ECONOMICS OF CONSUMER BEHAVIOUR

Dr.Shylajan

Todays Discussion
Fundamental Economic Questions revisited What? Consumer Preferences Utility, Total Utility, Marginal Utility and Law of Diminishing Marginal Utility Budget Constraints Consumer Choice/Consumer Equilibrium

Consumer Behaviour
Why people buy goods and services?
Primary goal of consumers is maximization of satisfaction from consuming the goods Economists call this satisfaction Utility But how do we measure satisfaction???

Consumer Behaviour
Can satisfaction you derive from consumption of a good be measured in some units of measurement?

There are different opinions! Cardinal and Ordinal Approaches

To Cardinal Economists, the motivation to consume goods is to gain utility which is measurable in some numerical value

Consumer Behaviour
There are three steps involved in the study of consumer behavior.

1) To describe how and why people prefer one good to another.

Consumer Behaviour
2)

Then we will turn to budget constraints. People have limited incomes.

3) Finally, we will combine consumer preferences and budget constraints to determine consumer choices.

What combination of goods will consumers buy to maximize their satisfaction?

Consumer Behaviour
It is assumed that consumers always prefer more of any good to less. That is, consumer is rational. This is called economic rationality.
How can we determine the consumers preference?

It is by looking at the Utility.

Utility
Utility is the satisfaction or pleasure derived from consumption of a good or service.

Utility received from consumption varies from person to person. It is subjective.

Actual measurement of utility is impossible! But to Cardinalists

Utility
Ordinal Versus Cardinal Utility The actual unit of measurement for utility is not important- ordinal school of thought Therefore, an ordinal ranking is sufficient to explain how most individual decisions are made.

Total Utility
Total level of satisfaction derived from

all

units of a good consumed.

Suppose Good X.

U = f (x1, x2, x3) U(x1, x2, x3),.. = U1 (x1) + U2 (x2)+

Marginal Utility
Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good.

U
MU=

Q
Where U is change in utility Q is change in quantity consumed

Total Utility and Marginal UtilityA Hypothetical data

Units of Food Total Utility Consumed 0 0 1 40 2 60 3 70 4 75 Marginal Utility 40 20 10 5

Total and Marginal Utility

Example The marginal utility derived from increasing from 0 to 1 units of food might be 40 Increasing from 1 to 2 might be 20 Increasing from 2 to 3 might be 10

Observation: Marginal utility is diminishing

Law of Diminishing Marginal Utility

When more and more of a good is consumed, consuming additional amounts will yield smaller and smaller additions to utility.
The extra satisfaction of a good declines as people consume more and more.

This is a universal principle of human consumption behavior

Utility Maximization in a world of without Scarcity

If a good is free, you increase consumption as long as additional units provide you positive utility. In our previous example, consumer will consume 4 units. Thus his total utility is maximixed (75 Utils)

Utility Maximization in a World of Scarcity

But Goods are not free!

In the real world, consumption depends on tastes, Prices, and your income.
Now we will turn to Budget Constraints.

Budget Constraints
Preferences do not explain all of consumer behavior.
Budget constraints also limit an individuals ability to consume. Suppose you allocate your income for 2 goods, Food and Cloths

The Budget Line

Price of Food is Rs. 100 per unit Price of Cloths is Rs. 200 per unit

You have disposable income of Rs.800

Given the price and income, you have different consumption possibilities.

Budget Line shows all combinations of two commodities for which total money spent equals total income. Pf. F + Pc. C = Total Income
Spending on food +Spending on Cloth =Total Budget

Budget Constraints
Market Basket Food (F) Clothing (C) Total Spending Pf = (Rs.100) Pc = (Rs.200) PfF + PcC = Income

A B C D F

0 2 4 6 8

4 3 2 1 0

Rs.800 Rs.800 Rs.800 Rs.800 Rs.800

Budget Line-Graphically

Budget Line

Cloths
4 3 2 A B C

1 0
2 4

D
E 6 8

Food (per week)

Shift in Budget Line

Due to Income Changes
An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant). A decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant).

80

Cloths
4 3 New Budget line when income decreases 2

A B C D

New Budget Line when income increases

1 0
2 4 6

E
8 16 Food (per week)

Shift in Budget Line

Due to 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.

Cloths
4 3 2

Due to decrease in the price of Food

1 0
2 4 6 8 16 Food (per week)

Price of Food Decreases

Market Basket Food (F) Clothing (C) Total Spending Pf = (Rs.50) Pc = (Rs.200) PfF + PcC = Income

A B C D F

0 4 8 12 16

4 3 2 1 0

Rs.800 Rs.800 Rs.800 Rs.800 Rs.800

Cloths
4 3 Due to increase in the price of food 2

1 0
2 4 6 8

Food (per week)

Consumer Choice
How do you allocate our disposable income between the two goods to maximize utility?
Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.

Consumers will consider their

Preferences (utility)
Market prices, and their Income

Marginal Utility and Consumer Choice

Total utility is maximized when the total budget is spent and the marginal utility for the final unit consumed divided by that goods price is identical for each good

Consumer Choice- A hypothetical example

Suppose you want to consume Apple and Orange Price of Apple is Rs.8 per one. Price of Orange is Rs. 4 per one You have Rs. 40 with you. Then, how do you allocate your limited budget to maximize your total utility given the prices and preferences?

