ECO_100_Consumer_Behavior_Theory.ppt

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CONSUMER BEHAVIOUR
UTILITY THEORY
LECTURE NOTES

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CONSUMER BAHAVIOUR THEORY
 The theory of consumer behavior tries to explain the
consumption behavior of consumers.
 Is divided into three major elements
1. Rational Behavior : A consumer as an individual or a
household is an utility maximising entity and all decisions are
directed towards maximisation of total utility.
2. Preferences: The consumer’s preferences are known, and
can, at least, be ranked.
3. Budget Constraint: Consumers’ “money” is limited, or
scarce relative to their wants. Therefore the consumer will
maximize total utility given his or her limited budget, or
“money” income.

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THE CONCEPT OF UTILITY
Utility refers to the satisfaction/pleasure that each
choice provides to the decision maker.
Utility can also be defined as the power of
commodity to satisfy human needs
Utility Theory provides a methodological framework
for the evaluation of alternative choices made by
individuals, firms and organizations in maximizing
utility subject to their budget.

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Can Utility be Measured?
 There are different approaches used to answer this
question.
1. Cardinal Utility Approach
– The Cardinal utility approach is adopted by the
neo-classical economists, widely known as
Marshalling approach
2. Ordinal Utility Approach
– The Ordinal Utility Approach is adopted by
Modern Economists

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CARDINAL APPROACH
• The cardinalists assume that utility is
quantitatively/cardinally measurable. i.e it can
be measured in absolute terms.
• It can be measured like heights, weight, length
and temperature.
• The cardinalists used util as a measure of
utility/satisfaction under the assumption that
one unit of money equals to one util.
• It implies that price that a consumer pays for a
commodity equals the utility derived from the
commodity.

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TOTAL UTILTY
• With the cardinal approach, makes it possible to
define the total utility and marginal utility in
quantitative terms.
• Total utility (TU) : May be defined as the sum
of the utility derived from the consumption of a
commodity.
• If a consumer consumes 4 units of a commodity
and derives u1, u2,u3 and u4 utility from the
successive units consumed, then:
• TU=u1+u2+u3+u4

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TOTAL UTILITY Cont….
• If he/she consumes n units, the total utility (TU)
from n units can be expressed as: TUn=
U1+U2+U3+…+Un
• In case the number of commodities consumed and
their units are greater than one, then:
• TU= TUx+TUy+TUz+……+TUn
• Where subscripts x, y, z and n denote commodities

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MARGINAL UTILITY
• MU may be defined in the following ways:
1)MU is the addition to the total utility- utility
derived from the consumption of one
additional unit.
2)MU is the change in the total utility resulting
from the change in the consumption.
• MU is calculated as: MU= ΔTU
ΔQ
• Where ΔTU= change in total utility and
ΔQ= change in quantity consumed of a
commodity.

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THE LAW OF DIMINISHING MARGINAL
UTILITY
• The law of diminishing marginal utility
states that; as the quantity consumed of a
commodity increases per unit of time, the
utility derived from the successive units
goes on decreasing.

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THE LAW OF DIMINISHING
MARGINAL UTILITY Cont…..
• For example, suppose you are very hungry and
you are offered six mangoes to eat.
• The satisfaction which you will derive from the
first mango would be the maximum because
intensity of your hunger was the highest.
• When you eat the second mango, you derive a
lower satisfaction because intensity of your
hunger is reduced.
• As you go on eating more and more mangoes, the
intensity of your hunger goes on decreasing and
thus the satisfaction which you derive from the
successive units goes on decreasing.

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THE LAW OF DIMINISHING
MARGINAL UTILITY Cont…..
Assumptions of the Law of Diminishing MU
• The law of diminishing marginal utility holds under
certain given conditions.
1.Time period must be specified for law.
2. Consumer’s taste must remain unchanged during the
period of consumption
3.There must be continuity in consumption
4.The unit in consumption must be standard one,
example a cup of tea, a glass of water e.t.c
5.The mental state of an individual has to remain
constant during consumption.

