ECO101— PRINCIPLES OF MICROECONOMICS—Notes

Consumer Behaviour

Overview
The aim of this chapter is to analyse the behaviour of rational consumers when consuming goods and
services, to explain how they may allocate their income (budget) among various goods, and to relate the
curve to a model of consumer choice and utility maximization. In this analysis, the income and substitution
effects are highlighted and indifference curve analysis is introduced.

Marginal Utility Analysis

Utility is the satisfaction people derive from the consumption of goods and services. We will be mostly
concerned with marginal utility (the additional satisfaction one receives from the consumption of one
additional unit of a good). Total utility, on the other hand, is the total satisfaction one gets from consuming all
the units of a good.

Note that utility is not a characteristic of the good, but rather it is in the mind of the consumer. Therefore, the
value of utility each individual attaches to the consumption of one good may be different than the utility
derived by another person. Therefore, utility is subjective (it is personal for each individual).

Diminishing Marginal Utility: Imagine that you go to McDonalds and order a Big Mac. Initially you enjoy the
hamburger very much because you are hungry, therefore utility is very high. Now you order a second Big
Mac and you manage to finish it, but you start to get full. By the end of the second hamburger, the utility was
less than for the first one. In other words, your marginal utility (the additional satisfaction) is less than before,
even though the total utility (the sum of utilities for both hamburgers) is higher. If your buddy dares you to eat
a third Big Mac, you will probably take on the challenge and order the third hamburger. But since you are
nearly full, you really don’t enjoy it this time, and therefore, the marginal (additional) utility for the third Big
Mac is even less than before. Up to this point, your total utility still increases, though by smaller increments! If
your friend dares you to eat a fourth one (or even if the store offers free Big Macs), you would most probably
refuse to eat a fourth one because it might even make you throw up. In other words, you value the marginal
(additional) utility as zero (or may even be negative)!

We can generalise from the description of behavior above to say that the principle of diminishing marginal
utility says that as we consume successive (more and more) units of one good, the additional satisfaction
(marginal utility) we derive diminishes (gets less and less!).
MU = ∆TU / ∆Q
We can now represent the relationship between total utility and marginal utility in a table (schedule) as well
as in a graph, as shown below:

U t ilit y fro m c o n s u m in g B ig M a c s

U t ilit y ( U t ils )

1 3

1 1 T U

B ig M a c s T U M U
7
0 0 -
1 7 7
2 1 1 4
3 1 3 2
4 1 3 0
5 1 2 -1

0
1 2 3 4 5
-1 M U
N u m b e r o f B ig M a c s C o n s u m e d p e r V is it 3

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Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
We can identify the following relationships from the above graph:

• The TU curve slopes upwards, and reaches a maximum at the number of units where MU is zero (at
4 Big Macs).
• The MU curve has a negative slope reflecting the concept of diminishing marginal utility as explained
above

Budget Line (or Income Constraint)

As we mentioned in Chapter 1, human wants are unlimited, but resources are limited. For each individual
consumer (or business firm) there is a limited amount of income (or budget) per time period that can be
devoted for spending on goods and services.

This is the concept of a budget line (the income constraint). This determines the maximum bundle of goods,
which the consumer is able to consume (given the market prices of the goods) while living within his/her
means, in other words, his/her ability to pay for the goods, that is, within his/her income. Graphically, this
approach resembles the concept of the production possibility frontier (discussed in Chapter 1), although we
are examining consumption rather than production, in the sense that on one axis we measure the units of
one good and on the other axis the units of another good. The budget line indicates the combinations of two
goods, which a consumer can afford to buy.

In the graph below, we assume that the individual (say a student at Cyprus College) has a monthly income (a
budget) of £50, which he/she can spend on goods and services. We will assume for simplicity that the
student is faced with choosing between only two goods, meals and cigarettes. Assume further that the price
of meals = £1.0 and that of cigarette packs = £2.0. The insert in the graph below, presents the various
combinations of the two goods that the student can consume by fully spending his/her monthly income. The
budget line, which graphs these combinations of the two goods and represented by points A through F,
expresses the limits of the student’s spending capability with respect to consumption of meals and
cigarettes, again given the monthly income of £50 and the prices of the two goods.

