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UNIT ONE

Theory of Consumer Behavior


Introduction
• In our day –to- day life, we buy different goods and services for consumption. As
consumer, we act to derive satisfaction by using goods and services. But, have
ever thought of how your mother or any other person whom you know decides
to buy those consumption goods and services?
• Consumer theory is based on what people like, so it begins with something that
we can‘t directly measure, but must infer. That is, consumer theory is based on
the premise that we can infer what people like from the choices they make.
1.1 The concept of utility
• Economists use the term utility to describe 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. Given any two
consumption bundles X and Y, the consumer definitely wants the X-bundle than the Y-bundle if and only if
the utility of X is better than the utility of Y.
• Utility’ and ‘Usefulness’ are not synonymous. For example, paintings by Picasso may be useless
functionally but offer great utility to art lovers. Hence, usefulness is product centric whereas utility is
consumer centric.
• Utility is subjective. The utility of a product will vary from person to person.
• That means, the utility that two individuals derive from consuming the same level of a product may not be
the same.
• For example, non-smokers do not derive any utility from cigarettes.  Utility can be different at different
places and time.
• For example, the utility that we get from drinking coffee early in the morning may be different from the
utility we get during lunch time.
Approaches of measuring utility
• There are two major approaches to measure or compare consumer‘s utility: cardinal and ordinal approaches.
A 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. For example, we may say that consumption of an orange gives Bilen 10 utils and a banana
gives her 8 utils, and so on. From this, we can assert that Bilen gets more satisfaction from orange than from
banana.
Assumptions of cardinal utility theory
 The cardinal approach is based on the following major assumptions.
1. Rationality of consumers. The main objective of the consumer is to maximize his/her satisfaction given his/her
limited budget or income. Thus, in order to maximize his/her satisfaction, the consumer has to be rational.
2 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.
3. 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.
4. 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.
5. 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 total utility is given by TU = f ( X 1 , X 2 ...... X n ).
1.2 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
 Graphically, it is the slope of total utility.
 Mathematically, marginal utility and total utility r/p
 If TU is increase is positive.
 If TU is maximum point is at point zero.
 If TU is Decreasing MU is negative.
Quantity Total utility Marginal utility
0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 0
6 28 -2

Example of Total and marginal utility


• 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.
• The relation shape between TU and MU
• When TU is increasing, MU is positive.
• When TU is maximized, MU is zero.
The 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.
 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 .
Equilibrium of a consumer
 The objective of a rational consumer is to maximize total utility. As long as the additional unit consumed brings a
positive marginal utility, the consumer wants to consumer more of the product because total utility increases.
a) 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.
• Mux=Px
B 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.
• MUx/px=Muy/py=……….Mun/Pn
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 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. Therefore, the
consumer need not know in specific units the utility of various commodities to make his choice.
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 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 consistent. 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. 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.
END OF UNIT ONE
UNIT TWO
Theories of demand and supply
• 2.1 Theory of Demand
 Definition: Demand means the ability and willingness to buy a specific quantity of a commodity at the prevailing price in a
given period of time. Therefore, demand for a commodity implies a desire to acquire it, along with the willingness and ability
to pay for it.
 Thus, Demand = Willingness to buy + Ability to pay.
2.1.1 The Demand Schedule, Demand Function and the Demand Curve
 Demand Schedule is a table showing different quantities of commodity that consumer is willing to buy at different level
of prices, during a given period of time.
• The Demand Schedule shows the quantity demanded at each price.

Price of co e
in birr (per
0 5 10 15 20 25 30 35 40 45
KG
Quantity
demanded
9 8 7 6 5 4 3 2 1 0
 is a demand schedule, a table that shows the relationship between the price of coffee per kg and the quantity of coffee
demanded per kg. It shows how the quantity demanded of the good (coffee) changes as its price varies, ceteris paribus (all other
things remain constant).
 A demand curve is a curve that represents the relationship between the quantity of the good chosen by a consumer and the
price of the good. The independent variable (price) is measured along the vertical axis, and dependent variable (quantity) is
measured along the horizontal axis.
 Demand function is a mathematical relationship between price and quantity demanded, all other things remaining the same.
A typical demand function is given by: Qd=f(P) where Qd is quantity demanded and P is price of the commodity, in our case price of
orange.
Example: Let the demand function be Q = a+ bP
2.1.2 Factors affecting demand
 Determinants of demand are factors that cause the consumer to increase or decrease their demand for a particular commodity.
There are various factors affecting the demand for a commodity. Some of these are:
I. Price of the product
II Taste or preference of consumers
III Income of the consumers
IV Price of related goods
V Consumers expectation of income and price
VI Number of buyers in the market
2.1.3 Changes in quantity demanded and changes in demand
 Other things being equal, it designates the movement from one point to another point from one price quantity combination
to another on a fixed demand schedule or demand curve. The cause of such a change is an increase or decrease in the price
of the product being considered. Downward movement along the demand curve is called an extension of demand, while the
upward movement is a contraction of demand.
Change in Demand: A change in one or more of the determinants of demand (other than their own price) will change the
demand data (the demand schedule). A change in the demand schedule, or more graphically, a shift in the location of the
demand curve, is called a change in demand. An increase in demand causes the demand curve to shift upward to the right;
whereas, a decrease in demand causes the demand curve to shift downward to the left. In other words, while an increase in
demand is explained by an outward shift of the demand curve, a decrease in demand is explained by an inward shift of the
demand curve.
• 2.1.4 Derivation of market demand
• Based on the number of consumer, demand is classified as individual demand and market demand Individual Demand:
Individual demand may be defined as the quantity of a commodity that a person is willing and able to buy at given prices
over a specified period of time.
• E.G Suppose Mr. Adamu purchases a kg of banana when the price is Birr 25, and he purchases 2 kg for a week when the price
drops to Birr 20. And when the price further decreases to Birr 15 per kg, he buys 3 kg banana for a week, but when the price
rises to Birr 30 per kg, he buys zero kg of banana.
• This can be shown in the table 2.2 below.

