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The Theory of

Consumer
Behavior
Choice & utility
 Consumers play an important role in determining the demand for a firm’s
products. They are quality conscious and price sensitive. The success of
a product is dependent on the consumers’ acceptance of the product.
Price sensitive customers like to buy products in small quantities at
affordable prices. For example, Motorola had initially launched seven
models of cellular phones at high prices but none of them were
successful. On the other hand, Nokia launched a simple cellphone at an
affordable price, which captured the market. Therefore, firms must try
to offer products that are of high quality, at affordable prices. Consumer
behavior is an important determinant of the type of product a firm
should produce. Before launching a product a firm has to take into
consideration its target customers tastes and preferences. For example,
when Dabur Foods launched Real orange juice, consumers rejected it
because it tasted bitter. Research revealed that Indian consumers
wanted juices to be sweeter. Dabur then modified Real’s taste by
sweetening the orange juice.
 Consumer behavior assumes that every individual tries to maximize his
satisfaction by consuming products and service with the limited income
available to him at a particular time. This limited income can also be
referred to as the budget constraint.
 consumer behavior theory explains the relationship
between changes in price and consumer demand.
Variations in price determine whether a particular
product is in demand or not. If the demand for a
product is low in spite of the price being less, it can
be said that consumers are not accepting that
product. On the other hand, if the demand for a
particular product is high, then the price of the
product would increase. Hence, the manufacturer
can determine and fix prices of their products
according to the consumer demand. Thus,
consumer behavior plays an important role for
manufacturers decision making.
CHOICE AND UTILITY THEORY

 It is important to understand the difference between preference


and choice. The consumers may have preference when they
have a range of products to choose from. Preferences depend
upon the consumers’ likes and dislikes but the final decision
is dependent on budget constraints. In order to maximize
satisfaction, consumers have to choose the alternatives for
which the net benefit is more. Net benefit is calculated as the
difference between benefits and cost. Here, we assume that
the consumers have unlimited wants or preferences and
numerous choices to satisfy them. But the resources with the
consumers to satisfy all these wants are limited. This resource
limitation is the income constraint or budget constraint
referred earlier. Thus, the income constraint limits the
consumer from satisfying all his preferences and forces him
to make choices.

CHOICE AND UTILITY THEORY

 Utility in economics means the extent of satisfaction obtained


from the consumption of products and services by
consumers. The concept of utility was developed by
economists to explain the basic principles of consumer
choice and behavior. Given the available resources, the level
of income and market prices of various products, it is
assumed that the rational consumer allocates his spending in
such a way that the preferred combination gives him the
highest utility.
 The concept of utility is purely subjective i.e. there is no way of
measuring the amount of utility that a consumer might be
able to derive by consuming a particular product. In other
words, utility is the psychological satisfaction that a
customer derives by using a particular product. Hence, utility
is not measurable but can be compared. It helps to
understand how consumers make better choices. 

Measurement of Utility
 Utility can be measured using the cardinal approach and
ordinal approaches. The cardinal approach is based on the
Marshallian school of thought, while the ordinal approach
was proposed by the economists J.R. Hicks and P.G.D Allen.
 Cardinal utility approach
 According to Marshall, utility can be measured and quantified.
This approach is based upon certain assumptions like:
 Utility can be measured: This approach assumes that utility
can be measured in terms of units called as ‘utils,’ which are
measurable and quantifiable. It reveals how much money a
consumer is willing to pay for a given unit of product. In ‘util’
terms, the consumer can compare the utility of two products
say mineral water and soft drinks. Thus by comparing, one
can say that one bottle of mineral water provides him utility
equal to 5 utils, and one bottle of soft drink gives him utility
equal to 3 utils. 

Ordinal utility approach
 The proponents of the ordinal approach opine that
utility cannot be measured, but can only be
ranked in order of preferences. In other words,
instead of measuring the utility obtained from
products, they rank them in the order of
preferences to match consumers’ choice. Thus, it
explains that the customer is able to compare
different levels of satisfaction. Hence, if a
customer prefers commodity x to commodity y,
he will not be in a position to compare the
‘quantitative difference’ between the two-
satisfaction levels, but he can do qualitative
comparisons. This approach can be explained
with the help of indifference curve
Total Utility
 In a given period of time, the amount of utility a
person derives from the consumption of a
particular product is called total utility. In the
initial stages of consumption, the total utility
increases. After consuming certain number of
units the total utility becomes constant and
beyond that it starts reducing.  This means that
the consumption of a particular product gives
satisfaction to a person initially but after some
time, utility starts diminishing.

Marginal Utility

 According to Prof. Boulding, “The marginal utility of any


quantity of a commodity is the increase in total utility
which results from a unit increase in consumption.” In
other words, marginal utility of a commodity is the
additional utility derived by a consumer, by consuming
one more unit of that commodity. From the below table,
it is clear that every increase in the consumption of a
product reduces its marginal utility. Let us analyze the
relationship between total utility and marginal utility.
Marginal utility starts diminishing as the consumer
starts consuming more units of a product. When
marginal utility reaches zero, total utility reaches its
maximum and remains constant. When marginal utility
becomes negative it implies that the total utility has
started diminishing. 

