Session 7_8

Consumer Behavior
(Cardinal versus Ordinal approach)

Prof Subramania Raju Rajasulochana

Associate Professor
SBM, NMIMS Mumbai
Review
• 3 case lets & news clips- Applications of demand and supply
• Excel sheet-demand estimation
 Consumer Behaviour Theory

This is the underlying basis for demand curves.

Description of how consumers allocate incomes among
different goods and services to maximize their well-being.

Explains why “buy one, get one free” or “discount sale” works.
 Utility- the start point of demand

• The value a consumer places on a unit of a good or

service.
• Subjective-changes from person to person and
time to time.
• Revealed in people's choice or purchase of a
good/service.
Two major approaches to utility

Cardinal Approach Ordinal Approach

-Marshal - Hicks and Allen & Slutsky
- immeasurability of utility
-direct measuribility of utility
- Basic assumption: consumer can
through “utils” (imaginary units of rank market baskets (the most
satisfaction) desired basket is ranked first)
Tools used: Tools used:
- Preferences: Indifference curves
- Total and Marginal Utility
- Budget Constraints
- Utility maximizing rule - Consumer Equilibrium
Cardinal Approach
Total utility and marginal utility
• An individual demands a particular commodity because of the
satisfaction or utility received from consuming it. Up to a point, the
more units of a commodity the individual consumes per unit of time,
the greater the total utility received. Although total utility increases,
the extra or marginal utility received from consuming each additional
unit of the commodity usually decreases. This is the principle of
diminishing marginal utility.
Consumer equilibrium: Utility maximizing rule
• Assumption : rationality, clear preferences for goods and services, budget
constraints and prices of goods and services.
• To maximize satisfaction, the consumer should allocate his or her money
income so that the last money unit spent on each product yields the same
amount of extra (marginal) utility.
• That is,
MUx MUy Muz
--------- = ---------- = ---------
Px Py Pz

• When the consumer has “balanced his or her margins” using this rule, he
or she has achieved consumer equilibrium and has no incentive to alter his
or her expenditure pattern.
Ordinal Approach
Consumer Preferences: Indifference curves

● market basket (or bundle) List with specific quantities of one or more
goods.

TABLE 3.1 ALTERNATIVE MARKET BASKETS

MARKET BASKET UNITS OF FOOD UNITS OF CLOTHING

A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40

To explain the theory of consumer behavior, we will ask whether consumers

prefer one market basket to another.
Axioms about Preferences
1. Completeness: Preferences are assumed to be complete. In other words,
consumers can compare and rank all possible baskets. Thus, for any two
market baskets A and B, a consumer will prefer A to B, will prefer B to A, or
will be indifferent between the two. By indifferent we mean that a person will
be equally satisfied with either basket. Note that these preferences ignore
costs.

2. Transitivity: Preferences are transitive. Transitivity means that if a

consumer prefers basket A to basket B and basket B to basket C, then the
consumer also prefers A to C. Transitivity is normally regarded as
necessary for consumer consistency.
3. More is better than less: Goods are assumed to be desirable—i.e., to be
good. Consequently, consumers always prefer more of any good to less. In
addition, consumers are never satisfied or satiated; more is always better,
even if just a little better.
An Indifference Curve represents a distinct level of preference.

The indifference curve U1 that

passes through market
basket A shows all baskets
that give the consumer the
same level of satisfaction as
does market basket A; these
include baskets B and D.
Our consumer prefers basket
E, which lies above U1, to A,
but prefers A to H or G, which
lie below U1.

● indifference curve Curve representing all combinations of market baskets that

provide a consumer with the same level of satisfaction.
An indifference map
● indifference map Graph containing a set of indifference curves
showing the market baskets among which a consumer is indifferent.

An indifference map is a set

of indifference curves that
describes a person's
preferences.
Any market basket on
indifference curve U3, such
as basket A, is preferred to
any basket on curve U2
(e.g., basket B), which in
turn is preferred to any
basket on U1, such as D.
Indifference curves cannot intersect

If indifference curves U1 and

U2 intersect, one of the
assumptions of consumer
theory is violated.
According to this diagram, the
consumer should be
indifferent among market
baskets A, B, and D. Yet B
should be preferred to D
because B has more of both
goods.
The Slope of Indifference Curve- Convex to the origin

THE MARGINAL RATE OF

SUBSTITUTION
The magnitude of the slope of
an indifference curve
measures the consumer’s
marginal rate of substitution
(MRS) between two goods.
In this figure, the MRS
between clothing (C) and
food (F) falls from 6 (between
A and B) to 4 (between B and
D) to 2 (between D and E) to
1 (between E and G).
•The Marginal Rate of Substitution

● marginal rate of substitution (MRS) Maximum amount of a good

that a consumer is willing to give up in order to obtain one additional unit of
another good.

4. Convexity

Observe that the MRS falls as we move down the indifference curve. The
decline in the MRS reflects our fourth assumption regarding consumer
preferences: a diminishing marginal rate of substitution. When the MRS
diminishes along an indifference curve, the curve is convex.
 EXAMPLE 3.1 DESIGNING NEW AUTOMOBILES (I)

Preferences for automobile attributes can be described by

indifference curves. Each curve shows the combination of
acceleration and interior space that give the same
satisfaction.