Units of Cigarette Packs

Units of Units of
25 A Y Cig. packs Meals

Budget Line
A 25 0
20 B
B 20 10
C 15 20
C D 10 30
15 E 5 40
X F 0 50
10 D

E
5
F
10 20 30 40 50
Units of Meals

The budget line separates the affordable from the unaffordable. In other words, to the left of the budget line
all combinations (including the ones on the budget line) are affordable. To the right of the budget line, any
combination cannot be afforded, since it requires a higher budget than the £50 the students has. Therefore,
a point such as Y is not affordable, but a point such as X is affordable. In this case, however, the student is
not spending all his/her income. The student saves some of his/her income. For simplicity, we will assume
that students don’t save any of their income, but rather spend it all on meals and cigarettes in combinations
that they choose.

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Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
The Budget Equation
Let us examine the budget line using simple algebra. We defined the budget as the sum of expenditures by
the student on meals and cigarettes. The expenditure on each good is of course the number of units
consumed multiplied by the price of that good. Therefore in the case of the student in the above example:

Total Expenditure (Budget) = (Price of Meal X Quantity of meals)

+ (Price of cigarette pack X Quantity of Cigarette packs)

If we denote the price of meals as Pm, the number of meals as Qm, the price of cigarettes per pack as Pc, and
the number of cigarette packs consumed as Qc , then we can express the budget for the student as:

Y = PmQm+ PcQc

Using the prices of meals (£1) and cigarette packs (£2) as given above, we get:

Y = £1Qm+ £2Qc

The student can choose any combination of meals and cigarettes that satisfies the above equation, the
student’s budget constraint. If we assume that the student chooses the combination denoted by point C in
the above graph, then the expression of the budget line becomes:

£50 = (£1 X 20) + (£2 X 15). Therefore the budget constraint is satisfied.

In the same way, all points on the budget line will exactly use up all the available income of the student. We
said that point X (20 meals and 10 packs of cigarettes) is affordable since it lies inside and to the left of the
budget line, but that the student is not using all his/her income. Let’s see this calculation:

£40 = (£1 X 20) + (£2 X 10). Therefore, the student saves £10.

Likewise, let’s examine point Y (10 meals and 25 cigarette packs). The total expenditures (budget) becomes:

£60 = (£1 X 10) + (£2 X 25)

Therefore, the student does not have enough money (income or budget) to consume this combination of
goods. Point Y then is not an affordable combination.

Using the general budget equation Y = PmQm+ PcQc, we can derive a general expression to determine the
quantities of meals and cigarettes that is feasible (affordable) for the student to consume. If we solve the
budget equation for Qm, we get:

Qc = (Y / Pc) – (Pm / Pc) x Qm

So, given the income and the prices, the student must choose the number of meals and packs of cigarettes
per month that satisfy the following equation:

Qc = (£50 / £2) – (£1 / £2) x Qm or Qc = £25 – £0.5 x Qm

Real Income: The expression (Y / Pc) defines what we call real income, since it adjusts (divides) the money
income by prices to give us the purchasing power of the individual. It tells us in other words, the maximum
amount of a goods (cigarette packs in this case) that the student can afford to buy, and is the student’s real
income in terms of cigarette packs. Thus, the student’s real income in terms of cigarettes is 25 cigarette
packs per month. In terms of the graph, this is point A, which is also called the intercept—the point where the
budget line touches the axis.

Slope: As you recall, we defined in Chapter 2 the slope of a line as the change of the variable in the vertical
axis (the y -axis) over the change of the variable on the horizontal axis (the x –axis)—or (∆Υ / ∆Χ), where ∆
stands for “change in.” As a simple way of remembering the formula for the slope remember we defined it
as: (the rise ) / (the run). In the above graph, the slope of the budget line between point B and C is:

(∆Υ / ∆Χ) = - 5 / 10 = - 0.5 (a negative value indicates that the line is downward-sloping).

