Consumer Behaviour

In this chapter we study how a consumer chooses a bundle of goods.

We assume that consumers are rational. Rational means each consumer can choose the
best bundle of goods from a set of available bundles of goods.
We assume that there are only two goods, x1 , x2 say x1 is food and x2 is cloth. For the
consumer to choose the best bundle of goods we need the following requirements:

1. Any bundle x = (x1 , x2 ) of goods must be atleast as good as itself. This property
is called reflexivity.

2. The consumers should be able to compare all the available bundle of goods. Con-
sider any two bundles x, y of these two goods x = (x1 , x2 ) and y = (y1 , y2 ), If we
could compare the two bundles then we must have (x1 , x2 ) at least as good as (y1 , y2 )
or (y1 , y2 ) at least as good as (x1 , x2 ). This is called the completeness property.
If (x1 , x2 ) at least as good as (y1 , y2 ) and (y1 , y2 ) at least as good as (x1 , x2 ), then
the consumer is indifferent to choose between these two bundles x, y.
If (x1 , x2 ) at least as good as (y1 , y2 ) and (y1 , y2 ) is not at least as good as (x1 , x2 ),
then consumer prefers to choose the bundle x when the bundle y is also available.

3. Consider any three bundles of these two goods, x = (x1 , x2 ), y = (y1 , y2 ), z =

(z1 , z2 ). We are given that (x1 , x2 ) at least as good as (y1 , y2 ) and (y1 , y2 ) at least
as good as (z1 , z2 ), then (x1 , x2 ) atleast as good as (z1 , z2 ). This property is called
transitivity property.

If these three properties are satisfied than we can always order all the bundles of available
goods. If we can order the bundles then, the bundles which are at the top are the best
bundles.

Suppose completeness is violated, then we have atleast two bundles b = (b1 , b2 ), c =

(c1 , c2 ) such that we dont have (b1 , b2 ) at least as good as (c1 , c2 ) or (c1 , c2 ) at least as
good as (b1 , b2 ). In this situation we cannot compare b, c bundles. So we will not be able
to choose the best bundle.

Suppose we have three bundles a, b, c, the preference relation is of the following

nature a = (a1 , a2 ) is preferred to b = (b1 , b2 ), b = (b1 , b2 ) is preferred to c = (c1 , c2 ) and
c = (c1 , c2 ) is preferred to a = (a1 , a2 ). In this situation, we will not be able to choose the
best bundle, we will be in a cycle. This is because transitivity property is being violated.

We put some further restrictions on the preference of our rational consumer.

Consider any two bundles x, y and suppose x = (x1 , x2 ) y = (y1 , y2 ) then we
say that x = (x1 , x2 ) is atleast as good as y = (y1 , y2 ). Suppose x = (x1 , x2 ) > y = (y1 , y2 )

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then we say that x = (x1 , x2 ) is preferred to y = (y1 , y2 ). This property is called mono-
tonicity. In other words, more is better.

We assume that preferences are continuous. (Details of this property is beyond

the scope of this course).

If we have all these properties then we can represent the preference ordering over
bundles of goods through a utility function. In case of two goods, it is U (x1 , x2 ). When
the consumer consumes or chooses the bundle (x1 , x2 ), it attain U (x1 , x2 ) level of utility.
Utility is a real number.
If a bundle x = (x1 , x2 ) is preferred to another bundle y = (y1 , y2 ) then U (x1 , x2 ) >
U (y1 , y2 ).
If a bundle x = (x1 , x2 ) is indifferent to another bundle y = (y1 , y2 ) then U (x1 , x2 ) =
U (y1 , y2 ).

The consumer will choose those bundles which gives maximum utility. Con-
sumers are maximising their utility when they are choosing among the bundles.

Now we know that the consumer has a utility function. For a given utility
function, indifference curve is the combinations of good 1 and good 2 or bundles for a
given fixed level of utility. Indifference curves are the level curves. In figure1 1, we have
shown the indifference curves. The level of utility is increasing in the direction of the
arrow.

x2

x1

Figure 1: Indifference curves

From the monotonicity condition we get that indifference curves are always down-
ward sloping. Consider two bundles x = (x1 , x2 ), y = (y1 , y2 ) and suppose x1 > y1 and
x2 = y2 . From the monotonicity, we know that x is preferred to y. It implies U (x) > U (y).
The bundle x and y cannot be in the same indifference curve. For any bundle z to be
indifferent to the bundle y,we must have either z1 > y1 and z2 < y2 or z1 < y1 and
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In all the figures, the vertical axis represents good 2 (x2 ) and horizontal axis represents good 1 (x1 )

