You are on page 1of 58

TOPIC: THEORY OF CONSUMER BEHAVIOR

1. Consumer behavior: hypotheses and determinants. Consumer


preferences.

2. Total utility and marginal utility. The utility maximizing rule.

3. Indiference curves and their properties.

4. The buget line and its positioning in case of changes in consumer
income and in case of changes in price of one of the goods.

5. Consumer equilibrium.

6. Consumer equilibrium in the case of changes of consumer
income: income-consumption curve and Engel curve.

7. Consumer equilibrium in the case of price change of one of the
good: price-consumption curve and individual demand curve.

8. Substitution effect and income effect.
In economic theory consumer behavior is a proces of
formation of consumer demand for various goods,
depending on the individuals income, preferences and
price level.

Consumer is an economic agent, whose
objective is to maximize the satisfaction of his needs
through consumption of goods purchased for a
certain income. In reality, the consumers have to
choose the basket of consumer goods from a variety
of goods on the market. In other words,
consumers are facing the problem of choice.
The basket of consumer goods includes the quan-
tities of various consumer goods that provide certain
satisfaction.
In the process of free choice, consumers
will take the following interrelated
decisions:
1. What to buy? (to choose preferable
goods, with the highest utility);

2. How much to buy? (based on the
existing market price);

3. Is it possible to buy the goods?
(based on disposable income and
existing market price).
The choice of consumer is based on
the following hypotheses:
Freedom of decision and action of a
consumer
Consumer rationality
Consumer sovereingty
Limited consumers income
Subjective utility assessment and the
tendency for its maximization
The consumer is sovereign (king), based
on the following:
His needs serve as a point of
reference for producer;

His decisions predetermine the
market demand;

He is the one, who asses the rezults
of the production.
The consumer behavior and choices are
influenced by the factors, that can be clasified as
follows:
socio-demographic factors;
social-economic factors;
psychological factors;
institutional factors.

Conclusion:

The complexity of rational choice under the
conditions of the contemporary economy.


In the process of choice the consumer acts in
accordance with his preferences. The theory of
consumer behavior starts from a series of assumptions
about the nature of consumers preferences:

1.Assumption of comparison and ranking of
consumers preferences: between two market basket A
and B, he will choose one of three possibil alternatives:
*would prefer A to B, (A ` B);
* Would prefer B to A, (B ` A);
*is indifferent towards the two market
basket, considering them to be
equivalents, (A ~ B).
Prefered
relations
Indiferent
relations
2.The consumers preferences are
transitive: consumer ranks different
market basket and compares them in
pairs:

if A ` B and B ` C A ` C .

3.The consumer always prefers more to
less: if A (X, 2Y) and B (X, Y): A ` B.

Deci, consumatorii prefer o cantitate mai
mare de bunuri unei cantiti mai mici.

The most preferable market basket gives the highest
level of satisfaction, or utility to a consumer.
Utility is initial category in the theory of consumer
behavior ( J. Bentham (1748-1831).Utility of a good or
service reflects the consumers satisfaction which he
expects to obtain.
Utility is a subjective notion. Utility of same goods is
different for different people (for example, the utility of
glasses for a weak seeing man and a healthy man is
different).
In assessing the utility historically there were two
approaches:
1.Cardinal approach (classical) of utility (XIXc.). A
significant contribution to its development has the
following economists: S. Jevons, K. Menger, L. Walras.
In their view, utility was measurable in a cardinal sense,
which means the quantitative measure of the utility of a
good using a conventional unit utile (1 utile,2utiles etc).


.
2. Ordinal (neoclassical) approach (end of
XIX-first half of XX c.). In developing this
concept,a special rol have scientists V. Pareto, J.
Hicks and R.Allen., who are known as ordinalists.
Ordinal utility approach assume that utility
is measurable in an ordinal sense, which means
that a consumer can only rank various market
baskets with regard to the satisfaction they give
him (first, second, third etc.).
In other words, the consumer rationally
orders (ranks) his preferences in relation
to the total satisfaction, which is intended to be
obtained.
Total utility is the total satisfaction received from
consuming an amount of goods.
The utility function has the following form:

Marginal utility is the extra utility received from
consuming one additional unit of the good.
Moreover, marginal utility is the change in total
utility resulting from consumption of additional units of
the respective good.
The Formula for calculation of Marginal utility is:



To be expressed in mathematical term, the MU can be
defined as the partial derivative of the 1-st grade of utility
function: MU(Qx) = (TUx)'.

