CHAPTER THREE

THEORY OF CONSUMER BEHAVIOR

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 Introduction
In our day –to- day life, we buy different goods and
services for consumption.
As consumer, we act to derive satisfaction by using
goods and services.
But, have you ever thought of how your mother or any
other person whom you know decides to buy those
consumption goods and services?
Consumer theory is based on what people like, so it
begins with something that we can‘t directly measure,
but must infer.
That is, consumer theory is based on the premise that
we can infer what people like from the choices they
make.
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 Continued…
Consumer behaviour can be best understood in
three steps.
First, by examining consumer‘s preference, we
need a practical way to describe how people
prefer one good to another.
Second, we must take into account that
consumers face budget constraints – they have
limited incomes that restrict the quantities of
goods they can buy.
Third, we will put consumer preference and
budget constraint together to determine
consumer choice.
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 Consumer preferences
A consumer makes choices by comparing bundle of
goods.
Given any two consumption bundles, the consumer either
decides that one of the consumption bundles is strictly
better than the other, or decides that she is indifferent
between the two bundles.
If she always chooses X when Y is available, then it is
natural to say that this consumer prefers X to Y.
We use the symbol ≻ to mean that one bundle is strictly
preferred to another, so that X ≻Y should be interpreted as
saying that the consumer strictly prefers X to Y, in the
sense that she definitely wants the X bundle rather than
the Y-bundle.
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 Continued…
If the consumer is indifferent between two bundles of
goods, we use the symbol ∼ and write X~Y.
Indifference means that the consumer would be just as
satisfied, according to her own preferences, consuming
the bundle X as she would be consuming bundle Y.
If the consumer prefers or is indifferent between the
two bundles we say that she weakly prefers X to Y and
write X ⪰ Y.

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 The Concept of Utility
Economists use the term utility to describe the

satisfaction or pleasure derived from the consumption

of a good or service.
In other words, utility is the power of the product to

satisfy human wants.

Given any two consumption bundles X and Y, the

consumer definitely wants the X-bundle than the Y-

bundle if and only if the utility of X is better than the
utility of Y.
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Approaches to measure utility
There are two major approaches to measure or
compare consumer‘s utility:
 cardinal and
 ordinal approaches

The cardinalist school postulated that utility can

be measured objectively.
According to the ordinalist school, utility is not
measurable in cardinal numbers rather the
consumer can rank or order the utility he derives
from different goods and services.

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 The cardinal utility theory
According to the cardinal utility theory, utility is
measurable by arbitrary unit of measurement called
utils in the form of 1, 2, 3 etc.
For example, we may say that consumption of an
orange gives Bilen 10 utils and a banana gives her 8
utils, and so on.
From this, we can assert that Bilen gets more
satisfaction from orange than from banana.

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 Rationality of Consumers:- in order to maximize
Assumptions of Cardinal Utility theory

his/her satisfaction, the consumer has to be rational

Utility is cardinally Measurable:- Utility is
measured in subjective units called utils.
Constant marginal utility of money:- A given unit
of money deserves the same value at any time or place
it is to be spent.
Diminishing marginal utility (DMU):- the
marginal utility of a commodity diminishes as the
consumer acquires larger quantities of it.
The total utility of a basket of goods depends on
the quantities of the individual commodities:-
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TU = f ( X1 , X2 ......X n ).
 Total and Marginal Utility
Total Utility (TU)
It refers to the total amount of satisfaction a
consumer gets from consuming some
specific commodity at a particular time.
As the consumer consumes more of a good
per time period, his/her total utility
increases.
However, there is a saturation point for that
commodity.

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 Marginal Utility (MU)
It refers to the additional(extra) utility obtained
from consuming an additional unit of a commodity.
In other words, marginal utility is the change in
total utility resulting from change in the
consumption of commodity.
Graphically, it is the slope of total utility.
Mathematically, the formula for marginal utility is:

MU= TU/ Q

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Hypothetical table showing TU and MU of
consuming Oranges (X)
Units of
Quantity 4th
0 5th 6th
(x) Unit
1st Unit 2nd unit 3rd unit
unit Unit Unit
consume
d
TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils
MUX - 10 6 4 2 0 -2

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 TU and MU curves
As it can be observed
from the figure,
When TU is increasing,
MU is positive.
When TU is maximized,
MU is zero.
When TU is decreasing,
MU is negative.

