TOPIC 4

CONSUMER BEHAVIOR THEORY

Total utility
This refers to the level of utility or satisfaction derived from consuming a particular
commodity.

Marginal utility
This is the extra satisfaction derived from the consumption of an additional unit of a
commodity.

Is consumer utility measurable?

Economists have two approaches to this.
i) Cardinal Approach
ii) Ordinal Approach

Cardinal approach
This belongs to the Cardinalists who believed that utility is measurable in its own units
called utils. E.g. 10 crates of soda and 1 loaf of bread yield 1000 utils. The concept of
diminishing marginal utility was developed by the Cardinalists to justify their argument.

Example
Suppose Garrison derives utility by consuming good x as shown below.

TOTAL MARGINAL UTILITY

¤ UNITS UTILITY(TUx) (MUx)
0 0 0
1 20 20
2 45 25
3 60 15
4 59 -1
5 53 -6

CURVES FOR TOTAL AND MARGINAL UTILITIES.

80

60
TOTAL UTILITY(Tux)
UTILITY

40

20 MARGINAL UTILITY
(Mux)
0
1 2 3 4 5 6
-20
UNITS

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Conclusion

At the highest point of Tux, MUx is equal to zero.

Equilibrium in cardinal approach

Lest assume a consumer has the option of choosing between two goods x and y whose
prices are Px and Py. To maximize utility, (at equilibrium) the consumer will allocate his
income such that the utility he derives from an extra income on x equals the utility
derived from an extra income on y.

The equilibrium condition is stated as;

Suppose Px decreases, ceteris paribus:
MUx = MUy
MUx > MUy
Px Py
Px Py

Conclusion
Since the consumer is assumed to be rational, he will consume more of good x so that he
will increase the total utility from x. But due to law of diminishing marginal utility, MUx
eventually declines therefore he will continue consuming more of good x until where:

MUx = MUy
Px Py
Example
A consumer derives the following utilities by consuming several units of good x and y.
Prices for x and y are 2 and 3 per unit respectively. Based on the carrdinal approach,
determine:

1. MUx, MUy, MUx/Px and MUy/Py

2. The equilibrium quantities of x and y which maximizes his or her utility.

Units TUx TUy MUx MUy MUX/Px Muy/Py

0 0 0 _ _ _ _
1 16 30 16 30 8 10
2 30 57 14 27 7 9
3 42 80 12 23 6 7.666667
4 52 98 10 18 5 6
5 60 112 8 14 4 4.666667
6 66 122 6 10 3 3.333333
7 70 130 4 8 2 2.666667
8 72 135 2 5 1 1.666667
9 70 137 -2 2 -1 0.666667
10 66 136 -4 -1 -2 -0.33333

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 Solution
At maximum utility, MUx/Px = MUy/Py = 6
He or she will consume 3 units of x and 4 units of y.

Weaknesses of cardinal approach

1. It is difficult to measure utility in the real world.

2. Other factors such as price, tastes, income are held constant.

Ordinal approach
This belongs to the ordinalists who argue that utility is not measurable objectively but
rather individuals rank the bundles of goods available to them in order of their
preferences. E.g. first, second, third etc.

Example
If Morris prefers goods A, B, C and D, in that order, then his preferences can be
expressed as A>B>C>D. The ordinals use indifference curves and budget lines in
analyzing consumer demand.

Indifference curves
Refers to a curve which gives all the possible combinations of two goods which yield the
same level of utility to a consumer.

Good Y

15
A

B
10
C
5 Ux

0
4
Good X

All combinations along the curve give the same or equil marginal utilities.
A = B = C because they are equally satisfying.
A set of the above indifference curves gives an indifference map.

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Good y
C

U3
B

A
U2

U1

Good x

A<B<C because the indifference curves which are further away from the origin denote a
high level of satisfaction.

Observation
It’s always assumed that the consumer is rational in selecting the various options
available to him or her.

Assumptions of consumer rationality

1. completeness
Consumers should be able to rank all their preferences over the entire field of
choice.
2. transitivity
Consumer behavior should be transitive, if he has to rank good A, B and C, and
that A>B and B>C, then A>C.
3. Non – satiation
The consumer will prefer more to less. That is he should prefer the highest
possible indifference curve.

The above assumptions give an insight to indifference curves.

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Characteristics of indifference curves

1. Indifference curves should not intersect

A
Uo
B

U1 X
C

The above means that point A has two levels of utilities which is impossible. This
violates the assumption of transitivity because:
A = B because they lie on the same line and similarly A = C because they lie on same
indifference curve therefore B = C which is not correct.

2. Indifference curves are downward sloping

As we substitute good x for good y, (moving from point A to B), more units of y are
given up as more units of x are obtained if the same level of utility is to be
maintained.

