Mr. P.

Nandakumar Assistant Professor KVIMIS

 Approaches
Total

to Consumer Behaviour

utility Marginal Utility Law of Diminishing Marginal utility Indifference Curve Indifference Map Budget Line

 The

principle assumption upon which the theory of consumer behavior is built on: A consumer attempts to allocate his/her limited money income among available goods and services so as to maximize his/her utility (satisfaction). Useful for understanding the demand side of the market. Utility - amount of satisfaction derived from the consumption of a commodity .measurement units utils

 Cardinal

we can assign values for utility. Propounded by Marshalling Known as Utility Approach or Marshalling Approach

Utility Approach - assumes that

E.g., derive 100 utils from eating a full meal

Ordinal

- does not assign values, instead works with a ranking of preferences. Propounded by Hicks & Allen Also known as Indifference Curve Analysis

Utility Approach

 Total

utility (TU) - the overall level of satisfaction derived from consuming a good or service Marginal utility (MU) additional satisfaction that an individual derives from consuming an additional unit of a good or service.

TU MU Q

Example : Q 0 1 2 3 4 TU 0 20 27 32 35 MU --20 7 5 3

5 6 7

35 34 30

0 -1 -4

TU, in general, increases with Q At some point, TU can start falling with Q (see Q = 6) If TU is increasing, MU > 0 From Q = 1 onwards, MU is declining principle of diminishing marginal utility As more and more of a good are consumed, the process of consumption will (at some point) yield smaller and smaller additions to utility

TU 35 Total utility(in utils)

30 25
20 15 10 5 0 1 2 3 4 5 Quantity 6 Q

MU

Marginal utility (in utils)

20 15 10 5 0 -5 1 2 3 4 5 6 Q

Quantity

Meaning : The first unit of consumption of a good or service yields more utility than the second and subsequent units

 So

far, we have assumed that any amount of goods and services are always available for consumption In reality, consumers face constraints (income and prices):

Limited consumers income or budget Goods can be obtained at a price

Marginal utility per rupee additional utility derived from spending the next rupee on the good

MU per rupee =

MU Price

MU X MU Y PX PY

MU X MU Y PX PY

 Consumers

objective: to maximize his/her utility subject to income constraint 2 goods (X, Y) Prices Px, Py are fixed Consumers income is Known

 Suppose:

X = Banana Y = Orange

Assume:

Price of Banana(X), PX = Rs.2 Price of Orange(Y), PY = Rs.10

Qx 1 2 3 4

TUX 30 39 45 50

MUX 30 9 6 5

MUx Px 15 4.5 3 2.5

QY 1 2 3 4

TUY 50 105 148 178

MUY 50 55 43 30

MUy Py 5 5.5 4.3 3

5
6

54
56

4
2

2
1

5
6

198
213

20
15

2
1.5

Price of X, Px = RS. 2

Price of Y, Py = RS. 10

 Presence

of 2 potential equilibrium positions suggests that we need to consider income. To do so let us examine how much each consumer spends for each combination. Expenditure per combination

Total expenditure = PX X + PY Y Combination A: 3(2) + 4(10) = 46 Combination B: 5(2) + 5(10) = 60

 Scenarios:

If consumers income = 46, then the optimum is given by combination A. .Combination B is not affordable If the consumers income = 60, then the optimum is given by Combination B.Combination A is affordable but it yields a lower level of utility

Marginal utility analysis requires some numerical measure of utility in order to determine the optimal consumption combinations
Economists have developed another, more general, approach to utility and consumer behavior This approach does not require that numbers be attached to specific levels of utility

 All

this new approach requires is that consumers be able to rank their preferences for various combinations of goods
the consumer should be able to say whether
Combination A is preferred to combination B Combination B is preferred to combination A. or Both combinations are equally preferred

Specifically,

Indifference curve shows all combinations of goods that provide the consumer with the same satisfaction, or the same utility Thus, the consumer finds all combinations on a curve equally preferred
Since each of the alternative bundles of goods yields the same level of utility, the consumer is indifferent about which combination is actually consumed

 Indifference

analysis is an alternative way of explaining consumer choice that does not require an explicit discussion of utility. Indifferent: the consumer has no preference among the choices. Indifference curve: a curve showing all the combinations of two goods (or classes of goods) that the consumer is indifferent among.

common shape for an indifference curve is downward sloping.

For the consumer to be indifferent to the bundle of goods chosen, as less of one good is consumed, more of another must be consumed.

The indifference curves are not likely to be vertical, horizontal, or upward sloping.

A vertical or horizontal indifference curve holds the quantity of one of the goods constant, implying that the consumer is indifferent to getting more of one good without giving up any of the other good. An upward-sloping curve would mean that the consumer is indifferent between a combination of goods that provides less of everything and another that provides more of everything. Rational consumers usually prefer more to less.

An indifference curve for work and leisure

 The

slope or steepness of indifference curves is determined by consumer preferences.

It reflects the amount of one good that a consumer must give up to get an additional unit of the other good while remaining equally satisfied. This relationship changes according to diminishing marginal utilitythe more a consumer has of a good, the less the consumer values an additional value of that good. This is shown by an indifference curve that bows in toward the origin.

Indifference curves cannot cross. If the curves crossed, it would mean that the same bundle of goods would offer two different levels of satisfaction at the same time. If we allow that the consumer is indifferent to all points on both curves, then the consumer must not prefer more to less. There is no way to sort this out. The consumer could not do this and remain a rational consumer.

 An

indifference map is a complete set of indifference curves. It indicates the consumers preferences among all combinations of goods and services. The farther from the origin the indifference curve is, the more the combinations of goods along that curve are preferred.

 The

indifference map only reveals the ordering of consumer preferences among bundles of goods. It tells us what the consumer is willing to buy. It does not tell us what the consumer is able to buy. It does not tell us anything about the consumers buying power. The budget line shows all the combinations of goods that can be purchased with a given level of income.

 The

budget line is an important component when analyzing consumer behavior. The budget line illustrates all the possible combinations of two goods that can be purchased at given prices and for a given consumer budget. The amount of a good that a person can buy will depend upon their income and the price of the good.

 If

consumer income increases then the consumer will be able to purchase higher combinations of goods. An increase in consumer income will result in a shift in the budget line. The prices of the two goods have remained the same, therefore, the increase in income will result in a parallel shift in the budget line.

 If

income is held constant, and the price of one of the goods changes then the slope of the curve will change. In other words, the curve will rotate depending upon the change in the price of the goods.

 The

indifference map in combination with the budget line allows us to determine the one combination of goods and services that the consumer most wants and is able to purchase. This is the consumer equilibrium.
demand curve for a good can be derived from indifference curves and budget lines by changing the price of one of the goods (leaving everything else the same) and finding the equilibrium points.

The

The consumer maximizes satisfaction by purchasing the combination of goods that is on the indifference curve farthest from the origin but attainable given the consumers budget.

By changing the price of one of the goods and leaving everything else the same, we can derive the demand curve. In (a), the price of a gallon of gasoline doubles, rotating the budget line from Y1 to Y2. The consumer equilibrium moves from point C to E, and the quantity demanded of gasoline falls from 3 to 2.

 Chapter

-5 Theory of Consumer Behavior, R.Saravanan, R.Karuppasamy, Economic Analysis for Business, SCITECH Publications Chapter-5, Demand & Consumer Behavior Paul A. Samuelson and William D. Nordhaus, Economics, 18th edition, Tata McGraw Hill, 2005 Chapter 21, The Theory of consumer choice N. Gregory Mankiw, Principles of Economics, 3rd edition, Thomson learning, New Delhi, 2007