By: MOHIT DAHIYA ABHISHEK MAZEE JUHI PREMI AMIT YADAV

Theory of Consumer Behavior

Useful for understanding the demand side of the market. Utility - amount of satisfaction derived from the consumption of a commodity .measurement units utils

Theories of Consumer Choice

The Cardinal Theory

Utility is measurable in a cardinal sense

The Ordinal Theory

Utility is measurable in an ordinal sense

The Cardinal Approach

Nineteenth century economists, such as Jevons, Menger and Walras, assumed that utility was measurable in a cardinal sense, which means that the difference between two measurement is itself numerically significant. UX = f (X), UY = f (Y), .. Utility is maximized when: MUX / MUY = PX / PY

The Ordinal Approach

Economists following the lead of Hicks, Slutsky and Pareto believe that utility is measurable in an ordinal sense--the utility derived from consuming a good, such as X, is a function of the quantities of X and Y consumed by a consumer. U = f ( X, Y )

Total utility and marginal utility

Total utility (TU) - the overall level of satisfaction derived from consuming a good or service Marginal utility (MU) additional satisfaction that an individual derives from consuming an additional unit of a good or service.

TU MU Q

Total utility and marginal utility

Example (Table 4.1): Q 0 1 2 3 4 TU 0 20 27 32 35 MU --20 7 5 3

5 6 7

35 34 30 36

0 -1 -4

TU, in general, increases with Q At some point, TU can start falling with Q (see Q = 6) If TU is increasing, MU > 0 From Q = 1 onwards, MU is declining principle of diminishing marginal utility As more and more of a good are consumed, the process of consumption will (at some point) yield smaller and smaller additions to utility

Total Utility Curve

TU 35 Total utility(in utils)

30 25
20 15 10 5 0 1 2 3 4 5 Quantity 6 Q Figure 4.1

Marginal Utility Curve

MU Marginal utility (in utils) 20 15 10 5 0 -5 1 2 3 4 5 6 Q

Quantity

Figure 4.2

Consumer Equilibrium
So far, we have assumed that any amount of goods and services are always available for consumption In reality, consumers face constraints (income and prices):

Limited consumers income or budget Goods can be obtained at a price

Some simplifying assumptions

Consumers objective: to maximize his/her utility subject to income constraint 2 goods (X, Y) Prices Px, Py are fixed Consumers income (I) is given

Consumer Equilibrium

Marginal utility per peso additional utility derived from spending the next peso on the good

MU MU per peso P

Consumer Equilibrium

Optimizing condition:
MU X MU Y PX PY

If
MU X MU Y PX PY spend more on good X and less of

THE LAW OF DEMAND

A Closer Look The Income Effect A lower price frees income for additional purchases - and vice versa The Substitution Effect A lower price relative to other goods attracts new buyers - and vice versa

LAW OF DIMINISHING MARGINAL UTILITY

rational behavior

budget constraint