TOPIC: THEORY OF CONSUMER BEHAVIOR

1. Consumer behavior: hypotheses and determinants.

2. Utility and its types. The laws of Gssen.
3. Indiference curves and their properties.
4. The buget line and consumer equilibrium.
5. Income-consumption curve and Engel curve.
6. Price-consumption curve and individual demand curve.

The most important goal of Consumer as

economic agent is to maximize the satisfaction of his
or
her
needs
through
consumption of
goods purchased for a certain (limited) 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
problem ofchoice.

facing

the

In the process of free choice,

consumers will take the following
interrelated decisions:
1. What to buy? (to choose a market
basket with preferable goods goods with the highest utility);
2. How much to buy? (to analyze
the existing market price);
3. Is it possible to buy the
goods? (to compare disposable
income with price and preferences).

 Determinants of consumers choice

- Preferences,
- Income,
-The utility of the purchased goods,
-The price of the purchased goods,
- Prices of other goods,
- Fashion
-others
Conclusion:The complexity of
choice
of consumer

Hypotheses
of
choice are following:

consumers

Freedom of decision and action of

a consumer
Consumer rationality
Consumer sovereingty
Limited consumers income
Subjective utility assessment
and the tendency for its
maximization

Utility is initial category in the theory of consumer

behavior.
In order to make some decisions about market
basket, first of all a rational consumer will analyze the
utility.
The most preferable market basket gives the highest
level of satisfaction, or utility to a consumer.
Utility of a good or service reflects the consumers
satisfaction which he expects to obtain.

In assessing the utility historically there

were two approaches:

Cardinal (classical) approach

Ordinal
approach

(neoclassical)

position of cardinal
theory:

subjective, individual assessment of utility

quantitative measuring of utility using

a conventional unit - "utile
the principle of diminishing marginal
utility( the first law of of Gssen);
the rule of maximizing utility(the
second law of of Gssen).

Types of utility:
Total utility is the total satisfaction received from
consuming an amount of goods.
The utility function has the following form:

TU f QX i

Marginal utility is the extra utility received from

consuming one additional unit of the good.
The Formula for calculation of Marginal utility is:

MU Q X i

TU

Q X i

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)'.

While consuming a quantity of a good, the changes in MU

and TU are interdependent.

Consumed
quantity of a
specific good Qx

Total utility (utile)

TUx

20

35

45

50

50

45

Marginal utility
(utile) Mux
20
15
10
5
0
-5

Qx (quantity)

Utility (Tux, MUx)

Analyzing the evolution of TU and MU

we can draw the following
conclusions:
1. As an
additional
unit of a
given
good
is
consumed 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),
and total utility reaches its highest level (TUx=50 utile),
respectively
Qx=5
units is the
optimal amount of
consumption.
3. If consumption continues, MU becomes negative
and total utility decreases.

 The law of diminishing marginal utility(the

first law of Gssen)
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:
U 1 > U 2 > U i
where U i - marginal utility of
commodity i (1, 2, 3.)

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 utilitymaximizing rule ( 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:

MU X MU Y
MU Z

...
PX
PY
PZ

Marginal utilities (MU) of Goods and MU/P

Using the II law of Gssen, determine the optimal
combination of Juice and Pizza, if income of a student is 70
m. u., and price of one unit of juice equals to 10 m.u., price of
pizza is 20 m.u.

Juice

Pizza

Amount of
consumed
goods (Q)

MU

MU/P

MU

MU/P

1
2
3
4
5
6

6
5
4
3
2
1

6/10=0,6
0,5
0,4
0,3
0,2
0,1

10
8
7
5
4
3

10/20=0,5
0,4
0,35
0,25
0,2
0,15

position of Ordinal theory:

- ranking market basket (A, B, C) in terms of
their preference and the utility for the consumer.
-

introduction of research tools:

a) the indifference curve,
b) marginal rate of substitution, and
c) the budget line;

- maximizing utility by choosing the most preferable

market basket (using fully consumers income in
conditions of actual prices).

The ordinal 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 possible alternatives:
*would prefer A to B, (A
* Would prefer B to A, (B

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.

In the theory of consumer behavior indifference

curves provide a ranking of the individuals
preference.

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.

What is preferable ?

Cake

Alternative market basket

10

Marke
tbasket
a
b
c
d

X
(Cola, un.)
1
2
6
8

Y
(cake, un.)
8
6
2
1

2
1

X
0

1 2

Indifference curve

Cola

What is preferable ?

YC

YB

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.

