Analysis of

Consumer Behavior

T.J. Joseph

Fundamentals of Consumer Choice

Factors

affecting choice:

Limited income necessitates choice.

Consumers make choices
purposefully.
One good can be substituted for
another.
Consumers must make decisions
without perfect information, but
knowledge and past experience will
help.

Utility
Utility:

The extent of satisfaction

obtained from the consumption of the
goods and services preferred by
consumers

If buying a copy of Microeconomics

book makes you happier than
buying one T-shirt, then we say that
the book gives you more utility
than the T-shirt.

Utility
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

Cardinal Versus Ordinal Utility

Cardinal

Utility Function: utility

function describing the extent to which
one market basket is preferred to
another.

Cardinal

Utility: Gives a numerical

score representing the satisfaction
that a consumer gets from a given
market basket.

Cardinal Versus Ordinal Rankings

Ordinal

Utility Function: places market

baskets in the order of most preferred
to least preferred, but it does not
indicate how much one market basket is
preferred to another.

The actual unit of measurement for

utility is not important.

Therefore, an ordinal ranking is sufficient

to explain how most individual decisions
are made.

Cardinal Versus Ordinal Rankings

Given the assumptions, it is possible to show

that people are able to rank in order all possible
situations from least desirable to most

if A is preferred to B, then the utility assigned

to A exceeds the utility assigned to B
U(A) > U(B)

Utility rankings are ordinal in nature

they record the relative desirability of

commodity bundles

It is also impossible to compare utilities

between people

Cardinal Utility Analysis

Total

Utility (TU)

The total satisfaction that a person

gains from all units of a commodity
consumed within a given time period
Marginal

utility (MU)

The additional satisfaction gained from

consuming one extra unit within a
given period of time

Diminishing Marginal Utility

Law of diminishing marginal
utility:

As the rate of consumption

increases, the marginal utility
derived from consuming additional
units of a good will decline.

The Demand Curve

A consumer's willingness to pay for a
unit of a good is directly related to the
utility derived from consumption of the
unit.
The law of diminishing marginal utility
implies that a consumer's marginal
benefit, and thus the height of their
demand curve, falls with the rate of
consumption

The Demand Curve

Joness demand for frozen pizzas,
(given by the demand curve),
reflects the law of diminishing
marginal utility.

Price

Joness demand curve

for frozen pizza
MB1

$3.50
Because marginal utility (MU)
falls with increased consumption,
$3.00
so does a consumers maximum
willingness to pay -- marginal
Price =$2.50
$2.50
benefit (MB).
A consumer will purchase until
MB = Price . . . so at $2.50 Jones
would purchase 3 frozen pizzas and
receive a consumer surplus shown
by the shaded area (above the price
line and below the demand curve).
MB4 < MB3 < MB2 < MB1
because
MU4 < MU3 < MU2 < MU1

MB2
MB3
MB4

$2.00

d = MB

4 Frozen pizzas
per week

Consumer Equilibrium With Many Goods

Each

consumer will maximize his/her satisfaction by

ensuring that the last dollar spent on each
commodity yields an equal degree of marginal
utility.

MUB
MUN
MUA
PA = PB = . . . = PN
The Equilibrium Condition or the Utility
Maximising Condition for a Consumer
when he picks up a basket of
commodities is:
Equal marginal utilities per rupee for

Questions for Thought

1. A consumer is currently purchasing 3
pairs of jeans and 5 t-shirts per year. The
price of jeans is $30, and t-shirts cost
$10. At the current rate of consumption,
the marginal utility of jeans is 60 and the
marginal utility of t-shirts is 30. Is this
consumer maximizing his utility? Would
you suggest he buy more jeans and fewer
t-shirts, or more t-shirts and fewer jeans?
2. If the price of gasoline goes up and Dan
now buys fewer candy bars because he
has to spend more on gas, this would best
be explained by the substitution effect.

