TOPIC: THEORY OF CONSUMER BEHAVIOR

1. Consumer behavior: hypotheses and determinants.

2. Utility and its types. The laws of Gössen.

3. Indiference curves and their properties.

4. The buget line and consumer equilibrium.

5. „Income-consumption” curve and Engel curve.

6. „Price-consumption ” curve and individual demand curve.

The most important goal of Consumer as economic agent is to maximize the satisfaction of his or her needs through consumption of goods purchased for a certain (limited) income. 

In reality, the consumers have to choose the basket of consumer goods from a variety of goods on the market. 

In other words, consumers are facing the problem of choice.

In the process of free choice, consumers will take the following interrelated decisions:

1. What to buy? (to choose a market basket with preferable goods - goods with the highest utility);

2. How much to buy? (to analyze the existing market price);

3. Is it possible to buy the goods? (to compare disposable income with price and preferences).

• Determinants of consumers’ choice

• - Preferences,

• - Income,

• -The utility of the purchased goods,

• -The price of the purchased goods,

• - Prices of other goods,

• - Fashion

• -others

• Conclusion:The complexity of choice of consumer

Hypotheses of consumers’ choice are following:

Freedom of decision and action of a consumer

Consumer rationality

Consumer sovereingty

Limited consumer’s income

Subjective utility assessment and the tendency for its maximization

Utility is initial category in the theory of consumer behavior.

In order to make some decisions about market basket, first of all a rational consumer will analyze the utility.

The most preferable market basket gives the highest level of satisfaction, or utility to a consumer.

Utility of a good or service reflects the consumers’

satisfaction which he expects to obtain.

.

•In assessing the utility historically there were two approaches:

•Cardinal (classical) approach

•Ordinal (neoclassical) approach

position of cardinal theory:

• subjective, individual assessment of utility

• quantitative measuring of utility using a conventional unit - "utile”

• the principle of diminishing marginal utility( the first law of of Gössen); 

• the rule of maximizing utility(the second law of of Gössen).

Types of utility:Total utility is the total satisfaction received from

consuming an amount of goods.The utility function has the following form:

Marginal utility is the extra utility received from consuming one additional unit of the good.

 The Formula for calculation of Marginal utility is:

To be expressed in mathematical term, the MU can be defined as the partial derivative of the 1-st grade of utility function: MU(Qx) = (TUx)'.

iXQfTU

i

i

XX Q

TUQMU

While consuming a quantity of a good, the changes in MU and TU are interdependent.

Consumed quantity of a

specific good Qx

Total utility (utile) TUx

Marginal utility (utile) Mux

0 020

15

10

5

0

-5

1 20

2 35

3 45

4 50

5 50

6 45

Qx (quantity)

Util

ity (T

ux, M

Ux)

Analyzing the evolution of TU and MU we can draw the following conclusions:

1. As an additional unit of a given good is consumed  MU decreases and TU will increase, but each time at a lower rate.

2. In the point of satiety, the marginal utility is zero (MUx=0), and total utility reaches its highest level (TUx=50 utile), respectively Qx=5 units is the optimal amount of consumption.

3. If consumption continues, MU becomes negative and total utility decreases.

• The law of diminishing marginal utility(the first law of Gössen)

• The law of diminishing marginal utility states that as the amount of a commodity consumed increases, the marginal utility of the last unit consumed tends to decrease:

МU Х1 > МU Х2 … > МU Хi

where МU Хi - marginal utility of commodity i (1, 2, 3….)

Each consumer tends to maximize the total utility from consumption of purchased goods. Meanwhile the consumer is interesed in eficient use of his financial resourses. Which principles will a rational consumer follow?

In microeconomics this principle reflects the utility-maximizing rule ( the second Law of Gössen).

The second Law of Gössen assumes, that in order to maximize utility, consumer allocate money income in such a way, that the last dollar spent on each product purchased yields the same amount of marginal utility:

Z

Z

Y

Y

X

X

P

MU

P

MU

P

MU ...

Marginal utilities (MU) of Goods and MU/P

Amount of consumed goods (Q)

Juice Pizza

MU MU/P MU MU/P

1234567

6543210

6/10=0,60,50,40,30,20,10

10875431

10/20=0,50,4

0,350,250,2

0,150,05

Using the II law of Gössen, determine the optimal combination of Juice and Pizza, if income of a student is 70 m. u., and price of one unit of juice equals to 10 m.u., price of pizza is 20 m.u.

position of Ordinal theory:- ranking market basket (A, B, C) in terms of

their preference and the utility for the consumer. - introduction of research tools: - a) the indifference curve,- b) marginal rate of substitution, and - c) the budget line;

- maximizing utility by choosing the most preferable market basket (using fully consumer’s income in conditions of actual prices).

