Theme 4. THEORY OF CONSUMER BEHAVIOR

Objectives:

knowledge of elements of the consumer behavior model and their importance in decision making process;

explanation of the cardinal theory of consumer behavior in the context of:

deepening the notions of utility, total utility and marginal utility;

decreasing marginal utility ( I-st Law of Gossen);

total utility maximizing rule (II-nd Law of Gossen);

explanation of the ordinal theory of consumer behavior and its tools:

indifference curve and its properties for rational consumer;

budget line, taking into consideration the price of two goods and consumers income;

consumers equilibrium through equating the marginal rate of substitution (the slope of the indifference curve) to the ratio of goods prices (the slope of the budget line);

plotting income-consumption curve in terms of changes in income;

plotting price-consumption curve, analyzing the effects of changes in price of goods;

identification of the differences between the substitution and income effects;

determination of ways of practical application of the model of consumer behavior.

Analysis of the Consumer Behavior is one of the key issues of economic theory, which allows

the understanding of the way the changes in income and price affect individuals' decisions. This

knowledge will allow to understand the process of formation of consumption demand, its elasticity

level, the factors influencing the dynamics of individual demand, as well as to demonstrate

consumer sovereignty, or the influence of the consumers’ choice upon the producer's behavior.

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4.1. Consumer Behaviour: hypotheses and determinants

In economic theory, consumer behaviour is a process of formation of consumer demand for

various goods, depending on the individual's income, preferences,  and price 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 from a variety of goods on the market. In other words, consumers are facing the problem

of choice - the process of formation of a consumer program (basket of consumer goods) within

disposable income and market price - specification of quantities of various consumer goods

that provide certain satisfaction.

Within the theory of consumer choice are analysed reasons and determinants of consumption

behaviour, principles and mechanism of decision-making process of a rational consumer.

The choice of representative (average) consumer is based on the following assumptions:

• freedom of decision and action of the consumer;

• consumer rationality;

• consumer sovereignty;

• limited consumer's income;

• subjective utility assessment  and the tendency for its maximization.

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

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 it possible to buy the goods? (based on disposable income and  existing

market prices).

The rational consumer assumption is in fact a capability of an efficient choice, meaning the

maximization of the satisfaction of needs within limited disposable income. Rational consumer is

also called "homo oeconomicus". According to the French economist Charles Gide, "Homo

oeconomicus is a skeleton ... which allows the economic science to develop.”

Economists consider consumers’ power and sovereignty in the market economy as the ability

to lead and influence the producers’ fate. The consumer is sovereign (king), based on the following:

his needs serve as a point of  reference for producers;

his decisions predetermine the  market demand for goods and services, which, in its

turn, manifests in a decisive  influence on national economic development;

he is the one, who asses the results of  production activity.

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As a rational human being, each consumer is interested in maximizing satisfaction derived

from consumption of goods purchased with his financial resources.

Box 4.1. Historical insights

For the first time, the concepts of consumption and consumer, as a specific economic agent of economic life, were analyzed by classical economists: A. Smith, D. Ricardo, JBSay. They determined the role of consumer in the process of reproduction as a free (takes decisions independently) and sovereign (satisfaction of his needs directs production) economic agent.

The first to introduce the concept of utility in the social sciences was English philosopher Jeremy Bentham (1748-1831). He believed that society should be organized according to "the principle of utility," utility that he defined as "property of an object ... to produce pleasure, good or happiness ... or to prevent pain - evil or unhappiness." [P.Samuelson, W.Nordhaus „Economie politică”. Bucureşti, 2000, p.103]

Later, the  neoclassics L. Walras, Jevons S. and K. Menger,  followed by V. Pareto, E.Böhm-Bawerk, Fr.Vieser, founded the theory of rational consumer.

The consumer behaviour and choices are influenced by the factors that can be classified as follows:

• socio-demographic factors;

• socio-economic factors;

• psychological factors;

• institutional factors.

Socio-demographic factors (directly or indirectly influencing consumer choice) include: sex,

age, social status, education level, living environment (urban, rural), occupation, family

composition.

Socio-economic factors that have a multilateral influence on consumer behaviour include:

material needs, household income, prices of goods and services, taxes, inflation, the quantity

and quality of goods and services, the welfare etc.

Psychological factors in consumer behavior indicate terms of preferences, motivations,

perceptions, expectations, individuality or the tendency to imitate.

Institutional factors include customs and national traditions (for example, Christmas is

celebrated differently by Catholics and Orthodox), rules and standards governing the consumption

sphere (eg, legal restrictions on the sale of alcoholic beverages and tobacco).

The multitude of factors influencing consumer behaviour means the complexity of rational

choice under the conditions of the contemporary market economy.

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As an initial category, in the theory of consumer behaviour appears the utility of a

good, which is treated unevenly by the economic science.  In assessing the utility historically there

were two approaches:

1. Cardinal approach (classical) of utility has emerged in the nineteenth century. A significant

contribution to its development had the following marginal economists: S. Jevons,

Menger K., L. Walras, who believed that each economic good can be assigned a number, called

the cardinal utility (e.g. 4, 6, 8 etc.)... This vision assumes:

 subjective, individual assessment of utility

quantitative measure of the utility of a good using a conventional unit - "utili" (this is how

the name cardinal appears);

decreasing marginal utility ( Ist Law of Gossen);

maximization of consumer utility at given income ( II nd Law of Gossen).

2. Ordinal approach (Neoclassical) of utility appeared later (end of XIX century – first half of

the twentieth century), due to the impossibility of measuring cardinal utility of particular goods. In

developing this concept, a special role have scientists J. Hicks and R.Allen, influenced in their turn

by the works of V. Pareto, Edgeworth F. and E. Slutsky, who are known as ordinalists.

Ordinal utility approach involves ordering combinations of goods, measured by the scale of

ordinal numerals (first, second, third, etc.).. In other words, the consumer rationally orders (ranks)

his preferences in relation to the total satisfaction, which is intended to be obtained.