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Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
In economic terms now, the slope of the budget line is determined by the relative prices, that is, the ratio of
the prices of the two goods in question (Pm / Pc) and indicates how many units of one good must be given up
(sacrificed) in order to consume one more unit of the other good. In our example, it is the ratio of meal prices
to cigarette prices (£1 / £2). The slope here then is 0.5. It indicates that to consume one more meal the
student must give up (sacrifice) half a pack of cigarettes. This is nothing more than the student’s opportunity
cost of meal consumption!

Adjustments (Changes) in Income

Let us now examine the case of an increase in the level of the student’s income, assuming for now that
relative prices of goods remain constant. This means that the slope of the budget line—which is given by the
ratio of prices (Pm / Pc)—remains the same as the original one (in this case it stays at - 0.5).
What changes is only the intercept of the budget line given by (Y / Pc), since we assume that money income
(Y) changes. Graphically this is represented by a rightward (outward) shift of the budget line.

For example, if we assume that the student’s income increase to £60 per month, then with prices remaining
the same, the maximum number of cigarettes that the student can consume if all income is devoted to
smoking is 30 cigarette packs per month (instead of 25 previously)--£60 / £2 = 30.

Cigarette packs
30

25 Income of £50

Income of £60

50 60 Meals

Adjustments (Changes) in Prices

Let us now examine the adjustment to quantities consumed when relative prices change, assuming that
income remains fixed at the previous level. When the price of a good decreases, then the budget line must
shift outward at that particular axis, rotating around the intercept, in other words, the point where it cuts the
other axis. In our example, where cigarettes are measured on the vertical axis and meals on the horizontal
axis, the slope of the budget line (Pm / Pc) at the original income of £50 was found to be – 0.5 ( = £1 / £2). If
we now assume that the price of meals decreases to £0.75 (75 cents), then the slope of the budget line
would get smaller -- £0.75 / £2.0 = 0.375, instead of 0.50 before—and the line would rotate outwards to the
right. With the reduction in the price of meals to £0.75 the maximum number of meals that the student can
consume now is approximately 66 meals per month (again assuming that the income remains fixed at £50.

Cigarette packs

25
Pm= £1.0

Pm= £0.75

Pm= £1.25

40 50 66 Meals

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Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
If we now assume that the price of meals increases to £1.25, then the slope of the budget line increases (it
becomes steeper) since the relative price ratio is now £1.25 / £2.0 = 0.625, compared with 0.50 previously.
Therefore the line would rotate inwards to the left. As a result of the increase in the price of meals, the
student would be able to afford at the maximum 40 meals per month (£50.0 / £1.25 = 40).

Notice that in both the cases of a decrease and an increase in the price of meals, the intercept remains
unchanged. Recall that the expression for the intercept is (Y / Pc). Since neither income (Y) or the price of
cigarettes has changed, the value of the intercept remains unchanged at 25.

Utility Maximization
Since people’s incomes (their budgets) are limited, and given the prices of goods, the rational consumer is
expected to choose and consume that combination of goods and services that would give him/her the
maximum satisfaction (utility). In making their choices, people (consumers) seek to get the maximum
possible satisfaction from the goods and services, given their available budgets. In other words, they try to
maximize their total utility.

Let’s continue with the example of the student we were using above, to see how she/he decides to allocate
her/his income (budget) between meals and cigarettes to derive the maximum utility (satisfaction).

The rule is that the rational consumer would maximize utility at the point where the marginal utility derived
per pound spent form each good is equal for all goods consumed. This measure of optimum comparative
marginal utility is derived by dividing the Marginal Utility of each good (the extra satisfaction derived from
consuming an extra unit of a good) by the price of the good. This may be expressed as:

(MUm / Pm) = (MUc / Pc),

where MUm and MUc are the respective marginal utilities of meals and cigarette smoking. In other words, the
rational consumer is interested to get maximum utility from his money spent whether he is consuming meals
or cigarettes. The point may become clearer if we assume that the two ratios are not equal. Specifically, let’s
assume that both MUm and MUc are equal to 10 units of utility (satisfaction). Given the prices of the two
goods used in the example above (Pm = £1.0 and Pc = £2.0), we end up with an inequality of the two ratios:

(MUm / Pm) > (MUc / Pc) Î (10 / £1.0) > ( 10 / £2.0) Î 10 > 5

In this case, the student gets more utility from a pound spent on meals than from a pound spent on
cigarettes. Naturally then he would tend to switch money from cigarette smoking to meals, thereby increasing
his total (combined) utility. This process of readjustment of consumption habits will continue until the last
pound spent derives the same amount of utility whether spent on meals or on cigarettes.

