LECTURE NOTES –CH 6

CONSUMER BEHAVIOR
My Lecture Notes are written in summary and point form- they
emphasize important concepts, do not regurgitate the book, and are
consequently not meant to be a replacement of the book- If you want
to benefit from these notes you must read the book first (before
coming to class).

Learning Outcomes

• Understand concepts of Marginal and Total Utility and the associated concept of
maximizing Total Utility- which will happen when the consumer’s satisfaction from
spending a dollar is the same for all commodities consumed or in other words the MU per
$ is the same for all products that he spends on.
• Understand the concept of consumer surplus
• Understand that a change in price can be decomposed into an income and a substitution
effect on the quantities demanded.

Total and Marginal Utility

Econmists have not found any way to measure an indivisuals satisfaction which they refer to
as utility. That is something that the individual can determine in their mind by their own
subjective yardsticks. Total utility thus is the cumulative satisfaction derived by an
individual through consuming “x” number of units of a commodity. Marginal utility on the
other hand is the satisfaction derived by consuming an additional unit (the marginal unit) of a
commodity.

Diminishing Marginal Utility

It is assumed that the satisfaction derived by the individual reduces with each unit of
consumption of a particular commodity – this is referred to as the law of diminishing
marginal utility. Assume you are hungry, so the first slice of pizza gives you some defined
amount of satisfaction which you can measure in your mind, let’s say on a scale of one to ten.
While your hunger may not be satiated with just one slice and you may want another one,
nevertheless, the second slice while still very desirable would give you just a wee bit less
satisfaction than the first slice, and the third slice even less. Note that while your marginal
utility is decreasing with each additional unit of consumption, the total utility (which is
simply the sum of the utilities derived from each previous unit of consumption) is increasing.
To understand these points see figure 6.1.
 Utility Schedules and Graphs
100 • • • •
Movies •
80 • total utility
attended Total Marginal •
per month
•
Utility Utility 60

ytili t U
•
0 0 40
30
1 30
20
•
2 50 20
3 65 15
4 75 10
5 83 8 0 2 4 6 8 10
6 Quantity of Movies
6 89
7 93 4
3 30
8 96
2
9 98
1 20 • marginal utility
10 99
10 •
M •
• •
ar 0 2 4 6 8 10
gin Quantity of Movies
al Slide 6-4
Ut
ilit
y

The Utility Maximizing Decision

Q. Say an individual has some finite income, how much should he spend on each of the
various commodities available to him such that he ends up maximizing his utility
(satisfaction)?
A. A consumer should allocate his expenditures (given some market prices) such that the
utility obtained from the last dollar spent on each product is equal.

Explanation: If two products give equal satisfaction and one of these products is more
expensive than the other, it stands to reason that the consumer should spend his money on the
cheaper good, because the satisfaction derived from the expensive good is the same aas the
cheaper good – so why spend more if the same satisfaction can be derived from the cheaper
good.

Suppose cashews give more satisfaction

Consumer Surplus (see Fig 6.2)

Consumer surplus is simply the difference between what you are willing to pay for a particular
unit of consumption and what you actually end up paying based on market prices. Supposing
you are consuming 3 glasses of beer, and the amount you are willing to pay to obtain the first
glass is $4, but the market price is only $3 per glass, therefore, the consumer surplus on the first
glass equals $1. For the second glass, if you are willing to pay $3.50, the consumer surplus is 50
cents, and on the third glass if you are willing to pay $3.25. Total consumer surplus over three
glasses of beer is $1.75. thus, consumer surplus on each unit consumed is the difference between
the market price and the maximum price that the consumer is willing to pay to obtain that unit.

Q. What is the rationale for the consumer willing to pay less to obtain each successive unit of
the commodity.
A. The reason is that each additional unit of consumption gives less satisfaction to the consumer
therefore he is willing to pay less.