Decision Making Process of a Consumer

Preferences vs. Choices

Preference Set a set of goods and

services he/she wants (likes or dislikes)

Opportunity Set (choices) a set of goods

and services he/she can buy with the
limited income (budget)

Given these two sets the consumer can list

out the feasible set of wants, which can be
satisfied and also arrive at a combination
that maximizes his satisfaction/benefits.

Model of Rational Choice

There are three steps involved in the study

of consumer behavior.
1) Consumer preferences.
What

the consumer wants to do

How and why people prefer one good to another.

2) Budget constraints.
What

the consumer can afford to do

People have limited incomes.

3) Rational Decision
What

combination of goods will consumers buy

to maximize their satisfaction?
Combine consumer preferences and budget
constraints to determine consumer choices
(optimal decision).

Axioms of Rational Choice

Given

an individuals preferences, economics

provides an optimal and rational solution to
the problem of choice, under certain
assumptions:

Assumption

of Completeness:

if A and B are any two commodities, an

individual can always specify exactly one of
these possibilities:
I

prefer A to B

prefer B to A

am indifferent between A and B

Axioms of Rational Choice

Assumption

of Transitivity
(Consistency):

if A is preferred to B, and B is preferred

to C, then A is preferred to C

assumes that the individuals choices

are internally consistent

Assumption

of Non-Satiation:

A rational consumer prefers more of a

good to less of a good

Consumer
Preferences

Market Baskets
A

market basket is a collection of one

or more commodities.

One

market basket may be preferred

over another market basket containing
a different combination of goods.

Market Baskets
Market Basket

Units of Food

(in 000 calories)

Units of Clothing

10

16

12

06

04

14

01

04

Indifference Curves
Indifference

curves represent all

combinations of market baskets that
provide the same level of satisfaction
to a person.

Indifference Curves
B

Clothing 16
(units
per week) 14

12

Combinations of B, A,
D, E and G give same
level of utility

F
C

More preferred

F is more preferred

10

C is less preferred

8
D

6
4

Less preferred

U1

2
1

Food
(000 calories per week)

Indifference Curves - Properties

(1) Indifference curves slope downward to
the right (negative MRS)

If it sloped upward it would violate the

assumption that more of any commodity is
preferred to less.

(2) Indifference curves are convex to the

origin

As more of one good is consumed, a

consumer would prefer to give up fewer units
of a second good to get additional units of the
first one (diminishing MRS)

Indifference Curves - Properties

A

Clothing 16
(units
per week) 14

12

Observation: The amount

of clothing given up for
a unit of food decreases
from 6 to 1

-6

10

-4

Question: Does this

relation hold for giving
up food to get clothing?

1
-2

1 -1
1

2
1

Food
(units per week)

Indifference Curves - Properties

(3) Indifference curves cannot cross.

This would violate the assumption that

more is preferred to less.

(4) Any market basket lying above and

to the right of an indifference curve is
preferred to any market basket that
lies on the indifference curve.

Indifference Curves - Properties

Clothing
(units per week)

U2

Indifference Curves
Cannot Cross

U1

The consumer should

be indifferent between
A, B and D. However,
B contains more of
both goods than D.

A
B
D

Food
(units per week)

Indifference Curves - Properties

Clothing
(units per week)

Market basket A
is preferred to B.
Market basket B is
preferred to D.

D
B

U3

U2
U1
Food
(units per week)

Marginal Rate of Substitution

The

marginal rate of substitution (MRS)

quantifies the amount of one good a
consumer will give up to obtain more of
another good.

It is measured by the slope of the

indifference curve.

Along an indifference curve there is a

diminishing marginal rate of substitution.
Note: the MRS for AB was 6, while that for DE
was 2.

Marginal Rate of Substitution

A

Clothing 16
(units
per week) 14

12

MRS C

MRS = 6
-6

10

-4

MRS = 2

1
-2

1 -1
1

2
1

Food
(units per week)

Marginal Rate of Substitution

Perfect

Two goods are perfect substitutes

when the marginal rate of
substitution of one good for the
other is constant.

