Consumer behavior Approaches Consumer Equilibrium

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Mr. P. Nandakumar

Assistant Professor

KVIMIS


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Approaches to Consumer Behaviour

Total utility

Marginal Utility

Law of Diminishing Marginal utility

Indifference Curve

Indifference Map

Budget Line


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The principle assumption upon which the theory of

consumer behavior is built on:

A consumer attempts to allocate his/her

limited money income among available goods andservices so as to maximize his/her utility(satisfaction).

Useful for understanding the demand side of themarket.

Utility - amount of satisfaction derived from theconsumption of a commodity .measurementunits utils


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Cardinal Utility Approach - assumes thatwe can assign values for utility.

Propounded by Marshalling

Known asUtility Approach

or MarshallingApproach E.g., derive 100 utils from eating a full meal

Ordinal Utility Approach - does not

assign values, instead works with a ranking ofpreferences. Propounded by Hicks & Allen

Also known as Indifference Curve Analysis


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Total utility(TU) - the overall level ofsatisfaction derived from consuming a goodor service

Marginal utility(MU) additionalsatisfaction that an individual derives fromconsuming an additional unit of a good orservice.

TUMU

Q


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Q TU MU

0 0 ---

1 20 20

2 27 7

3 32 5

4 35 35 35 0

6 34 -1

7 30 -4

Example : TU, in general, increases

with Q

At some point, TU can startfalling with Q (see Q = 6)

If TU is increasing, MU > 0 From Q = 1 onwards, MU is

declining principle ofdiminishing marginal utility As more and more of agood are consumed, theprocess of consumption will(at some point) yield smallerand smaller additions toutility

Example


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510

15

2025

30

35

0 1 2 3 4 5 6

Quantity

Totalutility(in

utils)

Q

TU


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-5

0

5

10

15

20

1 2 3 4 5 6

Quantity

Mar

ginalutility(

inutils)

Q

MU


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Meaning :

The first unit of

consumptionof a good or

service yields

more utility

than the

second and

subsequent

units


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So far, we have assumed that any amountof goods and services are always availablefor consumption

In reality, consumers face constraints(income and prices):

Limited consumers income or budget

Goods can be obtained at a price


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Marginal ut i l i ty per rupee additional utility derivedfrom spending the next rupee on the good

MU per rupee = MU

Price

X Y

X Y

MU MU

P P

X Y

X Y

MU MU

P P


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Consumers objective: to maximize his/her

utility subject to income constraint

2 goods (X, Y) Prices Px, Py are fixed

Consumers income is Known


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Suppose: X = BananaY = Orange

Assume:

Price of Banana(X), PX = Rs.2

Price of Orange(Y), PY = Rs.10


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Qx TUX MUX MUx

Px

QY TUY MUY MUy

Py

1 30 30 15 1 50 50 5

2 39 9 4.5 2 105 55 5.5

3 45 6 3 3 148 43 4.3

4 50 5 2.5 4 178 30 3

5 54 4 2 5 198 20 2

6 56 2 1 6 213 15 1.5

Price of X, Px = RS. 2 Price of Y, Py = RS. 10


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Presence of 2 potential equilibriumpositions suggests that we need to considerincome. To do so let us examine how much

each consumer spends for eachcombination.

Expenditure per combination

Total expenditure = PX X + PY Y

Combination A: 3(2) + 4(10) = 46 Combination B: 5(2) + 5(10) = 60


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Scenarios:

If consumers income = 46, then the optimum

is given by combination A. .Combination B is

not affordable

If the consumers income = 60, then the

optimum is given by CombinationB.Combination A is affordable but it yields a

lower level of utility


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Marginal utility analysis requires somenumerical measure of utility in order todetermine the optimal consumptioncombinations

Economists have developed another, moregeneral, approach to utility and consumerbehavior

This approach does not require that numbersbe attached to specific levels of utility


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All this new approach requires is thatconsumers be able to rank theirpreferences for various combinations of

goods

Specifically, the consumer should beable to say whether

Combination A is preferred to combination B

Combination B is preferred to combination A.or

Both combinations are equally preferred


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Indifference curve shows all combinations ofgoods that provide the consumer with thesame satisfaction, or the same utility

Thus, the consumer finds all combinations on acurve equally preferred

Since each of the alternative bundles of goods

yields the same level of utility, the consumer isindifferent about which combination isactually consumed


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Indifference analysis is an alternative way

of explaining consumer choice that does

not require an explicit discussion of

utility. Indifferent: the consumer has no

preference among the choices.

Indifference curve: a curve showing all

the combinations of two goods (or classes

of goods) that the consumer is indifferent

among.


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A common shape for an indifference curve is

downward sloping.

For the consumer to be indifferent to the bundle

of goods chosen, as less of one good is consumed,

more of another must be consumed.


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The indifference curves are not likely to be

vertical, horizontal, or upward sloping.

A vertical or horizontal indifference curve holds the

quantity of one of the goods constant, implying that the

consumer is indifferent to getting more of one goodwithout giving up any of the other good.

An upward-sloping curve would mean that the consumer

is indifferent between a combination of goods that

provides less of everything and another that provides

more of everything. Rational consumers usually prefer more to less.


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An indifference curve for work and leisure


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The slope or steepness of indifference curves is

determined by consumer preferences. It reflects the amount of one good that a consumer must

give up to get an additional unit of the other good whileremaining equally satisfied.

This relationship changes according to diminishing marginal

utilitythe more a consumer has of a good, the less the

consumer values an additional value of that good. This is

shown by an indifference curve that bows in toward theorigin.


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Indifference curves cannot cross.

If the curves crossed, it would mean that the

same bundle of goods would offer two different

levels of satisfaction at the same time.

If we allow that the consumer is indifferent to

all points on both curves, then the consumer

must not prefer more to less.

There is no way to sort this out. The consumer

could not do this and remain a rational

consumer.


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An indifference map is a complete set of

indifference curves.

It indicates the consumers preferences

among all combinations of goods andservices.

The farther from the origin the

indifference curve is, the more the

combinations of goods along that curve

are preferred.


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The indifference map only reveals theordering of consumer preferences amongbundles of goods. It tells us what theconsumer is willing to buy.

It does not tell us what the consumer isable to buy. It does not tell us anythingabout the consumers buying power.

The budget line shows all thecombinations of goods that can bepurchased with a given level of income.


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The budget line is an important component

when analyzing consumer behavior.

The budget line illustrates all the possible

combinations of two goods that can bepurchased at given prices and for a given

consumer budget.

The amount of a good that a person can buy

will depend upon their income and the priceof the good.


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If consumer income increases then the

consumer will be able to purchase higher

combinations of goods.

An increase in consumer income will result ina shift in the budget line.

The prices of the two goods have remained

the same, therefore, the increase in income

will result in a parallel shift in the budgetline.


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If income is held constant, and the price of

one of the goods changes then the slope of

the curve will change.

In other words, the curve will rotatedepending upon the change in the price of

the goods.


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The indifference map in combination withthe budget line allows us to determine theone combination of goods and services thatthe consumer most wants and is able to

purchase. This is the consumer equilibrium. The demand curve for a good can be derived

from indifference curves and budget lines bychanging the price of one of the goods

(leaving everything else the same) andfinding the equilibrium points.


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The consumer maxi-

mizes satisfaction bypurchasing the

combination of

goods that is on the

indifference curve

farthest from the

origin but attainable

given the

consumers budget.


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By changing the price of

one of the goods and

leaving everything else

the same, we can derivethe demand curve.

In (a), the price of a gallon

of gasoline doubles,

rotating the budget line

from Y1 to Y2. Theconsumer equilibrium

moves from point C to E,

and the quantity

demanded of gasoline

falls from 3 to 2.


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Chapter -5 Theory of Consumer Behavior,

R.Saravanan, R.Karuppasamy, Economic

Analysis for Business, SCITECH Publications

Chapter-5, Demand & ConsumerBehavior Paul A. Samuelson and William D.

Nordhaus, Economics, 18th edition, Tata

McGraw Hill, 2005

Chapter 21, The Theory of consumer choiceN. Gregory Mankiw, Principles of Economics,

3rd edition, Thomson learning, New Delhi,

2007

Consumer behavior Approaches Consumer Equilibrium

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