The ordinal analysis is based on the ability of consumers to compare consumption programs

in terms of consumer preferences. Meanwhile, the preferable consumption programs are those

with the highest total utility when the equivalent consumption programs have the same level

of utility. Ordinal approach assumes:

prioritization of consumption programs based on consumer preferences (this way there

is no need to measure the utility of each item consumed);

comparison of consumption programs, respectively their ranking accordingly to

consumer preferences and financial possibilities;

introduction of research tools in the theory of consumer choice: the indifference curve,

marginal rate of substitution and the budget line;

Maximization of obtained consumer utility by choosing the most desirable set of goods

(consumption program) of all possible variants.

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Consumer Preferences

In the choosing process the consumer acts in accordance with his preferences. In essence they

(the preferences) characterize different systems of individual values for certain goods in relation to

the total utility. Consumer choice theory starts from a series of assumptions, underlying his

decision and permitting him the rational ranking of consumption programs.

1. Assumption of comparison and ranking of consumer preferences: between two sets of

goods, A and B, he will choose one of three possible alternatives:

a) would prefer set A instead of B, (A B);

b) would prefer set B instead of A, (B A);

c) is indifferent towards the two sets of goods, considering them to be equivalents, (A ~ B).

Statements a) and b) mean preferable relations that allow to compare two sets of goods and to

determine the preferred set. For example, the set, which consists of two pairs of jeans and a pair

of sneakers, is more preferable than the set, which consists of a pair of jeans and a pair of sneakers.

Situation c) illustrates the relationship of indifference, which means that two sets provide the

same satisfaction to the customer, so he shows the same preference to them. For example, the set,

which consists of a kilo of apples and a pound of pears is equivalent to the set, which consists of a

pound of plums and a pound of peaches.

In situation when you check these conditions, the consumer is able to fully rank his

preferences, and as well the utilities of goods.

2. The transitivity of the option : the consumer ranks different sets of goods and compares

them in pairs: if he prefers set A to set B and set B to set C, then, it means that he prefers the set A

to set C: if A B and B C → A C.

For example, if set of household goods Phillips is more preferable as set Samsung and

Samsung set is more preferable as Scarlett set, then the Phillips set is more preferable as Scarlett set.

Thus, transitivity is a statement of rational consumer behavior. Without preference transitivity

the consumption program is considered irrational.

3. Nonsatisfaction (greed)assumption : if there are two sets of goods A and B, with the same

quantity of good X and a larger quantity of good Y in set B, then the consumer will prefer the set B.

For example, the set of goods consisting of 2 kg of biscuits and 3 kg of chocolates is more

preferable as the set consisting of 2 kg of biscuits and 1 kg of chocolates. So, consumers prefer a

more then less.

In conclusion, if a consumer is offered two baskets of goods, of all possible, he will choose the

set, which corresponds to his preferences. When a good is consumed, we obtain a benefit or

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satisfaction. Economists call this satisfaction utility and believe that when consumers choose

between different goods, they tends to get the highest utility in relation to their income.

4.2. Total and Marginal Utility

Utility of a good or service reflects the consumers’ satisfaction which he expects to obtain.

This involves a subjective notion. In William Shakespeare's view, the goods themselves can be

neither good nor bad, it all depends on our assessment.

Amount of utility can be determined by consumer, but the utility of same goods is different for

different people (for example, the utility of glasses for a weak seeing man and a healthy man is

different).

According to cardinalists approach, the utility can be measured by a number of abstract units

(util). The amount of utility depends on the quantity of goods consumed. Followers of cardinalists

theory operate with the notion of total utility, and, respectively, of marginal utility. This concept

shows the specific dependence of satisfaction of needs upon amount of consumed good.

Total utility represents the satisfaction obtained through the consumption of successive

quantity of a good in a given period.

Total utility function has the following form:

[ 4.1 ]

Where TU – total utility, QXi – successive quantity of one good

Marginal utility is the additional satisfaction received by individual when consuming an

additional unit of a good or service. 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:

[ 4.2 ]

Where MU – marginal utility

To be expressed in mathematical terms, the marginal utility can be defined as the partial

derivative of 1st order of utility function. Thus , MU (Qx) = (TUx) '.

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Initially, the principle of marginal utility of a good was defined by a mathematician and

economist - Gossen, in the mid XIX century, but only at the end of the century, his ideas were

recognized and accepted in economics under his name.

The size of marginal utility is influenced by various factors:

Volume or quantity consumed of a given good.

Box 4.2. Historical insights

Acording to marginalists, exactly the utility of the last unit of a given good determines its price. Marginality principle allowed to explain the ” water – diamonds” paradox, mentioned by Adam Smith in the eighteenth century, in his „Wealth of Nations, an Inquiry into the Nature and Causes”

Nothing is more useful than water, yet it is still sold for nothing. Conversely, the diamond has no value to use and yet a lot of other goods are exchanged for diamonds” [P.Samuelson, W.Nordhaus „Economie politică”. Bucureşti, 2000, p.111]

The answer is that diamonds are very rare and the cost of obtaining each new diamond is very high, water is a relatively abundant resource and the costs of obtaining it are relatively low.

The importance of the good and the intensity with which the needs are manifested is

different

Box 4.3. Historical insights

E.Bohm-Bawerk, notorious representative of Austrian neoclassical school, outlined the essence of the principle of marginal utility, applying his research in "Robinson method." Suppose, says Austrian professor, that somewhere, in an isolated area, at a forest edge, lives a landowner who has 5 sacks of wheat. What will he do with this product? The first bag of wheat is of paramount importance for the recluse, he would starve without it, the second allows him to empower and strengthen his health, with the third sack of the grain he feeds the birds, to have meat and eggs, the fourth sack is used to produce brandy. Finally, the fifth sack of wheat he gives to his parrot, who sings to him and drives away his sadness. 

As shown in the example above, each of the five sacks of wheat, have different utility for their owner.  In this case, which is the value of a sack of wheat, how can it be measured? Here, Bohm-Bawerk, and also Karl Menger introduces the concept of marginal utility, that the value of property is determined by its marginal utility, that is the least important, in our example, the last sack of wheat, the one that the parrot will eat. Why? Because, this particular sack, the householder from the forest will be prone to change to something else, as it has the lowest utility for him. And if it happens so, that he would lose the first bag, it will replaced by the fifth, and in no way by the second or third. 