The ordinal theory of consumer behavior starts from a series of assumptions about the nature of consumer’s preferences:

1.Assumption of comparison and ranking of consumer’s preferences: between two market basket A and B, he will choose one of three possible alternatives:

*would prefer A to B, (A B);

* Would prefer B to A, (B A);

*is indifferent towards the two market

basket, considering them to be

equivalents, (A ~ B).

Prefered relations

Indiferent relations

2.The consumer’s preferences are transitive: consumer ranks different

market basket and compares them in

pairs:

if A B and B C → A C .

3.The consumer always prefers more to less: if A (X, 2Y) and B (X, Y): A B.

In the theory of consumer behavior indifference curves provide a ranking of the individual’s preference.

Indifference curve shows alternative combinations of two economic boons, that give the consumer equal utility (TU) or satisfaction.

An indifference curve is the set of points representing market basket among which the concumer is indifferent.

Cola

Cake

A

B

CD

Marketbasket

X (Cola, un.)

Y (cake, un.)

abcd

1268

8621

Alternative market basket

X

6

8

0

12

10

1 2 6 8

What is preferable ?

Indifference curve

Y

An indifference map is a graph of the entire set of indifference curves, each one farther away from the origin, corresponding to increasing levels of total utility.

B

C

A

X

U3

U2

U1

XB XC XA

YC

YB

YA

What is preferable ?

Properties of indifference curves:

1. Indifference curve situated further from the origin, coresponds to a higher level of utility and is more preferable for consumer, meaning: U1 < U2 < U3

2. Indifference curves can never intersect.

A

C

B

X

Y

U1

U2

XB XC

YB

YC

3. Indifference curve are usually negatively sloped and are convex to the origin. A

B

C

D

X (pears)

Y (apples)

∆X

∆Y

Economists use the term of Marginal rate of substitution of goodY for good X – MRSxy , which means the “level” till which the substitution of one good for another is justified.

Marginal rate of substitution is the amount of one good that an individual is willing to give up in order to get one more unit of another good and while maintaining the same level of total utility:

X

Yxy Q

QMRS

TU – const.

y

xxy MU

MUMRS

or

U1

U2

X

YSpecial cases of indifference curves

X

Y

U1U2

U3U4

U5

U1 U2 U3

X

Y

X

Y

A

B

H

K

0

I/Py

I/Px

The budget line is a set of alternative combinations of quantity of good X and Y that the consumer can buy.

What is attainable ?

The budget line equation can be represented as follows:

YyXx QPQPI To draw a straight line is sufficient to know its two extreme points:

Xy

x

yr Q

P

P

P

IQ y

x

y

xx Q

P

P

P

IQ

The slope of the budget line in absolut value is the tangent of the angle ABO of triangle AOB (figure 11):

Py

Px

PxI

PyI

OB

AOtgABO

E

B

C

D

M

F0 1 2 3 4 5 6

(I/Px ,O)

A

X

2

4

6

8

10

Y

N

(O,I/Py)

Cake

Cola

Cake

Cola

7

10

14 J

A

M

N F K

I =30 lei

I ↑=42 lei

I2 ↓=21 lei

753,5

X

Y a) Consequences of changes in consumers disposable income

I, Px, Py – constant (Px=6 lei, Py=3 lei) The budget line will shift

up (to the right), paraleel to the original line (figure 13).

X

Y

Cola

Cake

A

F5

H

10

10

Px =3 lei

Px =6 lei Px

b) Consequences of changing of price of good X (Px) I, Py – constant

1.A decrease in the price of good X (Px↓), ceteris paribus, leads to decrease of the slope of buget line in the absolut value.

X

Y

A

FN

10

52,5

Px =6 lei

Px =12 lei

Px

Cake

Cola

2. As the price of good X rises (Px↑), the absolute value of the slope of a buget line increases comparativ to the absolute value of the slope of initial budget line

Px↑; I – constant; Py – constant

Consumer equilibrium. Consumer reaches equilibrium state, when he fully uses his disposable income and maximizes satisfaction from the consumption of a set of goods (X,Y).

Rational consumer choice can be summarized in the following table:

QUESTION PROBLEMGRAPHICAL

INTERPRETATION

What want consumers?

PrefferencesIndifference Map

What can consumers?

Constraints Budget line

What do consumers?

optimal choice of consumer

Point of equilibrium of consumer

Graphic, the point where the budget line is tangent to the highest attainable indifference curve determines the equilibrium (optimum) of consumer. At this point, the slope of indifference curve (reflects the -MRSxy) equals to the slope of the budget line (is --Px / Py):

y

y

x

x

y

x

y

x

y

x

y

x

P

MU

P

MUsau

P

P

MU

MU

P

P

MU

MU

The consumer’s equilibrium condition requires that the ratio of marginal utilities of goods X and Y is equal to the prices ratio.