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z2 > y2 . This implies that indifference curves are downward sloping. It is depicted in
figure 2.

x2
z

y x

indifference curve

x1

Figure 2: Implication of Monotonicity

Still we can have indifference curves of the following nature:

x2

x1

Figure 3: Violation of convexity

We impose the convexity condition to get a well behaved indifference curve. Con-
sider two bundles x, y. If a consumer is indifferent between x and y bundle. Then any
linear combination of x and y that is .x + (1 )y, > 0 must be preferred to x and y.
In other words average is preferred to extremes. Convexity along with all other conditions
mentioned above ensures indifference curves of the nature depicted in figure 1.

For differentiable utility function, U (x1 , x2 ), the slope of the indifference curve
is the marginal rate of substitution of good 1 for good 2. It is, dU = U (x 1 ,x2 )
x1
dx1 +
U (x1 ,x2 )
x2
dx2 = 0.
U (x1 ,x2 )
dx2 x1
= U (x 1 ,x2 )
= marginal rate of substitution.
dx1
x2
If we are increasing one unit of good 1 how much units of good 2 must be decreased
to stay at the same level of utility? U (x 1 ,x2 )
x1
= M u1 is the marginal utility from good
U (x1 ,x2 )
1, x2
= M u2 is the marginal utility from good 2. Marginal utility is defined as

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the changes in the level of utility due to change in the amount of one good keeping the
amount of other good constant.
U (x1 ,x2 )
dx2 x1 M u1
= U (x ,x )
= .
dx1 1 2 M u2
x2
This marginal rate of substitution is the rate at which the consumer is willing to substi-
tute one good for the other where the utility level is fixed. Convexity of the preference
ensures that marginal utility from a good is always decreasing when we increase the con-
sumption of that good.

The consumers are constrained by the income they have. We represent income
by m. The consumers have to buy the goods from the market. While buying they have
to pay the price of the good. We assume that the price of the good 1 is p1 and price
of good 2 is p2 . From these two things price and income, we get the feasibility set of a
consumer. It is the the budget set, p1 x1 + p2 x2 m. p1 x1 is the expenditure on good 1,
p2 x2 is the expenditure on good 2. Total expenditure should always be less than equal
to total income.

The budget line is represented in figure 4.

x2
budget line

x1

Figure 4: Budget set

All the bundles of good 1 and 2 on or below the budget line are affordable to the
consumer. If the price of good 1 that is p1 increases the budget line will change as shown
in figure 5. Now lesser bundles will be available.

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 x2
old budget line

new budget line

x1

Figure 5: Price of good 1, p1 increases.

If there is increase in income m, the budget line will shift outward as shown in
figure 6. If there is decrease in income, the budget line will shift inward.

x2
new budget line

old budget line

x1

Figure 6: When income increases.

The slope of the budget line is given as dx

dx1
2
= pp12 . This is the exchange rate, the
rate at market is allowing to exchange one good for another. At a fixed level of income,
if a consumer buys one extra unit of good 1 then how much he has to forgo good 2.

While choosing a bundle of goods, the consumer maximizes utility given his bud-
get constraint. Consumer is basically solving a constraint optimization problem when he
is choosing a bundle of goods. Consumer chooses the amount of good 1 and good 2 and
takes price of good 1 and good 2 as given and his income level is also given.
We write this problem as:
Maximizes U (x1 , x2 ) ( objective function)
Subject to p1 .x1 + p2 .x2 m ( budget constraint).

The above optimization problem has been illustrated in a figure 7. Given the

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budget line, the optimal point is that point where the indifference curve is tangent to
the budget line. The points on the indifference curves which are above the budget line
are not affordable, so not optimal. Points below the below budget line are affordable but
the indifference curve which just touches the budget line gives higher level of utility than
those which cuts budget line in atleast two points. The utility level is increasing in the
north east direction. This is the reason why at the optimal point the slope of budget line
budget should be equal to slope of the indifference curve,
U (x1 ,x2 )
x1 M u1
U (x1 ,x2 )
= = pp21 .
M u2
x2
This is true for well behaved utility functions which are differential.

x2

x1

Figure 7: Utility maximization for a given budget.