U3
U2

YA

U1
XB

XC

XA

Properties
curves:

of

indifference

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

2. Indifference curves
never intersect.

can

A
YC
YB

C
U1

U2

XB

XC

Y
(apples)

3. Indifference curve are

usually negatively sloped and
are convex to the origin.

A
Y

B
C

X
(pears)

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:
Q

MRS xy

QX

TU const.

or

MU x
MRS xy
MU y

Special cases of indifference

curves

U2
U1
X

Y
U
5

U
4 U
3

U
2

U
1

Y
U
1

U
2

U
3

What is attainable ?
A

I/Py

The budget line is a set of

alternative combinations
of quantity of good X and
Y that the consumer can
buy.

B
0

I/Px

The budget line equation can be represented as

follows:

I Px QX Py QY

To draw a straight line is sufficient to know its two

extreme points:

Px
I
Qr
QX
Py Py

Py
I
Qx
Qy
Px Px

The slope of the budget line in absolut

value is the tangent of the angle ABO of triangle
AOB (figure 11):
I
AO
Px
Py
tgABO

I
OB
Py
Px

Cake

Y
10

(O,I/Py)

F
0

(I/Px ,O)
6

X
Cola

Cake

14

a) Consequences of changes
consumers disposable income

I, Px, Py constant
(Px=6 lei, Py=3 lei)
I =30 lei

10 A

The budget line will shift

up (to the right), paraleel
to the original line (figure
13).

I =42 lei

I2 =21 lei

N
3,5

F
5

K
7

in

Cola

Cake

10

b) Consequences of changing of price of

good X (Px)
I, Py constant
A

1.A decrease in the price of

good X (Px), ceteris paribus,
leads to decrease of the slope
of buget line in the absolut
P =3 lei
value.
x

Px

Px =6 lei

F
5

1
0

X
Cola

Cake

Y
10 A

Px =6 lei

2. As the price of good X rises

(Px), the absolute value of the
slope of a buget line increases
comparativ to the absolute
value of the slope of initial
budget line

Px =12 lei

Px; I constant; Py constant

Px

N
2,
5

F
5

X
Cola

Consumer equilibrium. Consumer reaches equilibrium

state, when he fully uses his disposable income and maximizes
satisfaction from the consumption of a 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?

Point of
optimal choice
equilibrium of
of consumer
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):

MU x
Px
MU x Px
MU x MU y

sau

MU y
Py
MU y Py
Px
Py
The consumers equilibrium condition
requires that the ratio of marginal utilities of
goods X and Y is equal to the prices ratio.

Y
10 A

Cake

a
E

2
1

F
0

1 2

U3
U2
U1

X
Cola

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.
1. An increase in the consumer income (I), moves the
budget line parallel to itself to the right and consumer
equilibrium point E0 moves to right (up) to the point
E2.
2. A decrease in the 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 E1.

Y
M
E2

C
A

E1

U3

U2
U1

X1

X0

X2

E2

I2

I0

I1

E1

X1

X0

X2

Income-consumption is the unity of

consumer optimum points E0, E1, E2
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.

The positioning trajectory of

income-consumption curve and
the Engel curve is influenced by
the nature of the consumption
goods.
U3

U2

For primary necessity

d
goods,
0 I 1
curve is very steep
and close to the OY
axis.

U1

For luxury goods, E I 1

curve is close to the axis OX

U3
U2
U1
O

Y
d

For inferior goods,E I 0

U3

U2
U1

Y
d

For neutral goods, E I

Income-consumption
curve is a vertical line.

U3

U2

U1

Consumption
expenditures

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.
Cloth
House
Food

Income of
households

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 E0 to E1.
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 E0 to E2.

Y1
Y0

E1

E2
E0

Y2

U1
X1

P1

U2
X0

X2

E1

E0

P0
P2

X1

X0

E2

X2

U3

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.

Cake

1
0
9
8
7
6
5
4

I=30 lei
Px=6 lei

M
b

I=21 lei
Px=3 lei

3
2
1

I=30 lei
Px=3 lei

1 2

3 4 5

7 8

H
9 10

Cola

Application of the theory of consumer

behavior:
Surplus of consumer
Paradox of A. Smith diamants

water
The Value of time
Cash and noncash gift-giving

Price

Price

10
9
8

10
9

Surplus of
consumer

Market price

7
6

2
1
0 1 2 3 4 5 6
a) Individual demand

Surplus of
consumer

2
1

Access to Internet (hour) 0 1 2 3 4 5 6

b) Market demand

Acces to Internet (hour)