Perfect

Substitutes

Complements

Two goods are perfect complements

when the indifference curves for the
goods are shaped as right angles.

Marginal Rate of Substitution

Apple
Juice
(glasses) 4

Perfect
Perfect
Substitutes
Substitutes

1
0

Orange Juice
(glasses)

Marginal Rate of Substitution

Left
Shoes

Perfect
Perfect
Complements
Complements

1
0

Right Shoes

Budget Constraints

Budget Constraints

Preferences do not explain all of consumer

behavior.

Budget constraints also limit an individuals

ability to consume in light of the prices they
must pay for various goods and services.

The budget line indicates all combinations of

two commodities for which total money spent
equals total income.

The budget line depends on three parameters

price of good X
price of good Y
income of consumer

The Budget Line

Let F equal the amount of food

purchased, and C is the amount of
clothing.

Price of food = Pf and price of clothing

= Pc

Then Pf F is the amount of money spent

on food, and Pc C is the amount of
money spent on clothing.

PFPCI

F
The budget line
thenCcan be written:

The Budget Line

Market Basket

Food (F)

Clothing (C)

Total Spending

Pf = (Rs.20)

Pc = (Rs.10)

PfF + PcC = I

12

120

10

120

120

120

120

120

120

The Budget Line

PC = Rs.10

Clothing 16
(units
per week) 14

(I/Pc ) 12
10

I = Rs.120

Budget Line 20F + 10C = 120

2
Slope C/F - - PF/PC
1

B
C

Not affordable

4
2

Pf = Rs.20

Affordable

G
6 (I/Pf )

Food
(units per week)

Slope of the Budget Line

Equals

the relative price of food F to

clothing C
PF

Slope

PC

Its

the amount of clothing C that has

to be given up to purchase one more

C
P
F
unit of foodSlope
F

PC

11

The Budget Line

As consumption moves along a budget line

from the intercept, the consumer spends
less on one item and more on the other.

The slope of the line measures the relative

cost of food and clothing.

The slope is the negative of the ratio of

the prices of the two goods.

The slope indicates the rate at which the

two goods can be substituted without
changing the amount of money spent.

The Budget Line

The

vertical intercept (I/PC), illustrates

the maximum amount of C that can be
purchased with income I.

The

horizontal intercept (I/PF),

illustrates the maximum amount of F
that can be purchased with income I.

Shifts in the Budget Line

Changes

in the prices of the goods or

income shift the budget line

change in income (holding prices

constant) causes a parallel shift the
budget line

change in the price of one good

swivels the budget line (i.e. the slope
changes)
12

The Effect of Income Changes

Clothing
(units
per week)

A increase in
income shifts
the budget line
outward

24
18

A decrease in
income shifts
the budget line
inward

12
6
L3

L2

L1
(I =60)

(I = 240)

(I = 120)

12

Food
(units per week)

Effects of Changes in Income and Prices

Effects

of Price Changes

If the price of one good increases,

the budget line shifts inward,
pivoting from the other goods
intercept.

If the price of one good decreases,

the budget line shifts outward,
pivoting from the other goods
intercept.

The Effect of Price Changes

Clothing
(units
per week)

An increase in the
price of food to
Rs.40 changes
the slope of the
budget line and
rotates it inward.
A decrease in the
price of food to
Rs.10changes
the slope of the
budget line and
rotates it outward.

12

L3
(PF = 40)

L1

L2
(PF = 20)

(PF = 10)
9

12

Food
(units per week)

Effects of Changes in Prices

If the two goods increase in price, but the

ratio of the two prices is unchanged, the
slope will not change.

The budget line will shift inward to a point

parallel to the original budget line.

If the two goods decrease in price, but the

ratio of the two prices is unchanged, the
slope will not change.

