CONSUMER BEHAVIOR

THEORY
Ms. Hosana Edwin
 CONSUMER THEORY
• Consumers are faced with numerous selection of
goods and services from which they can choose to
consume.
• The set of all reasonable bundles is called a
consumption set.
• The set of a bundle that a consumer can afford given
his income/wealth and prices of the various
commodity is called a budget set.
Why Individuals Choose Different quantities at different prices?

Consumers are encouraged to demand certain quantities of goods and service at different
quantities due to the following reasons
• Budget
Consumer are restricted on how they choose subject to the amount of
wealth/income that they have access to. Their selection cannot really go above their
budget.
• Preferences and Taste
How can a consumer be satisfied with a particular good or services is subjective to his
individual taste and preference. The level of satisfaction is measured in terms of utility.

Utility is the measure of how a good satisfies a need.

• Utility Maximization
Given a preferences and restrictions (budget),
consumer maximizes his/her utility of consumption.
Maximization is the process of choosing in such a
way that one gets as much as possible of something
else.
Budget Constraint/Budget Line/Consumption
Possibility Curve
• Budget Constraint is a line showing the largest
possible combination of goods and services that a
consumer can afford/purchase subject his income and
prices of the goods.
• It is a downward sloping straight line
Budget Constraint ……….
• Consider a consumer in an economy where there are
two goods X1 and X2
• Their prices are P1 and P2 respectively
• Suppose that the consumer has money income m
• From this information:
 The budget constraint is given by:

p1 x1 + p2 x2 ≤ m. Note: For eqn (=)

x2

C
B


A

X1
• Point A: Expenditure < Income
• Point B : Expenditure = Income
• Point C : Expenditure > Income
Budget Constraint ……….
• Suppose you have an income of TZS. 10/= and you can afford to buy
maize flour which is TZS. 1/= per Kilo, and beans which is TZS. 2/= per
Kilo. How much can we buy for each respective good?
• This is found by taking =
Where, m = Income
P = Price.
Thus for Maize= = 10
Beans = = 5
Budget Constraint ……….
• Therefore the specified quantities that can be bought by the
income of TZS. 10/= can appear as:-
MAIZE

10

5 BEANS
Budget Constraint ……….
• The budget constraint represents opportunity cost.
• It also shows the scarcity in goods and services we are able to buy since
our income is limited, and these products have prices hence we cannot
get in abundance.

NB:
- It is worthy mentioning that if we have just two goods, good 1 and 2,
with prices P1 and P2. A basket that consists of quantity Q1 of good 1 and
Q2 of good 2 is written as (q1,q2). For example in the previous example
of maize and beans the information could have been written as (5,10),
meaning that 5 Kilos of beans (good 1) and 10 Kilos of maize (good 2).
Budget Constraint ……….
• The price of the basket (q1,q2) is then : -

• If we have a limited amount of income (money) to these

goods, this will impose a restriction on how much we can buy
of each good. Let m denote the amount of money available,
the price of the basket chosen must not exceed m. The
different combinations of good 1 and good 2 that cost exactly
m can be written as:-
m=
Slope of the Budget Constraint
• The slope of the budget line can simply be obtained by finding a
change in the vertical axis divided by the change in horizontal axis.

• Slope = =
= *
=-
Slope of budget constraint….
• Since the budget line is a straight line then we expect
the slope to be constant throughout the line.
• The slope of the Budget Line is what is economically
termed as Marginal Rate of Transformation (MRT).
• MRT is the rate at which a consumer with fixed
income can exchange commodity 1 for 2 in the
market.
MRT= -
• Suppose you have two goods pizza (price 10) and
nyama choma (price 20). MRT will then be -10/20= -
0.5
• This means that you have to forego half of a nyama
choma if you want to consume one more unit of pizza.
Or you can state that you have to forego 2 units of
pizza to get one more unit of nyama choma -20/10= -
2.
• This shows the price of pizza measured in nyama
choma (not money) is half a nyama choma (price).
BUDGET LINE AND CHANGES IN INCOME AND PRICE
• We have seen so far how income and price influence (restricts) what
consumer can buy. It is important to trace the changes that can occur
in consumption patterns when either Income or Price changes.
IF PRICE INCREASES:
Good 1
m/p1