Conditions for reproduction of a given good.

Box 4.4. Historical insights

Works of art, antiques, "couture clothes" (Giorgio Armani, Christian Dior, Chanel), whose conditions of reproduction are limited or impossible have an increased marginal utility and respectively, prices.

Example: In May 1990, the painting of Vincent van Gogh  "Portrait of Dr. Gachet" was sold at auction for 82.5 million dollars. [Campbell R. McConnell, Brue Stangly L. "Economics. Principles, Problems and Policies. , 13th edition, 1996]

While consuming a quantity of a good, the changes in marginal and total utility are

interdependent. The relationship between total and marginal utility can be illustrated by data in

Table 4.1.

Table 4.1

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Correlation between total and marginal utility

Consumed quantity of a specific good

Qx

Total utility (util) TUx

Marginal utility (util) MUx

0 0-

1 2020

2 3515

3 4510

4 505

5 500

6 45-5

The Interdependence of marginal utility and total utility functions is reflected in Figure 4.2..

On the graphs ordinate are given the total utility (TUX) and the marginal utility (MUX) and on the

abscissa - the quantities of goods consumed X (Qx).

Figure 4.2. Evolution of total and marginal utility

Analyzing the evolution of total and marginal utility, we can draw the following conclusions:

As an additional unit of a given good is consumed (up to Qx = 5), marginal utility decreases

(MUx curve has a descending character) and total utility will increase, but each time at a lower

rate.

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TU

MU

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

reaches its highest level (TUx=50utili) respectively Qx=5 units is the optimal amount of

consumption.

If consumption continues Qx> 5 units, marginal utility becomes negative and total utility

decreases.

As the needs of the individual are satisfied, marginal utility decreases. This relationship is

known as law of diminishing marginal utility or the first law of Gössen. The law of diminishing

marginal utility assumes that as an individual consumes more of a good (x1, x2, ... xi), the

marginal utility will get less by consuming additional units of the given good:

According to this law, when the good is available in large quantities, one additional unit of

good consumed will bring a lower level of satisfaction and vice versa. For example,

an individuals’ need to eat an ice cream on a hot day is very big, the desire to consume the second,

third etc. ice cream is very small. This fact does not mean the reduction of total satisfaction. On the

contrary, the total satisfaction increases, but with a decreasing rate. If the individual continues

to eat ice cream, total utility continues to grow, but slower, while marginal utility is decreasing.

For different goods are characteristic different rhythms ("Speed") of reduction of the marginal

utility. For comparison, the utility obtained by consumers from the second good (eg, umbrella,

glasses, washing machine) is reduced sharply, approaching zero. Meanwhile, the utility from

consumption of the second good (eg, candy, citrus fruit, spreads, etc..) remains quite high.

However, the reduction of marginal utility influences the consumer demand dynamic. High

rates of reduction of marginal utility changes insignificantly the sensitivity of consumer demand to

changes in prices and, vice versa, the slow reduction of marginal utility rates, ceteris paribus,

increases the sensitivity of consumer demand: at lower prices, consumers are willing to buy more

goods.

Box 4.5. The determination of marginal utility and consumer point of satiety

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Utility function has the following form: TU=10 + 30Q – 3Q2.1) Determine marginal utility for Q=4.2) Determine the optimum volume of consumption (point of satiety, where TU is maximum).

Solution. For the total utility function TU=10 + 30Q – 3Q2, the marginal utility will be represented through the following relation: MU= (TU)’= (10 + 30Q – 3Q2)’ = 30 – 3 2 Q = 30 – 6Q. 1) for Q=4; MU=30 – 6 4 = 6 (utili)2) The maximization of total utility is obtained in the point of satiety. Thus, applying the condition for

maximizing total utility we have: MU=0 30–6Q=0 Q=5 units.Replace Q=5 units in the total utility function and determine its maximum value:

TU=10 + 30Q – 3Q2 = 10 + 30 5 – 3 52 = 85 (utili).

Total Utility maximizing rule

According to the cardinal approach, each consumer tends to maximize the total utility from

consumption of purchased goods, but their marginal utility decreases. Meanwhile, the

consumer is interested in efficient use of his financial resources. Which principles will a

rational consumer follow?

To maximize satisfaction, the consumer will spend his disposable income in such a way,

so that the last unit of money spent to purchase each good, would bring the

same marginal utility. In microeconomics, this situation represents total utility maximizing rule

or Gossen's II Law.

The second law of Gössen assumes that in order to maximize total utility, the consumer must

distribute his income in such a way, so that the marginal utilities - weighted to the price of the

goods are equal.

In this case, the marginal utility per monetary unit, appropriate to the good X, is equal to the

marginal utility per monetary unit appropriate to the good Y.  In this case, the consumer is in

equilibrium, because he cannot increase the total utility by giving up one good for another.

If we take in cosideration several goods (X, Y,… Z ) the condition of consumers’ equilibrium is

as follows:

, [ 4.3 ]

where: MU – marginal utility of goods X, Y,… Z; P – price of goods X, Y,…. Z.

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Briefly, the condition of consumer equilibrium is determined by the equality of marginal

utilities weighted to price of all goods in the consumer program. In equilibrium state, the consumer

maximizes his total utility.

Box 4.6. The determination of the optimum combination of goods

Assume that a student byes 2 goods: juice and pizza. Data regarding their marginal utility is presented in the table Table 4.2

Marginal Utility (MU) of goods and MU/P

Consumed units

Juice PizzaMU MU/

MUM

1/P234567

6543210

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

10875431

10/20=0,50,40,350,250,20,150,05

Determine by applying the second Law of Gossen, the optimal combination of goods to the consumer and the maximum total utility if his income is 70 um. The price of a pack of juice = 10 mu and pizza = 20 mu.

Solution.According to cardinal approach, rational consumers will reach equilibrium if the condition will be: the marginal utilities-weighted to price of all goods are equal ( II Law of Gossen). Consumer equilibrium condition will be represented as follows:

.