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TOTAL AND MARGINAL UTILITY
Cont…
• Table 1: Total and Marginal Utility
No. of
Mangoes
Total Utility
(utils)
Marginal Utility
(utils)
0 0
1 24 24
2 42 18
3 54 12
4 60 6
5 60 0
6 54 -6

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Cont…
Total Utility (utils)
0
10
20
30
40
50
60
70
0 1 2 3 4 5 6 7
No of mangoes
TU
Figure 1

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Cont…
Marginal Utility (utils)
-10
-5
0
5
10
15
20
25
30
0 1 2 3 4 5 6 7
No of Mangoes
MU
Figure 2

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Cont…
Relationship btn Total and Marginal Utility
-10
0
10
20
30
40
50
60
70
0 1 2 3 4 5 6 7
Number of Mangoes
Total
&
Marginal
Utility
TU
MU
Figure 3

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Cont….
• Relationship between TU and MU
• A slope of the total utility curve is marginal utility.
• The shape of the total utility curve, increasing at a
decreasing rate, reflects the law of diminishing
marginal utility.
• This means that marginal utility is high for small
quantities, declines, and then becomes negative as the
quantity consumed increases.
• Total utility reaches its maximum at 60 when 5 units of
mangoes are consumed.
• At this point MU= 0.
• Consumption of the 6th unit of mangoes yields negative
utility of 6 and therefore total utility starts declining.

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CONSUMER EQUILIBRIUM
• How a consumer allocates his money income
between the various goods and services he
consumes to maximize utility?
• Assumptions:
1. Rationality: consumer buys first a commodity
which yields the highest utility and the last
which gives the least utility.
2. The consumer has limited money to spend on
goods and services.

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CONSUMER EQUILIBRIUM Cont….
3. Every rational consumer intends to maximize his
satisfaction from his given money income.
4. Utility can be measured in absolute terms. Utility
of one unit of a commodity equals the amount of
money paid for it.
5. Marginal utility is diminishing
6. Marginal utility of money remains constant and
each unit of money has utility equal to 1.

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CONSUMER EQUILIBRIUM Cont…
• Consumer Equilibrium: One Commodity Case.
• The utility maximizing consumer reaches his
equilibrium when:
• MUx = Px(Mum)
– MUx =Marginal Utility of commodity x
– Mum= Constant Marginal Utility of money
– Px= Price of commodity X.

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• MUx = Px(Mum)
• This equation states that, the consumer will be in
equilibrium when marginal utility of commodity x
is equal to constant marginal utility of money as
weighted by price of commodity x.
• Since MU of money is constant, then this
equation can be written as MUx = Px
• Alternatively the consumer reaches equilibrium
when MUx
Px

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Figure 4 MUx = MUx=PX
Px
0 Q
E Px
MU
Quantity
MUx
Consumer’s
Equilibrium

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• From the figure:
• Consumer is in equilibrium at point E, where
MUx= Px .
• Below point E, MUx< Px. The consumer can
increase MU by reducing his consumption.
• At any point above point E, consumer gets
satisfaction less than maximum.
• Therefore point E is the point of equilibrium.

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• Equilibrium for two-commodity case:
• Suppose the consumer spends his income between
two commodities X and Y so that:
MUx = Px
MUy=Py
• Alternatively:
MUx and MUy
Px Py

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• These equations can be written together and
equilibrium conditions for two-commodity case
can be expressed as:
MUx = Px
MUy Py
• Or
MUx =MUy
Px Py

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• Consumer Disequilibriam
MUX > MUY
PX PY
• The consumer is not maximizing total utility given
this inequality.
• At this point, the marginal utility/shilling for Good
X is greater than the marginal utility/shilling for
Good Y.
• The consumer will be motivated to adjust his/her
quantities of the two goods so as to increase his/her
total utility.
• In this case, the consumer will buy more X and less
Y. As a result, the consumer will move closer to
the consumer equilibrium.

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MUX < MUY
PX PY
• The consumer is not maximizing total utility given
this inequality.
• At this point, the marginal utility/shilling for Good
Y is greater than the marginal utility/shilling for
Good X.
• The consumer will be motivated to adjust his/her
quantities of the two goods so as to increase his/her
total utility.
• In this case, the consumer will buy more Y and less
X. As a result, the consumer will move closer to the
consumer equilibrium.

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• The General Case
• The two-commodity case provides the basis for
generalizing the consumer’s equilibrium.
• Suppose a consumer consumes A to Z goods and
services, his equilibrium condition may be
expressed as:
• MUA=MUB=MUC+…………………..MUZ
PA PB PC PZ

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DIAMOND-WATER PARADOX
• Why is water, an essential good, priced so low, and
diamonds, a non-essential good, priced so high?
What do total utility and marginal utility have to do
with this?
MUwater (low) = MUdiamonds (high)
Pwater (low) Pdiamonds (high)
• The marginal utility of water is low due to large use,
but the total utility is high.
• The marginal utility of diamonds is high due to
limited supply, but the total utility is low.
• Key point = Prices is relating to marginal utility not
to total utility.

