Topic 4 FINAL.ppt

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TOPIC: THEORY OF CONSUMER BEHAVIOR

1. Consumer behavior: hypotheses and determinants. Consumer

preferences.

2. Total utility and marginal utility. The utility maximizing rule.

3. Indiference curves and their properties.

4. The buget line and its positioning in case of changes in consumerincome and in case of changes in price of one of the goods.

5. Consumer equilibrium.

6. Consumer equilibrium in the case of changes of consumer

income: „income-consumption” curve and Engel curve.

7. Consumer equilibrium in the case of price change of one of the

good: „price-consumption ” curve and individual demand curve.

8. Substitution effect and income effect.



In economic theory consumer behavior is a proces of

formation of consumer demand for various goods,

depending on the individual’s income, preferences andprice level.

Consumer is an economic agent, whose

objective is to maximize the satisfaction of his needs

through consumption of goods purchased for a

certain 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 .

The basket of consumer goods includes the quan-

tities of various consumer goods that provide certain

satisfaction.



In the process of free choice, consumers

will take the following interrelated

decis ions :

1. What to buy? (to choose preferable

goods, with the highest utility);

2. How much to buy? (based on the

existing market price);

3. Is i t poss ib le to buy the goods?

(based on disposable income and

existing market price).



The choice of consumer is based on

the following hypotheses:

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



The consumer is sovereign (king), based

on the following:

His needs serve as a point of

reference for producer;

His decisions predetermine the

market demand;

He is the one, who asses the rezults

of the production.



The consumer behavior and choices are

influenced by the factors , that can be clasified as

follows:

socio-demographic factors;

social-economic factors;

psychological factors;

institutional factors.

Conclusion:

The complexi ty of rat ional choice under the

cond i tions of the contemporary econom y .



In the process of choice the consumer acts in

accordance with his preferences. The theory of

consumer behavior starts from a series of assumptions

about the nature of consumer’s preferences:

1.Assumpt ion of compar ison and ranking of

consumer ’s preferences: between two market basket A

and B, he will choose one of three possibil 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

transit ive: 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.

Deci, consumatorii preferă o cantitate mai

mare de bunuri unei cantităţi mai mici.



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

Util ity is initial category in the theory of consumer

behavior ( J. Bentham (1748-1831).Utility of a good orservice reflects the consumers’ satisfaction which heexpects to obtain.

Utility is a subjective notion. Utility of same goods isdifferent for different people (for example, the utility of

glasses for a weak seeing man and a healthy man isdifferent).In assessing the utility historically there were two

approaches:1.Card inal approach (class ical) of u ti l i ty (XIXc.). A

significant contribution to its development has thefollowing economists: S. Jevons, K. Menger, L. Walras.In their view, utility was measurable in a cardinal sense,

which means the quantitative measure of the utility of agood using a conventional unit – “utile” (1 utile,2utiles etc).

.



2. Ordinal (neoc lass ical) app roach (end of

XIX-first half of XX c.). In developing this

concept,a special rol have scientists V. Pareto, J.Hicks and R.Allen., who are known as ordinalists.

Ordinal utility approach assume that utility

is measurable in an ordinal sense, which means

that a consumer can only rank various market

baskets with regard to the satisfaction they give

him (first, second, third etc.).

In other words, the consumer rationallyorders (ranks) his preferences in relation

to the total satisfaction, which is intended to be

obtained.



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.

Moreover, marginal utility is the change in total

utility resulting from consumption of additional units of

the respective 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)' .

i X Q f TU

i

i

X

X Q

TU Q MU



The size of marginal utility is influenced by various

factors :

Volume or quanti ty consumed of a given

good.

The importance of the good and the

intensity with which the needs are

manifested.

Conditions for reproduction of a given

good.



While consuming a quantity of a good, the changes in MU

and TU are interdependent. The relationship between TU and

MU can be illustrated by data in table and graphically.

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

3 454 50

5 50

6 45



Qx (quantity)

U

t i l i t y ( T u x ,

M U x )



Analyzing the evolution of TU and MU we can

draw the following conclusions:

1. As an additional unit of a given good is consumed (upto Qx = 2), MU decreases and TU will increase, but eachtime at a lower rate.

2. In the point of satiety, the marginal utility is zero (MUx=0)for Qx=5 units, but total utility reaches its highest

level (TUx=50 utile), respectively Qx=5 units is theoptimal amount of consumption.

