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Chapter 6 Chapter 6 theory of theory of Consumer behaviorConsumer behaviorChapter 6 Chapter 6 theory of theory of Consumer behaviorConsumer behavior

Chapter 2Chapter 2 talks about talks about market market

demanddemand, but market is made of many , but market is made of many

individuals with different incomes, individuals with different incomes,

tastes, etc.tastes, etc.

Individual consumerIndividual consumer is assumed to is assumed to

be be rationalrational and wish to and wish to maximizemaximize his/her his/her

well-being.well-being.

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In this chapter you will encounter:In this chapter you will encounter:

• Indifference curve

• The marginal rate of substitution (MRS)

• The concept of utility

• The budget line

• The equilibrium market basket

• Deriving individual demand curve and market demand curve

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6.1Consumer preferences and utility

Complete information

Preference ordering

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The concept of utility

WhyWhy people consumer?

To satisfy their unlimited desire, to be satisfactory.

UtilityUtility indicated the level of enjoyment or preference attached by this consumer to this market baskets.

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The utility Function

utilityBenefits consumers obtain from the goods

and services they consume.

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Cardinal Utility & Ordinal Utility

• Cardinal utility believes that utility could be measured & added (utility unit & marginal analysis);

• Ordinal utility holds that utility could only be ordered and cannot be measured (indifference curve).

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Cardinal utilityCardinal utility

Total & Marginal UtilityTotal & Marginal Utility

Total utility Total utility (TU(TU ）） refers the refers the degree of satisfaction degree of satisfaction from the whole from the whole consumptionconsumption

Marginal Marginal utilityutility （（ MUMU ）） refers the refers the additional additional satisfactionsatisfaction from one more unit of from one more unit of consumptionconsumption

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),( 21 XXUTU

ii X

UMU

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Law of Diminishing UtilityLaw of Diminishing Utility

As more of a product is consumed, the degree of satisfaction consumers get from every additional unit is decreasing. Marginal utility (MU) is decreasing. The law of diminishing utility.

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Ordinal utilityOrdinal utility

• Ordinal utility holds that utility cannot be measured but can be ordered according to consumers’ preferences.

• Different product combinations may be viewed as having same utility,

• And these combinations of same utility consist of one Indifference Curve (IC).

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6.2 Indifference CurveIndifference Curve

Indifference CurveIndifference Curve (IC) contains points (IC) contains points

representing representing market basketsmarket baskets among which the among which the

consumer is consumer is indifferentindifferent..

),( 21 XXfU

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indifference curveA locus of points representing different bundles of goods and services, each of which yields the same level of total utility.

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XX11

XX22

OO

II22

II33

II11

Indifference curve（ IC）

Increasing satisfactionIncreasing satisfaction

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The important things of IC

1. IC is convex to the origin.

2.Every indifference curve must (?) slope downward and to the right;

3. Indifference curves cannot intersect.

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Another important but not mentioned

thing about IC:

A consumer has many indifference curves;

How do you understand this attribute?

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U = f（ X1， X2） = U1U = f（ X1， X2） = U1

XX11

XX22

ΔΔXX11=1=1

ΔΔXX22

OO

ICIC

ΔΔXX11=1=1

A

B

CΔX2 /ΔX1

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Marginal Rate of SubstitutionMarginal Rate of Substitution ( (MRSMRS) )

MRSMRS is defined as the number is defined as the number

of units of of units of good Ygood Y that must be given that must be given

up if consumer is to receive an extra up if consumer is to receive an extra

unit of unit of good Xgood X and to maintain a and to maintain a

constant level of satisfaction.constant level of satisfaction.

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To calculate MRSTo calculate MRS

1

212 X

XMRS

1

2

1

2

012 d

dlim

1 X

X

X

XMRS

X

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• Not all indifference curves must

slope downward.

• Can you name some other

cases?

• What will the IC of substitutes

& complements?

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IC of substitutes IC of substitutes

)0(1

212

C

CX

XMRS

XX11

XX22

II22

II11

OO

21

XX11

XX22

II22

II11

0

1

212 X

XMRS

IC of compliments IC of compliments

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6.2.4A Marginal Utility Interpretation of MRS

ΔU=(MUxX Δ X)+(MUyX Δ Y)=O

- ΔY/ ΔX=Mux/Muy

MRS= Mux/Muy

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The budget line

• Consumers want to be most satisfactory, but to be constrained by their income (budget).

• Budget refers to various possible combinations of products that consumers can buy when their income & products’ prices are set.