A similar conclusion can be arrived by looking at the same relationship from a different angle using the
following expression (which is equivalent to the previous one):

(MUm / MUc) = (Pm / Pc)

This says that the student will derive the maximum utility from his income if the ratio of the marginal utilities
of the two goods is equal to their relative prices. Again, by investigating a situation where there is no equality
between the ratios would clarify things better. Assume as we did above that the marginal utility of one extra
meal is the same as that for smoking an extra pack of cigarette (10 units of satisfaction or utility), yet the
student pays twice the price for a pack of cigarettes than for a meal (£2 instead of £1). Therefore, the
equality of the ratios does not hold.

(MUm / MUc) > (Pm / Pc) Î (10 / 10) > (£2.0 / £1.0 ) Î 1 > 0.5

As we concluded above, the student in this case would tend to switch money from cigarette smoking to
meals from which the student gets more utility per pound spent, thereby increasing his total (combined)
utility. This process of readjustment of consumption habits will continue until the last pound spent derives the
same amount of utility whether spent on meals or on cigarettes.

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Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
Indifference Curve Analysis

The concept of indifference curve analysis (or utility analysis) is based on some key assumptions:
• Firstly, we assume that consumers can rank their preferences or tastes between these alternative
combinations, giving a consistent utility ranking;
• Secondly, we assume that rational consumers prefer more good to less; and
• Thirdly, that to hold utility constant, less needs given up of one good, to obtain successive equal
increases in the quantity of the other good (the assumption of diminishing marginal rates of
substitution).

An indifference curve shows the various combinations of two goods that yield the same utility or satisfaction
to the consumer. Indifference curves are negatively sloped because by consuming more of say meals, the
individual would have to consume less of the other good (say cigarettes) in order to remain on the same
indifference curve (that is, have the same level of satisfaction).

The amount of cigarettes that the consumer would be willing to give up in order to acquire one additional unit
of meals is called the marginal rates of substitution (MRS). Algebraically this is represented as:

MRS = ∆ Qc / ∆ Qm PmQm+ PcQc

This can be illustrated on the graph using the concept of the indifference curve. When a consumer (student)
has a lot of one good, but little of the other, they would be willing to exchange a lot of the good, which is
plentiful, for a little of the good they are short of. Using our example, a hungry student would normally be
prepared to give up several packs of cigarettes for some more meals – you can’t live on cigarettes alone.

An indifference curve like U2

Cigarettes (Y) shows the combination of
consumption of cigarettes and
meals that yield the same utility
• Indifference curves slope
downwards
• Their slope gets smaller
∆Y U3 as we go from left to right
• They never intersect
∆X U2
U1

Number of Meals (X)

Note that as we move down an indifference curve, the MRS declines (i.e., the individual is willing to give up
less and less of cigarettes for each additional meal. This declining nature of the MRS is reflected in the
convex shape of the indifference curves. Note also that if goods are close substitutes for each other then the
curves will be less ‘curved’. If goods are not close substitutes then more will have to be given up of one to
compensate for an increase in the other, while utility remains constant.

Unlike demand curves, because of their nature, indifference curves cannot cross. This follows from
assumption No 2 above which says that more is preferred to less – thus crossed indifference curves would
be illogical.

Consumer Equilibrium
Using indifference curve and the budget line, we can show that the optimum point for consumption is the
tangency point between the budget constraint and the indifference curve representing consumption of the
greatest amount of goods. At that point there is nowhere upon the existing budget line which would result in
a greater satisfaction for the individual. Different individuals (with different indifference curves) will end up at
a different tangency point on the same budget line.