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• Early Economic Thought
– “value” was considered to be synonymous with
“importance”
– since prices were determined by humans, it was
possible for the price of an item to differ from its
value
– prices > value were judged to be “unjust”

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• The Founding of Modern Economics
– the publication of Adam Smith’s The Wealth of
Nations is considered the beginning of modern
economics
– distinguishing between “value” and “price”
continued (illustrated by the diamond-water
paradox)
• the value of an item meant its “value in use”
• the price of an item meant its “value in exchange”

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• Labor Theory of Exchange Value
– the exchange values of goods are determined by
what it costs to produce them
• these costs of production were primarily affected by
labor costs
• therefore, the exchange values of goods were
determined by the quantities of labor used to produce
them
– producing diamonds requires more labor than
producing water

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• The Marginalist Revolution
– the exchange value of an item is not determined by
the total usefulness of the item, but rather the
usefulness of the last unit consumed
• because water is plentiful, consuming an additional unit
has a relatively low value to individuals

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• Marshallian Supply-Demand Synthesis
– Alfred Marshall showed that supply and demand
simultaneously operate to determine price
– prices reflect both the marginal evaluation that
consumers place on goods and the marginal costs
of producing the goods
• water has a low marginal value and a low marginal cost
of production  Low price
• diamonds have a high marginal value and a high
marginal cost of production  High price

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THE ORDINALIST APPROACH-
INDIFFERENCE CURVE ANALYSIS
• Ordinal utility theory states that while the utility
of a particular good and service cannot be
measured using an objective scale, a consumer is
capable of ranking different alternatives available.
• This involves the qualitative assessment of
satisfaction.
• For example, a consumer can say that he prefers to
10 kgs of maize to 5 kgs of rice.

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Cont….
• Assumptions of Ordinal Utility Theory
1)Rationality: The consumer is a rational being. He
aims at maximizing his total satisfaction given his
income and prices of goods and services
2)Utility can be expressed ordinally. Consumer is able
to tell only order of his preferences
3)Transitivity: if A>B; and B>C, then A>C

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Cont….
4. Consistency of choice: If he prefers A to B in one
period, he will not prefer B to A in another period
5. Diminishing Marginal Rate of Substitution.
 The marginal rate of substitution means the rate at
which a consumer is willing to substitute one
commodity (X) for another (Y), i.e the units of Y he
is willing to give up for one unit of x so that his
total satisfaction remains the same.

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Cont….
 This rate is given by ΔY/ΔX.
 The assumption is that ΔY/ΔX goes on
decreasing, when a consumer continues to
substitute X for Y.

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• Indifference Curve Analysis combines two
concepts; indifference curves and budget lines
(constraints)
• Indifference Curve: May be defined as a curve
which represents combinations of two goods or
services which give the same level of utility to the
consumer.

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Cont….
• It can also be defined as a line that shows all the
possible combinations of two goods between
which a person is indifferent.
• Since each combination of two goods yields the
same level of utility, the consumer is indifferent
between any two combinations of goods.
• Indifference curve is also called Iso-Utility Curve
and Equal Utility Curve.

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Cont….
• Example: Suppose a consumer consumes only
two commodities X and Y, and he makes 5
combinations he calls a, b, c, d, and e.
• All these combinations yield the same level of
utility or they are all equally preferred.
• His combinations are presented in Table 1.

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Cont…..
Table 1. Indifference Schedule of Commodities X and Y.
Combination Good X Good Y Utility
a 5 25 u
b 7 15 u
c 12 10 u
d 20 6 u
e 30 5 u

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Cont…..
Figure 1: Indifference Curve
0
5
10
15
20
25
30
0 5 10 15 20 25 30 35
Good X
Good
Y
a
b
c
d e
g
f
5

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Cont…..
• All combinations (a, b, c, d, e) which fall along the
indifference curve, yield the same level of
satisfaction.
• Points g and f fall outside the indifference curve
(IC), therefore they yield different level of
satisfaction.

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INDIFFERENCE CURVE
ANALYSIS Cont…..
• Indifference Map
• Is a graph of indifference curves associated with
different utility levels.
• Indifference map contains a number of
indifference curves, ranked in the order of
consumer’s preferences

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Cont…..
• Figure 6: Indifference Map
Quantity of food per week
Consumer’s indifference map
Qty of clothing
per week

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Cont…..
• Each indifference curve represents the consumers
choices of two goods- choices at which he is
equally happy or indifferent, hence the term
indifference curves.
• Higher indifference curves give the consumer
more of satisfaction.
• Lower indifference curve gives the consumer less
satisfaction.
• The slope of Indifference curve is known as
Marginal Rate of Substitution and is convex to the
origin.

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MARGINAL RATE OF
SUBSTITUTION
• The Marginal Rate of Substitution
• Is a rate at which a consumer is willing to
substitute one good for the other.
• One of the basic assumption of indifference curve
analysis is that MRS diminishes.
• When a consumer substitutes one commodity (say
X) for another (say Y), The Marginal Rate of
Substitution (MRS) decreases as the stock of X
increases and that of Y decreases.