3. If consumption continues Qx>5 units, MU becomesnegative and total utility decreases.

The law of diminishing marginal utility states that as theamount of a commodity consumed increases, the marginal

utility of the last unit consumed tends to decrease:

i X X X

MU MU MU ...21



Each consumer tends to maximize the total uti l i ty from consumption of purchased goods. Meanwhile theconsumer is interesed in ef icient use of his f inancial

resourses. Which principles will a rational consumerfollow?

In microeconomics this principle reflects the uti l i ty-

maximizing rule or 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 uti l i ty:

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 PizzaMU MU/P MU MU/P

1

23

4

5

6

7

6

54

3

2

1

0

6/10=0,6

0,5 0,4

0,3

0,2

0,1

0

10

87

5

4

3

1

10/20=0,5

0,4 0,35

0,25

0,2

0,15

0,05

Determinaţi, aplicând prevederile Legii a II-a a lui Gössen,

combinaţia optimă de bunuri pentru consumator şi utilitateatotală maximală, dacă venitul acestuia este de 70 u.m., iar

preţul unui pachet de suc = 10 u.m. şi al pizzei = 20 u.m.



In the process of choice the consumer acts in

accordance with his preferences. The theory of

consumer behavior starts from a series of assumptions

about the nature of consumer’s preferences:

1.Assumpt ion of compar ison and ranking of

consumer ’s preferences: between two market basket A

and B, he will choose one of three possibil 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

transit ive: 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.

Deci, consumatorii preferă o cantitate mai

mare de bunuri unei cantităţi mai mici.



In the theory of consumer behavior indifference

curves have a prominent place. They are graphic

illustration of concumer preferences (Fr. Edgeworth,

1881).

Indi f ference curve shows alternat ive

combinat ions of two economic boons,

that give the consumer equal ut i l ity (TU) or

satisfaction.

An indifference curve is the set of points

representing market basket among which theconcumer is indifferent (figure 2). Different

indifference curves provide a ranking of the

individual’s preference.



Cola

Cake

A

B

C

D

Marketbasket

X(Cola, un.)

Y(cake, un.)

a

b

cd

1

2

68

8

6

21

Alternative market basket

X

6

8

0

12

10

1 2 6 8

What is preferable ?

Figure 2. Indifference curve

Y



An indifference map is a graph of

the entire set of indi fference curves ,each one farther away from the

origin, corresponding to increasing

levels of total utility. They describe

consumer preferences for certain

goodsB

C

A

X

U3

U2

U1

XB XCXA

YC

YB

YA

What is preferable ?



Propert ies of ind i fference 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 (figure 3)

Y



2. Indifference curves can

never intersect.

A

C

B

X

Y

U1

U2

XB XC

YB

YC



3. Indifference curve are

usually negatively sloped andare convex to the origin.A

B

C

D

X

(pears)

Y

(apples)

∆X

∆Y



Economists use the term of Marginal rate of substi tution of

good Y 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 thatan 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

Y xy

Q

Q

MRS

TU – const.

With changes in the quantity of goods X and Y,

consumer satisfaction is unchanged ( U = 0), then:

0 Y Y X x Q MU Q MU TU

y

x

X

Y

MU

MU

Q

Q

y

x xy

MU

MU MRS or



MRSxy has the following properties:

1.MRSxy tends to reduce when moving

along the indifference curve from left to

right. Consumers will give up smaller

quantities of Y to increase by one unit theconsumption of good X.

2. MRSxy is the measurement of the slope of an indifference curve at a particular point

on that indifference curve (figure 6).



A

B

U1

Y

X

Moving from A to B: the slope

of indifference curve will be

higher in the point A than in a

point B



U1

U2

X

Y

Special cases of indifference

curves

Y



X

Y

U1U2

U3

U4

U5



U1U2 U3

X

Y



X

Y

A

B

H

K

0

I/Py

I/Px

The budget l ine is a set of

al ternat ive combinations o f quant ity of good X and Y that

the consumer can buy.

What is attainable ?



The budget line equation can be represented as

follows:

Y y X x

Q P Q P I

To draw a straight line is sufficient to know its two

extreme points:

X

y

x

y

r Q P P

P I Q y

x

y

x

x Q P

P

P I Q

The slope of the budget l ine in absolut value is

the tangent of the angle ABO of triangle AOB(figure 11):

Py

Px

Px

I

Py I

OB

AOtgABO



E

B

C

D

M

F

0 1 2 3 4 5 6

(I/Px ,O)

A

X

2

4

6

8

10

Y

N

(O,I/Py)

C a k e

Cola



C a k e

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

C a k e

A

F

5

H

10

10

Px

=3 lei

Px =6 lei Px

b) Consequences of changing o f pr ice of good

X (Px) I, Py – constant

1. Decrease of price of good X(Px↓), ceteris paribus, leads to

decrease of the slope of buget

line in absolut value.



