Theory of Consumer Behaviour

Dr. Muhammad Shahadat Hossain Siddiquee

Professor, Department of Economics
University of Dhaka
Email: shahadat_eco@yahoo.com
Contact: +8801719397749
• Choice and Utility Theory,
• Marginal Utility and the Law of Diminishing Marginal
Utility,
• Relationship of Total and Marginal Utility,
• History of Utility Theory,
• Cardinal Versus Ordinal Utility Approaches,
• Equimarginal Principle,
• Budget line, Indifference Curve and Consumer
Equilibrium.
Model of Rational Choice
• Consumer Behavior
Utility Analysis
Consumer Preference Ordering
-what the consumer wants to do
Indifference Curve Analysis
• Constraints
Budget Constraint
• what the consumer can afford to do
• The Rational Decision
• the optimum decision given preferences and budget
constraint
consumer equilibrium
Consumer Behaviour: Utility Analysis
• Utility is the sense of pleasure, or satisfaction, that
comes from consumption
• The utility that a person derives from consuming a
particular good depends on person’s tastes or
preferences for different goods and services  likes
and dislikes
• Utility is subjective
• Generally have little to say about the origin of tastes
or why tastes differ across individuals, households,
regions, or countries
• We generally assume simply that tastes are given and
are relatively stable  different people may have
different tastes but an individual’s tastes are not
constantly in flux.
Total and Marginal Utility
• Total utility (TU) is the total satisfaction a person derives
from consumption
• Marginal utility (MU) is the change in total utility
resulting from a one-unit change in consumption of a good

Law of Diminishing Marginal Utility

• The more of a good an individual consumes per time
period, the smaller the increase in TU from additional
consumption
– That is, the smaller the marginal utility of each
additional unit consumed
• Applies to all consumption
Utility Derived from Water
Units of Water
Consumed Total Marginal
(8 ounce glass) Utility Utility
0 0 -
1 40 40
2 60 20
3 70 10
4 75 5
5 73 -2
The first column lists possible quantities of water a person might
consume after running on a hot day. The second column
presents the total utility derived from that consumption and the
third column presents the marginal utility of each additional
glass of water consumed  change in total utility from
consuming an additional unit.
Total and Marginal Utility
Because of
diminishing
Total Utility
marginal, each glass
adds less to total
utility  total utility
increases for the first
four glasses but at a
decreasing rate

In our example,
diminishing Marginal Utility
marginal utility
begins with the first
unit as seen by the
pattern of marginal
utility
Consumer Behavior: Consumer Preference
Ordering
• Consumer Opportunities
• The possible goods and services consumer can afford
to consume.
• Consumer Preferences
• The goods and services consumers actually consume.
• Given the choice between 2 bundles of goods a
consumer either
• Prefers bundle A to bundle B: A  B
• Prefers bundle B to bundle A: A  B
• Is indifferent between the two: A  B
Consumer Preference Ordering (contd.)
• Completeness
• The consumer is capable of expressing a preference for all
bundles of goods.
• A preferred to B, B preferred to A, or indifferent between
A and B

• Non-satiation
More is Better (always prefer more goods to less)

• Consistency (Transitivity)
• Given 3 bundles of goods: A, B & C.
• If A  B and B  C, then A  C.
• If A  B and B  C, then A  C.
 Consumer Behavior: Indifference
Curve Analysis
Indifference Curve
• Indifference curves are a graphical Good Y
representation of a consumer’s tastes for
the two goods III.
II.
• A curve that defines the combinations I.
of 2 or more goods that give a
consumer the same level of
satisfaction.
Since each of the alternative bundles of
goods yields the same level of utility, the
consumer is indifferent about which
combination is actually consumed