A
Y

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3. Indifference curves are convex to origin

If some units of y are to be given up, larger and larger amounts of x must be obtained to
compensate the consumer for the loss in utility and to live at the same level of satisfaction
therefore moving down the indifference curve the amount of y foregone keeps on
declining while the x units gained increases.
Convexity – defines the slope of indifference curve which is also referred to as the slope
of marginal rate of substitution

Good y

Good x

Marginal Rate of substitution (MRS)

This is the amount of good Y given up in order to obtain more of good X. This rate
reduces down the indifference curve because the rate of substitution declines hence
consistent with the law of Diminishing Marginal Rate of Substitution.

The budget line

This gives information about the consumers income and prices of goods x and y. Budget
line refers to the curve giving all possible combinations of two goods a consumer can buy
from a given amount of money.

For example:
Suppose Morris has Kshs. 100 to spend on good x and y whose prices are Kshs 10 and
20. Respectively Formulate an equation showing the various combinations.

10x + 20 y = 100 budget line / constrain.

X 0 5
Y 10 0

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 income exp. chart

12

10

8
good y

0
0 1 2 3 4 5
good x

Slope of curve = ∆ y/∆x = 8 /4 = 2

The slope of the budget line is also given by the price ratios.

Consider the price ratios, Py / Px = 2

Equilibrium under ordinal approach

To derive consumer’s equilibrium under ordinal approach, we superimpose the

indifference curve on the budget line.

Good y

y E

Good x

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 At E the consumer can purchase the maximum units which will give him the maximum
utility. Equilibrium is given at E where the budget line is just tangent to an indifference
curve. Initially at E the indifference curve and the budget line are the same therefore:

MRSxy = Px / Py

Constrained Utility Optimization Problem

The utility function for consumption of two commodities, X and Y for a certain
household is given as follows:

U = Z = 3x2 + 2y2
The price per unit of good X and Y is $ 3 and $4 respectively. The consumer has a budget
of $220. Find the amounts of good X and Y that the household should consumer to
maximize his utility. Calculate the maximum utility for the household.

Solution
Maximize U = Z = 3x2 + 2y2 subject to 3x + 4y = 220

MU X PX 6X 3
=  =  Y = 2 X  3 X + 4(2 X ) = 220
MU Y PY 4Y 4
 X = 20  Y = 40
U = 3(202 ) + 2(402 ) = 4400

Effects of change in income on consumer equilibrium

An increase in consumer income enables him or her to enjoy a higher level of utility.
That is the budget line shifts to the right but remains parallel to the original one.

Good y

Income
consumption
curve

y E

Good x

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Effects of change in price of good X on consumer equilibrium
The effect of this is to tilt or rotate the budget line.
E.g. suppose the price of x is halved, reduced by 50% ceteris paribus. This tilts the budget
line from AB to AB1; a further reduction tilts it further to AB2. The locus of points of
consumer equilibrium (points of tangency between indifference curves and budget lines)
is known as income consumption curve (ICC) i.e. E1, E2, E3, etc

E3

E2

E1

B B1 B2
Separating income and substitution effects of a price change
A decrease in price of a commodity leads to an increase in quantity demanded due to:

1. Income effect.
2. Substitution effect

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Case of a normal good

Good y

E0
C
E1
E2

O
Xo X2 B X1 B1 Good x
The original budget line is AB, and the consumer is at equilibrium E0. Suppose price of
good x decreases ceteris paribus, this tilts the budget line to AB1 and a new equilibrium
E1.
Eo – E1 represents the total effect of the price fall. This can be split into income and
substitution effect by assuming that we consume for the price fall by drawing a parallel
budget lineC. This gives the equilibrium point E2.

E1 E2 = Income effect.
Eo E2 = substitution effect.

Total effect = Income effect + Substitution effect.

Substitution effect is always negative for normal goods. This is because if price of a
commodity increases, its demand decreases.
Income effect is either positive or negative depending on the nature of the commodity.
For normal goods it is positive.

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Case for inferior good

Good y

A
E1

C Eo
E2

O
Xo E1 X2 B B1 Good x

EXERCISE 4

1. The following table shows hypothetical figures for total utility derived from
consumption of three goods, A, B and C by a farmer. The prices of A, Band C are
Kshs. 5, 3 and 2 respectively.
No. of units Total Utility Total Utility Total Utility
Consumed TUA TUB TUC
2 72 60 64
4 120 104 120
6 160 136 160
8 191 160 188
10 228 180 204
12 248 188 216
14 260 192 224

a) Determine the marginal utilities for each good

b) Find the optimal quantities of each good for consumption
c) Find the total expenditure at the optimal level of consumption
d) What is the effect of a reduction in the price of A both in the short-run and
the long-run equilibrium

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2. Suppose a consumer has a utility function expressed as:
U = 60Q13/4 Q2 2/3
In which Q1 and Q2 represents amounts of two composite commodities Q1 and
Q2 whose prices per unit are kshs 18 and Kshs 15 respectively. She has Kshs
4,800 to spend on the two commodities.

i) Using Lagrange method, formulate the augmented objective function and

find the first-order conditions for utility maximization.

ii) Determine the optimal values of that would maximize utility Q1 and Q2

iii) Find the maximum utility attainable.

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