There will be consumer surplus on every unit consumed up to that last unit of consumption
where the value placed by the individual equals the market price. Thus, there is no consumer
surplus for that last unit consumed – but there is certainly consumer surplus reaped by the
individual for each and every unit consumed before that last unit.
Fig 6.2
The Concept
Consumer surplus is the difference between what is actually paid and what
the consumer is willing to pay.

Amount Consumer
Glasses consumer is surplus if the 3.00
of Milk willing to pay price is $.30 per
per week for this glass glass
First $3.00 $2.70 2.00
Second 1.50 1.20
Third 1.00 0.70
Fourth 0.80 0.50 1.00 Market
Fifth 0.60 0.30 price
Sixth 0.50 0.20 0.30
Seventh 0.40 0.10
ss al Gr ep kli Mf o eci r P

Eighth 0.30 0.00

Quantity of milk glasses
Ninth 0.25 ----
Tenth 0.20 ----
Slide 6-8

The first two columns of Fig 6.2 show the quantities consumed (Col 1) and the price paid for
each unit (Col 2). In other words, this is the data for a demand curve. The general rule is that
the individual will keep on buying as long as the value placed by him on that unit is greater than
the value charged by the market for that unit. When the market price is $3 he will buy only one
glass; when it is $1.50 he will buy 2 glasses and so on. Note that on the 9th unit the individual is
willing to pay $0.25 but the market price is still $0.30 per glass, clearly, the individual’s
willingness to pay is less than the market’s valuation for that unit. Therefore, the individual will
certainly not purchase the 9th unit or any more u nits after that. In terms of the demand curve the
willingness to pay is measured by the distance from the base to any point on the demand curve.

Q. What is the difference between the consumer surplus for the individual and the consumer
surplus for the market?
A. The market demand curve is simply the summation of the demand curves of all the
individuals who constitute the demand for that market. In other words, the market demand
curve is nothing more than the summation of the individual demand curves for any product
“x”. Just as was the case for the individual consumers’ consumer surplus, we can say that the
consumer surplus for the entire market is equal to the area under the market demand curve
but above the price line for any product “x”.

Consumer’s Utility Maximizing Choice (Fig 6.A4)

Before we can maximize utility let us understand the idea of a preference map. Let’s say the
individual is choosing between clothing and food,
 Quantity of clothing per week

Consumer’s indifference map

Quantity of food per week

Each indifference curve represents the consumers choices of two goods- choices at which he is
equally happy or indifferent, hence the term indifference curves. Each higher indifference curve
represents more consumption of at least one good, hence consumer is more happy on
indifference curve I2 than I1.

The Budget Line and it’s Slope (Fig 6A3)

As explained in the introductory lecture, points inside the budget line are combinations of x and
y, which do not exhaust the budget. Points outside the budget line cannot be consumed with the
existing prices and income. The points on the budget line show all combinations of the two good
x and y, that the individual can consume, given the prices of those goods and his money income.

Slope of the Budget Line

Equation of the budget line
E = Pf F + Pc C or in terms of x&y we can write E=PxX + Py Y

X= E/Px and Y=E/Py

Slope = vertical distance / horizontal distance = 60 / 30 = -2

The minus sign indicates that if the individual purchases more of one good he has to decrease his
purchases of the other.
The numerical value of the slope tells us how much of one good must be given up to obtain one
more unit of the other. Thus, the slope of -2 tells us that to buy one unit of food the individual
must give up buying 2 units of clothing.

The slope of the budget line is the relative price of the two goods. In this example, of food and
clothing the slope of the budget line is determined by the relative price of food in terms of
clothing, Pf/Pc. We know that Pf = $24 per unit of food and Pc=$12 per unit of clothing.
Therefore the slope of the budget line = the relative price = Pf/Pc = 24/12 = 2. All that the slope
is telling us is the opportunity cost of food in terms of clothing. The opportunity cost of food in
terms of clothing is measured by the (absolute value of the) slope of the budget line, which is
equal to the relative price ratio Pf/Pc.