A
B

m/p’2 m/p2 Good 2

• Suppose a consumer is facing a budget constraint as defined by budget line
A. if there is an increase in price of Good 2 while the price for Good 1
remains the same this means that was previously available (what our
income could buy) is reduced from m/p2 to m/p’2.
• The amount of Good 1 that we can afford subject to our income will remain
to be the same, thus a consumer will now face a new budget constraint.
• The new budget constraint will be drawn from the same position of m/p1
(remained constant) in the y axis joining to a new point of m/p’2 in the x
axis.
• The budget constraint has now changed from budget line A – B.
Increase in Price Cont…..
Good 1

m/p1

m/p’1
A
B

m/p2
Good 2

• Suppose prices of good 1 have increased while those of Good 2 have

remained to be the same. What can you say about the diagram?
When Income changes (Increase and Decrease)
• The effect of either an increase or a decrease in income is somewhat
different from the that of a change in price. In price we saw that a
change in price of one good does not change the amount that can be
obtained in the market for the other good.
m’/p1
Good 1
m/p1

m’/p1 B3
B
B2

m‘/p2 m/p2 m’/p2

Good 2
• Quite the contrary to a change in price, a change in income does
affect the amount of goods 1 and 2 that can be consumed be
respectively.
• From the budget line B, where the constraints are (m/p1,m/p2); if
income increases for any particular reason then the consumer can
buy more quantities of good 1 and good 2 respectively.
• The budget constraint for consumer now shifts up to define a new
budget line B3, the constraint now becomes (m’/p1,m’p2).
• On the vertical line (good 1) quantity (units) increases from m/p1 to
m’/p1 and on the horizontal line (good 2) quantity also increases from
m/p2 to m’/p2.
• What can you say when income decreases?
Check on
• What happens when Price for both Good 1 and Good B?
Increases
Decreases
• What happens if both price for good 1 and 2 increases while Income
Decreases?
• What happens if price for good 1 decreases while that of good 2
remain the same?
• What happens if price of good 2 decreases while that of good 1
remain the same?
 PREFERENCE AND
INDIFFERENCE CURVE

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Preferences
• We should be able to compare anything with anything
else. This is done through what we call preference
order.
• Assume that individual always knows what she
prefers, she prefers basket A to basket B, she prefers B
to A, or she is indifferent between them.
• Bundle/basket A is strictly preferred (s.p.), weakly
preferred (w.p.) of indifferent (ind.) to bundle B.

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• If A is w.p. to B and B is w.p. to A, we say A is
indifferent to B.
• If all baskets are ordered accordingly, we have a
preference order.
• Such an order is valid for a certain individual.

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 Indifference Curves
• A curve showing all combinations of baskets of goods
that provide a consumer with the same level of utility.
• Indifferent curves (ICs) are graphical representations of
consumer preferences.
Good 2

Indifference
Curve

Good 1
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•Total Utility
The total benefit that a consumer gets
from consuming goods and services
across everything that he consumers.
•Marginal Utility
Additional benefit that a consumer gets
by consuming one more unit of a
good/service.
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•We talk about utility since a consumer always
thinks about maximizing her total utility,
however it will be a surmountable task to
measure total utility.
•Therefore we will assume that there is a level of
satisfaction that a consumer already has by
consuming a particular good and thus our main
concern will be what additional benefit is she
getting from a unit increase in consumption.
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 Indifference Maps
• An indifference map is a set of ICs showing the
preference of an individual. i.e. More than one IC.
Quantity 2

Quantity 1

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 Properties of Indifference Curves of Two Goods
• ICs of two goods are negatively sloped (slopes downward to the
right).
An increase in the consumption for one good in the particular
bundle will result in the decrease on the consumption of the other
good in the very same bundle.
• ICs cannot cross each other (never intersect).
If they cross each other it will imply that at a single curve there are
two different levels of utility because each indifferent curve represents
all the bundles that provide the same utility.
• ICs are convex to the origin
ICs bow inward to the origin, this shows that an increase in the
consumption of one product will cause a decrease in the consumption
7/6/23
of the other. 29
Properties of ICs cont.
• ICs are continuous .
This means no gaps in terms of consumer preferences.
• Higher indifference curve shows higher satisfaction level
Basket that are further away from the origin (0,0) are
better than the one that are closer to the origin since they
show the highest level of utility that a consumer can get from
consuming a particular bundle (two goods)

