Consumer Behaviour

Aims & Objectives• After studying this lesson, you will be able to understand:

• Concept of Utility & utility theory• Law of diminishing marginal utility & Law of equi-marginal

utility• Consumer’s equilibrium• Downward slope of demand curve• Income effect & substitution effect• Market demand curve• The paradox of value• Consumer Surplus• Indifference Curve, budget constraint & consumer’s equilibrium• Price Consumption Curve• Income Consumption Curve• Applications & Extension

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Slope of demand curve: explained with utility analysis• Recall: A demand curve, each point on which shows

the quantity purchased of a good at a given prices, is downward sloping as quantity demanded of a good is inversely related to its price

• Now Qs. is: Why does quantity demanded move in the opposite direction to that of price?

• Answer to this lies in utility analysis.

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Utility• Utility is the satisfaction one gets from consuming a good

or service• Not the same as usefulness• Subjective• Difficult to quantify

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Utility analysis• Util is one unit of satisfaction or pleasure• Two important concepts of utility are: Total Utility (TU)

and Marginal Utility (MU)• TU – sum total of utility derived from all units of a good

consumed• MU – additional utility derived from each additional unit of

a good consumed. Thus, MU = d(TU)/dq = TUn+1 – Tun

Where ‘q’ denotes units consumed and ‘n’ and ‘(n+1)’ denotes two successive units consumed

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Relation between Total Utility and Marginal Utility

LO1

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Tota

l Uti

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tils

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TU(1)Tacos

ConsumedPer Meal

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Law of diminishing marginal utility• Marginal utility usually diminishes throughout or may rise

briefly at first and then diminish throughout. This tendency leads to a very important law – the Law of Diminishing Marginal Utility (LDMU)

• The Law states - As a consumer consumes more and more units of a particular good, the Marginal utility derived from each additional unit diminishes

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Consumer’s Equilibrium

• Equilibrium for any economic agent refers to a state of balance in terms of his receipts & what he has to forego

• For a consumer the balance is ensured when the utility he receives from consumption of a good is equal to what he foregoes by the way of price he pays for the good

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Slope of demand curve explained by LDMU• Let a consumer buying/consuming good X be initially in

equilibrium i.e. MUx = Px i.e. what he is receiving as utility is exactly balanced by what he is foregoing as price. He is making the best use of his resources to reach the maximum satisfaction/value

• Now let Px ↓ ⇒ MUx > Px ⇒ equilibrium disturbed. The consumer is now getting more value than he is foregoing. So he would want to get more and increase his consumption ⇒ Qx ↑. As Qx↑, MUx ↓ (LDMU works) and the system starts moving back to MUx = Px . The consumer reaches equilibrium once again. In the process Qx ↑. Thus as Px ↓ Qx ↑ which explains the inverse prices quantity relationship for a product.

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Law of equi-marginal Utility (LEMU)

• In the real world a consumer takes his consumption decision not with respect to one product but with respect to a number of products he purchases/consumes. Thus, he does not quite reach his equilibrium when MUx = Px

• He reaches his equilibrium when marginal utility of his expenditure in all directions of his purchases are equalized i.e. if he is buying two goods X & Y at prices Px & Py then he is in equilibrium when

MUx/Px = MUy/Py = MUm where Mum denotes marginal utility from total money he

has.This is referred to as consumers’ equilibrium as per law of equi-marginal utility

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Slope of demand curve explained by LEMU• Let a consumer buying/consuming two goods X & Y be

initially in equilibrium i.e. MUx/Px = MUy/Py i.e. the marginal utility of expenditure on X is equal to the marginal utility of expenditure on Y. Hence he consumes both and maximizes his utility.

• Now let Px ↓ ⇒ MUx/Px > MUy/Py ⇒ equilibrium disturbed. The consumer’s MU of expenditure on X is greater than MU of expenditure on Y and hence he wants buy more of X with his scarce money ⇒ qx ↑. As qx↑, MUx ↓ (LDMU works) and the system starts moving back to MUx/Px = MUy/Py . The consumer reaches equilibrium once again. In the process qx ↑. Thus as Px ↓ qx ↑ which explains the inverse prices quantity relationship for a product

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Numerical Example

LO2

The Utility Maximizing Combination of Apples and Oranges Obtainable with an Income of $10

(2)Apple (Product A):

Price = $1

(3)Oranges (Product B):

Price = $2

(1) Unit of

Product

(a)Marginal

Utility,Utils

(b)Marginal Utility per

dollar(MU/Price)

(a)Marginal

Utility,Utils

(b)Marginal Utility per

dollar(MU/Price)

