 44 20 24 4 20 20 00 4 194 Units 80 114 . otherwise. ‡ CS = TU ± (P * Q). ‡ CS = Price prepared to pay ± Actual price paid.

‡ The portion of the change in the quantity demanded that is attributable to a change in its relative price is referred to as the Substitution Effect. lead to greater purchases of the good. he or she can purchase more goods and services. is referred to as the Income Effect.Income and Substitution Effects ‡ A person¶s real income. ‡ The portion of the change in the quantity demanded that is attributable to a change in real income. or purchasing power. and a rise in real income can. ‡ A fall in the relative price of a good will. rises if with a given absolute income. brought about by a change in absolute price. .

Income and Substitution Effects .