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Consumer theory
Consumer theory helps understand how individuals make choices given limited budgets to maximize satisfaction or utility. It assumes consumers are rational and want to maximize utility subject to budget constraints. There are two main approaches - the cardinal and ordinal theories. The cardinal theory assumes utility is quantitatively measurable while the ordinal theory only requires preferences can be ranked. Both use concepts like total utility, marginal utility, indifference curves, and budget constraints to model consumer choice and derive the downward sloping demand curve. The law of diminishing marginal utility states that as consumption of a good increases, the marginal utility from each additional unit decreases. This forms the basis for consumer demand curves and many economic implications.
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Consumer theory
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- 2. 2 What is ConsumerTheory? Helps to understand the behaviour of individual customers. How they decide which combination of goods and services they should buy and in what quantity to maximise their satisfaction. Satisfaction has a name : UTILITY Assumes that consumers are rational. Rational consumers want to maximise utility, given budget constraints. Is irrational buying possible?
- 3. 3 Consumer Theory -Why? – to understand the foundations of market demand – These theories explain the story behind the downward sloping demand curve
- 4. 4 Theories of ConsumerChoice The Cardinal Theory – Utility is measurable in a cardinal sense The Ordinal Theory – Utility is measurable in an ordinal sense
- 5. 5 The Cardinal Approach: Features Utility is the want satisfying ability of a commodity Concept introduced by Alfred Marshal, Jeremy Bentham Measured in “utils”
- 6. 6 Total utility Total utility: sum of utility derived from consumption Marginal utility: rate of change of TU from one more unit of extra consumption. MUn = TUn – TUn-1 MU= Δ TU/ Δ Q
- 7. 7 Understanding TU andMU Unit of mango Total utility MU 1 10 10 2 20 10 3 29 9 4 37 8 5 43 6 6 48 5 7 51 3 8 52 1 9 52 0 10 50 -2
- 8. 8 Assumptions of Cardinal UtilityAnalysis: Rationality of consumer Cardinal measurability of utility MU of money is constant Diminishing marginal utility Utility is additive – TUn = Ux + Uy + Uz+…. + Un
- 9. 9 LDMU: Carl Menger1840 Irrefutably true. The additional utility that a person derives by consuming an extra unit of a commodity diminishes, TU increases at a decreasing rate.
- 10. 10 TU No. of mangoes Max TU=saturation point TU curve No. of mangoes MU MU curve When TU = max, MU =0
- 11. 11 Applying The LDMU LDMUis the basis of the downward sloping demand curve. The idea : As consumer’s consume more of the same commodity , they like less of it and so will be willing to pay only a lower price.
- 12. 12 Applying the LDMU: 2 good case Consumer rationally allocates his limited income using the Law of equi-marginal utility which is : Condition for utility maximisation=> decision making rule for all rational consumers MUx/ Px = MUy/ Py = MU m…. In a two commodity world. MUm = MU of money which is a constant.
- 13. 13 An example: Consumer Equilibrium AppleMUa Mua/Pa Banana MUb MUb/Pb 1 60 1 60 2 48 2 55 3 42 3 50 4 36 4 45 5 30 5 40 6 24 6 35 7 18 7 20 Pa= Rs3 Pb = Rs5 MU m = 10
- 14. 14 Criticisms: Utility is notcardinally measurable MU of money is not constant Doesn’t explain inferior goods/ giffen goods Failure to distinguish between income effects and substitution effects.
- 15. 15 Practical implications of LDMU Whatwould happen if we had only one company producing only one good of it’s kind? Diversification in Production: to overcome the resistance of the consumers and in order to secure higher profits, the producers continuously introduce newer varieties of the products with new design, shape, color, technique and presentation.
- 16. 16 Practical Implications for LDMU Basisfor Progressive Taxation As the rich have lower marginal utility of money as compared to the poor people due to greater stock of money, they should be taxed at a higher rate. Household Expenditure: This law governs our daily expenditure. Since larger purchases reduce marginal utility, we restrict the purchase of a particular commodity, as we cannot afford to waste our limited resources.