First 10 10 24 12

Second 8 8 20 10

Third 7 7 18 9

Fourth 6 6 16 8

Fifth 5 5 12 6

Sixth 4 4 6 3

Seventh 3 3 4 26-12

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LO2

Sequence of Purchases to Achieve Consumer Equilibrium, Given the data in Table 1

Choice Number Potential Choices

Marginal Utility

per Dollar Purchase DecisionIncome

Remaining

1 First AppleFirst Orange

1012

First orange for $2 $8 = $10 - $2

2 First AppleSecond Orange

1010

First apple for $1 and Second orange for $2

$5 = $8 -$3

3 Second AppleThird Orange

89

Third orange for $2 $3 = $5 - $2

4 Second AppleFourth Orange

88

Second apple for $1 and Fourth orange for $2

$0 = $3 - $3

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Decision making Process13

Deriving the Demand Curve

LO3

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Slope of a demand curve revisited

• The inverse price-quantity relationship and hence the downward slope of a demand curve may also be explained with the help of the following two concepts:

• Income effect• Substitution effect

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Income effect• When the price of a commodity falls less has to be spent on

the purchase of the same quantity of the commodity. This leads to an increase in purchasing power of the money with the buyer. This is referred to an increase in real income of the consumer.

• The increase in real income leads to an increase in purchase of the commodity whose price has fallen. This is referred to as income effect of a price change.

Px ↓ → Real income ↑→ Qx ↑

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Income effect negative or positive?

• Px ↓ → Real income ↑→ Qx ↑ ⇒ income effect is positive ⇒ X is a normal good

• Px ↓ → Real income ↑→ Qx ↓ ⇒income effect is negative ⇒ X is an inferior good

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Substitution Effect• When price of a commodity falls, its becomes cheaper

relative to other commodities. This leads to substitution of other commodities( which are now relatively more expensive) by this commodity. Thus the demand for the cheaper good rises. This is called the substitution effect.

Px ↓→ it is relatively cheaper and hence attractive→ Qx ↑

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Substitution effect negative or positive?• Substitution effect is always positive.

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Inferior good vs Giffen good

• A good with negative income effect is referred to as inferior good

• A good whose negative income effect dominates the positive substitution effect is a Giffen good.

• Thus, all Giffen goods are inferior goods but all inferior goods are not Giffen goods

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Market Demand Curve

• The market demand curve is the sum of individual demands at each price

• Graphically, a market demand curve is the horizontal summation of individual demand curves

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Consumer’s surplus• This refers to the difference between what a consumer is

willing to pay and what he actually pays

D

P

Q

A

D’

Consumer surplus

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Further Behind the demand curve

• Consumers equilibrium can also be explained using the two concepts of:

• Indifference curve• Budget Line

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Indifference Curves• An indifference shows various combinations of two goods

that fetches the same level of utility/satisfaction to the consumer

• Basic Characteristics of Indifference Curves▫ Higher indifference curves represent higher levels of

utility▫ Indifference curves do not intersect.▫ Indifference curves slope downward.▫ Indifference curves are concave to origin.

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Slope of an indifference curve & MRSxy

• Slope of an Indifference Curve = - dY/dX = the Marginal rate of technical substitution between X & Y (MRSxy) = -MUX/MUY

• The Marginal rate of technical substitution between X & Y (MRSxy) represents the rate at which X gets substituted for Y as a consumer moves down an indifference curve

• The MRSxy diminishes as one moves down an indifference curve. This is the Law of Diminishing Marginal Rate of substitution. This explains the concave to the origin (or convex from the origin) property of an indifference curve

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Budget Constraints

• Budget constraint shows the various combinations of two goods that a consumer can have for a given money outlay

• If a consumer is buying only two goods X and Y in quantities x & y respectively and at prices Px and Py respectively with his entire income M then M = xPx + yPyThis represents the consumer’s budget constraint or budget line

• Basic Characteristics of Budget Constraints▫ Shows affordable combinations of X and Y.▫ Slope of –PX/PY reflects relative prices.

• Effect of increase in relative prices• Slope of Budget line changes. It shifts outward/inward with one of its

points either on Y axis(when Px changes) or on X axis (when Py changes) remaining fixed

• Effects of Changing Income with prices constant▫ Income increase causes parallel outward shift.▫ Income decrease causes parallel inward shift.

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Optimal Consumption/consumer’s equilibrium• A consumer does his optimal consumption at the point

where his utility is maximized subject to this budget constraint i.e. he reaches the highest possible indifference curve given the budget constraint

• Mathematically, this Utility Maximization happens when the budget line becomes tangent to the highest possible indifference curve for the consumer. At this point slope of budget line becomes equal to slope of indifference curve (IC) i.e. -PX/PY = - MRSxy = - MUX/MUY. i.e.