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MARGINAL RATE OF
SUBSTITUTION Cont…
• Measuring MRS
• To explain symbolically, suppose that the utility
function of a consumer is given as:
• U = f (x, y)
• Suppose that the consumer substitute x for y.
• When consumer foregoes some units of y, his
stock of y decreases by –ΔY.
• His loss of utility may be expressed as:
–ΔY.MUy

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MARGINAL RATE OF
• On the other hand, as a result of this substitution,
his stock of X increases by ΔX.
• His utility from ΔX = +ΔX.MUx
• For the total utility U to remain the same; –
ΔY.MUy +ΔX.MUx =0
• (along an indifference curve U = 0)

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MARGINAL RATE OF
• Rearranging the terms we get:
–ΔY =MUx
ΔX MUy
• –ΔY = MRSxy =Slope of indifference curve
ΔX
When x is substituted for y.

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MARGINAL RATE OF
• Similarly,
• –Δx = MRSy,x when y is substituted for x.
Δy
NOTE THAT:
MRSxy= –ΔY =MUx
ΔX MUy
MRSy,x= –ΔX =MUy
ΔY MUx

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PROPERTIES OF INDIFFERENCE
CURVES
1. Indifference curves have a negative slope
An Indifference curve slopes downward from left
to right. The negative slope of the indifference
curve implies that:
a) Two commodities can be substituted for each
other.
b) If quantity of one commodity decreases,
quantity of the other commodity must increase
if the consumer has to stay at the same level of
satisfaction.

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CURVES

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CURVES
• In fig. 3.4 the two combinations of commodity
cooking oil and commodity wheat is shown by the
points a and b on the same indifference curve.
• The consumer is indifferent towards points a and b as
they represent equal level of satisfaction.
• At point (a) on the indifference curve, the consumer
is satisfied with OE units of cooking oil and OD units
of wheat.

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CURVES
• He is equally satisfied with OF units of
cooking oil and OK units of wheat shown by
point b on the indifference curve.
• It is only on the negatively sloped curve that
different points representing different
combinations of goods X and Y give the same
level of satisfaction to make the consumer
indifferent.

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CURVES Cont….
2. Indifference curves are convex to the origin.
• The curves are convex, which is a consequence
of the assumption that as consumers have less
and less of one good, they require more of the
other good to compensate.
• They are convex to the origin (bowed inward).
• This corresponding to the law of diminishing
marginal utility.

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CURVES Cont….

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CURVES Cont….
• In this figure (3.6) as the consumer moves from A to
B to C to D, the willingness to substitute good X for
good Y diminishes. This means that as the amount of
good X is increased by equal amounts, that of good Y
diminishes by smaller amounts.
• The marginal rate of substitution of X for Y is the
quantity of Y good that the consumer is willing to
give up to gain a marginal unit of good X. The slope
of IC is negative. It is convex to the origin.

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CURVES Cont….
3. Indifference curves do not intersect
• This is due to the assumption that consumers
will always prefer to have more of either good
than to have less.
• It is because at the point of tangency, the
higher curve will give as much as of the two
commodities as is given by the lower
indifference curve. This is impossible.

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CURVES Cont….

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CURVES Cont….
• In fig 3.7, two indifference curves are showing
cutting each other at point B. The
combinations represented by points B and F
given equal satisfaction to the consumer
because both lie on the same indifference
curve IC2.
• Similarly the combinations shows by points B
and E on indifference curve IC1 give equal
satisfaction top the consumer.

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CURVES Cont….
• If combination F is equal to combination B in terms
of satisfaction and combination E is equal to
combination B in satisfaction. It follows that the
combination F will be equivalent to E in terms of
satisfaction.
• This conclusion looks quite funny because
combination F on IC2 contains more of good Y
(wheat) than combination which gives more
satisfaction to the consumer. We, therefore, conclude
that indifference curves cannot cut each other.

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CURVES Cont….
4. Higher Indifference Curve Represents
Higher Level of satisfaction
• A higher indifference curve that lies above
and to the right of another indifference
curve represents a higher level of
satisfaction and combination on a lower
indifference curve yields a lower
satisfaction.

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CURVES Cont….

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CURVES Cont….
• In other words, we can say that the combination of
goods which lies on a higher indifference curve will
be preferred by a consumer to the combination which
lies on a lower indifference curve.
• In this diagram (3.5) there are three indifference
curves, IC1, IC2 and IC3 which represents different
levels of satisfaction. The indifference curve IC3
shows greater amount of satisfaction and it contains
more of both goods than IC2 and IC1 (IC3 > IC2 >
IC1).