We derive the demand function for a good from the utility maximization subject
to budget constraint. It is shown in figure 8.
In the upper panel of figure 8, the utility maximization subject to the budget
constraint is shown. The price of good 1 is decreasing so the budget line has moved in
north east direction. We keep the price of good 2 and income level fixed. We plot the
optimal quantity chosen at these different prices of good 1 in the lower panel. This gives
us the demand curve of good 1.

What is interesting here is that the demand curve is downward sloping. As

price of good 1 increases the quantity demanded decreases keeping other things constant.
Keeping other things constant means income and price of good 2 are fixed and utility
function is same.

The main reason for downward sloping demand curve is the following: as price
of good 1 increases, consumers substitute good 1 by good 2, so quantity demanded of
good 1 decreases. It is clear from the budget constraint as price of good 1 increases, the
available bundles also shrinks. The real income income falls ( pm1 falls) that is, to buy the
same amount of good 1 as earlier, the consumer requires higher amount of income. Due
to fall in real income, the demand for good 1 will fall. These two effects , when price of
good 1 increases consumer substitute good 1 by good 2 ( substitution effect) and at the
same time there is fall in real income, so consumer reduces quantity demanded ( income

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 x2

X1

Utility maximization
p1
P
p
P

X1
Demand curve of good 1

Figure 8: Derivation of demand curve of good 1

effect) works together. Thus, there is fall in quantity demanded when price of a good
increases.

If prices of good 1 and good 2 are fixed, only the income m increases, then quan-
tity demanded for both the goods or atleast one of the goods will increase. The quantity
demanded of only good 1 increases and quantity demanded of good 2 remains fixed or
falls, when the good 2 is an inferior good. Whenever there is increase in income, the
quantity demanded of an inferior good falls. Whenever demand for a good decreases
when the income increases, we say that that commodity is inferior goods ( bad). If both
the goods are not inferior, then demand for both the goods increases when income in-
creases.

We can also solve the optimization problem of the consumer through the La-
grangian method. We solve one example through this method. Suppose the utility
function is U (x1 , x2 ) = x1 .x2 . The utility maximization problem is:
Max x1 .x2
subject to p1 .x1 + p2 .x2 m.

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 The Lagrangian is L = x1 .x2 + (m p1 x1 + p2 x2 ), where is the Lagrange
multiplier.
Differentiating the Lagrangian with respect to x1 , x2 and we get,
L 1
x1
= x 1 x2 p1
L 1
x2
= x1 x2 p2 .
L

= m p 1 x 1 + p 2 x2 .

At optimal point
L
x1
= x1
1 x2 p1 = 0
L
x2
= x1 x1
2 p2 = 0.
L

= m p 1 x1 + p2 x2 = 0.
From first two equations, we get
x2
x1
= pp12 .
m
Substituting it in third equation we get, x1 = ( + ) ( p11 ). This is the demand function
m
of good 1. The demand function of good 2 is x2 = ( + )( p12 ). The demand functions are
function of price and income. It is clear that when price of good 1 increases, the quantity
demanded of good 1 decreases, it is similar for good 2. When income increases, the de-
mand for good 1 increases, similarly for good 2. Due to change in income, there is a shift
in demand function. When price changes, there is movement along the demand curve of
that good. If the price of the other good changes, there may be shift in the demand curve.

From the individual demand curves, we derive the market demand curve. The
market demand curve is the horizontal summation of the individual demand curves. It
is shown in figure 9. Suppose there are two consumers 1 and 2. The demand for good 1
of consumer 1 at price p is x11 (p) and of consumer 2 is x21 (p), the market demand at p is
x11 (p) + x21 (p).

p Individual 1 p Market Demand

p Individual 2

x1 x1 x1

Figure 9: Market demand curve from individual demand curves

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 Elasticity of demand curve of good x is

% change in quantity demanded x p

d = = , where p = price of good x.
% change in price p x
If |d | > 1 then it is elastic demand. If |d | < 1 then it is inelastic demand. If |d | = 1
then it is unitary elastic.

Income Elasticity of good x is

% change in quantity demanded x m
I = = , where m = income of individual.
% change in income m x
If I > 1 then it is a luxury good. If 0 d 1 then it is a normal good. If I < 0 then
it is an inferior good.

Cross elasticity of demand of good 1 is

% change in quantity demanded of Good 1 x1 p2

c = = , where p2 =
% change in price of good 2 p2 x1
price of good 2.
If c > 0 then good 1 and good 2 are substitute to each other. If c < 0 then good 1 and
good 2 are complementary to each good.