Total utility & marginal
utility
LAW OF DIMINISHING
MARGINAL UTILITY
 The law of diminishing marginal utility states that if a consumer
goes on consuming more units of a particular product at a
given point of time, his total utility increases but only at a
diminishing rate. The law says that more a consumer
consumes a product, the less is the utility he derives from the
consumption of the same product. In other words, the desire
of that product goes on decreasing as he consumes more and
more units of that product.
 According to Alfred Marshall, the law of diminishing marginal
utility is, “The additional benefit which a person derives from
a given increase of his stock diminishes with every increase
in the stock that he already has.”
 Marginal utility reveals how much a consumer is ready to
sacrifice for a particular product. Usually, the consumer pays
high price for the first unit of a product, since his desire to
get that product is very high. As he goes on consuming more
units of the same product, his utility level goes down and he
pays less for the same commodity.

Application and Uses of
Diminishing Marginal Utility
 Explains value paradox
 The law of diminishing marginal utility explains the
factors that determine the value of a product. Adam
Smith in his book “The Wealth of Nations” (1776)
formulated a theory to explain why different products
have different market values. In an attempt to explain
this theory, he introduced the ‘diamond-water’
paradox. He said that an essential commodity like
water is priced lower, when compared to a less
essential product like diamond. He explained this
through two concepts: value in use and value paradox.
Though diamond has a low value in use but a high
value in exchange while water has high value in use
but low value in exchange. Hence, ‘diamond-water’
paradox explains that the more quantity of a product
we have, the marginal utility starts diminishing. If the
availability of a product is less, marginal utility would
be high. 

 Explains the derivation of Law of
demand
 Diminishing marginal utility helps to derive
the law of demand and explain the
downward sloping of the demand curve. It
also helps to analyze why prices fall. It also
explains consumer surplus, and how it is
derived. 

LEMU
 According to Marshall, the law of equi marginal
utility says: “If a person has a product which can
be put to several uses, he will distribute it among
these uses in such a way that it has the same
marginal utility. If the product has a greater
marginal utility in one use than in another, the
person would gain by taking away some of the
product from the second use and applying it to the
first.”  In other words, the law states that the
consumer will spend his money income on
different products in such a way that the marginal
utility of each product is proportional to its price.
Hence, the consumer will have the same level of
satisfaction while consuming the two products. 
Demand
 By continuing to change the price of
good X [and holding all other variables,
PY , budget or income and preferences
constant,] the rest of the demand for
good X can be mapped.
 All price and quantity combinations
on the demand for X are equilibrium
points for the consumer [They are
maximizing utility; holding all other
variables, PY , budget or income and
preferences constant]
By changing the price of the good [in this case, good X]
and
holding all other variables [PY , budget or income and
preferences] constant, the demand for the good can be
The demand function
mapped.
is a schedule of the
quantities that P
individuals are willing
X5
and able to buy at a
schedule of prices 4
during a specific De
period of time, 3 m
an
ceteris paribus. 2 d
1

1 2 3 4 5 6 7 QX/ut
The demand function has a negative slope because of
the
income
Income and As
effect: substitution
the price effects.
of a good that you buy increases
and money incomeis held constant, your real income decreases
and you can not afford
to buy as much as you P
could before.
Substitution effect: As X5
the price of one good rises
4
relative to the prices of De
other goods, you will tend 3 m
to substitute the good 2
a nd
that is relatively cheaper 1
for the good that is
relatively more expensive. 1 2 3 4 5 6 7 QX/ut
Income effects
 As the price of a good that you buy
increases, you will have less real
income.
 This is the basis of price indices that
measure changes in real income as
prices rise or fall.
 The consumer price index is one of
the indices that is used [currently
there is a debate about how it is
calculated].
Substitution Effects

 As the price of a good increases


[decreases] while the prices of other
goods is constant, it becomes relatively
more [less] expensive.
 Individuals would substitute relatively
less expensive goods for relatively
more expensive ones even if their real
income were constant.
CONSUMER
SURPLUS
Notice that someone is willing and able to pay $6.80 for the
If the market price [established by S and D]
were
first $3,
unit.the buyer would purchase at $3 even though
they
PX
were willing to pay

pl
$6.80 for the first unit. 7

Sup
They receive utility 6.8
that they did not have 0 6

y
.
to pay for [6.80-3.00]. 5 consume
This is called consumer
4 r
surplus.
surplus
De
3 m
At market
2
a nd
Consumer surplus will be
equilibrium,
the area above the market 1
price and below the
demand 1 2 3 4 5 6 7 QX/ut
function.
Demand
 Demand functions can be derived from
utility [cardinal measures] or indifference
functions [ordinal measures]
 Normally, demand functions show and
inverse relationship between price and
quantity
 a change in price “causes” a change in
“quantity demanded”
 a change in any other variable [income,
prices of related goods, population,
preferences, . . .] will “cause a change in
demand” or shift of demand
The Indifference Curve

 Indifference Curve: A curve connecting the


set of bundles that are equally preferred to one
another. Here, the consumer would be
indifferent if offered a choice between any of
pair of bundles on the same indifference curve.