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CURVES Cont….
• When the individual has a relatively large amount
of good Y he is willing to forego 2 units of Y in
return for one more unit of good X and still feel
as well off.
• However, lower down the indifference curve, he
will only sacrifice less of Y (e.g. 0.5 units) for one
more unit of X as he begins to have to relatively
more of X than Y.

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CURVES Cont….
5. Indifference Curves do not Touch the
Horizontal or Vertical Axis
• One of the basic assumptions of indifference
curves is that the consumer purchases
combinations of different commodities.
• He is not supposed to purchase only one
commodity. In that case indifference curve
will touch one axis. This violates the basic
assumption of indifference curves.

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CURVES Cont….

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CURVES Cont….
• In fig. 3.8, it is shown that the in difference IC
touches Y axis at point C and X axis at point
E. At point C, the consumer purchase only OC
commodity of rice and no commodity of
wheat, similarly at point E, he buys OE
quantity of wheat and no amount of rice.
• Such indifference curves are against our basic
assumption. Our basic assumption is that the
consumer buys two goods in combination.

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BUDGET LINE
• A Budget Line (Budget Constraints)
• The budget line illustrates all the possible
combinations of two goods that can be purchased at
given prices and for a given level of income.
• The equation of the budget line is written as: Px.X+
Py.Y=I
• It means that the amount spent on good X plus the
amount spent on Y must equal the total income
available.

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BUDGET LINE Cont….
• Numerical Example:
• Suppose a consumer has a budget (income) of 60
shs.
• He consumes two commodities X and Y.
• Price of commodity X is 2 shs per unit and 1 shs
per unit of Y.

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• Figure 8: Budget Line
60
30
Good X
Good Y

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• With a limited budget the consumer can only
consume a limited combination of x and y.
• Note that the two endpoints of the budget line are
equal to income divided by the respective price (I
/ P), as they represent the units bought of one
good when all income is spent on that good.

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Market basket Biscuits per week Coffee per week
A 10 0
B 8 1
C 6 2
D 4 3
E 2 4
F 0 5

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(i) Market basket A in the table above shows that if
the whole amounts of $60 is spent on the purchase of
biscuits, then the consumer buys 10 packets of
biscuits at a price of $6 each and nothing is left to
purchase coffee.
(ii) Market basket F shows the other extreme. If the
consumer spends the entire amount of $60 on the
purchase of coffee, a maximum of 5 packets of coffee
can be purchased with it at a price of $12 each with
nothing left over for the purchase of biscuits.

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(iii) The intermediate market baskets B to E
shows the mixes of packets of biscuits and
packets of coffee that the cost a total of $60.
For example, in combination of market basket
C, the consumer can purchase 6 packets of
biscuits and 2 packets of coffee with a total
cost of $60.

78
• In the fig. 3.9 the line AF shows the various
combinations of goods the consumer can
purchase. This line is called the budget line.
• It shows 6 possible combinations of packets of
biscuits and packets if coffee which a
consumer can purchase weekly. These
combinations are indicated by points A, B, C,
D, E and.

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• Point A indicates that 10 packet of biscuits can
be purchased if the entire income of $60 is
devoted to the purchase of biscuits. Similarly,
point F shows the purchase of 5 packets of
coffee for the entire income of $60 per week.
• The budget line AF indicates all the
combinations of packets of biscuits and
packets of coffee which a consumer can buy
given the assumed prices and income.

80
• In case, a consumer decides to purchase
combination of goods inside the budget line
such as G, then it involves a total outlay that
is smaller than the amount of $60 per week.
• Any point outside the budget line such as H
requires an outlay larger than the consumer’s
weekly income of $60.

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• Slope of the Budget Line
The slope of the budget line can be written as
follows:
• Absolute slope=(-) ΔY = Px
ΔX Py
• The slope of the budget line equals the relative
price of good X to good Y.

82
• The slope of the budget line indicates how
many packets of biscuits a purchaser must give
up to buy one more packet of coffee.
• For example, the slope at point B on the
budget line is ∆Y / ∆X or two packets of
biscuits 1 = packet of coffee for our case.

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• This indicates that a move from B to C
involves sacrificing two packets of biscuits to
gain an additional one packet of coffee.
• Since AF budget line is straight, the slope is
constant at -2 packets of biscuits per one
packet of coffee at all points along the line.

