The Theory of

Consumer Behavior

1 April
Two Credit
 The Theory of Consumer
Behavior
The principle assumption upon which the
theory of consumer behavior and demand is
built is: a consumer attempts to allocate
his/her limited money income among
available goods and services so as to
maximize his/her utility (satisfaction).
 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
 Utility Concepts:
– The Cardinal Utility Theory (TUC)
• Utility is measurable in a cardinal sense
• cardinal utility - assumes that we can assign
values for utility, (Jevons, Walras, and
Marshall). E.g., derive 100 utils from eating a
slice of pizza
– The Ordinal Utility Theory (TUO)
• Utility is measurable in an ordinal sense
• ordinal utility approach - does not assign values,
instead works with a ranking of preferences.
(Pareto, Hicks, Slutsky)
 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 Cardinal Approach

 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.
Formula :
MU = Change in total utility
Change in quantity
= ∆ TU
∆Q
 The Cardinal Approach
 Law of Diminishing Marginal Utility (Return) = As more
and more of a good are consumed, the process of
consumption will (at some point) yield smaller and
smaller additions to utility

 When the total utility maximum, marginal utility = 0

 When the total utility begins to decrease, the

marginal utility = negative (-ve)
 EXAMPLE

Number Total Marginal

Purchased Utility Utility

0 0 0

1 4 4

2 7 3

3 8 1

4 8 0

5 7 -1
 The Cardinal Approach
 TU, in general, increases
with Q
 At some point, TU can start
falling with Q (see Q = 5)
 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
 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

 Consumer’s objective: to maximize

his/her utility subject to income
constraint
 2 goods (X, Y)
 Prices Px, Py are fixed
 Consumer’s income (I) is given
 Consumer Equilibrium

 Marginal utility per price  additional

utility derived from spending the next
price (RM) on the good
 MU per RM = MU

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 Y

 Numerical Illustration
Qx TUX MUX MUx QY TUY MUY MUy
Px Py
1 30 30 15 1 50 50 5
2 39 9 4.5 2 105 55 5.5
3 45 6 3 3 148 43 4.3
4 50 5 2.5 4 178 30 3
5 54 4 2 5 198 20 2
6 56 2 1 6 213 15 1.5
 Simple Illustration

 Suppose: X = fishball
Y = fishcake

 Assume: PX = 2
PY = 10
 Cont.

 2 potential optimum positions

 Combination A:  X = 3 and Y = 4
– TU = TUX + TUY = 45 + 178 = 223
 Combination B:  X = 5 and Y = 5
– TU = TUX + TUY = 54 + 198 = 252
 Cont.

 Presence of 2 potential equilibrium

positions suggests that we need to
consider income. To do so let us examine
how much each consumer spends for
each combination.
 Expenditure per combination
– Total expenditure = PX X + PY Y
– Combination A: 3(2) + 4(10) = 46
– Combination B: 5(2) + 5(10) = 60
 Cont.

 Scenarios:
– If consumer’s income = 46, then the
optimum is given by combination A.
.…Combination B is not affordable
– If the consumer’s income = 60, then the
optimum is given by Combination
B….Combination A is affordable but it
yields a lower level of utility
 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 )
 Cont.

 Ordinal Utility Theory (TUO)

– Can be measured in qualitative, not quantitative, but
only lists the main options (indifference
curves & budget line).
 Rational human beings will choose to maximize
the utility by selecting the highest utility
 Difference consumers, difference utilities.
 INDIFFERENCE CURVE (IC)

 Curve where the points represent a

combination of items when the consumer at
indifference situation (satisfaction).
 Axes: both axes refer to the quantity of
goods
 For the combination that produces a
higher level of satisfaction, the curves shift to
the right (IC2) from the first curve (IC1)
 In contrast, the curves shift to the left (IC-1)
 INDIFFERENCE CURVE

goods Y
M

S
A

C
T D IC2
IC1

IC-1

O
4 7 11
goods X
PROPERTIES OF INDIFFERENCE CURVE

 Downward sloping from left to right: This shows an increase

in quantity of certain good.
 Convex to the origin: the marginal rate of substitution (MRS) decreased
– MRS = quantity of goods Y willing to substitute to obtain one
unit of goods X & this substitution is to maintain its position at the
same level of satisfaction
 Do not cross (intersect): consumer preferences transitive
– Eg : Quantities X and Y for the combination of A> a combination
of B;  utility A> B *
When cross = C, so the utility A = C & B = C;  utility A
= B = C. This is not transitive as above *
 Different ICs show different level of satisfaction. Far from the origin,
the higher the satisfaction.
IC curves can not intersect
Good Y