( )
i
X
Q f TU =
( )
i
i
X
X
Q
TU
Q MU
A
A
=
The size of marginal utility is influenced by various
factors:

Volume or quantity consumed of a given
good.
The importance of the good and the
intensity with which the needs are
manifested.
Conditions for reproduction of a given
good.
While consuming a quantity of a good, the changes in MU
and TU are interdependent. The relationship between TU and
MU can be illustrated by data in table and graphically.
Consumed
quantity of a
specific good Q
x

Total utility (utile)
TU
x

Marginal utility
(utile) Mu
x

0 0

20
15
10
5
0
-5
1 20
2 35
3 45
4 50
5 50
6 45

Qx (quantity)
U
t
i
l
i
t
y

(
T
u
x
,

M
U
x
)

Analyzing the evolution of TU and MU we can
draw the following conclusions:

1. As an additional unit of a given good is consumed (up
to Qx = 2), MU decreases and TU will increase, but each
time at a lower rate.
2. In the point of satiety, the marginal utility is zero (MUx=0)
for Qx=5 units, but total utility reaches its highest
level (TUx=50 utile), respectively Qx=5 units is the
optimal amount of consumption.
3. If consumption continues Qx>5 units, MU becomes
negative and total utility decreases.
The law of diminishing marginal utility states that as the
amount of a commodity consumed increases, the marginal
utility of the last unit consumed tends to decrease:
i
X X X
MU MU MU > > ...
2 1
Each consumer tends to maximize the total utility
from consumption of purchased goods. Meanwhile the
consumer is interesed in eficient use of his financial
resourses. Which principles will a rational consumer
follow?

In microeconomics this principle reflects the utility-
maximizing rule or the second Law of Gssen.
The second Law of Gssen assumes, that in order to
maximize utility, consumer allocate money income in
such a way, that the last dollar spent on each product
purchased yields the same amount of marginal utility:
Z
Z
Y
Y
X
X
P
MU
P
MU
P
MU
= = = ...
Marginal utilities (MU) of Goods and MU/P
Amount of
consumed
goods (Q)
Juice Pizza
MU MU/P MU MU/P
1
2
3
4
5
6
7
6
5
4
3
2
1
0
6/10=0,6
0,5
0,4
0,3
0,2
0,1
0
10
8
7
5
4
3
1
10/20=0,5
0,4
0,35
0,25
0,2
0,15
0,05
Determinai, aplicnd prevederile Legii a II-a a lui Gssen,
combinaia optim de bunuri pentru consumator i utilitatea
total maximal, dac venitul acestuia este de 70 u.m., iar
preul unui pachet de suc = 10 u.m. i al pizzei = 20 u.m.
In the process of choice the consumer acts in
accordance with his preferences. The theory of
consumer behavior starts from a series of assumptions
about the nature of consumers preferences:

1.Assumption of comparison and ranking of
consumers preferences: between two market basket A
and B, he will choose one of three possibil alternatives:
*would prefer A to B, (A ` B);
* Would prefer B to A, (B ` A);
*is indifferent towards the two market
basket, considering them to be
equivalents, (A ~ B).
Prefered
relations
Indiferent
relations
2.The consumers preferences are
transitive: consumer ranks different
market basket and compares them in
pairs:

if A ` B and B ` C A ` C .

3.The consumer always prefers more to
less: if A (X, 2Y) and B (X, Y): A ` B.

Deci, consumatorii prefer o cantitate mai
mare de bunuri unei cantiti mai mici.

In the theory of consumer behavior indifference
curves have a prominent place. They are graphic
illustration of concumer preferences (Fr. Edgeworth,
1881).
Indifference curve shows alternative
combinations of two economic boons,
that give the consumer equal utility (TU) or
satisfaction.

An indifference curve is the set of points
representing market basket among which the
concumer is indifferent (figure 2). Different
indifference curves provide a ranking of the
individuals preference.
Cola
Cake
A
B
C
D
Market
basket
X
(Cola, un.)
Y
(cake, un.)
a
b
c
d
1
2
6
8
8
6
2
1
Alternative market basket
X
6
8
0
1
2
10
1 2 6 8
What is preferable ?
Figure 2. Indifference curve
Y
An indifference map is a graph of
the entire set of indifference curves,
each one farther away from the
origin, corresponding to increasing
levels of total utility. They describe
consumer preferences for certain
goods
B
C
A
X
U
3
U
2
U
1
XB XC
XA
YC
YB
YA
What is preferable ?

Properties of indifference curves:

1. Indifference curve situated further from
the origin, coresponds to a higher level of
utility and is more preferable for consumer,
meaning:
U1 < U2 < U3 (figure 3)

2. Indifference curves can
never intersect.
A
C
B
X
Y
U1
U2
XB XC
YB
YC
3. Indifference curve are
usually negatively sloped and
are convex to the origin. A
B
C
D
X
(pears)
Y
(apples)
X
Y
Economists use the term of Marginal rate of substitution of
goodY for good X MRSxy , which means the level till
which the substitution of one good for another is justified.
Marginal rate of substitution is the amount of one good that
an individual is willing to give up in order to get one more
unit of another good and while maintaining the same level of
total utility:
X
Y
xy
Q
Q
MRS
A
A
= TU const.
With changes in the quantity of goods X and Y,
consumer satisfaction is unchanged (A U = 0), then:


0 = A + A = A
Y Y X x
Q MU Q MU TU
y
x
X
Y
MU
MU
Q
Q
=
A
A

y
x
xy
MU
MU
MRS =
or

MRSxy has the following properties:

1.MRSxy tends to reduce when moving
along the indifference curve from left to
right. Consumers will give up smaller
quantities of Y to increase by one unit the
consumption of good X.