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The slope of Indifference Curve
• The slope of indifference is of vital importance. It is important to think
about what the slope means.
• If you choose some basket on one of the curves, how much would
you be willing to give up of good 2 to get one more unit of good 1.?
• Suppose you’re willing to give up only small quantity of good 2, the
magnitude of the slope would be small, whereas if you were willing to
give up a lot., it would be large.
• Marginal Rate of Substitution (the slope of IC)
How many units on a good an individual is willing to give up for an
additional unit of another good (in terms of units rather than money)

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• This is calculated as:-
MRS =
=
• Slope of the ICs shows the amount of one good
(commodity) that a consumer is willing to substitute
for an extra unit of another good.
• Under normal circumstances the MRS will slope less
and less to the right, implying that MRS is decreasing.
• The slope of IC is –ve, it shows that one gets less
(minus) of one good to get more (plus) of the other.
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The ICs for Perfect Substitutes

• Consumer likes two goods equally so only the total number of the
goods matters. Example blue and black Pen.
• ICs are downward sloping straight lines

Black Pen Perfect Substitutes

(q2)

Blue Pen (q1)

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The ICs for Perfect complementary goods

Good 1 Complementary
Goods

Good 2
ICs for complementary goods
• These are goods that are consumed together, thus a consumer
needs them both to have any use of them. e.g example left
and right shoe. One has no use for one without the other.
• This causes the indifference curve to become L shaped.
Suppose we get the left shoe units as many as possible we will
still get the very same level of utility as before.
• The indifference curve therefore is vertical along the vertical
axis (q2) and horizontal along horizontal axis (q1).
• The only way to get higher levels of utility is to get more of
both good 1 and good 2.
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 Utility Maximization: Optimal Consumer Choice
• So far we have described how consumers choose goods
subject to their limitations (scarceness; income; the budget
line), then we described preferences.
• To determine the optimal choice we need to put both of
them together.
• If we assume that any consumer maximize her utility, we will
be able to predict which basket of goods she will choose.
• A consumer will choose a point on an indifference curve that
she can afford and that gives her maximum utility. In a typical
indifference curve this usually singles out one point.
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• This is shown as follows:
q2

C
* *D
A I3
*
B I2
*
I1

q1
• Which of the points A - D that the consumer is at optimal, utility
maximizing, choice?

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• Point B is optimal? No, A is better than B since is on a higher
indifference curve. The consumer can also afford A, since A is
on the budget line
• What about C is it optimal? No, C is on the same indifference
curve as B and is therefore it is as good as B. However, A is
better than B and therefore A must be better than C.
• Is point D optimal? D is on a higher indifference curve than
any other baskets, therefore produces the highest level of
utility. However, the consumer cannot afford D since it lies
outside the budget line. Therefore D, is not an optimal
choice.

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• What about A, Is it optimal? A is optimal, it is the only bundle that
given IC and BL produces a maximum level of utility. All other points
that lie on or below the BL produces lower levels of utility.
• At point A, an IC just touches the BL, i.e. the budget line is a tangent
to the indifference curve.

Point A has an interesting property,

• It is the point where the budget line and the indifference curve have
exactly the same slope.
• Remember the slope of BL is the quotient between the prices (-p2/p1)
which we referred to as MRT, and that the slope of IC is MRS.
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• A criterion for being exactly at the point where we maximize utility is
then that
MRT = MRS
• However, there are cases when the point of utility
maximization does not fulfill this criterion.
• For instance, the indifference curves for perfect substitutes
and complementary goods.
• If a BL is fixed into any of those graphs, we will find that the
criterion MRT=MRS is not fulfilled.

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• For perfect substitutes, the consumer will usually
maximize her utility at either X-axis or at the Y-axis,
where she only consumes one of the goods.
• This is called a corner solution.
• If the budget line is parallel to an indifference curve,
the consumer can choose any point on the line. She
can afford them all, and she is indifferent between all
of them.

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• For complementary goods she will maximize her
utility at a point where an indifference curve has
a corner.
• In such a point the curve has no defined slope
(since it has different slopes to the left and to
the right) and hence MRS does not exist.

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 Strategy for finding the point of utility
maximization
• Draw the budget line.
• Find the Indifference curve that just touches the budget line (tangent
to the budget line), in normal circumstances there is only one such
indifference curve.
- All other indifference curves either crosses the budget line or do not
touch it at all.
- However, it is relevant to check if there does exist a corner solution
• The point of utility maximization is the point of tangency (or the
corner solution).