Good X
An Indifference Curve
•Suppose there are only two goods
available: pizzas and movie videos
•Point a shows the consumption 10
bundle consisting of 1 pizza and 8
video rentals
8 a
•Moving from point a to point b, we
are willing to give up 4 videos to get a
second pizza (total utility is the same at
points a and b, so is point c and d). 5
4 b
c
Points a, b, c, and d can be connected to 3
d
form the indifference curve, I, which 2 I
represents possible combinations of
pizza and videos that would keep the
0
person at the same level of total utility. 1 2 3 4 5 10
Pizzas per week
 Indifference Curves

• Along an indifference curve, there is an inverse

relationship between the quantity of one good
consumed and the quantity of another
consumed  indifference curves slope down
Marginal Rate of Substitution
Qy
MRS 
Qx

• The marginal rate of substitution (MRS) measures the

amount of one product a consumer must be given to
compensate for giving up one unit of the other.
• The marginal rate of substitution quantifies the
amount of one good a consumer will give up to obtain
more of another good.
• It is measured by the slope of the indifference curve.
• MRS is the absolute value of the ratio of ΔQy to ΔQx
 Marginal Rate of Substitution

• The marginal rate of substitution, or MRS,

between pizza and videos indicates the number of
videos that the consumer is willing to give up to get
one more pizza, while maintaining the same level of
total utility

• The MRS measures the consumers willingness to

trade videos for pizza
 Marginal Rate of Substitution (MRS)

• The law of diminishing marginal rate of

substitution says that as a persons consumption of
pizza increases, the number of videos that they are
willing to give up to get another pizza declines
• This implies that the indifference curve has a
diminishing slope
As we move down the indifference curve, the
consumption of pizza increases and the marginal
utility of additional pizza declines (i.e., Indifference
curves are also convex to the origin  they are
bowed inward toward the origin).
 Indifference Map

• An individual’s preferences can be illustrated by

a set of indifference curves - an indifference
map
• Each curve in the map reflects a different level
of utility
An Indifference Map
Because both goods yield
marginal utility, the

Vid e o r entals per week

consumer prefers more of
each, rather than less 10
 curves farther from the
origin represent greater
consumption levels
 total utility along I2 is
higher than I1, I3 higher than 5
I4
I2, etc
I3
I2
The combination on each I1
successive indifference curve
reflects greater amounts of
both goods 0 5 10
Pizzas per week
 Constraint: Budget Constraints

• Preferences do not explain all of consumer behaviour.

• Budget constraints also limit an individual’s ability to
consume in light of the prices they must pay for
various goods and services.
Budget Constraints

• The Budget Line

• The budget line indicates all combinations of
two commodities for which total money is
spent.
The Budget Line
• LetF equal the amount of food purchased, and C is the
amount of clothing.
• Then PFF is the amount of money spent on food, and
PCC is the amount of money spent on clothing.
• The budget line then can be written:

P FF  P C C  I
Alternative Market Baskets

Market Basket Food (F) Clothing (C) Total Spending

($1) ($2)

A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
A Budget Line
Clothing
(units
per week)
(I/PC) = 40 A
Budget Line F + 2C = $80

B
30
10 1
D Slope C/F  -  - PF/PC
2
20
20
E
10
G
Food
0 20 40 60 80 = (I/PF) (units per week)
Budget Constraints

• The Budget Line

• As consumption moves along a budget line
from the intercept, the consumer spends
less on one item and more on the other.
Budget Constraints
• The Budget Line
• 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.
 Budget Constraints

• The Budget Line

• The vertical intercept (I/PC), illustrates the maximum
amount of C that can be purchased with income I.
• The horizontal intercept (I/PF), illustrates the maximum
amount of F that can be purchased with income I.
Constrain: The Budget Constraint

• Opportunity Set Y
The Opportunity Set
• The set of consumption bundles
that are affordable.
• PxX + PyY  I.
• Budget Line Budget Line

• The bundles of goods that

exhaust a consumers income.
• PxX + PyY = I. Px
• Market Rate of Substitution Py
• The slope of the budget line
X
• -Px / Py
 Market Rate of Substitution (Contd.)