FIGURE 3.7
PREFERENCES FOR AUTOMOBILE ATTRIBUTES

Owners of Ford Mustang coupes (a) are The opposite is true for owners of
willing to give up considerable interior space Ford Explorers. They prefer interior
for additional acceleration. space to acceleration (b).
• Utility and utility functions
● utility Numerical score representing the satisfaction that a
consumer gets from a given market basket.
● utility function Formula that assigns a level of utility to individual
market baskets.

UTILITY FUNCTIONS AND

INDIFFERENCE CURVES
A utility function can be
represented by a set of
indifference curves, each with
a numerical indicator.
This figure shows three
indifference curves (with
utility levels of 25, 50, and
100, respectively) associated
with the utility function:

u (F,C ) = FC
Marginal Utility and MRS
• Consider a consumer consuming a bundle (x, 𝑦), that gives him utility
level of 𝑢(𝑥, 𝑦).
△𝑈
• 𝑀𝑈𝑥 = , given the amount of 𝑦. That is, △ 𝑈= 𝑀𝑈𝑥 △ 𝑥
△𝑥
△𝑈
• 𝑀𝑈𝑦 = , given the amount of 𝑥. That is, △ 𝑈= 𝑀𝑈𝑦 △ 𝑦
△𝑦

• MRS measures the slope of the IC, that is, △ 𝑦/△ 𝑥.

• Consider a change in the consumption of each good, (△ 𝑥,△ 𝑦), that
keeps utility constant.
Marginal Utility and MRS ( Contd )
• A change in consumption that moves us along the indifference curve,
is given as:
𝑀𝑈𝑥 △ 𝑥+𝑀𝑈𝑦 △ 𝑦=△ 𝑈= 0
Solving for the slope of the indifference curve we have
△𝒚 𝑴𝑼𝒙
MRS = - =
△𝒙 𝑴𝑼𝒚
The negative MRS indicates more of good x is to be compensated with
less of good y in order to keep the same level of utility.
Deloitte: Shoppers Adopt Frugal Behaviors to Fight Food Inflation
 Budget Constraints
● budget constraints Constraints that consumers face as a result
of limited incomes.
• The Budget Line
● budget line All combinations of goods for which the total amount of money
spent is equal to income.

PF F  PC C  I
Assume the price of food of PF = $1 per unit, and the price of clothing of PC = $2 per
unit, and the consumer has an income of $80
Market baskets associated with the budget line F + 2C = $80

TABLE 3.2 MARKET BASKETS AND THE BUDGET LINE

MARKET BASKET FOOD (F) CLOTHING (C) TOTAL SPENDING
A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
A BUDGET LINE
A budget line describes the
combinations of goods that
can be purchased given the
consumer’s income and the
prices of the goods.
Line AG (which passes
through points B, D, and E)
shows the budget associated
with an income of $80, a price
of food of PF = $1 per unit,
and a price of clothing of PC =
$2 per unit.
The slope of the budget line
(measured between points B
and D) is −PF/PC = −10/20 =
−1/2.
C  ( I / PC )  ( PF / PC ) F (3.2)
• The Effects of Changes in Income and Prices

EFFECTS OF A CHANGE IN
INCOME ON THE BUDGET
LINE
INCOME CHANGES
A change in income (with
prices unchanged) causes the
budget line to shift parallel to
the original line (L1).
When the income of $80 (on
L1) is increased to $160, the
budget line shifts outward to
L2.
If the income falls to $40, the
line shifts inward to L3.
EFFECTS OF A CHANGE IN
PRICE ON THE BUDGET
LINE
PRICE CHANGES
A change in the price of one
good (with income
unchanged) causes the
budget line to rotate about
one intercept.
When the price of food falls
from $1.00 to $0.50, the
budget line rotates outward
from L1 to L2.
However, when the price
increases from $1.00 to
$2.00, the line rotates inward
from L1 to L3.
 Consumer Choice

The maximizing market basket must satisfy two conditions:

1. It must be located on the budget line.

2. It must give the consumer the most preferred combination of goods and
services.
Tangency condition

MAXIMIZING CONSUMER
SATISFACTION
A consumer maximizes
satisfaction by choosing
market basket A. At this
point, the budget line and
indifference curve U2 are
tangent.
No higher level of
satisfaction (e.g., market
basket D) can be attained.
At A, the point of
maximization, the MRS
between the two goods
equals the price ratio. At B,
however, because the
MRS [− (−10/10) = 1] is
greater than the price ratio
(1/2), satisfaction is not
maximized.
Satisfaction is maximized (given the budget constraint) at the point where

MRS = PF/PC (3.3)

● marginal benefit Benefit from the consumption of one additional unit

of a good.

● marginal cost Cost of one additional unit of a good.

So, we can then say that satisfaction is maximized when the marginal
benefit—the benefit associated with the consumption of one additional unit of
food—is equal to the marginal cost—the cost of the additional unit of food.
The marginal benefit is measured by the MRS.