MUX/PX = MUY/PY. Condition for Consumer’s equilibrium. This is same as obtained from Law of equi-marginal utility

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Each of A, B, C represents consumer’s Equilibrium for different budget constraint faced by the consumer.

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Price consumption curve, Income consumption curve, Engle curve• Price-consumption Curve

▫ Shows how consumption is affected by price changes (movement along demand curve).

• Income-consumption Curve▫ Shows how consumption is affected by income changes

(shifts from one demand curve to another).• Engle Curves

▫ Plot between income and quantity consumed. Consumption of normal goods rises with income. Consumption of inferior goods falls with income

(rare).

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Applications and Extensions

• New products• iPod

• Diamond-water paradox• Opportunity cost and time

LO5 6-34

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The iPod

• The iPod came on the market in November 2001. Less than six years later, Apple sold its 100 millionth unit. Furthermore, those units enabled Apple to sell more than 2.5 billion songs through its online iTunes store.a. The swift ascendancy of the iPod resulted mainly from a leapfrog in technology Not only is the iPod much more compact than the portable digital CD player that it replaced, it can hold a lot more songs.b. This example demonstrates a simple but important point: New products succeed by enhancing consumers’ total utility.

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Diamond-water paradox

• Why does water so essential and hence valuable for life command either a small or no price? While diamond which is only an item of conspicuous consumption command such a high price?

• The answer lies in the fact that while diamond is scarce, water is abundant. Besides, as price for water is fixed based on additional units of consumption, the additional units of utility derived from consumption of additional units of water gradually diminishes.

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Opportunity cost and time• Time also has a value, so this must be considered in decision

making and utility maximization. The total price of an item must include the opportunity cost of the time spent in consuming the product, i.e., the wage value of an hour of time. When the opportunity cost of time is considered, consumer behavior appears to be much more rational.1. Highly paid doctors may not spend hours hunting for bargains because their time is more valuable than the money to be saved from finding the best buy.

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Prospect Theory• Traditional theory asserts that people are always rational

and are not impacted by emotion. →this is what we have done in utility theory

• Behavioral economics focuses on consumers’ decisions in light of emotion and negative possible outcomes.▫ Status quo – gains and losses are essentially measured against

the change in the status quo.▫ We know about diminishing marginal utility with goods but

there’s also diminishing marginal disutility with losses where there’s a much greater decrease in marginal utility with the first loss.

▫ People are loss averse and will feel losses to a greater magnitude than gains of an equal amount.

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Prospect theory: examples and applications

• Losses and Shrinking Packages.▫ When making purchases, consumers tend to focus only on price

when determining their gains and losses.▫ Therefore to makeup for increased costs, Hershey’s decreased the

size of their chocolate bar in order to avoid an increase in price.▫ The important point is that consumers don’t view this as a loss

because they focus on price and price didn’t change (no observable change in status quo).

• Framing Effects and Advertising▫ Evaluation of gains and losses largely depends on a person’s mental

frame and when new information is introduced to change a person’s frame their gains/losses are called framing effects. For example, making Rs 100,000 may be appealing to someone until they find out they

had been earning Rs. 140,000. Another example of framing is in advertising. Often burger producers label burger as

“80% lean” not “20% fat” because 80% lean is framed as a gain.

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Prospect theory: examples and applications• Mental accounting and over priced warranties

▫ Sometimes consumers don’t view all of their consumption options simultaneously as predicted by the utility-maximization rule. Richard Thaler called it mental accounting when consumers looked at some purchases as isolated transactions.

▫ When making big-item purchases like a Rs.80,000 TV, the buyer is offered a warranty. The buyer often looks at this transaction in isolation, viewing this as a potential Rs.80,000 loss if the TV breaks. The buyer is usually enticed to buy the warranty even though there’s a small possibility of it breaking because the consumer doesn’t consider their future income.

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Nudging

• Behavioral economics examines how consumers arrive at decisions that may appear on the surface to be irrational. Behavioral economists explain these nuisances through the lens of “nudges” which are very subtle ways to “encourage” individuals to behave in a specific way.▫ Example, a power company in California sent bills to their

customers with their usage and neighbors’ usage along with and as an indication of whether or not they used too much energy, or were doing a great job conserving. The smilies proved to be an effective “nudge.”

• A key point is that nudges are a form of manipulation to get an individual to do what someone wants him to do.

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Thank You