Price of banana in Birr/kg 10 15 20 25 30


Quantity demanded in kg 5 3 2 1 0
• :
Market Demand Market demand refers to the total quantity that all the users of a commodity are willing and able to buy at a
given price over a specific period of time. The market demand for the commodity is simply the horizontal summation of the
demand of all the consumers in the market. In other words, the quantity demanded in the market at each price is the sum of the
individual demands of all consumers at that price.
 Thus, the market demand for a commodity shows the various quantities of the commodity demanded in the market per unit of
time at an alternative price for the commodity holding everything else constant. However, if individual demand schedules were
expressed as demand curves, the market demand curve would be derived by taking the horizontal summation of individual
demand curves.
Numerical Example: Suppose the individual demand function of a product is given by:
QI = 50 - 5P and there are about 100 identical buyers in the market. Then the market demand function is given by:
⇒Qm = (50 – 5P) 100 ⇒
Market Demand (Qm ) = 5000-500P
2.2Theories of supply
 Supply may be defined as the various amounts of a product that a producer (firm) is willing and able to produce and make
available for sale in the market over a specific time period, at given prices, ceteris paribus. Holding other factors constant, the
quantity supplied of a good or service is the amount offered for sale at a given price.
2.2.1. Supply function, Supply schedule, and Supply curve
 A Supply function: is a statement that states the relationship between the quantity supplied (as a dependent variable) and its
determinants (say price, as independent variable). Suppose that a single producer’s supply function for commodity X is given as:
QX =F(PX )=a+bP, ceteris paribus.
 The supply schedule: is a tabular presentation of the (law of) supply. By substituting various “relevant” prices of X into the above
supply equation, we get the producer’s supply schedule shown in table .

Price per 0 10 15 22 35 43 56 67 78 106


unit (in
Birr/kg)

Quantity 0 1 2 3 4 5 6 7 8 9
supplied (in
kg)
 The supply curve: is a graphical depiction of the supply schedule. Plotting each pair of values from the supply schedule in the table.
 The curve is, more or less functional in accordance with the law of supply, which states that, in general, the higher the price of a
good, the greater the quantity of the good suppliers are willing and able to make available in the market.
 The slope of a supply curve: the Law of supply expresses the direct relationship between the prices of a commodity and its quantity
supplied. Price and supply are positively related. Hence, the slope of the supply curve is positive.
2.2.2 Changes in quantity supplied and changes in supply
 A change in quantity supplied: as we stated earlier, as the price of a goods increases, the quantity supplied increases. We call this
kind of movement along the supply curve a “change in quantity supplied.” Thus, movement along the supply curve is caused by a
change in the commodity’s own price. In such a situation, the supply curve remains the same. Other things being constant, the
movement along the (same) supply curve is caused by a change in the price of the good.
 Change in supply: this kind of change refers to a shift in the position of the supply curve caused by a change in something other
than the commodity’s own price. A shift in the supply curve may be caused by change in the prices of other goods, a change in the
prices of factors of production, a change in production technique or a change in the goals of the producer.
2.2.3 Factors affecting supply
 Apart from the change in price which causes a change in quantity demanded, the supply of a particular product is determined by:
I. Price of inputs ( cost of inputs)
II. technology
III . prices of related goods
IV. sellers‘ expectation of price of the product
V. taxes & subsidies
VI. number of sellers in the market
VII. weather, etc.
2.2.4 Derivation of the market supply curve
 market supply in a given market is the summation of the individual suppliers in that market.
 market supply is the horizontal summation of the individual supply curves .
 Example: Suppose there are 120 sellers of potatoes (in tons) in a market and the sellers have a more or less similar supply
curve of the form (supply equation) Qs = 20p - 5. Driven by the market supply equation. What is the quantity supplied in the
market when the price is Birr 4?
Solution: i. Market supply is
Qm = Qs x 120 = 120 (20p - 5)
Qm = 2400p – 600 (market supply equation).
ii. Total quantity (market) supplied at price Birr 4 is;
Qm (p=4) = 2400 (4) – 600 =9600 - 600 = 9000 tons