84
• In other words, the slope tells us the rate at which
the individual can trade off one good for the other
- e.g. the amount of Y that has to be foregone in
order to purchase one more unit of X
• Example: The slope of the budget line in figure 5
is:
Px = 2 = 2
PY 1
• i.e. two units of Y have to given up in order to
buy one more unit of X

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Shifts in the Budget Line
•Any change in one or more of the parameters of
the budget line (income and prices) will clearly
result in a shift in its position.
•A change in income shifts the budget line parallel
to the original line – (relative prices are
unchanged)
•A change in the price of one good shifts the
budget line and changes its slope – (relative prices
are different)

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• An equal percentage change in the price of both
goods shifts the budget line parallel to the original
• Example
• Assume consumer’s income increased to 90 shs,
and price of good X and Y remain the same i.e
Price of X= 2 shs and Price of Y 1 shs

87
(i) Income changes: When there is change in
the income of the consumer, the prices of
goods remaining the same, the price line shifts
from the original position.
• It shifts upward or to the right hand side in a
parallel position with the rise in income.

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• A fall in the level of income, product prices
remaining unchanged, the price line shifts left
side from the original position.
• With a higher income, the consumer can
purchase more of both goods than before but
the cost of one good in terms of the other
remains the same.

90
• In the fig. 3.10 (a), a change in income is
shown when product prices remain unchanged.
The rise in income results in a parallel upward
shifts in the budget line from L1 M1 to L2M2.
The consumer is able to purchase more of both
the goods A and B.

91
(ii) Price changes. Now let us consider that
there is a change in the price of one good. The
income of the consumer and price of other
good is held constant.
• When there is a fall in the price of one good
say commodity A, the consumer purchases
more of that good than before. A price change
causes the budget line to rotate about point L
fig. 3.10 (b).

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• It becomes flatter and give the new budget line
from LM1 to LM2. A flatter budget line
means that the relative price of the good A on
the horizontal axis is lower. If the greater
amount is spent on the purchase of good A, the
consumer can buy increased OM2 amount of
good A.

94
Figure 9: An increase in consumer’s Income
Figure 4: An increase in consumer income

95
• If consumer’s income fell then there would be a
corresponding parallel shift to the left to represent
a fall in the potential combinations of the two
goods that can be purchased.

96
• A change in the price of a good and the budget
line
• If income is held constant, and the price of one of
the goods changes then the slope of the curve will
change.
• In other words, the curve will rotate.

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• Suppose there is a reduction of price of good x
from 2 shs to 1 shs.
• The reduction of the price of good x from 2 shs to
1 shs means that on a fixed budget of 60 shs, the
consumer could purchase a maximum of 60 units,
as opposed to 30.
• Note that the price of good y has remained fixed,
hence the maximum point for good y will remain
fixed

98
Figure 10: A change in price

99
CONSUMER EQUILIBRIUM
• Consumer Equilibrium:
• The rational consumer wants to maximize utility
subject to his preferences and budget constraint;
• i.e. he/she will choose from the affordable bundles
of goods the one which gives them the most
utility.
• Specifically, the consumer chooses the point on
the budget line which is on the highest attainable
indifference curve.

100
Figure 11. The optimum consumption point
B
C
D
F

101
• At A, utility is maximized subject to the budget
constraint.
Why?
• Because any other point on the budget line (e.g.
points B & C) or within it (e.g. point D) is on a
lower indifference curve.
• Bundles beyond the budget line (e.g. point F) are
unobtainable.

102
• A rational, maximizing consumer would prefer
to be on the highest possible indifference curve
given their budget constraint.
• This point occurs where the indifference curve
touches (is tangential to) the budget line.
• In the case of Figure 11, the optimum
consumption point occurs at point A on
indifference curve I3.

103
• Equilibrium Conditions
Looking at Figure 11; it is clear that two
conditions characterize the optimum point A:
1.All income is spent - the individual must
choose a point on the budget line.
2.The slope of indifference curve (I2) equals
the (absolute) slope of the budget line: i.e.
MRSxy=Px
Py

104
INCOME AND SUBSTITUTION
EFFECTS
• Income and Substitution Effects
• Indifference analysis can be used to analyze how a
consumer would change the combination of two
goods for a given change in their income or the
price of the good.
• If we assume that the good is normal, then the
increase in price will result in a fall in the quantity
demanded.
• This is for two reasons; the income effect (have a
limited budget, therefore can purchase lower
quantities of the good) and the substitution effect
(swap with alternative goods that are cheaper).

105
SUBSTITUTION EFFECT
Figure 12

106
SUBSTITUTION EFFECT Cont….
• The substitution effect is the effect observed with
changes in relative price of goods.
• The graph 12 shows the effect of a price increase for
good Y.
• If the price of Y increases, the budget constraint will
pivot from BC2 to BC1.
• Notice that because the price of X does not change,
the consumer can still buy the same amount of X if he
or she chooses to buy only good X.
• On the other hand, if the consumer chooses to buy
only good Y, he or she will be able to buy less of
good Y because its price has increased.