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 The Law of diminishing marginal Utility (LDMU)
The law of diminishing marginal utility states that as
the quantity consumed of a commodity increases per
unit of time, the utility derived from each successive
unit decreases, consumption of all other commodities
remaining constant.
In other words, the extra satisfaction that a consumer
derives declines as he/she consumes more and more of
the product in a given period of time.
This gives sense in that the first banana a person
consumes gives him more marginal utility than the
second and the second banana also gives him higher
marginal utility than the third and so on.
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 Continued…
The law of diminishing marginal utility works under
the following conditions/ assumptions
i. The consumer is rational .
ii. The products are assumed to be the same or
identical or Homogenous .
iii. There is no time gap in consumption of the goods.
iv. The consumer taste or preference is assumed to be
the same or unchanged.

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 Equilibrium of the consumer: According to cardinal utility theory
The objective of a rational consumer is to maximize
total utility.
As long as the additional unit consumed brings a
positive marginal utility, the consumer wants to
consumer more of the product because total utility
increases.
However, given his limited income and the price level
of goods and services, what combination of goods and
services should he consume so as to get the maximum
total utility?

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 a) the case of one commodity
The equilibrium condition of a consumer that
consumes a single good X occurs when the marginal
utility of X is equal to its market price.
 MUx = Px

At any point above point C (like point

A) where MUX > PX, it pays the
consumer to consume more.
When MUX < PX (like point B), the
consumer should consume less of X.
At point C where MUX = PX the
consumer is at equilibrium.
Equilibrium condition of
consumer with only one
commodity

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 b) the case of two or more commodities
For the case of two or more goods, the consumer‘s
equilibrium is achieved when the marginal utility per
money spent is equal for each good purchased and his
money income available for the purchase of the goods
is exhausted.
That is
MUx = MUx = … = MUn, and PxQx + PyQy+ … + PnQn = M
Px Py Pn
Where M is the income of the consumer

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 limitations of cardinal approach
The assumption of cardinal utility is doubtful because
utility may not be quantified. Utility cannot be
measured absolutely (objectively).
The assumption of constant MU of money is
unrealistic because as income increases, the marginal
utility of money changes.

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 The Ordinal (indifference curve) Utility
Theory
States that utility being a subjective and abstract
concept can’t be measured.
i.e it may not possible for a consumer to express the
utility of a good in cardinal number.
It can be measured only in ordinal terms, that is in
terms of greater than(>),less than(<) or equal to(=).
it implies that a consumer can list all the commodities
he consumes in the order of his preference.

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Assumptions of Ordinal Utility theory
 Consumers are rational- aims to maximizing their
satisfaction or utility given their income and market prices.
 Utility is ordinal, i.e. utility is not absolutely (cardinally)
measurable.
 Consumers are required only to order or rank their
preference for various bundles of commodities.
 Diminishing Marginal Rate of Substitution (MRS):
 MRS is the rate at which a consumer is willing to substitute
one commodity (x) for another commodity (y) so that his
total satisfaction remains the same.
When a consumer continues to substitute X for Y the rate
goes decreasing and it is the slope of the Indifference curve.

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 Con’t
 The total utility of the consumer depends on the
quantities of the commodities consumed.
i.e TU=f(X1,X2,X3……..Xn).
 Preferences are transitive and consistent:
It is transitive in the senses that if the consumer prefers
market basket X to market basket Y , and prefers Y to Z,
then the consumer must also prefers X to Z.
When we say consistent it means that if market basket X
is greater than market basket Y (X>Y) in a certain period
then Y must not greater than X in another period (Y not
>X).
 All goods are “are good” (i.e desirable) rather than “bad”.
So that living costs aside consumers always prefer more of
any good to less.
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Indifference Set, Curve and Map
Indifference Set/ Schedule: It is a combination of
goods for which the consumer is indifferent, preferring
none of any others.
 It shows the various combinations of goods from
which the consumer derives the same level of utility.
Indifference Schedule
Bundle A B C D
(Combination)

orange (X) 1 2 4 7

Banana (Y) 10 6 3 1

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 Con’t
Each combination of good X and Y gives the consumer equal
level of total utility.
Thus, the individual is indifferent whether he consumes
combination A, B, C or D.
Indifference Curves(IC): an indifference curve shows the
various combinations of two goods that provide the
consumer the same level of utility or satisfaction.
It is the locus of points (particular combinations or bundles
of good), which yield the same utility (level of satisfaction)
to the consumer, so that the consumer is indifferent as to the
particular combination he/she consumes.
By transforming the above indifference schedule into
graphical representation, we get an indifference curve.