2. MRSxy is the measurement of the slope of
an indifference curve at a particular point
on that indifference curve (figure 6).
A
B
U1
Y
X
Moving from A to B: the slope
of indifference curve will be
higher in the point A than in a
point B
U
1
U
2
X
Y
Special cases of indifference
curves
X
Y
U1
U2
U3
U4
U5
U1
U2
U3
X
Y
X
Y
A
B
H
K
0

I/Py
I/Px
The budget line is a set of
alternative combinations of
quantity of good X and Y that
the consumer can buy.
What is attainable ?
The budget line equation can be represented as
follows:
Y y X x
Q P Q P I + =
To draw a straight line is sufficient to know its two
extreme points:
X
y
x
y
r
Q
P
P
P
I
Q =
y
x
y
x
x
Q
P
P
P
I
Q =
The slope of the budget line in absolut value is
the tangent of the angle ABO of triangle AOB
(figure 11):
Py
Px
Px
I
Py
I
OB
AO
tgABO = = =
E
B
C
D
M
F
0 1 2 3 4
5
6
(I/Px ,O)
A
X
2
4
6
8
10
Y
N
(O,I/P
y
)
C
a
k
e

Cola
C
a
k
e

Cola
7
10
14
J
A
M
N F K
I =30 lei

I =42 lei

I2 =21 lei

7 5 3,5
X
Y
a) Consequences of changes in
consumers disposable income
I, Px, Py constant
(Px=6 lei, Py=3 lei) The budget line will shift
up (to the right), paraleel
to the original line (figure
13).
X
Y
Cola
C
a
k
e

A
F
5
H
10
10
P
x
=3 lei

P
x
=6 lei
P
x
+
b) Consequences of changing of price of good
X (Px)
I, Py constant
1. Decrease of price of good X
(Px), ceteris paribus, leads to
decrease of the slope of buget
line in absolut value.

X
Y
A
F N
10
5 2,5
P
x
=6 lei
P
x
=12 lei

P
x
|
C
a
k
e

Cola
2. As the price of good X rises
(Px), the absolute value of the
slope of a buget line increases
comparativ to the absolute
valueof the slope of initial
budget line
Px; I constant; Py constant
Consumer equilibrium. Consumer reaches equilibrium
state, when he fully uses his disposable income and maximizes
satisfaction from the consumption of set of goods (X,Y).
Rational consumer choice can be summarized in the
following table:
QUESTION PROBLEM
GRAPHICAL
INTERPRETATION
What want
consumers?
Prefferences Indifference Map
What can
consumers?
Constraints Budget line
What do
consumers?
optimal choice of
consumer
Point of
equilibrium of
consumer
Graphic, the point where the budget line is tangent to
the highest attainable indifference curve determines the
equilibrium (optimum) of consumer. At this point, the slope
of indifference curve (reflects the -MRSxy) equals to the
slope of the budget line (is --Px / Py):
y
y
x
x
y
x
y
x
y
x
y
x
P
MU
P
MU
sau
P
P
MU
MU
P
P
MU
MU
= = =
The consumers equilibrium condition requires that
the ratio of marginal utilities of goods X and Y is equal
to the prices ratio.
The utility-maximizing combination of good X and Y
provides to consumer the maximum possible satisfaction
compared to other alternatives.
Cola
a
E
c
d
C
a
k
e

A
F
X
Y
8
6
2
1
10
5
0
1 2 8
U
1
U
2
U
3
U1
U2
U3
A
Qx
Qy
0
In some cases the consumer is willing to buy only one
good from the market basket, giving up the other good.
MRSxy being higher or lower than the prices ratio.
Such equilibrium is called corner equilibrium.
In case when consumer purchases only
good Y (Qx = 0), equilibrium is at point A,
where MRSxy < Px / Py.

Qx
Qy
U1 U2 U3
B
0
When consumers buy
only good X (Qy =
0),equilibrium of consumer
is in point B, where:
MRSxy > Px / Py. When
Equilibrium point of consumer is affected by changes in
disposable income and commodity prices.
The case of change of consumer disposable income.
The sensitivity of consumer equilibrium to income
changes can be described by drawing two curves:
income-consumption curve and Engels curve (figure
18).
1. An increase in consumer income (I), moves the
budget line parallel to itself to the right and consumer
equilibrium point E
0
moves to right (up) to the point
E
2.