One point to understand is that the relative price Pf/Pc = is consistent with an infinite number of
absolute prices of food and clothing. If pf = 100 and Pc=50, it is still necessary to sacrifice 2
units of clothing to acquire one unit of food. Thus, relative, not absolute prices determine
opportunity cost. Or in other words, it is the ratio of the two prices rather than the absolute
dollar price of the two goods that determines opportunity cost.

STOP AND TAKE A DEEP BREATH: We have just studied the concept of opportunity cost
which is very different from the dollar cost of a single commodity that we are used to as laymen.
Economists always talk of opportunity cost – the cost of getting one more unit of a commodity
by giving up some of the other commodity- note here the cost being measured in terms of how
many units of the other commodity we gave up.

Utility Maximizing Choice

 Quantity of clothing per week

Consumer’s Utility Maximizing Choice of 2 Goods

FIG 6A- 4

Quantity of food per week

Q. What combination of the two goods would the individual choose?

A. He can purchase any combinations which lie along the budget line, but which one will he
choose?
Given his budget and market prices, the individual will choose the highest indifference curve and
that is point E.

If he chooses a, b, c or d, e, f, he can do better than that, and that is only possible at point E on
indifference curve I4.

Q. Why is point a not a utility maximizing choice?

A. Because if he reduces the quantity of clothing and increases some quantity of food he can end
up at point b or point c, which are on higher indifference curves. Each higher indifference
curve carries combinations of clothing and food which give more satisfaction than the lower
indifference curve. Thus, point c is preferable to b, is preferable to a. Similarly, d on
Indifference curve I3 is a combination which is preferred over e and f which are on lower
indifference curves. But the individual can still do better than consuming at c and d. If he
 starts off from c he can do better by reducing clothing and increasing food till he reaches the
combination of food and clothing given by point E. Similarly, if he is at d he can do better
by increasing clothing and reducing food till once again he reaches the combination of the
two commodities given by point E.

Q. Why can’t he do better than point E

A. Any combinations lying on indifference curves higher than I4 are simply not affordable
given his income and market prices for clothing and food. Therefore, the highest attainable
point or the utility maximizing choice is only and only point E.

INCOME AND SUBSTITUTION EFFECTS OF A PRICE CHANGE

Whenever prices fall or rise they produce two kinds of effects on our spending behavior (the
income and substitution effects of the price change). Supposing prices of good x fall, we know
that immediately it would produce a substitution effect i.e. consumers would switch from those
goods towards x for which x is a substitute in consumption – this is called the substitution effect
of a price change or simply the substitution effect. We also get another effect called the income
effect of price change: a fall in the price of x leaves more money in the consumer’s pocket. He is
now free to spend this extra purchasing power on any commodity that is part of his consumption
basket. Thus a fall (rise) in price increases (decreases) real income and this is the income effect.

How much will real income increase?

It depends on what proportion of expenditures he was doing towards the commodity whose price
has fallen (or risen)- if he was spending a large proportion of his income on x (say 70%) then a
drop in price of x would release more funds for use towards other consumption goods. Say you
were spending all of your income towards cashews and prices of cashews drop by 40%- his
income increases by 40%, if price drops by 50% his income doubles. If you were buying two
goods in some proportion then a drop in price of any of these goods would still produce an
income effect though not as much as the case of a single good consumption.

What will be the effect of this increase in income?

We know from our definitions of normal and inferior goods that the increase in income would
increase the demand for all normal goods (and this includes both types of normal goods that is
necessities and luxuries) and decrease his demand for inferior goods (if the good has become an
inferior good at some level of income prior to this increase in income).

Isolating the Income and Substitution Effects

Note that no one comes and tells us after a price change that so much will be the income effect
on your consumption and so much would be the substitution effect of a price change. But
conceptually we can still isolate the substitution and income effects. Suppose before the price
change the individual was maximizing utility by consuming the optimal amount of both X and Y.
In other words the individual was maximizing his total utility by choosing X & Y in a
combination such that marginal utility per dollar is equal on both goods MUx/Px = MUy/Py .
(Do you understand the rationale for that?????? You must, this is crucial !!!!)

