Theory of consumer behavior

Dr Poonam Apeejay Institute of technology

Consumer theory
How should a consumer spend his income on different goods and services so that he may get maximum satisfaction or he may be in equilibrium.

Consumer behaviour
To introduce the crux of consumer behaviour, choices and preferences. To explain the nuances of utility analysis, marginal utility, total utility and law of diminishing marginal utility. To explain the difference between cardinal and ordinal utility analyses of consumer behaviour.

To discuss how consumer equilibrium is attained subject to budget constraint. To illustrate the concept of consumer surplus and its application in decision making.

Concept of utility
Commodities are desired because of their utility
Utility is the attribute of a commodity to satisfy or satiate a consumers wants Utility is the satisfaction a consumer derives from consumption of a commodity

Mathematically: utility is the function of the

quantities of different commodities consumed:

U= f(m1, n1, r1)

Theory of consumer behavior

Utility : Benefits consumers obtain from goods & services they consume is utility. A utility function shows an individuals perception of the utility level attained from consuming each conceivable bundle of goods

Concept of utility
Assume consumers have complete information about availability, prices, & utility levels of all goods & services All bundles of goods can be ranked based on their ability to provide utility for any pair of bundles A & B:
Prefer bundle A to bundle B Prefer bundle B to bundle A Indifferent between the two bundles

Cardinal utility
Marshall and Jevons revealed that Utility is a cardinal concept and is measurable (in utils) like any other physical commodity Total Utility (TU)
Sum total of utility levels out of each unit of a commodity consumed within a given period of time

Marginal Utility (MU)

Change in total utility due to a unit change in the commodity consumed within a given period of time.

Concept of utility
Law of Equimarginal Utility
Marginal utilities of all commodities should be equal
The consumer has to distribute his/her income on
different commodities so that utility derived from last unit of each commodity is equal for all other commodities in the consumption basket

Concept of utility
Law of Diminishing Marginal Utility
Marginal utility for successive units consumed goes on decreasing. When the good is consumed in standard quantity, continuously and in multiple units and the good is not addictive in nature.

Marginal Rate of Substitution

MRS shows the rate at which one good can be substituted for another while keeping utility constant
Negative of the slope of the indifference curve Ratio of the marginal utilities of the goods

Y MU X MRS X MUY

Marginal Utility and Demand Curve

MU curve is downward sloping. For any given amount of income when price of the commodity is PC, the consumer would consume QC quantity of the commodity (point C on the MU curve, where MU= PC) When price increases to PB, the consumer has to readjust consumption to restoring level of utility. the new equilibrium is at point B on the MU curve where MU= PB As price goes on increasing, the desired consumption of the commodity for the consumer goes on diminishing and vice versa. Points A, B, C, and so on, would thus lie on the demand curve of the consumer for the commodity.

MU, P

PA PB PC

A B C

MU=D

QA QB

QC Quantity

Ordinal utility
Edgeworth, Fisher and others negate the physical measurement of utility.
A consumer is able to rank different combinations of the commodities in order of preference or indifference. Utility is not additive but comparative

Indifference Curve Analysis (J.R. Hicks and R.G.D. Allen ) Indifference curve: Locus of points which show the different combinations of two commodities among which the consumer is indifferent, i.e. derives same utility.
Since all these points render equal utility to the consumer, an indifference curve is also known as an isoutility (iso meaning equal) curve.

Properties of Indifference Curves

Indifference sloping. curves are downward This is because of the assumption of non-satiation Higher indifference curve represents higher utility

Y A

Good Y

B C D

Indifference curves can never intersect

Indifference curves are convex to the origin.

IC2
IC1

This is because two goods cannot be perfect substitutes of each other

Good X

Exceptional Shapes of Indifference Curves

QY

Perfect Substitutes

QY

Perfect Complements

QX

QX

QY

Irrational Behaviour

QY

Social Bads

QX

O QX

Consumers Equilibrium
Consumer would reach equilibrium point, i.e. highest level of satisfaction given all constraints at the highest indifference curve he/she can reach. Budget line of a consumer, consists of all possible combinations of the two commodities that the consumer can purchase with a limited budget: Budget constraint depends upon income of the consumer and prices of the commodities in the consumption basket.

Conditions for consumers equilibrium:

Consumer spends all income in buying the two commodities; hence point of equilibrium will always lie on the budget line.
Point of equilibrium will always be on the highest possible indifference curve the consumer can reach with the given budget line.

Consumer is able to maximize utility at a point where the budget line is tangent to an indifference curve This is the highest possible curve attainable by the consumer, subject to budget constraint.

Budget line may shift either upwards or downwards due to any change in income of the consumer while price of the commodities remaining same Swivel at one point when price of one of the commodities changes, while income and price of other commodity remain same.

Consumers Budget Line

Shows all possible commodity bundles that can be purchased at given prices with a fixed money income

M PX X PY Y
or

M PX Y X PY PY

Budget line
Budget line also called price line shows budget of the consumer in terms of goods x and y, implying how much goods x and y consumer can buy with his given income. It is drawn on the assumptions that income of the consumers does not change and that price are given for x and y goods.

Properties of budget line

It slopes downward, implying more of one good is possible only when combined with less of other and It is straight line, implying one good can be substituted for the other at a constant rate. It also implies that price of one good in terms of other is constant

Typical Budget Line

5.5)
M P Y

(Figure

A
M PX X P P Y Y

Quantity of Y

Quantity of X

M PX

Shifting Budget Lines (Figure

5.6)
120 R A F A

Quantity of Y

Quantity of Y

100 80

100

N 240

C 125

B 200

D 250

160 200

Quantity of X

Quantity of X

Panel A Changes in money income

Panel B Changes in price of X