X

Y

A

FN

10

52,5

Px =6 lei

Px =12 lei

Px

C a k e

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

valueof 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 set of goods (X,Y).

Rational consumer choice can be summarized in thefollowing table:

QUESTION PROBLEMGRAPHICAL

INTERPRETATION

What want

consumers? Prefferences Indifference 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 theslope of the budget line (is --Px / Py):

y

y

x

x

y

x

y

x

y

x

y

x

P

MU

P

MU

sau 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.The utility-maximizing combination of good X and Y

provides to consumer the maximum possible satisfaction

compared to other alternatives.

Y



Cola

a

E

c d

C a k e

A

F X

Y

8

6

2

1

10

50 1 2 8

U1

U2

U3



U1

U2

U3

A

Qx

Qy

0

In some cases the consumer is willing to buy only one

good from the market basket, giving up the other good.

MRSxy being higher or lower than the prices ratio.

Such equilibrium is called “corner” equilibrium.

In case when consumer purchases only

good Y (Qx = 0), equilibrium is at point A,

where MRSxy < Px / Py.



Qx

Qy

U1 U2 U3

B0

When consumers buy

only good X (Qy =

0),equilibrium of consumer

is in point B, where:

MRSxy > Px / Py. When



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

The case of change of consumer disposable income.

The sensitivity of consumer equilibrium to incomechanges can be described by drawing two curves:“income-consumption” curve and Engel’s curve (figure18).

1. An increase in consumer income ( I↑), moves thebudget line parallel to itself to the right and consumer

equilibrium point E 0 moves to right (up) to the point

E 2.

2. A decrease in 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 E 1 (figure 18a ).

Y



X

E 1

E 0

E 2

0

X

I

I 1 I 0

I2

E 2

E 0 E 1

I

U1

U2

U3

I

A

B

C

D N

M

X0X1 X2

X0X1 X2



“Income-consumption” is the unity of

consumer optimum points E 0

, E 1

, E 2

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 timeat various income levels.

Y



X

Y

U3

U2

U1

O

The positioning trajector y of “

income-consumption” curve and

the Engel curve is influenced by

the nature of the consumptiongoods.

For primary necessity

goods,

curve is very steepand close tothe OY

axis.

10 d

I

Y



X

Y

U1

U2

U3

O

For luxury goods,

curve is close to the axis OX

1 E d

I

Y



X

Y

U1

U2

U3

O

For in fer ior goods, 0 E d

I

Y



X

Y

U1

U2

U3

For neutral goods, .

“Income-consumption”

curve is represented by a

vertical line.

0 E d

I



Cloth

House

Food

C o n s u m p t i o n

e x p

e n d i t u r e 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 lessdegree than income increases. The higher the proportion of

income spent on food in a nation, the poorest the nation is

taken to be.



Agrement

1,9Comunicaţii4,7

Transport

4,5

Sănătate5,9

Dotarea locuinţei3,7

Întreţinerea

locuinţei15,3

Învăţământ0,5

o e ur ,

restaurante

2,3

Încălţăminte, îmbrăcăminte

11,6

Băuturialcoolice, tutun

1 9

Produse

alimentare

43,7

Diverse

3,9

ţările cu venituri înalte:



0 10 20 30 40 50 60 70 80

Tanzania

Madagascar

Vietnam

Sierra Leone

Indonezia

Moldova

ţările cu venituri joase:

Argentina

MexicRusia

Thailand

Brazilia

ţările cu venituri medii:

Danemarca

Marea Britanie

Canada

SUA

Japonia

ţările cu venituri înalte:

Figure 26.

The part of

expendituresfor 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 E 0 to E 1 (figure 26a ).

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 E 0 to E 2 .

YA



X

P1

P0

P2

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



THE SUBSTITUTION AND INCOME EFFECT in thecase 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 subst i tut ion effect measures the increase in the

quant i ty demanded of a good when i ts pr ice fal ls

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 thegood Y and more of good X, moving to another point on the Sameindifference curve.

The incom e effect measu res 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 curveto another curve. The income effect depends on the nature of the

goods.

Y



Cola

C a k e

1 2 3 4 56 7 98 10

1

23

4

5

6

7

8

910

A

H

b

v

k

M

F N

I=30 lei

Px=6 lei

I=21 lei

Px=3 lei

I=30 lei

Px=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

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Topic 4 FINAL.ppt