Now we calculate marginal utilities-weighted to price – applying the II Law of Gossen:

6,010

6

S

S

P

MU

Based on Law, are determined three combinations of consumption:1) 2 juices + 1 pizza (MUs/Ps = 0,5; MUp/Pp = 0,5)2) 3 juices + 2 pizza (MUs/Ps = 0,4; MUp/Pp = 0,4)3) 5 juices + 5 pizza (MUs/Ps = 0,2; MUp/Pp = 0,2)

Determine the costs to purchase alternative sets of goods:1) 10 2 + 1 20 < 70 – same combination is impossible; 2) 10 3 + 2 20 = 70 – this combination can be realized; 3) 10 5 + 20 5 >70 – this combination is impossible.

Thus, the optimum combination of goods is 3 juices and 2 pizza.

Utility maximizing rule is widely used in daily practice. Consumers in their choice, prefer

more efficient and more expensive goods: sticks  instead  of a disk, digital cameras instead of film

cameras, automatic washing machines instead of mechanical. The producers as well react to this

law,by improving their goods and changing prices.

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Rational consumer should compare the marginal utility with opportunity costs. Utility

maximizing rule extends as well to the use of time. In everyday life, it is known that some

individuals value timesaving, while others waste it, in order to save money. For example, some

people to save money, are ready to stand in long lines to pay bills, use trolleybusses and trains.

Others prefer "speed" in transactions and movements: Internet payment services, travel by taxi,

plane. These differences in behavior can be explained by different evaluation of time by each

individual. Thus, the unemployed, retired people consider the opportunity cost of time being low, as

they have it in abundance and do not appreciate it quite high, while high-income businessman, on

the contrary,  values his productive time very high.

Marginal utility theory has a number of applications that allow testing of predictions of this

theory. Thus, along with other factors the price of any good reflects the influence of marginal utility.

For example, consumption goods (which exist in excessive amounts, have a reduced marginal utility

per unit), are sold at lower prices compared to exclusive assets (which amount is limited).

Another important application of marginal utility theory is the phenomenon  of consumer

surplus.

. Consumer surplus is the difference between the maximum price of the good  which the

consumer is willing to pay (demand price) and the market price in a given time.

Usually this is the difference between the amount of money consumers are willing to pay for

the good and the amount that they actually pay. Consumer surplus can be determined with the help

of the demand curve.

Box 4.7. Model of determining consumer surplus

Assume  that a student has a daily disposable income of 36 lei, which he  is willing to spend for Internet

access. The price of Internet access in a Internet Cafe is 6 lei per hour. Determine consumer surplus (the student).

If the student would  visite the Internet-Caffe for an hour a day, he would be willing to spend 9 lei. If he is to

visit the café two hours a day, he would be willing to pay only 8 lei, and even 7 lei if he would need Internet three

hours per day. Market price is 6 lei. The total amount that the student was willing to pay for 4 hours is 30 lei

(9 8 7 6). He pays only 24 lei (4  6). As such, the additional value that he wins is 6 lei (30-24). This amount

represents the amount of consumer surplus in this example. Graphic interpretation is shown in Figure 4.3.

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a) cazul cererii individuale b) cazul cererii de piaţă

Figure 4.3. Consumer surplus

Cardinal theory of consumer behavior allows to  determine the laws and principles of his

choice. At the same time, it is subject to criticism:

utility can not be measured using quantitative indicators;

theory is abstracted from daily life due to  consideration that consumers do not make so

many mathematical calculations;

simplified analysis of reality, because the expected marginal utility depends on

consumption of other goods that are part of the consumption program.

4.3. Indiference curves

In consumer behavior research indifference curves have a prominent place. They are graphic

illustrations of consumer preferences. For the first time indifference curves, as a research tool of

consumer behavior, were used by Fr.Edgeworth, follower of ordinal approach, in 1881.

Indifference curve reflects consumer preferences and shows alternative combinations of

goods, which allows the consumer to obtain the same level of utility

In graphical interpretation , indifference curve represents a set of of points whose coordinates

show combinations of goods that create equal utility (Figure 4.4). Respectively, the consumers is

indiferent regarding what combination of goods to choose. To understand the significance of

the curves we will analyse a consumer choice situation -  a student, with a limited consumer

program up to two goods: X(Internet access) and Y (Xerox service). Alternative consumer programs

equivalent after total utility, are presented in Table 4.3.

Preţul Preţul

Accesul la Internet (ore)

Accesul la Internet (ore)

surplusul consumatorului

surplusul consumatorului

Preţul pieţei

D D

10

9

8

7

6

5

4

3

2

1

10

9

8

7

6

5

4

3

2

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

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Table 4.3Equivalent set of services

Setul X ( Internet, hours) Y (Xerox, pag.)abcd

1268

80602010

Using data from the table we plot  indifference curve. Each point on that curve (a, b, c, d)

reflects one of the combinations of services X and Y, which equally satisfies the needs of the

consumer.

Figure 4.4. indiference Curve

For the student these set of services (a, b, c, d) have the same total utility, and due to this, he is

indiferent towards in his choise.

Consumer preferences can be illustrated with a variety of indifference curves, each reflecting

a certain level of satisfaction. Series of these curves form a map of indifference curves.

Map of indifference curves includes the totality of indifference curves that describe

consumer preference for certain goods.

YXerox (pag)

d

100

80

60

20

10

U1

a

b

c

0 1 2 3 4 5 6 7 8 9 10XInternet (hours)

14

Figure 4.5. Map of indiference curves

Indifference curves reflect the order of the different levels of satisfaction of consumers.

Properties of Indiferesnce curves:

1. Indiference curve situated further away from the origin, corresponds to a higher level of

utility and is more preferable for consumer; meaning U1 < U2 < U3 (figure 4.5). Combination

C on indiference curve U3 is more preferable as combination B on curve U2 and combination

A on curve U1 acording to non-satiesity (greed) axiom.

2. Indifference curves  of a consumer  never intersect.  If two indifference curves would intersect,

point of intersection A of Figure 4.6 would correspond simultaneously to two different levels

of satisfaction, which conflicts with the concept of indifference curve and the transitivity

axiom. If A~ B and A ~ C, then B ~ C, which is impossible because B lies on indifference

curve U1 and point C is on indifference curve U2, which requires larger quantities of good X

and good Y.