2. A decrease in consumer income (I ), moves the budget
line parallel to itself to the left and consumer
equilibrium point moves to the left (down) to the
point E
1
(figure 18a).
X
Y
E
1

E
0

E
2


0
X
I
I
1

I
0

I
2

E
2


E
0

E
1

I |
U
1

U
2

U
3

I+
A
B
C
D N
M
X0 X1 X2
X0 X1 X2
Income-consumption is the unity of
consumer optimum points E
0
, E
1
, E
2

corresponding to all possible levels of money
income, ceteris paribus.


Engels curve (E. Engel (1821-1896) is
derived from the income-consumption
curve and shows the amount of a good that
the consumer would purchase per unit of time
at various income levels.

X
Y
U
3

U
2

U
1

O
The positioning trajectory of
income-consumption curve and
the Engel curve is influenced by
the nature of the consumption
goods.
For primary necessity
goods,
curve is very steep
and close tothe OY
axis.
1 0 < <
c
d
I
X
Y
U
1

U
2

U
3

O
For luxury goods,
curve is close to the axis OX
1 >
E
d
I
X
Y
U
1

U
2

U
3

O
For inferior goods,
0 <
E
d
I
X
Y
U
1

U
2

U
3

For neutral goods, .
Income-consumption
curve is represented by a
vertical line.
0 =
E
d
I
Cloth
House
Food
C
o
n
s
u
m
p
t
i
o
n

e
x
p
e
n
d
i
t
u
r
e
s

Income of
households
Christian Engel was a XIX-th century German statistician
who did pioneering work related to such curves,which are
important for studies of family expenditure patterns. Looking
to Engel the family expenditures for food will rise in less
degree than income increases. The higher the proportion of
income spent on food in a nation, the poorest the nation is
taken to be.
Agrement
1,9
Comunicaii
4,7
Transport
4,5
Sntate
5,9
Dotarea locuinei
3,7
ntreinerea
locuinei
15,3
nvmnt
0,5
Hoteluri,
restaurante
2,3
nclminte,
mbrcminte
11,6
Buturi
alcoolice, tutun
1,9
Produse
alimentare
43,7
Diverse
3,9
0 10 20 30 40 50 60 70 80
Tanzania
Madagascar
Vietnam
Sierra Leone
Indonezia
Moldova
rile cu venituri joase:
Argentina
Mexic
Rusia
Thailand
Brazilia
rile cu venituri medii:
Danemarca
Marea Britanie
Canada
SUA
Japonia
rile cu venituri nalte:
Figure 26.
The part of
expenditures
for food in the
family budget
in %.
The CASE OF A CHANGE IN THE PRICE OF A
GOOD, CETERIS PARIBUS:
a) IF Px, the absolute value of the slope of the
budget line increases and the budget line will change
its initial position from AB to AC, and the point of
equilibrium will move from E
0
to E
1
(figure 26a).

b) If Px, the absolute value of the slope of the
budget line decreases and the budget line will change
its initial position from AB to AD, and the point of
equilibrium will move from E
0
to E
2
.
X
Y
P1
P0
P2
Y1
Y2
Y0
E1
E0
E2
X1 X0 X2
U
1
U
2

U
3

D
A
B C
E1
E0
D
X1 X0 X2
E2
THE SUBSTITUTION AND INCOME EFFECT in the
case of NORMAL GOODS
Total effect of changes in the price of a good can be divided
into two effects: the income effect and substitution effect.
The substitution effect measures the increase in the
quantity demanded of a good when its price falls
resulting only from the relative price decline and independent of
the change in real income. If the price of good X decreases, the
consumer substituites good Yby good X, purchasing less of the
good Y and more of good X, moving to another point on the Same
indifference curve.
The income effect measures the increase in the quantity
purchased of a good resulting from the increase in real income and
purchasing power of a consumer that accompanies a price decline.
This effect involves the movement from initial indifference curve
to another curve. The income effect depends on the nature of the
goods.
Cola
C
a
k
e

1 2 3 4 5
6 7 9 8 10
1
2
3
4
5
6
7
8
9
10
A
H
b
v
k
M
F N
I=30 lei
Px=6 lei
I=21 lei
Px=3 lei
I=30 lei
Px=3 lei
Y
X
Surplus of consumer

Paradox of A. Smith diamants
water

The Value of time

Cash and noncash gift-giving
Application of the theory of consumer
behavior:
0 0 1 2 3 4 5 6 1 2 3 4 5 6
1 1
2 2
3 3
4 4
5 5
6 6
7 7
8 8
9 9
10 10
Price Price
Access to Internet (hour) Acces to Internet (hour)
D
D
Market price
Surplus of
consumer
Surplus of
consumer
a) Individual demand b) Market demand