ECONOMICS OF

CONSUMER

BEHAVIOURDr.C S Shylajan

Today’s Discussion• Fundamental Economic Questions revisited

What?

• Consumer Preferences

Utility, Total Utility,

Marginal Utility and Law of Diminishing Marginal Utility• Budget Constraints

• Consumer Choice/Consumer Equilibrium

Consumer Behaviour• Why people buy goods and services?

Primary goal of consumers is maximization of satisfaction from consuming the goods

Economists call this satisfaction “Utility”

• But how do we measure satisfaction???

Consumer Behaviour

• Can satisfaction you derive from consumption of a good be measured in some units of measurement?

There are different opinions! Cardinal and Ordinal Approaches

To Cardinal Economists, the motivation to consume

goods is to gain utility which is measurable in some numerical value

Consumer Behaviour

• There are three steps involved in the study of consumer behavior.

1) To describe how and why people prefer one good to another.

Consumer Behaviour2) Then we will turn to budget

constraints.

• People have limited incomes.

3) Finally, we will combine consumer preferences and budget constraints to determine consumer choices.

What combination of goods will consumers buy to maximize their satisfaction?

Consumer Behaviour

It is assumed that consumers always prefer more of any good to less. That is, consumer is rational. This is called economic rationality.

How can we determine the consumers preference?

It is by looking at the Utility.

UtilityUtility is the satisfaction or pleasure derived from consumption of a good or service.

Utility received from consumption varies from person to person. It is subjective.

Actual measurement of utility is impossible!But to Cardinalists believe it is possible

Utility

Ordinal Versus Cardinal Utility

The actual unit of measurement for utility is not important- ordinal school of thought

Therefore, an ordinal ranking is sufficient to explain how most individual decisions are made.

Total Utility

Total level of satisfaction derived from all units of a good consumed.

Suppose Good X.

U = f (x1, x2, x3…)

U(x1, x2, x3),.. = U1 (x1) + U2 (x2)+…

Marginal Utility

Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good.

U MU=

Q

• Where U is change in utility Q is change in quantity consumed

Total Utility and Marginal Utility- A Hypothetical data

Units of Food Consumed

Total Utility Marginal Utility

0 0 -

1 40 40

2 60 20

3 70 10

4 75 5

5 74 -1

Total and Marginal Utility

• Example

– The marginal utility derived from increasing from 0 to 1 units of food might be 40

– Increasing from 1 to 2 might be 20

– Increasing from 2 to 3 might be 10

Observation: Marginal utility is diminishing

Law of Diminishing Marginal Utility

• When more and more of a good is consumed, consuming additional amounts will yield smaller and smaller additions to utility.

• The extra satisfaction of a good declines as people consume more and more.

This is a universal principle of human consumption behavior

Utility Maximization in a world of without Scarcity

• If a good is free, you increase consumption as long as additional units provide you positive utility.

• In our previous example, consumer will consume 4 units. Thus his total utility is maximixed (75 Utils)

Utility Maximization in a World of Scarcity

• But Goods are not free!

• In the real world, consumption depends on tastes, Prices, and your income.

• Now we will turn to Budget Constraints.

Budget Constraints

Preferences do not explain all of consumer behavior.

• Budget constraints also limit an individual’s ability to consume.

• Suppose you allocate your income for 2 goods, Food and Cloths

The Budget Line• Price of Food is Rs. 100 per unit

• Price of Cloths is Rs. 200 per unit

• You have disposable income of Rs.800

• Given the price and income, you have different consumption possibilities.

• Budget Line shows all combinations of two commodities for which total money spent equals total income.

Pf. F + Pc. C = Total Income

Spending on food +Spending on Cloth =Total Budget

Budget Constraints

A 0 4 Rs.800

B 2 3 Rs.800

C 4 2 Rs.800

D 6 1 Rs.800

F 8 0 Rs.800

Market Basket Food (F) Clothing (C) Total Spending Pf = (Rs.100) Pc = (Rs.200) PfF + PcC = Income

4

3

2

1

02 4 6 8

Food (per week)

Cloths A

B

C

D

E

Budget Line

Budget Line-Graphically

Shift in Budget Line

Due to Income ChangesAn increase 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).

4

3

2

1

02 4 6 8

Food (per week)

Cloths A

B

C

D

E

New Budget Line when income increases

80

16

New Budget line when income decreases

Due to Price Changes

If the 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.

Shift in Budget Line

4

3

2

1

02 4 6 8

Food (per week)

Cloths

16

Due to decrease in the price of Food

Price of Food Decreases

A 0 4 Rs.800

B 4 3 Rs.800

C 8 2 Rs.800

D 12 1 Rs.800

F 16 0 Rs.800

Market Basket Food (F) Clothing (C) Total Spending Pf = (Rs.50) Pc = (Rs.200) PfF + PcC = Income

4

3

2

1

02 4 6 8

Food (per week)

Cloths

Due to increase in the price of food

Consumer Choice

• How do you allocate our disposable income between the two goods to maximize utility?

Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.

