Chapter 6

Consumer Behavior Theory

Consumer Behavior Theory
Consumer Behavior Theory
A study on consumer responses in regards to their
choice and patterns of consumption
Utility Approach
1. Utility is defined as the satisfaction obtained fromconsuming a commodity
2. Objective of Utility approach is to achieve Consumer Equilibrium.
3. Consumer Equilibrium is reached when satisfaction derived from the
consumers pattern of consumption is maximized
Cardinal Approach
1. Utility is measurable
2. The unit of measurement is known as utils
3. Thus, utility from alternatives can be
mathematically operated i.e. added /
subtracted
Ordinal Approach
1. Utility is NOT measurable
2. But the utility derived from the alternatives
can be compared and ranked
Consumer Behavior Theory Cardinal Approach
Cardinal Approach
Total Utility
Total satisfaction that a person
from the consumption of
certain goods
Marginal Utility
The additional utility derived from the
consumption of one more unit of the same
kind of goods or services
=


Law of Diminishing Marginal Utility
As consumption for the same goods and
services increases, additional utility derived
diminishes other things being equal.
Law of Diminishing Marginal Utility
Example: The units of apple consume, the lesser the additional satisfaction derived will be
Consumer Behavior Theory Cardinal Approach
Relationship between Total Utility and Marginal Utility:
1. When TU is increasing, MU will be positive
2. When TU is at its maximum, MU will be zero
3. When TU is decreasing, MU will be negative
Assumptions made for Law of Diminishing Marginal
Utility to hold:
1) Identical and homogenous product
2) Consumption happen within the same time frame
3) No change in taste
4) No change in price
5) Suitable quantity of consumption
Law of Equi-Marginal Utility to find Consumer Equilibrium
Definition :
It states that other things being equal, a consumer has the highest / maximum level of satisfaction derived
from his fixed budget, when the marginal utility derived from the last unit of money spent on each item that
he purchases tends to be equal.
Therefore to maximize utility, the Law of Equi-Marginal Utility has to be satisfied e.g. assuming the consumer
is only purchasing 3 products, then :


=


=


Where X = product X, Y = product Y, Z = product Z
Note : Total expenditure of all goods must be equal to the total budget allocated to maximize utility.