2.3 Market Equilibrium


 the term ‘equilibrium’ means the “state of rest”. In the context of market analysis, equilibrium refers to the market condition
that once achieved, tends to persist. This condition occurs when the quantity demanded of the commodity equals the quantity
supplied of the commodity. This equality produces an equilibrium price (market- clearing price).

2.3.1. The derivation of equilibrium


Market equilibrium explains the balance between demand and supply for a commodity. That is, equilibrium occurs when the
quantity demanded by the buyers equals the quantity supplied by the sellers in a particular market, so that the market clears.
 The price level at which the market reaches equilibrium is called the ‘market clearing/ equilibrium price’, and the corresponding
quantity is called the ‘equilibrium quantity”. The equilibrium price in a free market is determined by the market forces of demand
and supply.
 equilibrium price: ‘equilibrium’ means “in balance” or “at rest”. Graphically: this is the price at which the quantity demanded and
the quantity supplied are equal.
2.3.2. The concepts of excess demand and excess supply
 Excess demand occurs when the quantity demanded is greater than the quantity supplied, which leads to a shortage in the market.
Excess supply occurs when the quantity supplied exceeds the quantity demanded, resulting in a market surplus.
2.3.3 Effects of change in demand and supply on equilibrium quantity and price
 We know that demand might change because of fluctuations in consumer tastes or incomes, changes in consumer expectations, or
variations in the prices of related goods. Supply might change in response to changes in resource prices, technology, etc.
 Changes in Demand: Suppose that supply is constant and increases in demand, leads to a rise in both the equilibrium price and
quantity; and also if there is demand fall it leads to decrease in both the equilibrium price and quantity demanded.
 Change in Supply: Let’s suppose demand is constant but supply increases (decreases). This will affect the equilibrium by lowering
(rising) the new market- clearing price and raising (lowering) the new equilibrium quantity.
2.4 Elasticity's of Demand and Supply
2.4.1The Elasticity of Demand
 Elasticity of demand is the measure of the responsiveness of demand for a commodity to changes in any of its
determinants, such as the price of the commodity, price of related goods, and consumers’ income.
. Accordingly, there are three basic elasticity's:
I. Price elasticity of demand,
II. Cross-price elasticity of demand &
III. Income elasticity of demand
I . Price elasticity of demand
 Price elasticity of demand is a measure of the degree of responsiveness (or sensitiveness) of consumers to changes in the price
of the commodity itself. It may be defined as the ratio of the percentage change in quantity demanded to the percentage
change in price. In other words, the price elasticity of demand ( ) is the percentage change in the quantity demanded divided
by the percentage change in price.
 Price elasticity of demand is of two types: point elasticity and arc elasticity of demand. Point elasticity of demand: measures
elasticity at a (given) point or for a very small change in price.
Whereas, arc elasticity refers to price elasticity over a distance on the demand curve. In other words, arc elasticity measures the
average responsiveness of consumer demand to changes in price over a range of extended prices.
Interpreting Price Elasticity of Demand Values
a) Price Elastic Demand: demand is said to be relatively elastic if a specific percentage change in price results in a larger
percentage change in quantity demanded. Then, will be greater than 1.
b) Price Inelastic Demand: If a given percentage change in price is accompanied by a relatively smaller change in the quantity of
the good or service, then demand is said to be relatively price inelastic.
c) Unitary Elastic: When a percentage change in price and the accompanying percentage change in quantity demand are equal,
the case separating elastic and inelastic demands is said to be unitary elastic.
d) Perfectly Inelastic: this is a situation in which the quantity demanded of a certain product is invariable relative to the change in
the price. The elasticity coefficient is equal to zero ( =0).This shows that a change in the price of a good or service does not bring
about in any change in the quantity demanded.
e) Perfectly Elastic: denotes that a 1% change in price results in an infinite change in quantity demanded. In this regard, the consumer
can buy all possible quantities at the given price and nothing else at other prices.
The price elasticity of demand depends on the following factors :
 Nature of the commodity
 Availability of close substitutes
 People with high incomes are less affected by price changes than people with low incomes.
 Proportion of income spent on the commodity:
 Urgency of demand / postponement of purchase
 Durability of a commodity:
 Product purchase frequency or recurrence of demand
 Time

II . Cross Elasticity of Demand

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