Consumer Equilibrium- Example

Units of Apple 0 1 2 TU MU MU/P Units of TU MU MU/P Orange P= P=4 Rs.8 56 32 7 4 0 1 2 0 40 68 88 108 40 28 20 8 10 7 5

0 56 88

3
4 5

112
130 142

24
18 12

3
2 1/4 1 1/2

3 4
5

100 12
114 6

3
2

150

1 1/2

Marginal Utility and Consumer Choice

Condition for Consumer equilibrium if we choose two goods, Food and Cloths

MU Food / PFood MU Cloth / PCloth

This is referred to as the equal principle.

marginal

Summary
People behave rationally in an attempt to maximize satisfaction from a particular combination of goods and services. Consumer choice has two related parts: the consumers preferences and the budget line. Consumers make choices by comparing bundles of commodities. Consumers maximize satisfaction subject to budget constraints

Topics of Discussion
WHAT? What is behind the Law of Demand? Income Effect Substitution Effect Ordinal Approach to Consumer Behavior Consumer Surplus Types of Demand

What is behind the Law of Demand? Price Any logic from consumer behavior point of view?

Quantity demanded

Why do you purchase less at higher price and more at lower price?
Price changes alter your real income Money Income Vs eal Income A rise in prices decreases purchasing power, and a fall in prices increases purchasing power.

Recent rise in Petroleum price.

It causes an increase/decrease in the consumers willingness and ability to purchase a good. This income effect is one of the reasons for law of demand.

Any other explanation?

Suppose the price of a good rises, then you will consume less of that good. Why?

When the price of a good rises, consumers may switch to more affordable substitutes. This is second reason behind the law of demand

Ordinal Approach to Consumer Behavior

WHAT?

Ordinal approach to Consumer Behaviour Indifference curves Properties of ICs Consumer equilibrium using IC analysis

Ordinal Approach
Economic rationality is assumed
Consumers are able to rank their preferences for various combinations of goods A is preferred to combination B or both combinations A and B are equally preferred. If A is preferred to B, then A gives him more utility/satisfaction

Indifference Curve
Ordinal approach use indifference curves to analyze consumer preferences
An indifference curve shows all combinations of goods that provide the consumer with the same satisfaction, or the same utility. Numerical measure of utility is not required

Indifference Curve
All combinations on an IC are equally preferred.
Total utility is same at all combinations on an IC So consumer is indifferent about which combination to choose.

Properties of IC
IC slope downward Higher IC represent higher levels of utility
IC will not intersect

Indifference Map
An indifference map is a graphical representation of a consumers tastes for two goods Each curve in the map reflects a different level of utility

Then how we will decide given a consumers indifferent map, how much of each good will be consumed? This is a consumer choice problem

Consumer Choice/Equilibrium
For that we need to consider: The relative prices of the goods and
The consumers income

Consumer Equilibrium
The indifference curve indicates what you are willing to buy
The budget line shows what you are able to buy Now find out what quantities of each good you are both willing and able to buy.

Consumer Equilibrium
In equilibrium - that is, when the consumer maximizes utility- the last rupee spent on each good (Food and Cloth for instance) yields the same marginal utility.

MU Food / PFood MU Cloth / PCloth

Deriving a Demand Curve using Indifference Curve Analysis

Consumer Equilibrium changes when price of a good X reduces Then what happen to Budget Line? New Equilibrium points are formed. The concept of Price Consumption Curve The concept of Income Consumption Curve

The Concept of Consumer Surplus

The demand curve can be viewed as a willingness-to-pay curve. It shows the value that consumers place on extra units of the good. Consumer Surplus is the difference between what a person is wiling to pay for a commodity and the amount that he actually is required to pay

Consumer Surplus
Consumer surplus = total willingness to pay for a good - the total amount consumers actually do pay.
Consumer enjoys consumer surplus if he pays the same amount of money for each unit of good he buys.

Consumer Surplus (CS)

It is a measure of the net benefits received by the consumer.

CS occurs when people are able to buy a good for less than they would be willing to pay. They enjoy more utility than they had to pay for.

Application of Consumer Surplus

This concept has more public policy relevance.

Since it is a measure of the net benefits received by the consumer, government can estimate the loss or increase in consumer welfare due to any policy change.

Types of demand
Individual and Market Demand Direct and Derived Demand Total Market and Segmented Market Demand Domestic and Industrial Demand

Types of demand
Company and Industry Demand Final and Intermediate Demand Perishable and Durable goods demand New and replaceable Demand Autonomous and Induced Demand Short run and Long run Demand

When the price of a good increases, one Quiz effect of this price increase is that consumers of that good experience a decline in their purchasing power that is like a decline in income. For normal goods, this contributes to the law of demand. What is this effect called?
A. The substitution effect.

Time

B. The income effect.

TRUE OR FALSE:
The law of diminishing marginal utility states that as more and more units of a good or service are consumed, total utility becomes smaller and smaller.
a. True. b. False.

Quiz Time

In a consumer equilibrium, which of the following is true? a. The marginal utility from the last unit of each good
consumed is equal. b. The price of each unit consumed is equal. c. The total utility derived from consuming all the units of each good is equal.

d. The marginal utility per rupee spent is equal for the last unit of each good consumed.

Thank you