107
SUBSTITUTION EFFECT Cont….
• To maximize the utility with the reduced budget
constraint, BC1, the consumer will re-allocate
consumption to reach the highest available
indifference curve which BC1 is tangent to.
• As shown on the diagram below, that curve is I1,
and therefore the amount of good Y bought will
shift from Y2 to Y1, and the amount of good X
bought to shift from X2 to X1.
• The opposite effect will occur if the price of Y
decreases causing the shift from BC2 to BC3, and
I2 to I3.

108
INCOME EFFECT
• The income effect is observed through changes in
purchasing power.
• It reveals the change in quantity demanded
brought by a change in real income.
• Graphically, as long as the prices remain constant,
changing the income will create a parallel shift of
the budget constraint.
• Increasing the income will shift the budget
constraint right since more of both can be bought,
and decreasing income will shift it left.

109
INCOME EFFECT Cont……..
• Depending on the indifference curves, the amount
of a good bought can either increase, decrease or
stay the same when income increases.
• In the diagram 13, good Y is a normal good since
the amount purchased increased as the budget
constraint shifted from BC1 to the higher income
BC2.
• Good X is an inferior good since the amount
bought decreased as the income increases.

110
INCOME EFFECT Cont….
Figure 13-Income Effect

112
• In the diagram (3.12) wheat is measured along OX
and rise along OY. When the price line or budget line
is BB/ , the consumer gets maximum satisfaction or is
in equilibrium position at point K where it touches
the indifference curve IC1.
• The consumer buys OS quantity of wheat and ON
quantity of rice. We suppose now that the income of
the consumer has increased and the price line is now
CC1. Which shifts in a parallel fashion to the right.

113
• The consumer is in equilibrium at a level at
point L which is its equilibrium point. If there
is further increase in income: shift of the price
line now will be DD1, and the consumer is in
equilibrium at point T and will be purchasing
OZ quantity of wheat and OE quantity of rice.
• If these, equilibrium points K, L, T are joined
together by a dotted line passing through the
origin, we get income consumption curve
ICC.

114
• This shows that with the rise in income, the consumer
generally buys more quantities of the two
commodities rice and wheat. The income consumer is
now better off at T on indifference curve IC3 as
compared to L at a lower indifference curve IC2 .
• The income effect is positive in case of both the
goods rice and wheat as these are normal goods. The
income consumption curve ICC which is derived by
joining the successive equilibrium positions has a
positive slope.

115
Income Effect When Wheat is an Inferior
Good:
• Sometimes it also happens that with the rise in
income, the consumer buys more of one
commodity and less of another. For instance,
he may buy less of wheat and more of rice as
is, illustrated in figures 3.13.

117
• In diagram 3.13, the income consumption
curve bends back on itself. With the rise in
income, the consumer buys more of rice and
less of wheat.
• The price effect for rice is positive and for
wheat is negative. The good which is
purchased less with the increase in income is
called inferior good.

118
Income Effect When Rice is an Inferior Good:

119
• In the figure 3.14, it is shown that with the rise
in money income, the purchase of wheat has
increased from M1 to M4 indicating positive
income effect on the purchase of normal good
wheat.
• The income effect on inferior good is negative.
The income consumption curve ICC is starts
bending towards the horizontal axis which
shows that wheat is a normal good and rice is
inferior good.

120
PRICE EFFECT
• Price Effect on the Consumption of a Normal
Good:
• We now discuss the reaction of the consumer to the
changes in the price of a good while his money
income, tastes, preferences and prices of other goods
remain unchanged.
• When there is change in the price of a good shown on
the two axes of an indifference map, there takes place
a change in demand in response to a change in price
of a commodity, other things remaining the same, is
called price effect.

122
PRICE EFFECT Cont….
• For example in fig. 3.15, AB is the initial budget line.
It is assumed that the price of wheat has fallen and
the price of rice and the income of the consumer
remains unchanged. The price line takes a new
position AC and the equilibrium point shifts from P
to U.
• The consumer buys now OT quantity of wheat (the
amount demanded rises from OE to OT and OZ
quantity of rice. With further fall in the price of
wheat, the consumer is in equilibrium at point S,
where the budget line AD is tangent to a higher
indifference curve AC3.

123
• He buys now OF quantity of wheat and OR quantity
of rice.
• The rise in amount purchased of wheat (OE to OF) as
a result of a fall in its price is called price effect.
• The price effect on the consumption of a normal good
is negative. If we join the equilibrium points PUS, we
get price consumption curve (PCC) of the consumer
for the commodity wheat.