Cola

a

E

cd

Cake

A

F X

Y

8

6

21

10

50 1 2 8

U1

U2

U3

Equilibrium point of consumer is affected by changes in disposable income and commodity prices.

The case of change of consumer disposable income. The sensitivity of consumer equilibrium to income changes can be described by drawing two curves: “income-consumption” curve and Engel’s curve.

1. An increase in the consumer income (I↑), moves the budget line parallel to itself to the right and consumer equilibrium point E0 moves to right (up) to the point E2.

2. A decrease in the consumer income (I↓), moves the budget line parallel to itself to the left and consumer equilibrium point moves to the left (down) to the point E1.

X

Y

E1

E0

E2

0X

I

I1

I0

I2

E2

E0E1

I

U1

U2

U3

I

A

B

C

D N

M

X0X1 X2

X0X1 X2

“Income-consumption” is the unity of consumer optimum points E0, E1, E2 corresponding to all possible levels of money income, ceteris paribus.

Engel’s curve (E. Engel (1821-1896) is derived from the „income-consumption” curve and shows the amount of a good that the consumer would purchase per unit of time at various income levels.

X

Y

U3

U2

U1

O

The positioning trajectory of “ income-consumption” curve and the Engel curve is influenced by the nature of the consumption goods.

For primary necessity goods, curve is very steep and close to the OY axis.

10 d

I

X

Y

U1

U2

U3

O

For luxury goods, curve is close to the axis OX

1Ed

I

X

Y

U1

U2

U3

O

For inferior goods, 0Ed

I

X

Y

U1

U2

U3

For neutral goods, . “Income-consumption” curve is a vertical line.

0Ed

I

Cloth

House

Food

Con

sum

ptio

n

exp

endi

ture

s

Income of households

Christian Engel was a XIX-th century German statistician who did pioneering work related to such curves,which are important for studies of family expenditure patterns. Looking to Engel the family expenditures for food will rise in less degree than income increases. The higher the proportion of income spent on food in a nation, the poorest the nation is taken to be.

Agrement 1,9Comunicaţii

4,7Transport

4,5

Sănătate5,9

Dotarea locuinţei 3,7

Întreţinerea locuinţei

15,3

Învăţământ0,5

Hoteluri, restaurante

2,3

Încălţăminte, îmbrăcăminte

11,6

Băuturi alcoolice, tutun

1,9

Produse alimentare

43,7Diverse

3,9

0 10 20 30 40 50 60 70 80

Tanzania

Madagascar

Vietnam

Sierra Leone

Indonezia

Moldova

ţările cu venituri joase:

Argentina

Mexic

Rusia

Thailand

Brazilia

ţările cu venituri medii:

Danemarca

Marea Britanie

Canada

SUA

Japonia

ţările cu venituri înalte:

The part of expenditures for food in the family budget

in %.

The CASE OF A CHANGE IN THE PRICE OF A GOOD, CETERIS PARIBUS:

a)IF Px↑, the absolute value of the slope of the budget line increases and the budget line will change its initial position from AB to AC, and the point of equilibrium will move from E0 to E1.

b)If Px↓, the absolute value of the slope of the budget line decreases and the budget line will change its initial position from AB to AD, and the point of equilibrium will move from E0 to E2.

X

Y

P1

P0P2

Y1

Y2

Y0

E1

E0

E2

X1 X0 X2

U1 U2 U3

D

A

BC

E1

E0

D

X1 X0 X2

E2

THE SUBSTITUTION AND INCOME EFFECT in the case of NORMAL GOODS

Total effect of changes in the price of a good can be divided into two effects: the income effect and substitution effect.

The substitution effect measures the increase in the quantity demanded of a good when its price falls resulting only from the relative price decline and independent of the change in real income. If the price of good X decreases, the consumer substituites good Yby good X, purchasing less of the good Y and more of good X, moving to another point on the Same indifference curve.

The income effect measures the increase in the quantity purchased of a good resulting from the increase in real income and purchasing power of a consumer that accompanies a price decline. This effect involves the movement from initial indifference curve to another curve. The income effect depends on the nature of the goods.

Cola

Cake

1 2 3 4 5 6 7 98 10

123

456789

10A

H

b

v

k

M

F N

I=30 leiPx=6 lei

I=21 leiPx=3 lei

I=30 leiPx=3 lei

Y

X

Surplus of consumer

Paradox of A. Smith „diamants – water”

The Value of time

Cash and noncash gift-giving

Application of the theory of consumer behavior:

0 01 2 3 4 5 6 1 2 3 4 5 6

1 1

2 2

3 3

4 4

5 5

66

7 7

8 8

9 9

10 10

Price Price

Access to Internet (hour) Acces to Internet (hour)

DD

Market price

Surplus of consumer

Surplus of consumer

a) Individual demand b) Market demand