- 17. 17 Ordinal Theory: The actuallevel of utility generated from the consumption of a good is irrelevant. Consumers consume goods in bundles. Only the ranking of preferences is important. The consumer will try to reach equilibrium ,i.e. the most preferred commodity bundle subject to his budget constraint. This theory uses Indifference curves as a tool of analysis
- 18. 18 Ordinal Utility theory: Assumptions Consumer is rational. Consumer Preferences are based on utility. Consumer is clearly able to rank his preferences. Among two bundles, the one with the higher utility is the preferred bundle… More is better than less. If two bundles have the same utility, we say that the consumer is indifferent. Preferences are transitive. If bundle A> bundle B and bundle B > Bundle C then A>C.
- 19. 19 Indifference Curves Is acontour of all combinations of two goods among which the consumer is indifferent The set of all indifference curves that describe an individual’s preferences are referred to as an indifference curve map. An indifference curve connects all of the bundles that a consumer likes equally. We will assume only two goods when using indifference curve analysis.
- 20. 20 Indifference Curve Map- Properties An indifference curve should not slope up. Indifference curves can not cross one another. Better bundles are to the northeast. Indifference curves will not be “bowed out.”
- 21. 21 Li’s Preferences in IndifferenceCurves An indifference curve connects all the bundles that have the same utility. Higher indifference curves indicate more utility (IC2 is preferred to IC1). Lower indifference curves indicate less utility (IC1 is preferred to IC0). The indifference curve map is FULL of indifference curves. Li's Indifference Curves 0 5 10 15 20 25 30 0 10 20 Wheat Rice I2 I1 I0
- 22. 22 The Marginal Rateof Substitution The Marginal Rate of Substitution(MRS) tells us how much of one good Li would willingly trade for an incremental unit of the other good and remain indifferent. The MRS=|slope| of the indifference curve at a bundle. Common to assume the MRS declines as we move down an indifference curve. Li's Indifference Curves 0 5 10 15 20 25 30 0 10 20 Wheat Rice I2 I1 I0
- 23. 23 What is aBudget Constraint? A budget constraint is a straight line which shows all combinations of two goods that the consumer can buy with his given income.
- 24. 24 Example : Li’sDemand for Wheat and Rice Li’s demand for wheat and rice depends upon the prices for these goods, her income, and her preferences. Suppose we look first at her budget constraint: – Wheat costs Rs 4/kg. – Rice costs Rs2/kg. -- Leena has Rs 40 of income.
- 25. 25 Li’s Budget Constraint Themathematical expression for Li’s budget constraint is: I = PW W + PR R R = I/PR - (PW / PR)W the |slope| of the budget line is called the MRS=Marginal Rate of Substitution In this case it is PW / PR For Li : PW=Rs4 PR=Rs2 I=Rs40 MRS=2 Try to construct the budget line!!
- 26. 26 Budget Line gymnastics Anincrease in income only. An increase in the price of wheat only. A decrease in the price of rice only. Income doubles as do the prices of wheat and rice. Note: Changes in the price of wheat relative to the price of rice will change the MRS.
- 27. 27 How Much Wheatand Rice Li’s optimal amount of wheat and rice to consume is the amount that maximizes Li’s utility subject to her budget constraint. In the graph... – Get to the highest indifference curve possible – Stay on the budget constraint (b/c more is better)
- 28. 28 How to FindLi’s Best Combination Wheat Rice 20 10 IC0 IC1 IC2 W* R* The black bundle is best. The pink bundle is not the best. Li has spent all her income but is not on the highest indifference curve possible. Bundles n/e of IC0 are better and some are affordable. At (W*, R*) she is doing the best she can subject to her budget constraint.
- 29. 29 How to Findthe Best Combination Utility is maximized when: – the indifference curve is just tangent to the budget line. Utility is maximized when: – you are on the budget line and – the slope of the indifference curve equals the slope of the budget line
- 30. 30 The “bang perbuck” story Let MUW = Li’s marginal utility of wheat – it measures the change in utility as we change wheat consumption by an incremental unit while holding rice constant Let MUR = Li’s marginal utility of rice – it measures the change in utility as we change rice consumption by an incremental unit while holding wheat constant Common to assume that marginal utilities decline as we increase consumption - the law of diminishing marginal utility
- 31. 31 The “bang perbuck” story The MRS = MUW / MUR The ERS = PW / PR At an optimal bundle: MRS=ERS Rewritten we have: » MUW / MUR = PW / PR » MUW/PW = MUR/PR » bang/buck in wheat = bang/buck in rice
- 32. 32 Handling a changein PW Li wants to achieve the highest indifference curve that the budget constraints permit. The points A, B, and C represents the best that Li can do at prices of $4, $2, and $1 for wheat. The equation MRS=ERS is satisfied at each of the points. Li's Demand for Wheat 0 5 10 15 20 25 30 0 5 10 15 20 Wheat Rice I2 I1 I0 4 2 1 C B A
- 33. 33 Li’s Demand forWheat The table shows the amount of wheat that Li demands at each price. These are the points of tangency from the previous slide. Quantity Price Point 6 4 A 10 2 B 16 1 C Li's Demand for Wheat
- 34. 34 Graph of Li’sDemand for Wheat When we connect the points from the table in the previous slide we get Li’s demand for wheat. The points A, B, and C correspond to the tangencies of the budget constraint and the indifference curves. Li's Demand for Wheat 0 1 2 3 4 0 2 4 6 8 10 12 14 16 18 20 Quantity Price A B C
- 35. 35 Li’s Best Choice Reconsidered Considerthe choice at PW=Rs 2/ kg. The point B is optimal. The point A is feasible but inferior to all points on the red budget line between E and F. The point C is preferred to B but cannot be purchased with Li’s $40 income at the given prices; it is above the red budget line. The point E is feasible but Li prefers more wheat and less rice (B). The point F is feasible but Li prefers less wheat and more rice (B, again). There is no combination that Li prefers to B that she is able to buy. Li's Best Choice of Wheat and Rice 0 5 10 15 20 25 30 0 5 10 15 20 Wheat Rice I2 I1 I0 2 A E F B C
- 36. 36 Handling a changein PW Li wants to achieve the highest indifference curve that the budget constraints permit. The points A, B, and C represents the best that Li can do at prices of $4, $2, and $1 for wheat. The equation MRS=ERS is satisfied at each of the points. Li's Demand for Wheat 0 5 10 15 20 25 30 0 5 10 15 20 Wheat Rice I2 I1 I0 4 2 1 C B A
- 37. 37 Li’s Demand forWheat The table shows the amount of wheat that Li demands at each price. These are the points of tangency from the previous slide. Quantity Price Point 6 4 A 10 2 B 16 1 C Li's Demand for Wheat
- 38. 38 Graph of Li’sDemand for Wheat When we connect the points from the table in the previous slide we get Li’s demand for wheat. The points A, B, and C correspond to the tangencies of the budget constraint and the indifference curves. Li's Demand for Wheat 0 1 2 3 4 0 2 4 6 8 10 12 14 16 18 20 Quantity Price A B C
- 39. 39 Income and SubstitutionEffects: Price Decline, “X” normal When the price of a good falls, the quantity demanded rises for two reasons. The income effect: real income is higher because the same money income buys more at the lower prices. For normal goods, then, the income effect of a price fall is positive. The substitution effect: consumers substitute the now cheaper good for ones whose price has not fallen, real income held constant. This increase in demand is called the substitution effect of a price decline.
- 40. 40 General effect ofa price fall Income effect - you feel richer “X” normal Substitution Effect X now looks relatively cheaper PX falls Quantity demanded increases Quantity demanded increasesQuantity demanded decreases Total effect is the substitution effect AND the income effect working at the same time. “X” inferior