124
Price Effect When Commodity X is a Giffen Good:
• Giffen good is a particular type of inferior good.
When there is a decrease in the quantity demanded of
a good with a fall in its price, the good is called
Giffen good after the name of Robert Giffen.
• A British Economist Robert Giffen (1837-1910),
observed that sometimes it so happens that a decrease
in the price of a particular good causes its quantity
demanded to fall.

125
• The consumer spends the money he saves (by
curtailing the demand) on the purchase of
increased quantity of the other good.
• The decrease in the price of Giffen good has
an effect similar to an an increase in the
income of a buyer.
• This particular type of behavior of the
consumer to decrease demand for good when
its price falls is called Giffen Paradox.

127
• In fig. 3.16, the consumer is in equilibrium at
point E where the budget line AB is tangent to
the indifference curve IC1. The consumer
purchases OX1 quantity of Giffen good X and
OY1 quantity of good Y.
• When there is a reduction in the price of good
X but no change in the price of good Y, the
budget line AB/ will showing upward.

128
• The consumer is in equilibrium at point E/
where the budget line AB/ is a tangent to the
indifference curve IC2. In the new equilibrium
position, the consumer purchases only OX2
units of Giffen good X and OY2 units of good
Y.
• We find that the decrease in the price of Giffen
good X, its quantity purchased has fallen from
OX1 to OX2 and the quantity demanded of Y
commodity goes up from OY1 to OY2.

129
• The price effect on the consumption of Giffen
good is positive. If is indicated by the
backward bending PCC in the case of X as a
Giffen good.

130
EFFECTS TOGETHER
Figure 14: Income and Substitution Effects Together
A
B
C
G1
G3
G2

131
EFFECTS TOGETHER Cont…..
• Assume the original position was at point A and
price of X has increased.
• Due to the increase in the price of good x, the
budget line has rotated from B1 to B2 and the
consumption point has moved.
• The decrease in the quantity demanded can be
divided into two effects;
• The substitution effect
• The substitution effect is when the consumer
switches consumption patterns due to the price
change alone but remains on the same
indifference curve.

132
EFFECTS TOGETHER Cont…..
• To identify the substitution effect a new budget
line needs to be constructed.
• The budget line B1* is added, this budget line
needs to be parallel with the budget line B2 and
tangential to I1.
• Therefore, the movement from Q1 to Q2 is purely
due to the substitution effect.

133
CONSUMER BEHAVIOUR cont….
• The income effect
• The income effect highlights how consumption will
change due to the consumer having a change in
purchasing power as a result of the price change.
• The higher price means the budget line is B2, hence
the optimum consumption point is Q2. This point is
on a lower indifference curve (I2).

134
• When price of one good increases, the consumer
income is so increased so that he or she can remain
equally well-off as before the price changed.
• The consumer income is increased so that he/she is
back to original indifference curve.
• The logic behind increasing income is that, after the
increase in price the consumer becomes worse-off as
the purchasing power will fall.
• The increased amount is known as Compensating
Variation in Income (CV).

135
Quantity of x
Quantity of y
U1
A
Suppose the consumer is maximizing
utility at point A.
U2
B
If the price of good x rises, the consumer
will maximize utility at point B.
The consumer’s utility
falls from U1 to U2

136
Quantity of x
Quantity of y
U1
A
U2
B
CV is the amount that the
individual would need to be
compensated
The consumer could be compensated so
that he can afford to remain on U1
C

137
SEMINAR QUESTIONS
1. Define the concept of utility. With the aid of
diagrams show the relationship between TU and
Marginal Utility
2. Distinguish between the following concepts
a)Ordinal and Cardinal utility
b)The law of Diminishing Marginal Utility and the
law of Diminishing marginal rate of substitution
c)Budget line and Indifference curve
d)Income and substitution effect

138
SEMINAR QUESTIONS Cont…
3. Based on the assumptions of Ordinal utility
theory discuss on the shape of Indifference
curve
4. What are the properties of Indifference Curve
5. Explain why indifference curves cannot
intersect.
6. What would the indifference curves look like
for the following types of goods:
a) Perfect substitutes?
b) Perfect complements?

139
7. Based on Ordinalist approach discuss how a
consumer maximize his/her utility
8. Given the following information about an
individual’s consumption possibilities between
two goods, X and Y. I = 100shs; PX = 10 shs;
PY = 5 shs
a) Calculate and draw the individual’s budget
line

140
b) Show what happens to the budget line when:
i) Income decreases by 20%
ii) PY rises by 40%
iii)Both prices fall by 10%
Hint: Start from the original budget line in each
case

141
9. Explain why the consumer would not be in
equilibrium at point B in the following diagram.
What should the consumer do?
Good X
Good Y
U 1
U 2
E
B
X*
Y*

ECO_100_Consumer_Behavior_Theory.ppt

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