Theory of Consumer Choice

Theory of Consumer Behaviour

Why to study? Facilitates estimation of Market

demand for product(market demand is summation of individual demand)

Theory: Given money income and price of commodities, consumer plans spending income so as to attain the highest possible satisfaction or utility.

Role of Consumer…..

Issues related to Decision Making Process(Product Market)

Demand for the Product is determined by Consumer Behaviour

Consumer: Unlimited wants but limited income Necessity for allocation of resources among various

wants to get maximum possible satisfaction.

Consumer is having a PREFERENCE SET (list of wants) and OPPORTUNITY SET (constraints including limited income, operation in the same market)

Adoption of Optimization Technique to chose a commodity basket that can provide maximum satisfaction

Different Approaches to Measurement of Utility What is Utility?

Satisfaction a consumer derives from consumption of commodities

Can we measure Utility? Two different approaches

A. Cardinal School: Utility is measurable just as price and quantity

Some argues it can be measured in monetary units (by the amount of money the consumer is willing to sacrifice for another unit of a commodity)

Others argue one can assign a number of ‘utils’ to consumption of each commodity

Few cardinalists argue utility is measurable and additive (Marshall, Walras)

Others argue it is cardinal but cannot be added (not additive utility)- Edgeworth, Fisher

Marginal Utility and Total Utility

William Stanley Jevons (1835-1882) build relationship between Utility & Price.

Coined Marginal Utility and linked Marginal Utility to Price instead of Total Utility.

The change in total utility per unit change in the quantity of a commodity consumed-Marginal Utility.

With increase in consumption of commodities Total Utility increases but Marginal Utility Declines. Once Consumption reaches maximum, Marginal Utility will become Zero (saturation point). Further increase in consumption of commodity will lead to fall in Total utility and negative Marginal Utility.

Measurement of Utility….

Ordinal School: Wilfred Pareto et.al. Utility cannot be measured. ‘The consumer need not know in specific units the utility of

various commodities to make his choice’-A Koutsoyiannis Rank Commodities in order of Preferences based on

satisfaction that each bundle can provide.

Adopted INDIFFERENCE CURVES Approach & Revealed Preference Hypothesis.

Cardinal Approach: Assumptions

Rationality: Consumer is assumed to be rational. Utility is measurable and can be measured most

conveniently by MONEY Constant Marginal Utility of Money

Diminishing Marginal Utility: Utility gained from consumption of successive units declines.

*Total utility of a basket of goods depends on the quantities of the individual commodities.U=f(x1,x2,…xn)Total utilityU=U1(x1)+U2(x2)+..+Un(xn)

Criticism of Cardinal Approach

Assumption of Cardinal utility: Satisfaction can not be measured objectively.

Marginal utility (MU) of money can not be constant. As income goes up, MU goes down.

Money can not be used as a measuring rod since its own utility undergoes change.

Diminishing MU is derived from introspection.

Table1 : Total Utility & Marginal Utility

Quantity Total MarginalConsumed Utility Utility

0 0 -1 10 102 18 83 24 64 28 45 30 26 30 07 28 -2

Source: D Salvatore (2005):Microeconomic Theory, P.63

Total Utility

Indifference Curve….. An indifference curve is a graph showing

different bundles of goods, each measured as to quantity, between which a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for one bundle over another. In other words, they are all equally preferred. One can equivalently refer to each point on the indifference curve as rendering the same level of utility (satisfaction) for the consumer.

ClothingUnits per week

Food (units per week)

40

20

10

30

50

0 X

Y

A

E

C

Indifference Curves

An indifference curve depicts bundles of goods/commodities that leave the consumer equally well-off.

Every point on an Indifference Curve (IC) reflects combinations of goods that give the consumer a constant level of utility, i.e., all bundles are equally preferred in an IC).

Food (units per week)

Clothing(Units per week)

A

B

Why does IC slopes downward from Left to Right?