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IXPXP 2211

12

1

22 X

P

P

P

IX

XX11

XX22

I / PI / P22

I / PI / P11

Budget SpaceBudget Space

The budget line

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Variation of budget line

Discuss

PP11& P& P2 2 hold constant while I changes;hold constant while I changes;

I holds constant while P1&P2 I holds constant while P1&P2 change proportionately;change proportionately; I holds constant while P1 or P2 I holds constant while P1 or P2 changes;changes; I, P1&P2 increase or decrease I, P1&P2 increase or decrease proportionately at the same time.proportionately at the same time.

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12

1

22 X

P

P

P

IX

XX11

XX22

I / P2

I / P1

I decrease I increaseI decrease I increase

“I” changes

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12

1

22 X

P

P

P

IX

XX11

XX22

I / P2

I / P1

P1 increases P1 decreases

P1 changes

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Question

What if P2 changes ?

And I, P1 & P2 change?

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The Equilibrium of Market Basket

• Consumers want to be most satisfactory;

• But they are constrained by their income (budget).

• Consumers (rational) want to maximize their utility with limited income.

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Budget line & Indifference curve

II11II22

II33

EE

12

1

22 X

P

P

P

IX

Discuss: How do you understand E?

Discuss: How do you understand E?

BB

CC2

1

1

212 d

d

P

P

X

XMRS

XX11

XX22

OO

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6.4.2marginal utility interpretation of equilibrium

)(2

2

1

1 n

n

P

MU

P

MU

P

MU

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Consumer Equilibrium

IXPXPXP nn 2211

)(2

2

1

1 n

n

P

MU

P

MU

P

MU

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Problem Try to find Utility Maximization consumer basket.

Problem Try to find Utility Maximization consumer basket.

Given the Utility function as follows, 3

1

3

1

),( YXYXU

And PAnd PXX=P=PYY=1 while Income=100=1 while Income=100 。。 Try to find Utility Maximization consumer basket.

3

1

3

2

3

1YX

X

UMU X

3

2

3

1

3

1

YXY

UMUY

IYPXPP

MU

P

MU

YX

Y

Y

X

X

100YX

YX

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Concluding remarksConcluding remarks

• Consumer basket is determined by both prices of product & his / her income.

• What if only prices change?

• What if only income changes?

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If only prices changeIf only prices change

PCCPCCPCCPCC

Price-Consumption curve

Price-Consumption curve

Price changes → PCC

Price changes → PCC

XX

YY

OO

II22

II33

II11

EE22

EE33

EE11

XXE1E1 XXE2E2 XXE3E3

37XX

YY

OOII22

II33

II11

EE22

EE33

EE11

XXE1E1 XXE2E2XXE3E3

AA11

AA22

AA33

ICCICC

If only income changesIf only income changes

Income changes → ICC

Income changes → ICC

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Deriving individual demand curveDeriving individual demand curveDeriving individual demand curveDeriving individual demand curve

A consumer’s demand curve

shows how much he or her will

purchase of the goods in question

at various prices of this good (when

other prices and the consumer’s

income are held constant).

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PCCPCC

Consumer Demand curve

Consumer Demand curve

PCC to Consumer Demand CurvePCC to Consumer Demand Curve

XX

YY

OOII22

II33II11

EE22 EE33EE11

XXE1E1 XXE2E2 XXE3E3

XX

PPXX

XXE1E1 XXE2E2 XXE3E3

PPE1E1

PPE2E2PPE3E3

X = fX = f （（ PPXX ））

)()()( iE

iiX XEP

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In fact, we could get Demand Curve from Utility Function.Given income (I) and Utility function as follows,

Try to get the consumer demand curve.

3

1

3

1

),( YXYXU

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3

1

3

2

3

1YX

X

U

3

2

3

1

3

1

YXY

U

Y

Y

X

X

P

MU

P

MU

YX YPXP

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IPYPX YX IPX X 2

XP

IX

2

YP

IY

2

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Summing individual consumer Summing individual consumer

demand curve horizontally wedemand curve horizontally we get get

the the market demand curvemarket demand curve..

To get market demand curve

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QQ QQ

Total marketTotal market

PP PP PP

QQQQ11 QQ22

Q=QQ=QAA+Q+QBB

Consumer AConsumer A Consumer BConsumer B

QQ11+Q+Q22

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The law of demand

There is an inverse

relationship between the price of a

good and the quantity demanded

assuming all other factors that

might influence demand are held

constant.

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Consumer surplusConsumer surplus

Consumer Surplus Consumer Surplus (propose(proposed by Marshell)d by Marshell) is the excess of th is the excess of the price which a person would be price which a person would be willing to pay rather than go e willing to pay rather than go without the good over that whicwithout the good over that which he actually does pay.h he actually does pay.