Y

YC

YB

YA A

B

C

X XB XC XA

U3

U2

U1

Y

YC

YB

A

B

C

X XB XC

U2

U1

15

Figure 4.6. Imposible way of sutiation of indiference curves

3. Indifference curves have a downward slope  and are convex to the origin of the coordinate

axes. Indifference curve slope indicates that increased consumption of one good from set of

goods will reduce consumption of other  good in the set, assuming that consumer satisfaction

remains constant. For the utility to remain unchanged, when the consumer diminishes purchse

of good Y, he will purchase additional units of good X (Figure 4.7). Exchange ratio is

negative, the slope of the curve is also decreasing.

Figura 4.7. Zone of substitution

On an Indifference curve, a substitution zone is designated  (arc AB in Figure 4.7), where an

effective substitution  of one  good for another is possible. In this case, economists use the concept

of marginal rate of substitution of good Y for X - MRSxy, which means the "level” till which the

substitution of one good for another is justified.

Marginal rate of substitution indicates the amount of the good, the consumer is willing to

give up in exchange for additional quantities of other good, ensuring the same level of total utility.

, TU – const. [ 4.4 ]

With changes in the quantity of goods X and Y, consumer satisfaction is

unchanged ( U = 0), then:

X

A

B

C

D

1 2 3 4 5 6 7 8 9 10

∆Y

∆X

–

+

10

9

8

7

6

5

4

3

2

1

Y (applemere)

16

[ 4.5 ]

[ 4.6 ]

According to the law of diminishing marginal utility there is an indirect correlation between

changes in the quantities of goods X and Y and between their marginal utilities. Respectively,

successive reduction of the consumed amount of  good Y  leads to the fact that for each exchanged

unit the marginal utility is higher than the previous one. At the same time  successive increase in the

quantity consumed of good X reduces the marginal utility of each additional unit consumed.

Thus, the marginal rate of substitution can be determined as the ratio of marginal utilities  of

two goods:

. [ 4.7 ]

Box 4.8. model of determining of MRS

Consumer is indiferent to two sets of goods: set A consists of 3 pears (X) and 10 apples(Y), and set B consists

of 4 pears and 7 apples (figure 4.7). Consumer tends to increase the consumption of pears, substituting apples for

pears.

Thus marginal rate of substitution equals:

Economic essence of the result shows that in order to  increase consumption of a pear the consumer should

sacrifice three apples. 

Marginal rate of substitution (MRSxy) has the following properties:

MRSxy equals the slope of indifference curve in a given point (Figure 4.8)

MRSxy size tends to reduce when moving along the indifference curve from left to right.

Consumers will give up smaller quantities of good Y to increase by one unit consumption of

good X. Analysing the geometric interpretation of  MRSxy, when moving from set A to set

B the size of given indicator ( ) in point A is greater than in point B.

17

Figure 4.8. Geometrical interpretation of MRS

MRSxy has a significance of opportunity costs. Consumers’ choice to increase consumption of

good (X) increases the opportunity costs due to scarifying a quantity of another good (Y).

Types of indiference curves

În afară de forma tradiţională a curbelor de indiferenţă, studiate mai sus, există şi alte tipuri.

Forma curbelor de indiferenţă diferă în raport de criteriul bunurilor consumate:

Indifference curves for perfect substitutes (white and pink roses, mineral bubbly and still water)

will be represented by parallel lines with negative slope, indicating that as consumption of good X

increases, the consumption of good Y decreases so that total utility remains unchanged (figure 4.9).

Figura 4.9. Indiference curves for perfect subsittutes

For perfectly substitutable goods the total utility function has the following form:

TU(x,y) = a QX + b QY, [ 4.8 ]

where a,b>0.

In this case, MRSxy has a constant value for diferent consumption levels

Indifference curves for perfectly complementary goods, the ones that are used only together (left

and right shoe) have a form of an 900 angle (figure 4.10).

Y

A

B

X

U1

Y

XU1 U2

18

Figure 4.10. Indifference curves for perfectly complementary goods

For perfectly complementary goods the utility function is:

TU(x,y) = min (aQx, bQy), [ 4.9 ]

where a,b>0.

In this case the goods perfectly complement each other and MRSxy=0, or doesn’t exist.

indifference curves for goods that give negative utility (antigood: tobacco, alcohol). As the

demand of the product (good) X increases, increases the demand of product Y (bad, harmful,

antigood) so that TU remains constant. Increasing consumption of antigood  causes  dezutility and

increasing consumption of "good"  product  increases utility. Utility function, in this case, has the

following form:

TU(x,y) = aQX – bQY, [ 4.10 ]

where a,b>0,

Indifference curves for harmful products have positive slopes (Figure 4.11)

Figura 4.11. Indiferecne curves with negative utility

indifference curves for neutral goods. Preference for neutral goods manifest when the consumer

is indiferent while consuming no matter what quantity of some good , but he is interested in

acquiring a given quantity of another good. In this case (Figure 4.12), indifference curves are

parallel to the neutral object (Y).

Y

X

U2

U1

Y U5

U4 U3

U2

U1

X

19

Y

X

U1 U2 U3

Figura 4.12. Indiference curves in case when good Y is neutral

In this case the utilyty fucntion has the folowing form:

TU(x,y) = a QX, where a>0. (whenY is a neutral good) [ 4.11 ]

So, as an additional unit of good X is consumed, the utility increases with a units, MRSxy=0.

4.4. Consumers’ budget constraint

Map of indifference curves shows  consumer preferences. It guides his decision to achieve the

highest possible indifference curve, which gives a maximum level of satisfaction. At the same time,

consumer choice is limited by his financial possibilities, namely, his behavior depends on disposable

income but also on prices of goods.

In order to to study the consumer's financial possibilities, we will analyse the budget

constraint.

Budget constraint represents the combinations of goods and services that a consumer can

purchase given current prices (Px and Py) with his or her disposable income (I)

When consumers fully use disposable income to purchase goods, we describe the consumer's

budget line. Graphically the budget line can be illustrated by a straight line  which provides the

multitude of combinations of goods (X, Y), which can be purchased on consumers’ disposable

income and based on the prices of goods X and Y.

Therefore the budget line equation can be summarized as follows:

, [ 4.12 ]

whre I is consumers’ income; Px – price for good X; Py –price for good Y.