=
When the Law of Equi-Marginal Utility is satisfied, consumers utility is maximized and therefore Consumer
Equilibrium is reached
Consumer Behavior Theory Cardinal Approach
Tutorial on Law of Equi-Marginal Utility
Assuming Wallace has a budget of RM37 and purchased 3 products with the price of RM5, RM1 and RM4 for the
respective products P,Q and R. The total utility schedule is as below:
Consumer Behavior Theory Cardinal Approach
Total
Utility
MU
P
/P
P
Total
Utility
MU
Q
/P
Q
Total
Utility
MU
R
/P
R
1 21 7 16
2 41 13 30
3 59 18 42
4 74 22 50
5 85 25 55
6 91 27 58
7 91 28 60
Quantity
Product P Product Q Product R
Compute the marginal utility per RM price above and find the Consumer Equilibrium
Ordinal Approach asserts that utility cannot be measured. Therefore, no value can be assigned to it. But it can compared and
ranked.
Central to Ordinal Approach is Consumer Indifference Curve and Consumer Budget Line.
Consumer Indifference Curve
Indifference curve represents all the possible combinations of two goods which will give the same level of satisfaction.
For all the possible point on the indifference curve, the total satisfaction will be equal.
Indifference Schedule and Curve
Consumer Behavior Theory Ordinal Approach
Combinations Y X
A 12 2
B 6 4
C 4 6
D 3 8
E 2 12
As shown on the Indifference Curve, points
A,B,C,D and E lie on the same curve therefore
yield the same level of utility.
The slope of the Indifference Curve represents
the Marginal Rate of Substitution, MRS i.e. how
many quantity of one product that the consumer
is willing to give up in order to increase
consumption of one extra unit of another
product, maintaining the same level of utility
MRS for point A to B is (6-12) / (4-2) = 3, MRS for
point B to C is (4-6) /(6-4) = 1 and MRS for point C
to D is (3-4) / (8-6) = 0.5
Good Y
Good X
Consumer Behavior Theory Ordinal Approach
Characteristics of an
Indifference Curve
Indifference curve slope downward from left to right. Therefore the lope is negative.
This is due to the substation effect.
Utility tends to increase as we increase the consumption on multiple products.
Therefore, to maintain the same level of utility, increasing consumption on
product, the consumption of another product has to be decreased
The shape of an Indifference Curve is
always Convex
This is due to the Law of Diminishing
Marginal Utility
As the consumption of certain good
increases, the satisfaction derived
will decrease.
Therefore the amount of quantity of
another product required to be given
up to maintain the same level of
utility decreases.
When there are few Indifference Curve on an Indifference Curve Map
The higher curve represent higher level of satisfaction
Indifference Curve never intersect because each Indifference Curve represents a distinct level of satisfaction
Indifference Curve never
touches the Y-axis or X-axis
This is because to maximize
utility consumers always
consume more than one
product
If the Indifference Curve
touches one of the axis, it
just means there are times
when consumers just
consume one product
Consumer Behavior Theory Ordinal Approach
Assumptions made
for Indifference
Curve
Consumers are fully rational
and always seek to
maximize welfare
Consumers know exactly their
preference and derive various
combinations of bundle of
goods / services to meet their
preference
Consumers preferences are
transient i.e. if they prefer B
to A and C to B, then he
must prefer C to A
r
Consumers can rank the
utility from each bundle of
goods / services by simple
comparison of the
satisfaction obtained from
each bundle of good
Budget Line
A Budget Line represents various combinations of two goods, which can be purchased with a given amount of money
(budget) and given the price of each unit.
Consumer Behavior Theory Ordinal Approach
Practical!
1. Given that Andy has a
budget of RM100 and
purchases two type of
products with prices
RM10 and RM20 for
product A and B
respectively. Draw a
budget line for these two
products
2. Illustrate how the Budget
Line will shift if prices for
both products increase
Budget Line changes as the below:
Type of Change Illustration Explanation
Change of
consumers income
Each Budget Line represents the fixed amount of
money consumers can spend on Good Y and X.
Therefore with prices equal, increase in income will
shift Budget Line from X to X
1
(to the right) and
decrease of income will shift Budget Line from X to X
2
(to the left)
Change in the prices
of goods
The quantity on the axis for each product is derived by
dividing the income with the price of that particular
product
Therefore, if the price of that particular product
decreases, then the quantity will increase for that
particular product as shown the shift X to X
1
, while the
quantity for another product i.e. Y is constant
Ithe price of one product increases, quantity for that
product will drop from Y to Y
1
, while the quantity for
another product i.e. X remains
Good Y
Good X X X
1
X
2
Good Y
Good X
Good Y
Good X
X X
1
Y
Y
1
Consumer Equilibrium
1. Recall that in Cardinal Approach, to reach Consumer Equilibrium, where consumers utility is maximized, Law of Equi-
Marginal Utility has to hold true
2. In Ordinal Approach, Consumer Equilibrium is reached when the consumers enjoy the highest possible satisfaction from a
bundle of goods with a given budget
Consumer Behavior Theory Ordinal Approach
At Point A where total utility is 100 and consumer is
consuming :
1. 20 units of shakes
2. 20 units of pizza
utility is maximized as it is the highest achievable
level of utility given the budget line.
Therefore Consumer Equilibrium is determined when
the slope of the indifference curve is tangent to the
budget line
20
20
Income Effect :
Consider the situation, what happens if consumer income changes, while prices remain.
Consumer Behavior Theory Ordinal Approach
Y
Y
1
Y
2
X
X
1
X
2
IC
IC
1
IC
2
Income
Consumption
Curve
Whenever income increase, while prices remain:
1. Both indifference curve and budget line will shift to the right.
2. Consumer Equilibrium will shift from A to B.
3. Therefore instead of only purchasing Y units of goods Y and X units
of goods Y, consumers now can purchase more units for each
product i.e. Y
1
and X
1
for product Y and X respectively
4. This shows a higher purchasing power
A
B
C
Whenever income decrease, while prices remain:
1. Both indifference curve and budget line will shift to the left.
2. Consumer Equilibrium will shift from A to C.
3. Therefore instead of only purchasing Y units of goods Y and X units
of goods Y, consumers now can purchase more units for each
product i.e. Y
2
and X
2
for goods Y and X respectively
4. This shows a lower purchasing power
Joining all the Consumer Equilibriums across income level, the curve is
known as Income Consumption Curve
Income Consumption Curve, ICC
1. It shows the relationship between changes in the level of income and corresponding changes in the Consumer
Equilibrium in relation to quantity of output consumed for each type of product
2. The shape of ICC tells the type of goods
Consumer Behavior Theory Ordinal Approach
When ICC bends towards X-axis
then the product represented in the
Y-axis is the inferior goods. In this
case will be rice
When ICC bends towards Y-axis
then the product represented in the
X-axis is the inferior goods. In this
case will be wheat
Practical !!!
Illustrate the shape of ICC when
wheat is a necessity good
Price Effect :
It explains what happens to the consumers equilibrium position when the price of one of the goods changes
while the price of other good remain constant
Price Consumption Curve shows the change of Consumer Equilibrium corresponding to the change in
consumption as price of one of the goods changes
Consumer Behavior Theory Ordinal Approach
PCC is non-linear and upward sloping as price of Good X decreases,
quantity demanded for Good X will increase initially but the demand will
slow down after certain threshold due to the below:
1. Law of Diminishing Marginal Utility
As more of Good X is consumed, marginal utility decreases,
therefore slow down the demand
2. Inelastic demand when quantity is high
Recall the elasticity of a demand curve is inelastic at the lower end
when quantity is large, therefore quantity demanded is no longer
responsive to the price change
3. After certain point, when consumption of Good X is sufficient large
and marginal utility decreases, consumer will transfer the savings of
lower price of Good X (boost of income) and increase the
consumption of Good Y.
Substitution Effect :
It explains what happens to the consumers equilibrium position when the price of one of the goods reduces
and another increases, while other factors remain constant.
Consumer Behavior Theory Ordinal Approach
Good Y
Good X
A
B
Y
Y
1
X
X
1
Due to the substitution effect when price of Good X decreases
and price of Good Y increases:
1. Budget line changes from YX to Y
1
X
1
2. Consumer Equilibrium shifts from A to B, where quantity
demanded for Good Y drops and quantity for Good X
increases