• The slope (gradient) of the budget line can be deduced as

follows:

I
Y PY P
( Absolute) Slope  ( )   X
X I PY
PX
• i.e. the slope of the budget line equals the relative price of
good X to good Y.
• In other words, the slope tells us the rate at which the
individual can trade off one good for the other without
changing the amount of money spent - e.g. the amount of Y
that has to be foregone in order to purchase one more unit
of X
Changes in the Budget Line

Quantity of Good Y Quantity of Good Y

15 20

15 Decrease
Increase in in Income
Price of X
10
Decrease in Increase
Price of X in Income

0 8 12 20 0 8 12 16
Quantity of Good X Quantity of Good X
(a) (b)
Budget Constraints

• The Effects of Changes in Income and Prices

• Income Changes
• Anincrease in income causes the budget line to shift
outward, parallel to the original line (holding prices
constant).
•A decrease in income causes the budget line to shift
inward, parallel to the original line (holding prices
constant).
Budget Constraints
• The Effects of Changes in Income and Prices
• Price Changes
• Ifthe price of one good increases, the budget line
shifts inward, pivoting from the other good’s intercept.
• If the price of one good decreases, the budget line
shifts outward, pivoting from the other good’s
intercept.
Budget Constraints
• The Effects of Changes in Income and Prices
• Price Changes
• If
the two goods increase in price, but the ratio of the
two prices is unchanged, the slope will not change.
• However, the budget line will shift inward to a point
parallel to the original budget line.
Budget Constraints
• The Effects of Changes in Income and Prices
• Price Changes
• Ifthe two goods decrease in price, but the ratio of
the two prices is unchanged, the slope will not
change.
• However, the budget line will shift outward to a
point parallel to the original budget line.
Consumer’s Equilibrium

Consumers seek to maximize total satisfaction,

which means reaching the highest possible
indifference curve

Consumers choose a combination of goods that will

maximize the satisfaction they can achieve, given the
limited budget available to them.
Consumer Choice
The maximizing market basket must satisfy two
conditions:
1. It must be located on the budget line.
2. The maximizing market basket must give the
consumer the most preferred combination of
goods and services.
Consumer Choice
• Recall, the slope of an indifference curve is:
C
MRS  
F
• Further, the slope of the budget line is:
PF
Slope  
PC
Consumer Choice

Therefore, it can be said that satisfaction is

maximized where:

PF
MRS 
PC
Consumer Choice

It can be said that satisfaction is maximized when

marginal rate of substitution (of F and C) is equal to
the ratio of the prices (of F and C).
Maximizing Consumer Satisfaction
Clothing
(units per
week)
40

B
30

A
20

U1
Budget Line
0 20 40 80 Food
(units per week)
Maximizing Consumer Satisfaction

Clothing
(units per
week) Point B does not
maximize satisfaction
40 because the
MRS (-(-10/10) = 1
B is greater than the
30 price ratio (1/2).
-10C
A
20

+10F U1
Budget Line
0 20 40 80 Food
(units per week)
Maximizing Consumer Satisfaction

Clothing
(units per
week) Market basket D
cannot be attained
40 given the current
budget constraint.
D
30

20
U3

Budget Line
0 20 40 80 Food
(units per week)
Maximizing Consumer Satisfaction
Clothing
(units per
week) At market basket A
the budget line and the
40 indifference curve are
tangent and no higher
level of satisfaction
30 can be attained.

A
20

U2
Budget Line
0 20 40 80 Food
(units per week)
Equilibrium Conditions
Looking at the diagram it is clear that two conditions
characterise the optimum point A:
All income is spent - the individual must choose a point
on the budget line not within it.
The slope of indifference curve (U2) equals the (absolute)
slope of the budget line: i.e.
PX
MRSY , X 
PY
In other words, at the equilibrium bundle, the rate at
which the consumer is willing to trade good X for good Y
(MRS) is exactly equal to the rate at which he/she can
trade good X for Y (relative price).