To draw a straight line is sufficient to know its two extreme points, points  of its intersection 

with the coordinate axes. Transforming  the budget line equation we obtain:

Q [ 4.13 ]

Q [ 4.14]

20

ratio indicates the maximum quantity of good Y, which can be purchased by the

consumer, spending his whole income, and reflects the maximum quantity of good X, which

can be purchased by consumers within its income. Figure 4.13 shows us a plotted budget line.

Figure 4.13. Budget line

Points A and B (Figure 4.13) are extreme points of the budget line, which inidcate the

maximum quantity of good X or Y if the other good is given up , using full income (I).

Segment AB is the set of combinations of various quantities of two goods X and Y which the

consumer can accept to purchase  using his entire income.

Points located below the budget line, such as, for example, point H (Figure 4.13), are

combinations of quantities of two goods X and Y, which have determined prices Px and Py, that do

not exceed the income limit (amount of  money). In this case relationship between X, Y, Px, Py and

I are as follows:

XPx + YPy < I [ 4.15 ]

Combinations situated to the right from the budget line , point K (Figure 4.13), exceed

the consumer income ( are unattainable). In this case relationship between X, Y, Px, Py and I are as

follows:

XPx + YPy > I [ 4.16 ]

Budget line slope in absolute value, is the tangent of the  angle  ABO of triangle  AOB.

[ 4.17 ]

In economic sense, the slope of the budget line  represents the ratio of prices of both goods

and expresses how much of good Y  you can substitute with good  X, or how much is worth a unit of

good X expressed in units of good Y. Mathematically speaking, the slope of the budget line is

A

XB

E

F (I/Px,O)

0 I/Px

• K

H •

Y

I/Py

21

derivative of  first order of linear function : Y = aX + b. According to the budget line equation (4.14)

we can determine its slope.Thus, the ratio   means slope (inclination) of the budget line.

Box4.9. Model of ploting a budget line

In order to plot a budget line, let’s assume that a student has an income I, equal to 30 lei, which he will spend

daily on two goods: access to Internet and Xerox services. You know the prices: access to the Internet per hour (Px) is

6 lei, and the price of Xerox services per page (Py) is 0.30 lei. Payment possibilities of mentioned goods   are shown

in Table 4.4:

Combinations of  consumption equal  after total expenses

Payment possibilities X(Internet, hours) Y(Xerox,p.)ABCDEF

012345

100806040200

Alternative possibilities A and F represent the extremes of the budget line. In case A, the student will spend all

his disposable income (30 lei) on Xerox  services  (100 pages) and for F, all income will be spent on access to Internet

(5 hours). Graphcly  the budget line  for the given student represents a line joining the two extreme points A and F,

located in the  two-dimensional space on the axes OX and OY (Figure 4.14).

Figure 4.14. Budget Line

On AF segment one can find  a set combinations that student can obtain, fully  using  his income in conditions

of existing prices. OAF area is the area where the consumer can determine his consumption possibilities.

Points below the budget line for example, point N, represent the combination, which does not exceed available

income. Combinations of goods above the budget line, for example M, exceed the consumers’ income  and are not

100

80

60

40

20

A (O,I/Py)

B

C

D

E

F (I/Px,O) 0 1 2 3 4 5 6 7 8 9 10

XAccessto Internet (houore)

N

M

AF – linia bugetului

YServicii Xerox

(pag)

22

accessible to the consumer.

In the given example, knowing that price Y equals 0,30 lei, and disposible income is 30 lei, quntity of good Y

( orthe A alternitive constitutes 100 pages of Xerox (30:0,30).

In the given example the budget line slope is :

The student may substitute an hour of Internet access with 20 pages of Xerox, so an hour of Internet access"costs"

20 pages of Xerox. Such a ratio is being reflected by a budget constraint with slope-20.

The budget line may change its position due to changes in consumer income or prices. Any

change in consumer income and consumer prices will determine a new budget line, respectively, a

new "zone" of consumption. Next, we analyze the influence of changes in disposable income (I), of

the change in prices (Px and Py) of one of the two goods (X or Y) on the budget line.

Consequences of changes in consumers’ disposable income

Changes in consumer income (ceteris paribus) will influence the quantities of consumed

goods. If consumer income increases (I↑; Px , Py – constant), the budget line will shift up ( to the

right), paraleel with the original line and the consumer will be able to buy a larger quantity of goods

(Figure 4.15). The ratio of prices of the goods does not change . So, the budget line slope doesn’t

change as well. 

In condition of reduction of income (I ↓ ; Px , Py – constant), vice versa, the budget line will

shift down (to tha left), parallel with the innitial.

Box 4.10. The positioningof the budget line in case of changes in disposable income 

Initial budget line of the student, based on income of 30 lei and price  for an hour of Internet access (Px) 6 lei,

and the price for a page of Xerox services (Py) of 0.30 lei. is AF (Figure 4.15). Suppose that students  income

increases to 42 lei, and prices remain constant. In these conditions it is possible to extend Internet access to 7 hours

(42:6) or to photocopy 140 pages(42:0,30).  budget line AF will shift up (to the right), to JK position. Vice versa, if

the income will drop to21 lei, Internet access will decrease to 3.5 hours (21:6), and Xerox services will be 70

pages (21:0,30). The new budget line is MN.

23

Figure 4.15. Dynamica of the budget line in the case changes in income

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

Decrease of price of good  X (Px↓), ceteris paribus, leads to decrease of the slope of

budget line  in absolute value. Thus, the slope of the new budget line  will be smaller than the slope

of initial line. Accordingly, OY segment remains constant. And when Px =0  the slope of budget 

line will be zero (horizontal), which means that consumers only buy good X.

As the price of good X rises (Px ↑), the absolute value of budget line slope  increases

comparative to   the absolute value of the slope  of initial budget line (Px ↑; I

- constant, Py - constant).

Box 4.11. The positioningof the budget line in case of changes in price of one of the goods

With a price decreas  of Internet access (Px ) from 6 to 3 lei lei, and the price for Xerox services (Py = 0, 30

lei) beeing constant, there is an opportunity within income (I = 30 lei) to double (from 5 to 10 hours) access to the

Internet.  As a result of price changes, budget line will change its position on the axis OX, and that will

change its slope (Figure 4.16.a).