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 Indifference map

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 Properties of Indifference Curves
Indifference curves have negative slope.
Indifference curves are convex to the origin.
A higher Indifference curve is always preferred to
a lower one.
Indifference curves cannot intersect each other.
If they did, the consumer would be indifferent between
A and C, since both are on indifference curve one (IC1).
Similarly, the consumer would be indifferent between
points A and B, since they are on the same indifference
curve, IC2.
By transitivity, the consumer must also be indifferent
between B and C.

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Cont.

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 Marginal rate of substitution(MRS)

MRS refers to the amount of one commodity that an

individual is willing to give up to get an additional unit
of another good while maintaining the same level of
satisfaction or remaining on the same indifference
curve.
MRSxy is defined as the number of units of
commodity Y that must be given up in exchange for an
extra unit of commodity of X so that the consumer
maintains on the same level of satisfaction.
It is the negative of the slope of an indifference curve
at any point of any two commoditiesysuch as X and Y.
 MRS X ,Y
i.e., Slope of indifference curve x
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 Level of consumption of good X and Y
Bundle A B C D
(Combination)

ORANGE (X) 5 10 15 20

Banana (Y) 30 20 12 8

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Cont.…

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 The Budget Line or the Price line
The budget line is a line or graph indicating different
combinations of two goods that a consumer can buy
with a given income at a given prices.
 Assumptions for the use of the budget line
 there are only two goods, X and Y, bought in
quantities X and Y.
Each consumer is confronted with market determined
prices.
The consumer has a known and fixed money income
(M).

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 Con’t
Assume that the consumer spends all his/her income
on two goods (X and Y), the budget constraint express
as;
M  PX X  PY Y
Where, PX=price of good X
PY=price of good Y
X=quantity of good X
Y=quantity of good Y
M=consumer’s money income
By rearranging the above equation, we can derive the
following general equation of a budget line.

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Cont.…
Example: A consumer has $100 to spend on two goods
X and Y with prices $3 and $5
respectively. Derive the equation of the budget line
and sketch the graph.

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Factors Affecting the Budget Line
 Effects of changes in income
keeping the prices of the commodities unchanged, if
the income of the consumer changes the budget line
also shifts.
Increase in income causes an upward shift of the
budget line .
While decreases in income causes a downward shift of
the budget line.
But the slope of the budget line (the ratio of the two
prices) does not change when income rises or falls.
The budget line shifts from B to B1 when income
decreases and to B2 when income rises

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 Cont.

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 Effect of change in price of the
commodity
Changes in the prices of X and Y is reflected in the shift of
the budget lines.

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 Cont’d
Note that changes in the prices of the commodities
change the position and the slope of the budget line.
 But, proportional increases or decreases in the price
of the two commodities (keeping income unchanged)
do not change the slope of the budget line if it is in the
same direction.

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 Equilibrium of the consumer: The ordinal utility approach

Consumer equilibrium is the point where a consumer

maximizes his total utility, given his income and the
market price of goods.
Two conditions must be satisfied for the consumer to
be in equilibrium.
 Foc is the slope of the IC must be equal to the slope
of the budget line (BL).i.e Mux/Muy=Px/Py
 Soc requires that the necessary condition must be
fulfilled at the highest attainable convex IC.(tangency)

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 The Indifference Curves (Map) & Consumer Eqbm
Y

MRS = MUx/MUy = Px/Py

a

b
I = PxX + PyY
c
U4
U3
d U2
e
U1
X
O

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 Example
A consumer consuming two commodities X and Y has
the following utility function .
If the price of the two commodities are 4 and 2
respectively and his/her budget is birr 60.
A. Find the quantities of good X and Y which will
maximize utility.
B. Find the MRSx,y at optimum.
 Solution
The Lagrange equation will be written as follows:

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