• Consumers will consider their

Preferences (utility)

Market prices, and their Income

Marginal Utility andConsumer Choice

Total utility is maximized when the total budget is spent and the marginal utility for the final unit consumed divided by that good’s price is identical for each good

Consumer Choice- A hypothetical example

• Suppose you want to consume Apple and Orange

• Price of Apple is Rs.8 per one.• Price of Orange is Rs. 4 per one • You have Rs. 40 with you.• Then, how do you allocate your limited

budget to maximize your total utility given the prices and preferences?

Consumer Equilibrium- Example

Units of

Apple

TU MU MU/P

P=

Rs.8

Units of Orange

TU MU MU/P

P=4

0 0 - - 0 0 - -

1 56 56 7 1 40 40 10

2 88 32 4 2 68 28 7

3 112 24 3 3 88 20 5

4 130 18 2 1/4 4 100 12 35 142 12 1 1/2 5 108 8 2

6 150 8 1 6 114 6 1 1/2

Marginal Utility andConsumer Choice

Condition for Consumer equilibrium if we choose two goods, Food and Cloths

This is referred to as the equal marginal principle.

ClothClothFoodFood PMUPMU //

Summary

• People behave rationally in an attempt to maximize satisfaction from a particular combination of goods and services.

• Consumer choice has two related parts: the consumer’s preferences and the budget line.

• Consumers make choices by comparing bundles of commodities.

• Consumers maximize satisfaction subject to budget constraints

Topics of Discussion

WHAT?

• What is behind the Law of Demand?• Income Effect• Substitution Effect• Ordinal Approach to Consumer Behavior• Consumer Surplus• Types of Demand

What is behind the Law of Demand?

Price

Quantity demanded

Any logic from consumer behavior point of view?

Why do you purchase less at higher price and more at lower price?

Price changes alter your real incomeMoney Income Vs eal IncomeA rise in prices decreases purchasing power, and a fall in prices increases purchasing power.

It causes an increase/decrease in the consumer’s willingness and ability to purchase a good. This income effect is one of the reasons for law of demand.

Recent rise in Petroleum price.

Any other explanation?

Suppose the price of a good rises, then you will consume less of that good. Why?

When the price of a good rises, consumers may switch to more affordable substitutes. This is substitution effect.

This is second reason behind the law of demand

Ordinal Approach to Consumer Behavior

WHAT?

• Ordinal approach to Consumer Behaviour

• Indifference curves

• Properties of ICs

• Consumer equilibrium using IC analysis

Ordinal Approach

• Economic rationality is assumed

• Consumers are able to rank their preferences for various combinations of goods

• A is preferred to combination B or both combinations A and B are equally preferred.

• If A is preferred to B, then A gives him more utility/satisfaction

Indifference Curve

• Ordinal approach use indifference curves to analyze consumer preferences

• An indifference curve shows all combinations of goods that provide the consumer with the same satisfaction, or the same utility.

• Numerical measure of utility is not required

Indifference Curve

• All combinations on an IC are equally preferred.

• Total utility is same at all combinations on an IC

• So consumer is indifferent about which combination to choose.

Properties of IC

• IC slope downward

• Higher IC represent higher levels of utility

• IC will not intersect

Indifference Map

• An indifference map is a graphical representation of a consumer’s tastes for two goods

• Each curve in the map reflects a different level of utility

• Then how we will decide given a consumer’s indifferent map, how much of each good will be consumed? This is a consumer choice problem

Consumer Choice/Equilibrium

We need to consider

• the relative prices of the goods and

• the consumer’s income

• Consumer Taste

Consumer Equilibrium• The indifference curve indicates

what you are willing to buy (Taste)• The budget line shows what you are

able to buy (Ability)• Now find out what quantities of each

good you are both willing and able to buy.

• Consumer will be at equilibrium when slope of IC is equal to slope of budget line

The Concept of Consumer Surplus

• The demand curve can be viewed as a willingness-to-pay curve.

• It shows the value that consumers place on extra units of the good.

• Consumer Surplus is the difference between what a person is wiling to pay for a commodity and the amount that he actually is required to pay

Consumer Surplus

• Consumer surplus = total willingness to pay for a good minus the total amount consumers actually do pay.

• Consumer enjoys consumer surplus if he pays the same amount of money for each unit of good he buys.

Consumer Surplus (CS)

• It is a measure of the net benefits received by the consumer.

• CS occurs when people are able to buy a good for less than they would be willing to pay.

• They enjoy more utility than they had to pay for.

Application of Consumer Surplus

• This concept has more public policy relevance.

• Since it is a measure of the net benefits received by the consumer, government can estimate the loss or increase in consumer welfare due to any policy change.

Quiz TimeWhen the price of a good increases, one effect of this price increase is that consumers of that good experience a decline in their purchasing power that is like a decline in income. For normal goods, this contributes to the law of demand. What is this effect called?

A. The substitution effect.

B. The income effect.

Quiz TimeTRUE OR FALSE:

The law of diminishing marginal utility states that as more and more units of a good or service are consumed, total utility becomes smaller and smaller.

a. True.

b. False.

In a consumer equilibrium, which of the following is true?

a. The marginal utility from the last unit of each good consumed is equal.

b. The price of each unit consumed is equal.

c. The total utility derived from consuming all the units of each good is equal.

d. The marginal utility per rupee spent is equal for the last unit of each good consumed.

Thank you