SUBSTITUTION EFFCET OF PRICE CHANGE

Now after the fall in price lets say that we counteract the increase in his purchasing power by
reducing his dollar income which has gone up in terms of quantities of goods that he can
purchase such that he cannot purchase anymore of goods X and Y that he was consuming before
(Note his real purchasing power has increased or his real income has increased although his
nominal income income remains the same as before- don’t get confused between real and
nominal- his nominal income is the same ie his dollar income and salary is still the same only his
purchasing power has gone up in terms of amount of goods that he can buy).

Q. What will happen to the consumer’s consumption of X after its fall in price but after we
also reduce the consumer’s income so that he can keep consuming the same units of X and
also of Other Goods (Y).

Q. Will he still consume the same amounts of X & Y?

A. Note his purchasing power is unchanged (after we reduced his income when prices of X fell)
but he will still not consume the same old consumption basket of X & Y. Irrespective of the fact
that his income is unchanged the fact remains that X is cheaper now and if he still consumes the
previous quantity of X, the MU derived from consuming a unit of X is greater than the MU
derived from spending a dollar on Y. Therefore the individual will move towards the cheaper
good X- as he does this MUx falls and MUy increases (why? Because he is consuming less units
of Y)- the equality of LHS and RHS of the utility maximization equation is restored again.

STOP: To see the substitution effect, when prices fell we kept income constant (at the level
before the price fall) to see the effect of the relative price change on consumption of X and
Y

Q. Why is it so confusing when we say that relative prices Px/Py have changed?
A. Of course when Px falls, the relative price of x, Px/Py has fallen.

INCOME EFFECT OF PRICE CHANGE

To see the pure substitution effect of a price change we held income constant- to see the income
effect we allow relative prices to change but hold real income constant at the level before the
price change.

Say Px rises, that reduces Real Income and the individual alters his consumption basket in
response to change in relative prices (he will consume less X and more Y as a consequence of X
becoming relatively more expensive).
Now let us increase the nominal income of the consumer so as to restore his original purchasing
power (or his real income). Well we know that if X is a normal good its consumption must
increase. The change in consumption of X as a response to increase in real income is called the
income effect.

Summary: the substitution effect leads people to buy more of goods whose relative prices
have fallen and the income effect leads people to increase the consumption of those goods
which are normal for them.

Implication: Because of the combined substitution and income effects the demand curve for
normal goods is downward sloping.

Q. What would be the shape of the demand curve if we had an inferior good?

A. Well, the substitution effect will always be positive but the income effect will be negative
– Generally speaking demand curves for inferior goods will be downward sloping (i.e.
substitution effect will be greater than income effect). But there are certain types of
inferior goods
Which could have upward sloping demand curves: (i) Sir Robert Giffen (1837-1910)
observed that when price of imported wheat went up, the price of bread increased and
people started buying more bread.

What is required to make a demand curve slope upwards?

(i) Firstly, the good has to be inferior – as Income increases we decrease consumption; and
conversely, as income decreases (after a price increase) we increase consumption.
(ii) Secondly to get a large income effect (which should be greater than the substitution
effect), its important that a large proportion of the income is going on that inferior good- if
the proportion of income is not large, the substitution effect would end up being greater
than the income effect and the demand curve would become downward sloping for that
inferior good.

(iii) Demand curve can be upward sloping again for conspicuous goods- if people think
there is snob value associated with certain goods, they buy more of such goods when their
prices go up. Thorstein Veblen (1857-1929) noted such goods which had snob appeal.

These people would only buy more of expensive goods if they were convinced that others
thought they had paid the higher price. Nevertheless such people would continue to buy
more at lower prices – as long as they believed that people thought that they had paid
higher prices.

Even if we have some conspicuous consumers with upward sloping demand curves, its not
necessary that the whole market demand curve would also be upward sloping.