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 Price changes effect on Consumer optimal choice
• Suppose prices of good 2 have increased while those of Good 1 have
remained to be the same.

Good 1
m/p1

m/p’2 m/p2 Good 2

Increase in Price Cont…..
• Suppose now prices of good 1 have increased while those of Good 2
have remained to be the same.

Good 1

m/p1

m/p’1
A

m/p2 Good 2
Effect of changes in income on consumer optimal choice

m’/p2
Good 2
m/p2

B3
m’/p2
B

B2

m‘/p1 m/p1 m’/p1

Good 1
 Income and substitution effects

• Read: income and substitution effects (Principles of economics pg.

450-452.
• The impact of a change in the price of a good on
consumption can be decomposed into two effects: an
income effect and a substitution effect
• income effect - the change in consumption that results when
a price change moves the consumer to a higher or lower
indifference curve
• substitution effect - the change in consumption that results
when a price change moves the consumer along a given
indifference curve to a point with a new marginal rate of
substitution
• To see what these two effects are, consider how our consumer might
respond when he learns that the price of Pepsi has fallen. He might
reason in the following ways:
• “Great news! Now that Pepsi is cheaper, my income has greater
purchasing power. I am, in effect, richer than I was. Because I am
richer, I can buy both more Pepsi and more pizza.” (This is the income
effect.)
• “Now that the price of Pepsi has fallen, I get more pints of Pepsi for
every pizza that I give up. Because pizza is now relatively more
expensive, I should buy less pizza and more Pepsi.” (This is the
substitution effect.)
 Utility
Utility as a measure of Preferences.
• Utility refers to the numerical scores arbitrarily assigned to basket of goods
to rank them according to one’s preference.
• Utility reflects preference and not necessarily happiness/satisfaction or social
welfare
• In the theory of consumer choice, there is a need for a function that
provides numerical representation of preference ordering.
• This enables us to apply the standard method of constrained maximization of
a function to obtain the solution to the consumer choice problem
• This is referred as utility function.
• It is a mathematical function that gives a numerical corresponding to the
level of utility a consumer attains.
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 Ordinal Utility
• People are able to rank in order all possible situations from least desirable to
most
• Economists call this ranking utility - if A is preferred to B, then the utility
assigned to A exceeds the utility assigned to B
U(A) > U(B)
• Utility is affected by the consumption of physical commodities, psychological
attitudes, peer group pressures, personal experiences, and the general
cultural environment.
• Economists generally devote attention to quantifiable options while holding
constant the other things that affect utility – ceteris paribus assumption.
 Ordinal Utility
• Utility rankings are ordinal in nature – they record the relative
desirability of commodity bundles
• Because utility measures are not unique, it makes no sense to consider
how much more utility is gained from A than from B
• It is also impossible to compare utilities between people
• Assume that an individual must choose among consumption goods x1,
x2,…, Xn
• The individual’s rankings can be shown by a utility function of the form:
• utility = U(x1, x2,…, xn)
Cardinal utility
• There are some theories of utility that attach a significance to the
magnitude of utility. These are known as cardinal utility theories.
• In a theory of cardinal utility, the size of the utility difference between
two bundles of goods is supposed to have some sort of significance.
• But how do we tell if a person likes one bundle twice as much as
another?
• How could you even tell if you like one bundle twice as much as
another?
Cardinal utility
• One could propose various definitions for this kind of assignment
• For example, I like one bundle twice as much as another if I am willing
to pay twice as much for it.
• Or, I like one bundle twice as much as another if I am willing to run
twice as far to get it, or to wait twice as long, or to gamble for it at
twice the odds.
• There is nothing wrong with any of these definitions; each one would
give rise to a way of assigning utility levels in which the magnitude of
the numbers assigned had some operational significance.
Cardinal utility
• But, knowing how much larger doesn't add anything to our
description of choice.
• Since cardinal utility isn't needed to describe choice behavior and
there is no compelling way to assign cardinal utilities anyway, we will
stick with a purely ordinal utility framework.
• In most cases Ordinal utility is useful in the indifference curve
approach than cardinal utility because in reality we can not measure
the value of preference of an individual consumer over the other.
END