 Why it is downward sloping? Because of the


law of opportunity cost.

 All bundles among which a consumer is


indifferent
◦ “Indifference map” is all of a consumer’s
indifference curves
◦ All bundles (Xa, Ya) such that:
 (Xa, Ya) ~ (X0, Y0)
Properties of Indifference

Curves

1. Every bundle is on some indifference


curve
2. Two indifference curves never cross

3. An indifference curve is not “thick”

4. Indifference curve slopes downward,

Diminishing MRS
5. A bundle that has more of all goods is on

a higher indifference curve (“no satiation”)


6. Rationality

7. Monotonicity – more of a good is

preferred to less
Indifference Curves

Rational--behave consistently
Good
Y

Indifference
Curve

Good
5 X
Good
Y

5
I
4
I Indifference
3
Map
I
2

I
1 Good
5 X
Indifference Curve:
All Bundles among which
a consumer is indifferent

A graph of all the indifference curves is called


an indifference map

There are infinitely many curves.


Marginal Rate of Substitution (MRS):

Slope of the Indifference Curve


Marginal Rate of Substitution

 Slope of Indifference Curve: shows


Marginal Rate of Substitution (MRS). The rate
at which one good can be traded off for
another while leaving the consumer equally-
off.
 MRS: At any point of IC, the rate at which
one good can be exchanged for another,
holding consumer satisfaction constant. Slope
= dY/dX
 Question
◦ How much more of a good (e.g., Y) would a
consumer require to compensate them for loss
of a unit of another good (e.g., X)
 Measurement
◦ MRS measures willingness to make this
substitution:
Figure 21-2. The Consumer’s
Preferences
Quantit
yof
Pepsi
C

B D
I
2
Indifference
A
curve, I
1
0 Quantit
yof
Pizza
Representing Preferences with
Indifference Curves
 An indifference curve is a curve that shows
consumption bundles that give the
consumer the same level of satisfaction.
Representing Preferences with
Indifference Curves
 The Consumer’s Preferences
◦ The consumer is indifferent, or equally happy,
with the combinations shown at points A, B,
and C because they are all on the same
curve.
 The Marginal Rate of Substitution
◦ The slope at any point on an indifference
curve is the marginal rate of substitution.
 It is the rate at which a consumer is willing to trade
one good for another.
It is the amount of one good that a consumer
requires as compensation to give up one unit of
the other good.
Figure 21-2. The
Consumer’s Preferences
Quantit
yof
Pepsi
C

B D
MR I
S 1
2
Indifference
A
curve, I
1
0 Quantit
yof
Pizza
Four Properties of Indifference
Curves
 Higher indifference curves are preferred to
lower ones.
 Indifference curves are downward sloping.
 Indifference curves do not cross.
 Indifference curves are bowed inward.
Figure 21-2. The Consumer’s
Preferences
Quantit
yof
Pepsi
C

B D
I
2
Indifference
A
curve, I
1
0 Quantit
yof
Pizza
Four Properties of Indifference
Curves
 Property 2: Indifference curves are
downward sloping.
◦ A consumer is willing to give up one good only if
he or she gets more of the other good in order
to remain equally happy.
◦ If the quantity of one good is reduced, the
quantity of the other good must increase.
◦ For this reason, most indifference curves slope
downward.
Figure 21-2. The Consumer’s
Preferences
Quantit
yof
Pepsi

Indifference
curve, I
1
0 Quantit
yof
Pizza
Figure 21-3. The Impossibility of Intersecting
Indifference Curves

Quantit
yof
Pepsi
C

0 Quantit
yof
Pizza
Four Properties of Indifference
Curves
 Property 4: Indifference curves are bowed
inward.
◦ People are more willing to trade away goods that
they have in abundance and less willing to
trade away goods of which they have little.
◦ These differences in a consumer’s marginal
substitution rates cause his or her indifference
curve to bow inward.
OPTIMIZATION: WHAT THE
CONSUMER CHOOSES

 Consumers want to get the combination


of goods on the highest possible
indifference curve.
 However, the consumer must also end up
on or below his budget constraint.
The Consumer’s Optimal
Choices

 Combining the indifference curve and the


budget constraint determines the
consumer’s optimal choice.
 Consumer optimum occurs at the point
where the highest indifference curve
and the budget constraint are tangent.
The Consumer’s Optimal Choice

 The consumer chooses consumption of


the two goods so that the marginal rate
of substitution equals the relative price.
 At the consumer’s optimum, the
consumer’s valuation of the two goods
equals the market’s valuation.

Figure 21-6. The Consumer’s Optimum

Quantit
yof
Pepsi

Optimu
m
B
A

I
3
I
I 2
1
Budget
constraint
0 Quantit
yof
Pizza