The budget line will shift outward to a

point parallel to the original budget line.

Consumer Choice
(Rational or Optimal Decision)

Equilibrium Conditions
All

income is spent (point E is on the

budget line)

The

slope of the indifference curve

equals the slope of the budget line

Marginal rate of substitution = the relative price ratio

16

Consumer Choice (Utility Maximization)

Consumers

choose a combination of
goods that will maximize the
satisfaction they can achieve, given the
limited budget available to them.

The

maximizing market basket must

satisfy two conditions:
1) It must be located on the budget line.
2) Must give the consumer the most
preferred combination of goods and
services.

Consumer Choice (Equilibrium)

Recall, the slope of an indifference curve is:

C
MRS
F

Further, the slope of the budget line

is:
PF
Slope
PC
Therefore, it can be said that satisfaction
is maximized where: PF
MRS

PC

It can be said that satisfaction is maximized when marginal rate of

substitution (of F and C) is equal to the ratio of the prices (of F and C).

Consumer Choice
Clothing
(units per
week)

Pc = 10

Pf = 20

I = 120
Point B does not
maximize satisfaction
because the
MRS
is greater than the
price ratio

12
B

Budget Line

4
U1
0

Food (units per week)

Consumer Choice
Clothing
(units per
week)

Pc = 10

Pf = 20

I = 120

12
Market basket D
cannot be attained
given the current
budget constraint.

8
4

U3
Budget Line
0

Food (units per week)

Consumer Choice (Equilibrium)

Clothing
(units per
week)

Pc = 10

Pf = 20

I = 120
At market basket A
the budget line and the
indifference curve are
tangent and no higher
level of satisfaction
can be attained.

12

8
A

6
4

At A:
MRS = Pf/Pc = -2

U2
Budget Line
0

Food (units per week)

Consumer Choice (Equilibrium)

From Cardinal Approach we know that the
consumer will be in equilibrium when:
MU C MU F

PC
PF
That is,

MU F
PF

MU C
PC

Therefore, we can say that satisfaction is

maximized where: PF MU F

MRS FC

PC

MU C

Income Consumption Curve (ICC)

When

income of the consumer increases,

keeping the prices of commodities the
same, the budget line shifts to the right

The

shift in budget line shifts the

equilibrium position of the consumer at a
higher indifference curve

Income

Consumption Curve (ICC) is the locus

of all such tangency points between the
budget lines and the indifference curves

ICC shows the effect of the change in income on the

equilibrium quantities purchased of the two
commodities

Income Consumption Curve (ICC)

Good Y

Income Consumption Curve

E3
E1

U3

E2
U2
U1

X1

X2

X3

Good X

Price Consumption Curve (PCC)

PCC

represents the successive points of

tangency between the different budget
lines and indifference curves because of
changes in the price of one of the
commodity, ceteris paribus
(Consumer income and prices of other
commodities remain the same)

The

demand curve of the consumer for a

commodity can be derived from the PCC
(Explain).

Price Consumption Curve (PCC)

Good Y

Price Consumption Curve

E1

E2

E3
U3
U2
U1
B

X1 X 2 X 3

D
Good X

Income & Substitution Effects

Substitution

the effect on consumption of a good

resulting only from the change in its
relative price (i.e. the slope of the budget
line)

Income

Effect

Effect

the effect on consumption of a good

resulting only from the change in real
income (i.e. the position of the budget
line)

Price Effect = Income Effect + Substitution Effect

A Fall in Price of Good X

All other
goods (Y)

Substitution effect:
E1 to E2
Income effect:
E2 to E3
E1
E2

E3
U2
U1

X1

X2

X3

Good X

References
1. Chapter 3 & 4 in Dominick Salvatore (2009)

Principles of Microeconomics, 5th edition,

Oxford Higher Education.
2. Chapters 21 in William Boyes and Michael

Melvin (2009), Textbook of Economics, 6th

edition, Biztantra publications.