Absolute value of the budget line slope decreases from 20 (initial budget line AF) up to 10 new budget line AH

. If the price of access to the Internet increase  from 6 to 12 lei, ceteris paribus,  the Internet access will be  

reduced twice (from 5 to 2.5 hours). The new budget line will move in the manner illustrated in Figure 4.16.b.

The absolute value of slope of new budget line AN increases and   will be  40 ,

XAccess to Internet (hour)

Y Xerox (pag)

140 J

100 A

70 M

0 1 2 3 3,5 4 5 6 7 8 9 10

N F K

I=30 lei

I =42 lei

I2 =21 lei

24

a) Px b) Px

Figura 4.16. The budget line in the case of changes in price of a good

According to the ordinal theory, consumer behavior is influenced by the following constraints:

disposable income and commodity prices. In everyday life, consumer choice is influenced by time,

as an additional constraint, which may explain the increasing popularity of consumption in network

restaurants: McDonald's, Bistro, restaurants and canteens, which save personal time. Times saving

costs are high, confirming the expression "time is money".

4.5. Consumer Equilibrium

The fundamental problem of consumer is the optimal use of available income under the

existing market price, based on individual preferences. He reaches equilibrium  state, when he finds

the optimal combination that will satisfy both his preferences and possibilities. This does not mean

that the given situation confirms absolute and complete satisfaction, it is just the best of the available

opportunities.

Rational consumer choice can be summarized in the following table:

Access toa Internet (hour)

Y xerox (pag)

100

80

60

40

20

0 1 2 3 4 5 6 7 8 9 10

A

Px

F H X

Px =3 lei

Px =6 lei

Access to Internet (hour)

Y xerox (pag)

100

80

60

40

20

0 1 2 2,5 3 4 5 6 7 8

A

Px

N F X

Px = 6 lei

Px =12 lei

25

Table 4.5

Question The problem to which it

responds

Graphical interpritation

What want consumers?

What can consumers?

What do consumers?

Preferences

Constraints

Choice of optimal combination  of consumption

Indiference Map

Budget Line

Consumer point of equilibrium

Source: Economie. ASE Bucureşti, 2005, p.62

Graphically, this situation will be there, where consumer preferences, described by the

"indifference map," will "meet" with possibilities, represented by budget line . The point where the

budget line is a tangent to one of consumer indifference curves determines equilibrium (optimum) of

the consumer.

Consumer equilibrium is that state, which gives him maximum total utility from full use of

income.

Thus, consumer equilibrium will designate that version of the income distribution which

ensures the maximum possible satisfaction compared to other alternatives.

Figure 4.17. Conmsumer equilibrium  (optimum of consumption)

Point E (Figure 4.17) gives the Customer the highest level of utility permited by the  budgetary

constraint AB. Here the consumer will be in equilibrium: he fully uses the  disposable income and

maximizes satisfaction  from consumption  of set of goods (XE, YE ). At this point, the slope of

indifference curve (MRSxy) coincides with the budget line slope (-Px / Py)

sau [ 4.18 ]

From analytical point of view, the consumer equilibrium condition requires that the ratio of

marginal utilities of goods X and Y, which reflects consumer preferences, is equal to the ratio of

26

Y

A

E

B

U3

U2

U1

XE

I/Py

YE

X I/Px

prices of the two goods. Thus, the optimal condition, according to the ordinal approach, has the

same economic effect as the utility maximizing rule in cardinal approach.

Given the previous example, where I = 30 lei, Px = 6 lei / hour, Py = 0.30 lei / page,  consumer

equilibrium (student) in graphical interpretation is the point E (Figure 4.18).

Figura 4.18. Consumer Equilibrium (student)

At this point, the optimal combination of goods, which includes 2 hours of Internet access and

60 pages of Xerox, provides  the student maximum utility.

Box 4.12. Exemple of determination of consumer equilibrium

The consumers’ utility fucntion is: . Consumers’ Income is 100 u.m., and Px and Py = 10

u.m. The optimum consumption program X, Y is to be determined.

Solution.

Equation of the budgetary line is 10X+10Y =100; optimum condition:

The functions of marginal utility for goods X and Y can be obtained by calcutating the first derivative of TU

function:

.

Then the sistem of equations looks like this:

Y Servicii Xerox

(pag)

100 A

80

60

20

10

U1

F

a

E

c d

0 1 2 5 8XAccess to Internet (hour)

27

which has the follwoing solutions:

So the optimal combination is given by 7 units of good X and 3 units of good Y.

To determine the optimal consumption program in terms of preferences that are describe by

the follwong type of functions: TU(x,y)</sub>= Xa Yb, the principle of the share (cotei-părţi) is

used . According to this principle:

; [ 4.19 ]

In this case X and Y expres the optimal consumption, but also represent the demand function deducted from the consumer  optimum. Often this function is used to assess effects of economic policy  upon consumer (eg tax changes) and demand forecasting.

Box 4.13. Example of determining consumer equilibrium on the basis of the share (cotei-părţi) principle.

Consumer's budget, equal to 90 lei, is intended to purchase cheese (X), the price of which is equal to 120 lei for

1 kg and biscuits (Y), whose price is 30 lei for 1 kg. Total utility function is TU = X2/3Y1/3. What is

the consumer's optimal consumption program?

Using the share principle (cotei-părţi),

* quntity of cheese (X) is determined by the formula:

* quntity of biscuti (Y) is determined by the formula: .

The situation presented in Figures 4.17 and 4.18 is often called the "internal" equilibrium of

consumer, which implies that the slope of indifference curve equals to the slope of budget line in

a given point. However, in some cases the consumer is willing to buy only one good, giving up the

other good, MRSxy being higher or lower than prices ratio. Such equilibrium is called "corner" ,

which is located on one of the axes of OX and OY, in the top of the angle formed by budget line.

In case when consumer purcahses only good Y (Qx = 0), equilibrium is at point A (Figure 4.19

a), where MRSxy < Px / Py. The slope of indifference curve at this point is less than the slope of the

budget line. When consumers buy only good X (Qy = 0), consumer equilibrium is in point B (Figure

4.19 b), where MRSxy> Px / Py. The slope of indifference curve at this point is greater than the

slope of the budget line.