C A IC1
B
IC2

Good X
 Budget line (BL)

 Line showing all combinations of items can be purchased for

a particular level of income (M) ;
M =PxQx + PyQy
 The slope depends on the prices of goods X and Y, the slope
= Px/Py
 Slope -ve: to use more goods X, Y should reduce & vice
versa
 In the X-axis, when the quantity Y = 0, all M used to
purchase X; M = PxQx Qx =M/Px
 At the Y axis, when the quantity X = 0, all M used to
purchase Y; M = PyQy Qy =M/Py
FACTORS SHIFT THE BUDGET LINE

 Changes in prices of goods X

Y

Px Px X
 EFFECTS OF PRICE CHANGES ON
THE BUDGET LINE
 When price of good X increases, the quantity of
good X is reduced (by maintaining the quantity of
Y) & vice versa.
 Points on the X axis shifted to the left (a
small quantity of X)
 When the price of Y increases, the quantity Y is
reduced (by maintaining the quantity of X) &
vice versa
 Point on Y axis move to the bottom
(small quantity in Y)
FACTORS SHIFT THE BUDGET LINE

 Changes in the price of goods Y

Y
Py

Py
X
FACTORS SHIFT THE BUDGET LINE

 Changes in income
Y

 X
 EFFECTS OF INCOME CHANGES ON
THE BUDGET LINE

 When M increases, QX and QY can be

bought even more, a point on the X
axis shifted to the right & a point on
the Y axis move on; & vice
versa when M decreases.
 CONSUMER EQUILIBRIUM
 With income (M) some combination of goods
that consumers choose the highest satisfaction
 Satisfied the same curves and budget lines are
connected
 The point where the curve IC and BL tangent
 Slope IC = BL
 Consumer choice influenced by income
 Increased income, increased consumer equilibrium
point
MAXIMIZE CONSUMER SATISFACTION

Y
M

F
C Indifference Curves (IC)

E Budget line (BL)

IC1
B
IC2
A D
IC3

IC4

O M1 X
 Price Consumption Curve (PCC)
 changes in Px

Y
Price Consumption Curve (PCC)

X
PCC = Line connecting the equilibrium points, E the event of changes to
the prices of goods.
 Formation of Demand Curve

 Outcome of PCC
Px

Dd
Qty X
Demand Curve for Normal Goods and Inferior Goods

 X axis, Y axis of the quantity of goods, the price of goods

 Px

Normal goods
Inferior goods
Qty X
 Normal goods= P , Dd
 Inferior goods= P , Dd
 INCOME CONSUMPTION CURVE (ICC)

 If a fixed price and income increases, the

budget line shifts to the right, thus shifting the
equilibrium point higher.
 Equilibrium point some income items associated
with the line - can be income consumption curve
(ICC).
 ICC shows the points for the combination
of goods that can be purchased when income
change and fixed in price.
 INCOME CONSUMPTION CURVE
(ICC)

Y
M
ICC

IC3

IC2

IC1

O
M1 M2 M3 X
 ENGEL CURVE

M
Engel curve for x

40

30

20

10

O
12 16 20 22 X
 ENGEL CURVE

 Relationship of income to the quantity of an

item
 Retrieved from ICC
 Get a quantity of goods X or Y that can be
purchased goods with an income
 Plot the quantity of X or Y against income
 Linking income changes with changes
in demand for goods at a fixed price
 Engel curve for luxury goods and
normal goods

M Normal goods

Luxury goods

O X
 Conclusion
 ToCB showing how it provides users a combination of sources of income
for many goods /services
 There are two types of utility theory:
– Cardinal  TU and MU
– Ordinal  curve IC and BL
 Equilibrium and utility maximization can be either TUC or TUO
 Equilibrium points of connection to produce PCC (change IN PRICE)
and ICC (change in income)
 Displaying Publication = PCC curve DD & ICC = Engel curve (EC)
 The types of goods obtained displaying income or price changes.
Thank You