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Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
 The optimum point (consumer
Cigarettes (Y)
equilibrium) is reached at point E
where the budget line is tangent
to the indifference curve.
A • Points A and B are also
D affordable but lie on a
E lower indifference curve
• Point D, on the other
hand, is not an affordable
U2 given the budget
B
U1
Number of Meals (X)

Substitution and Income Effects (Without Indifference Curves)

Recall that we have already come across the concepts of substitution and income effects when we first
introduced shifts in the demand curve. According to the substitution effect, a decrease in the price of a good
will always increase the quantity demanded of the specific good as consumers will switch away from the
consumption of substitute goods. This can be shown by the shift (rotation outward) of the budget line to a
new one. For example, from a point A on the original budget line the student moves to a point such as C on
the new budget line. This is the result of the combined effect of substitution (direct effect) and income
(indirect effect). The price decrease creates the real income effect since people now have more purchasing
power due to the decrease in the price of even one good (meals in this case). Therefore, the consumption of
meals (in addition to perhaps the consumption of cigarettes) will increase due to the real income effect. The
student moves to a point such as B. But part of the change from A to C is the direct impact of the substitution
effect brought about by the price change, as the student substitutes more meals for less cigarettes in an
attempt to maximize utility. The final change in quantity then is a combination of the substitution effect and
the income effect. This is shown graphically below:

In c o m e a n d S u b s t it u t io n E ffe c ts

C ig a r e t t e s

B
A
C

N e w B u d g e t L in e

O r ig in a l
B u d g e t L in e

I n c o m e M e a ls
S u b s titu tio n
T o ta l E ffe c t
1 1

Derivation of the Consumer’s Demand Curve

Using the concept just developed for price changes, we can now show how the individual consumer’s
demand curve is derived. In the upper portion of the graph below we have a situation where the price of
meals successively falls and this is shown by the rotation of the budget line outwards and to the right.

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Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
Equilibrium in each case is found at different points on the different budget lines reflecting the changing
preferences of the student at different meal prices, for example at £0.75, £1.00 and at £1.25.

We can now take the information from the upper portion of the graph about the combinations of prices and
quantities that the student maximizes his/her utility and put them in the standard demand graph where price
is shown on the vertical axis and quantity on the horizontal axis. This produces the three points on the lower
graph. If we join these three points we will derive the familiar downward-sloping demand curve, which shows
the inverse relationship between price changes and quantities demanded.

D e r iv a t io n o f C o n s u m e r D e m a n d C u r v e
C ig a r e tte p a c k s

P m = £ 1 .2 5
25
P m = £ 1 .0

P m = £ 0 .7 5

40 50 66 N u m b e r o f M e a ls

M e a l P r ic e s
£ 1 .5 0

1 .2 5

1 .0 0

0 .7 5

0 .5 0

40 50 60 N u m b e r o f M e a ls
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Derivation of the Market Demand Curve

So far we came full circle to the starting point of Chapter 3 where we drew the individual’s demand curve as
downward-sloping. With the analysis in this chapter we went deeper and investigated the behaviour of
individuals and explained why we end up with the downward-sloping demand curve.

The next step is easy and straight forward going from individual demand curves to market demand curves. If
we assume that the price of meals is £1.0 as in the example above and we want to find the total quantity
demanded by the class of ECO101A for the past month, we would simply ask all the students in the class
how many meals each one had during the month and simply add up all the numbers to get the total. We use
same principle in order to find graphically the market demand.

In the graph below we assume that there are only two students in the market. At £1.0 we ask them how
many meals they had during the month, and find that one had 20 meals and the second 25. Therefore, the
total market demand is 45 found by the horizontal summation of the two individual graphs.

References for further reading:

Bade, R. and Parkin, (2007). Foundations of Economics 3rd edition (Pearson Education).

Begg, D., Fischer, S. and Dornbusch, R. (2005). Economics 8th edition (McGraw-Hill).

Mankiew N. Gregory (2007). Principles of Economics 4th edition (Thomson, South-Western).

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Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
McConnel C. and S. Brue (2005). Economics 16th edition (McGraw-Hill).

Miller, R.L (2006). Economics Today 13th edition (Pearson Addison Wesley).

Sloman John (2006). Economics 6th edition (Prentice Hall).

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Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS