INTRODUCTION ECONOMICS

Arba Minch University

College of Business and Economics
Department of Economics
by
11/14/2022
Zigale Y.(M.Sc.) 1
 CHAPTER THREE
THEORY OF CONSUMER BEHAVIOR

3.1 Consumer preferences

Consumers are the principal actors (decision making units) of an economic

system.

A consumer makes choices by comparing bundle of goods.

Given any two consumption bundles, the consumer either decides that one of

the consumption bundles is strictly better than the other, or decides that she is

indifferent between the two bundles.

A)Strictly preferred
We use the symbol ≻ to mean that one bundle is strictly preferred to another,
 Cont’d …
 so that X ≻Y should be interpreted as saying that the consumer strictly
prefers X to Y.
 In the sense that she definitely wants the X-bundle rather than the Y-
bundle.

 B). Indifferent

 If the consumer is indifferent between two bundles of goods, we use the

symbol ∼ and write X~Y.
 Indifference means that the consumer would be just as satisfied,
according to her own preferences, consuming the bundle X as she
would be consuming bundle Y.
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 C).Weakly prefers
 If the consumer prefers or is indifferent between the two bundles we say that she
weakly prefers X to Y and write X ⪰ Y.

 3.2.The concept of utility

 Utility is describe as the satisfaction or pleasure derived from the
consumption of a good or service.
 In other words, utility is the power of the product to satisfy human
wants.
 Utility’ and ‘Usefulness’ are not synonymous. For example, paintings
by Picasso may be useless functionally but offer great utility to art
lovers.
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 Cont’d …
 Hence, usefulness is product centric whereas utility is consumer
centric.
 The same commodity gives different utilities to different
consumers.

 Properties of Utility
 Utility is a subjective phenomenon :This means utility is not
objective. Even for the same consumer, utility varies from unit
to unit, from time to time and from place to place.

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 3.3.Approaches of measuring utility
 There are two major approaches to measure or compare
consumer‘s utility: cardinal and ordinal approaches.

 3.3.1 The cardinal utility theory

 According to the cardinal utility theory, utility is measurable by
arbitrary unit of measurement called utils in the form of 1, 2, 3 etc.

 Assumptions of cardinal utility theory

 Rationality of consumers. The main objective of the
consumer is to maximize his/her satisfaction given his/her
limited budget or income.
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 Cont’d …
 Utility is cardinally measurable. According to the cardinal
approach, the utility or satisfaction of each commodity is
measurable. Utility is measured in subjective units called utils.

 Constant marginal utility of money. A given unit of money

deserves the same value at any time or place it is to be spent.

 A person at the start of the month where he has received

monthly salary gives equal value to 1 birr with what he may

give it after three weeks or so.

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 Cont’d …
 Diminishing marginal utility (DMU). The utility derived from

each successive units of a commodity diminishes. In other

words, the marginal utility of a commodity diminishes as

the consumer acquires larger quantities of it.

 The total utility of a basket of goods depends on the

quantities of the individual commodities. If there are n

commodities in the bundle with quantities X1, X 2,...X n , the

total utility is given by TU = f ( X1, X2......Xn )

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 Total and marginal utility
 Total Utility (TU) is the total satisfaction a consumer gets from consuming

some specific quantities of a commodity at a particular time.

 As the consumer consumes more of a good per time period, his/her total

utility increases. However, there is a saturation point for that commodity

beyond which the consumer will not be capable of enjoying any greater

satisfaction from it.

 Marginal Utility (MU) is the extra satisfaction a consumer realizes from

an additional unit of the product.

 In other words, marginal utility is the change in total utility that results

from the consumption of one more unit of a product. 9

 Cont’d …
 Mathematically, marginal utility is:

 Where, TU is the change in total utility, and Q is the

change in the amount of product consumed.

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 Cont’d …
 The total utility first increases, reaches the maximum (when the
consumer consumes 6 units) and then declines as the quantity
consumed increases.
 On the other hand, the marginal utility continuously declines (even
becomes zero or negative) as quantity consumed increases.

 When TU is increasing, MU is positive.

 When TU is maximized, MU is zero.
 When TU is decreasing, MU is negative

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Cont’d …

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 Law of diminishing marginal utility (LDMU)

 The law of diminishing marginal utility states that as the quantity

consumed of a commodity increases per unit of time, the utility

derived from each successive unit decreases, consumption of all

other commodities remaining constant.

 In other words, the extra satisfaction that a consumer derives

declines as he/she consumes more and more of the product in a

given period of time.

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 Cont’d …
 The law of diminishing marginal utility is based on the
following assumptions.
 The consumer is rational
 The consumer consumes identical or homogenous
product. The commodity to be consumed should have
similar quality, color, design, etc.
 There is no time gap in consumption of the good
 The consumer taste/preferences remain unchanged .

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 Consumer’s Equilibrium or Law of Equi-Marginal Utility

 a consumer will be in equilibrium when she/he spends her/ his

given income on the purchase of different commodities in such a
way so as to maximize her/his total utility.
 The law of equi-marginal utility states that a consumer gets
maximum satisfaction when the ratio of marginal utilities of all
commodities and their prices is equal.
 In other words, the consumer should incur expenditure on
different commodities in such a manner that the marginal utility
of the last Birr spent on each one of them is equal.
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 The case of one commodity
 The equilibrium condition of a consumer that consumes a single
good X occurs when the marginal utility of X is equal to its
market price.

 Given the utility function U  f (X )

 If the consumer buys commodity X, then his expenditure will be

 The consumer maximizes the difference between his utility and

expenditure. Max(U  QX PX )
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 Cont’d …
 The necessary condition for maximization is equating the
derivative of a function to zero. Thus,

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 Cont’d …
 At any point above point C (like point A) where MUX > PX, it
pays the consumer to consume more.
 When MUX < PX (like point B), the consumer should consume
less of X.
 At point C ,where MUX = PX the consumer is at equilibrium.

The case of two or more commodities

 For the case of two or more goods, the consumer‘s equilibrium
is achieved when the marginal utility per money spent is equal
for each good purchased and his money income available for the
purchase of the goods is exhausted.
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 Cont’d …
 That is,

 M is the income of the consumer

 Example: Suppose Saron has 7 Birr to be spent on two
goods: banana and bread. The unit price of banana is 1 Birr
and the unit price of a loaf of bread is 4 Birr. The total
utility she obtains from consumption of each good is given
below.

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Cont’d …

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 Cont’d …
 utility is maximized when the condition of marginal utility
of one commodity divided by its market price is equal to
the marginal utility of the other commodity divided by its
market price.

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oi) MU1/P1 = MU2/P2

ii) P1.Q1+ P2.Q2= M

(1*3) + (4*1) = 7

oThe total utility that Saron derives from this combination can be given by:
TU= TU1 + TU2
TU= 14 + 12
TU= 26
Given her fixed income and the price level of the two goods, no combination of the two
goods will give her higher TU than this level of utility.
 Limitation of the cardinal approach
 The assumption of cardinal utility is doubtful because
utility may not be quantified. Utility cannot be measured
absolutely (objectively).
 The assumption of constant MU of money is unrealistic
because as income increases, the marginal utility of money
changes.

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 The ordinal utility theory
 In the ordinal utility approach, it is not possible for consumers
to express the utility of various commodities they consume in
absolute terms, like 1 util, 2 utils, or 3 utils and so on.
 but it is possible to express the utility in relative terms.
 The consumers can rank commodities in the order of their
preferences as 1st, 2nd, 3rd and so on.
 As a general ordinal utility is not absolutely (cardinally)
measurable. Consumers are required only to order or rank
their preference for various bundles of commodities.

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 Assumptions of ordinal utility theory
 Consumers are rational - they maximize their satisfaction or utility
given their income and market prices.
 Utility is ordinal - utility is not absolutely (cardinally) measurable.
Consumers are required only to order or rank their preference for
various bundles of commodities.
 Diminishing marginal rate of substitution: The marginal rate of
substitution is the rate at which a consumer is willing to substitute
one commodity for another commodity so that his total satisfaction
remains the same.
 The rate at which one good can be substituted for another in
consumer‘s basket of goods diminishes as the consumer consumes
more and more of the good.
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 Cont’d …
 The total utility of a consumer is measured by the amount (quantities) of all
items he/she consumes from his/her consumption basket.

 Consumer’s preferences are transitivity. For example, if there are three

goods in a given consumer‘s basket, say, X, Y, Z and if he prefers X to Y and Y
to Z, then the consumer is expected to prefer X to Z. This property is known as
axioms of transitivity.

Indifference set, curve and map

 The ordinal utility approach is explained with the help of
indifference curves.
 Therefore, the ordinal utility theory is also known as the
indifference curve approach. 26
 Cont’d …
 Indifference set/ schedule is a combination of goods for which the
consumer is indifferent. It shows the various combinations of goods
from which the consumer derives the same level of satisfaction.

 In table above, each combination of good X and Y gives the

consumer equal level of total utility.
 Thus, the individual is indifferent whether he consumes combination
A, B, C or D
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 Cont’d …
 Indifference curve: When the indifference set/schedule is expressed
graphically, it is called an indifference curve.
 An indifference curve shows different combinations of two goods
which yield the same utility (level of satisfaction) to the consumer.

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 Cont’d …
 A set of indifference curves is called indifference map.

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 Properties of indifference curves
1) Indifference curves have negative slope (downward sloping to the
right). Indifference curves are negatively sloped because the
consumption level of one commodity can be increased only by
reducing the consumption level of the other commodity.
 In other words, in order to keep the utility of the consumer constant,
as the quantity of one commodity is increased the quantity of the
other must be decreased.

2) Indifference curves are convex to the origin.

 This implies that the slope of an indifference curve decreases (in
absolute terms) as we move along the curve from the left downwards
to the right. 30
 Cont’d …
 The convexity of indifference curves is the reflection of the
diminishing marginal rate of substitution.
 A higher indifference curve is always preferred to a lower
one. The further away from the origin an indifferent curve lies,
the higher the level of utility it denotes.
 Indifference curves never cross each other (cannot intersect).
The assumptions of consistency and transitivity will rule out the
intersection of indifference curves.
 Figure 3.4 below shows the violations of the assumptions of
preferences due to the intersection of indifference curves.

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Cont’d …

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 Marginal rate of substitution (MRS)
 Marginal rate of substitution is a rate at which consumers are
willing to substitute one commodity for another in such a way
that the consumer remains on the same indifference curve.
 Marginal rate of substitution of X for Y is defined as the number
of units of commodity Y that must be given up in exchange for
an extra unit of commodity X so that the consumer maintains
the same level of satisfaction.

 It is also possible to derive MRS using the concept of marginal

utility. MRS X ,Y is related to MUX and MUY as follows. 33
 Cont’d …

 Proof: Suppose the utility function for two commodities X and Y is

defined as: U  f (X,Y) Since utility is constant along an indifference
curve, the total differential of the utility function will be zero.
 and

 Example: Suppose a consumer‘s utility function is given by

U(X,Y) 

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 The Budget line or the price line
 Indifference curves only tell us about consumer preferences for any
two goods but they cannot show which combinations of the two
goods will be bought.
 In reality, the consumer is constrained by his/her income and prices
of the two commodities
 This constraint is often presented with the help of the budget line.
 The budget line is a set of the commodity bundles that can be
purchased if the entire income is spent.
 It is a graph which shows the various combinations of two goods that
a consumer can purchase given his/her limited income and the prices
of the two goods.

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 Cont’d …
 In order to draw a budget line facing a consumer, we consider the
following assumptions.
 There are only two goods bought in quantities, say, X and Y.
 Each consumer is confronted with market determined prices, PX
and PY.
 The consumer has a known and fixed money income (M).
 Assuming that the consumer spends all his/her income on the two
goods (X and Y), we can express the budget constraint as:

 By rearranging the above eq we obtain

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 Cont’d …

 Note that: The slope of the budget line is given is by

the ratio of the prices of the two goods).

 Any combination of the two goods within the budget line

(such as point A) or along the budget line is attainable.

 Any combination of the two goods outside the budget line

(such as point B) is unattainable (unaffordable).

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 Cont’d …

 Example: A consumer has $100 to spend on two goods X and Y with

prices $3 and $5 respectively. Derive the equation of the budget line
and sketch the graph.

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 the effect of changing income and price on budget line
Change in income: If the income of the consumer changes
(keeping the prices of the commodities unchanged), the budget
line also shifts (changes).
 Increase in income causes an upward/outward shift in the
budget line that allows the consumer to buy more goods and
services and
 decreases in income causes a downward/inward shift in the
budget line that leads the consumer to buy less quantity of the
two goods.
 It is important to note that the slope of the budget line (the ratio
of the two prices) does not change when income rises or falls.
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Cont’d …

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 Cont’d …
 Change in prices: An equal increase in the prices of the two goods
shifts the budget line inward. Since the two goods become expensive,
the consumer can purchase the lesser amount of the two goods.
 An equal decrease in the prices of the two goods, one the other hand,
shifts the budget line out ward. Since the two goods become cheaper,
the consumer can purchase the more amounts of the two goods.

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 Cont’d …
 If the price of good X decreases while both the price of good Y and
consumer‘s income remain unchanged, the horizontal intercept
moves outward and makes the budget line flatter.
 Effect of decrease in the price of only good X on the budget line

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 Equilibrium of the consumer
 a rational consumer tries to attain the highest possible
indifference curve, given the budget line.
 This occurs at the point where the indifference curve is tangent
to the budget line
 so that the slope of the indifference curve ( MRSXY ) is equal to
the slope of the budget line (PX / PY ).

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 Cont’d …
 Mathematically, consumer optimum (equilibrium) is attained at the
point where:
Slope of indifference curve = Slope of the budget line

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 Cont’d …
 Example: A consumer consuming two commodities X and Y
has the utility function U(X,Y)  XY 2X . The prices of the two
commodities are 4 birr and 2 birr respectively. The consumer
has a total income of 60 birr to be spent on the two goods.
a) Find the utility maximizing quantities of good X and Y.
b) Find the MRS X ,Y at equilibrium.

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 Cont’d …

Thanks

11/14/2022 46
 Thanks

11/14/2022 47