Assume Indifference Curve is upward Slopping?Implications: Violations of Assumption that more of any commodity is Preferred to less. How can a consumer become indifferent between two commodity bundles having different amount of goods? One is having more of both Food & Clothing as compared to other.

Can Indifference Curve become HORIZONTAL Straight Line? Can Indifference Curve become Downward Slopping

Straight Line? Can IC be concave to the Origin?

Indifference Curve is Convex to the Origin

Indifference Curves are CONVEX or Bowed Inward. WHY?

(A) Diminishing MRS Slope of Indifference Curve increases (less

negative) as one move down along the IC. Previous Exp. -6 to -4 for movement from A to B and B to D.

(B) Generally Consumers prefer Balanced Bundle (Containing both goods) to a basket constituting only ONE GOOD.

Diminishing Marginal Rate of Substitution

Marginal rate of substitution of X for Y: Reflects the number of units of commodity Y that must be given up for an extra unit of X so that the consumer maintains the same level of satisfaction.

How much of Y one can give up in order to gain one additional unit of X and still remain on the same Indifference Curve?

Decreasing Marginal Rate of Substitution expresses that number of units of ‘X’ consumer is willing to sacrifice in order to obtain an additional unit of ‘Y’ increases as the quantity of Y decreases. WHY?

Diminishing MRS or Downward Slopping IC

Shape of IC reflect how a consumer is willing to substitute one good for another.

For Movement from Commodity Bundle A to B consumer can give up 6 units of clothing for 1 extra unit of Food.

For Movement from B to D she can give up 4 units of Clothing for 1 extra unit of Food.

When she has more clothing and less of food, it will be feasible to give up more clothing to obtain more food.

-6

1-4

1

A

B

D

Food

Clothing

Diminishing MRS…..

Marginal Rate of Substitution = Slope of Indifference Curve.

(slope of IC is –dy/dx = MRSxy). Slope is Negative as change in Y and Change in X are in

opposite direction (one is +ve and other is –Ve). Diminishing MRS: Slope of IC DECREASES (in

absolute terms) as one move along the curve from left downwards to right.Implication: Commodities can substitute for one another, but not perfect substitutes.

Perfect substitute: Indifference Curve can be a negative sloped straight lineComplements: ICs are ‘L’ Shaped Curve (takes the shape of right angle)

Budget Constraint

A Budget constraint represents the combinations of goods and services that a consumer can purchase given current prices and his income.

The Budget Constraint

Budget Constraint:Constraints that consumers face as a result of limited income- Pindyck et.al.

Budget Line (constraint): All combinations of goods for which the total amount of money spent is equal to Income.

Any point on the constraint line equals Rs5,000, the income available to spend on the two products.

Pepsi (Rs 5)

Pizza (Rs 50)

B100

A1000

O

Budget Constraint

Shows what combination of goods the consumer can afford given his income and the prices of the two goods.

The slope of the budget constraint measures the rate at which the consumer can trade one good for the other.

The slope equals the relative price of the two goods, i.e. the price of one good compared to the price of the other.

Refer previous figure. Slope=OA/OB=(Y/Py)/ (Y/Px)=Px/Py

Where Y: Total income, Px and Py are price of x (Pepsi) and y (Pizza) respectively. Y/Py: Given income Y if she buys only y then how much she could buy. Y/Px: given income Y and Price of x as Px how much X she could buy.

Interpretation: Slope of Budget line is the ratio of Price of X to Price of Y.

Optimization: What does the Consumer Choose?

Given budget constraint, choose the bundle (goods) that can maximize satisfaction

Consumers would like to obtain the combination of goods on the highest possible indifference curve.

But budget constraint may restrict or limit the consumer to a lower indifference curve.

Optimum Choice….

Combination of indifference curve and budget constraint determines the optimum choice.

For Maximization of satisfactionFeasible basket should be located on the

budget line(Rules out any bundle below or above the budget

line)

Commodity basket must offer the consumer the most preferred combination of commodities.

Indifference Map Consumer’s

indifference curves, based on personal preferences

Pizza

Pepsi

I1

I2

I3

Consumer’s Optimal Choice

Equilibrium Situation….

Given the indifference map of the consumer and his budget line, the equilibrium is defined by the point of TANGENCY of the budget line with his/her possible IC.

At the point of tangency slopes of budget line Px/Py and slope of IC are equal.

But Slope of IC= MRSx,y=MUx/MUyOr MUx/MUy= Px/PyOr MUx/Px=MUy/Py

The Consumer’s Optimal Choice

Equilibrium Condition:(a) Necessary Condition:Marginal Rate of Substitution should be equal to ratio of commodity prices

MRSx,y = MUx/MUy= Px/PyOr MUx/Px= MUy/Px

Marginal utility of rupee spent on x and y should be equal to price of x and price of y.Marginal utility derived from last rupee spent on X must be equal to marginal utility derived from last rupee spent on Y.

Equilibrium….

Satisfaction is maximized when Marginal rate of substitution of X for Y is equal to the price ratios of two commodities. WHY?

Another Interpretation: Satisfaction is maximized when Marginal Benefit is equal to

Marginal Cost. Marginal Benefit: Benefit associated with the

consumption of one additional unit of the good (say food) Measured by MRSxy (the amount of Cloth willing to give up for an

additional unit of Food) Marginal Cost: Cost of additional unit of a good (say Food)

Measured by magnitude of slope of Budget line (price ratio of x & y). Let MRS= slope=1/2 Implies consumer is willing to give up ½ units of Cloth to obtain one unit

of food.Let Slope of Budget Line=1/2= PF/PC Where PF: Price of Food and PC: Price of Cloth

cost of getting 1 unit of Food is feasible by giving up ½ unit of Cloth- Price Ratio).

Equilibrium Condition….

(b) Sufficient Condition:Indifference curve to be convex to the origin. or Slope of the Indifference curve decreases (in absolute terms) as we move along the curve from left to right downwards

Extreme Indifference Curves

Perfect Substitutes: Two goods can be substituted for one another

at a constant rate (not necessarily 1) Indifference Curve: Downward Slopping

straight Line The indifference curves have a CONSTANT Marginal

Rate of Substitution Marginal Rate of Substitution is 1 to 1

(Slope of IC: -1) Equilibrium of a consumer may be a corner solution

(consumer spends all her income on one commodity)

I1 I2 I3

Perfect Substitutes

31

2

6

Mango Juice

Pineapple Juice

Perfect Complements

Two goods are consumed in a FIXED proportionIndifference curves have lines that are at right-angles to each other. ICs analysis is violated as there is no scope to substitute one good for otherEx: Consumption of Three Biscuits with one Cup of Tea (slope: Ratio of two goods consumed: 3)

Ex: Left Shoe and Right Shoe

Perfect Complements

I1

I2

Tea

Biscuit

2

6

Concave Indifference Curve

Consumer maximize utility by consuming only ONE commodity.

Consumer Prefer C to D as former is on a higher Indifference Curve.

I1

A

I2

B

C

D

Derivation of Demand Curve from IC Analysis

Initial equilibrium: e1. Assume price of Y and Income remain constant. Now Price of X (a normal good) declined. The budget line shifts to AB’ on account of rise in real purchasing power

of the consumer. The consumer can buy more of X ( and Y). New Equilibrium: e2 (x2, y2) as AB’ is tangent to a higher IC (IC2). New Equilibrium occurs to the right of the original equilibrium implying

increase in demand on account of fall in price of normal good. Assume the price to fall continuously and join the tangency point of

different budget line and IC. By joining the points one can get PRICE CONSUMPTION LINE (PCL). From PCL we can derive Demand Curve for Commodity X. At e1

consumer buys X1 at price Y1 and at e2 consumer buys X2 at price Y2.

Plot it in a graph paper to get the demand curve.

Theory of Consumer Behaviour

‘Description of how consumers allocate incomes among different goods and services to maximize their well-being’-Pindyck et.al.

Necessitates Preference Ordering of Commodities.

What is a Preference Ordering? ‘A Preference ordering is a scheme that enables

the consumer to RANK different bundles of goods in terms of their DESIREA BILITY or order of preference’-Anidya Sen (1998).

Assumptions about Preference Orderingor ‘Axioms’ of Consumer Theory

A. Completeness: Preferences to be complete.

Consumers can compare and rank their preferences among alternative available bundles of goods and services. Based on Ranking Consumer can be able to make a CHOICE between any two given bundles.

Either Prefer commodity bundle A (3 Apples, 3 Oranges) to B (2 Apples, 4 Orange), B to A or remain indifferent. (A is weakly preferred to B or B is Weakly preferred to A).

Note : Weakly Prefers: Consumer either prefers one of the two bundles or remain indifferent between the two

Assumptions……

B. Consistency and Transitivity of Choice: Preferences need to be consistent

If she chooses A over B in one period then she cannot chose B over A in another period.

Transitivity:▪ If A (4 Apples, 3 Oranges) is weakly preferred to B (5A,1O)

and B is weakly preferred to C (2A, 5O) then A is weakly preferred to C.

(if consumer thinks A is at least as good as B and B is at least as good as C, then A is at least as good as C)

Transitivity property facilitates making the ‘best choice’

Assumptions…….

C. More of any good is better than Less of it (Nonsatiation)

One bundle is preferred to other as it contains more quantity of items.

(Exception: Pollution and Garbage-Bad items. Two much consumption of sweet……!)

D. Law of Diminishing Marginal Rate of Substitution (MRS)Preferences are ranked in terms of indifference curves which are assumed to be convex to the origin.

How Changes in Income Affect the Consumer’s Choices

The increase in income shifts the budget constraint outward. This results in two affects: A parallel shift in the budget constraint. Allows the consumer to choose a better

combination of goods on a higher indifference curve.

Apple

Orange

QO

QA

An Increase in incomeshifts the budget

constraint.

I3

I1

I2

Income Consumption Curve

Normal versus Inferior Goods

If a consumer wants more of a good when his income rises, the good is called a normal good.

If a consumer buys less of a good when his income rises, the good is called an inferior good.

Income Consumption Curve: Engel Curve

Income Consumption: Locus of consumer optimum points resulting when only consumers income varies.

Engel Curve propounded by Ernst Engel Based on Family budget and expenditure

patterns. Shows the amount of a good that a

consumer would purchase per unit of time at various income levels

Money Income per unit of Time

Apple Consumed per unit of Time

Engel Curve

Engel Curve

If Engel Curve rises gently for some goods-Luxury Goods

Implication: Given increase in income leads to proportionately larger increase in quantity purchased.

Rapid increase in Engel Curve implies, given rise in income leads to proportionately smaller increase in quantity purchased.

Exp: Necessary Goods (food stuff)

Derivation of Demand Curve by using IC Approach

Derivation of Demand Curve

Price Effect, Income Effect & Substitution Effect

Splitting Price Effect into Income and Substitution Effect

With the fall in price of X, the Q.D went up from X1 to X2. The new Equilibrium Point is e2 in IC (II).

Total PRICE EFFECT can be decomposed into SUBSTITUTION EFFECT and INCOME EFFECT.

Let the real income be the same as before. To achieve this draw a budget line parallel (dotted line) to the new budget line (AB’).

Movement from e1 to e1’ : Substitution effect Movement from e1’ to e2: Income Effect Movement from e1 to e2: Price Effect.

Substitution Effect……

Substitution effect: Increase in the quantity bought as price of the commodity falls, after adjusting income so as keep the real purchasing power of the consumer the same as before. (Hicksian COMPENSATING VARIATION Method)

INCOME EFFECTDecline in Price leads to improvement in consumer’s purchasing power.Assuming the commodity is normal, She will spend more real income on X (Movement from X1’ to X2)- INCOME EFFECT OF PRICE CHANGE.

Thanks a lot