28

a) b)

Figura 4.19. Corner equilibrium of consumer

Optimal choice of consumer is affected by changes in disposable income and commodity

prices.

The case of change of consumer disposable income.

With the change of income, changes balance of the consumer equilibrium. Consumer

sensitivity to income changes is expressed and can be described by drawing two curves: "income-

consumption" curve and Engel's curve (Figure 4.20). "Income-consumption" curve was observed by

J. Hicks, who also called it "the living standard curve".

With income growth, consumer increases his consumption of both goods from the consumer

program as his purchasing power increases, but prices of both goods does not change. Thus, when

income increases (I ↑) consumer equilibrium Eo moves to right (up) to the point E2 and, conversely,

with a decrease in revenue (I ↓), consumer balance moves to the left (down) to the point E1 (Figure

4.20). A change in consumer income moves the budget line parallel to itself to the right (up), when

income increases and to the left (down) - when income is reduced.

Curve that links the points of equilibrium E0 , E1 , E2 and shows changes of consumer choice

of an individual in relation to income changes, is "income-consumption" curve .

Engel's curve is derived from the  "income-consumption" curve and reflects changes

inconsumer behavior towards one of goods X or Y to the change of the size

of income (I). Engel curve for good X is obtained by representing the previous curve  ("income-

consumption") from the XOY plan (Figure 4.20) in IOX plan, where I - income (Figure 4.20b).

Qy

Qx0

A

U1

U2

U3

Qy

Qx0 B

U1 U2 U3

29

Figure 4.20. Income – consumption curve and Engel curve

The positioning   trajectory of income-consumption curves  and the Engel curve is influenced

by the nature of the goods subject to consumption.

 For normal goods (eg as food, clothing and footwear ), whose consumption increases in

response to increasing income. In this case the slope  of income-consumption curve  and the

slope of Engel is positive, εi> 0 (Figure 4.20).

Y

X

X

I b) Engel curve

W

M

C

A

I2

I0

I1

E1

E0

E2

E2

E0

0 X1 X0 X2

0 X 1 X0 X2

I

I B D N

U2

U0

U1

E1

a)” income-consumption”curve

30

a) Incomet-consumption curve forgoods of first necessity (X)

b)income-consumption curve for luxury goods (X)

c)Income-consumption curve for inferior goods (X) d) Income-consuption curve for neutral goods (Y)

Figure 4.21. „Income-consumption” curve for different goods

For luxury goods (particular case of normal goods) which  consumption  increases in greater

proportion than income εi> 1. "Income-consumption" curve  is close to the axis OX and tends to

become parallel to it (Figure 4.21b). In this category of goods are included: luxury cars,

"couture" clothes, jewelry of precious metals and precious stones, etc..

For goods of first necessity and priority (eg, bread, milk, salt, soap), which consumption

increases at a  lower rate  than income, 0 <εi <1. "Income-consumption" curve is very steep and

close to the OY axis (Figure 4.21). Limit of  physical saturation  with basic goods have an

important role in guiding consumer behavior.

For inferior goods (for example, some foods like margarine, old-fashioned clothes and used

shoes) which consumption decreases when income increases, εi <0. "Income-consumption"

curve has negative slope (Figure 4.21.c).

For neutral goods (salt, toth paste) which consumption does not depend on changes of income εi

= 0. "Income-consumption" Curve is represented by a vertical line (Figure 4.21.d).

U1 U2

U3

Y

X

O

U3 U2 U1

Y

X

O

U3

U2

U1

Y

XO

U3

U2

U1

Y

XO

31

Ernest Engel, an economist and statistician, established way back in the nineteenth century

that in the distribution structure of households budgets the share of food expenditure in total

expenditure decreases, as income increases. He deduced this regularity generalizing his

observations of family budgets of workers, collected by Le Play in various European countries.

Researches conducted over the past 150 years (Working (1943), Houtakker (1957), Clemmens

(1996)) confirmed Engel's law and additionally dedecuted dependence of income on housing costs,

clothing, determining their typical elasticities: for expenditure for food - 0.6; for home maintenance

expenses - 0.8; for clothing expenses - 1.6. Engel's curves are described in Figure 4.22 for food

supplies, housing and clothing.

Figura 4.22. Engel curves

This law provides a tool to determine the influence of income changes on consumption

structure of population and international comparisons of living standards and poverty. As higher is

the share of food consumption in expenditure, the lower is the standard of living of the population.

The case of price change of one of the goods

The rising price of good X (Px ↑), ceteris paribus, will increase the absolute slope of the

budget line, the budget line will change its initial position from AB to AC, and the optimal

combination of consumption will move from Eo to E1 (Figure 4.23). Decrease in prices of good X

(Px ↓), ceteris paribus, will decrease the absolute value of the slope of the budget line and

Households income

cloth

houses

food

Con

sum

er e

xpen

ditu

res

expe

ndit

ures

cons

um

32

willchange the initial position AB to AD, and the optimal combination of consumption will be

transferred from Eo to E2.

Uniting the initial Eo and new consumer equilibrium points E1 and E2, we obtain the "price-

consumption" curve, which shows the evolution of the quantity of goods X and Y required if the

price of good X changes.

Figure 4.23. „Price-Consumption” curve and individual demand curve

From "price-consumption" curve can be deducted the individual demand curve, which

illustrates the relationship between price of good and quantity demanded of that good. Starting from

33

X1 X0 X2 D X

X1 X0 X2 X

Y

P2

P0

P1

PX

b) Individual demand curve

a)Price-consumption curve

E1

E0

C B

A

Y1

Y0

Y2U1

U2

U3

E1

E0

E2 D

E2

the "price-consumption", curve we build individual demand curve for good X, reflecting the price of

good X on the vertical axis. All points of equilibrium (E0, E1, E2) "price-consumption" curve

determines correlation " price of good X - quantity of good X "( P0X0 , P1X1 , P2X2), on the

individual demand curve (Figure 4.23.b).

If Px increases from Po to P1, the quantity of good X decreases from Xo to X1, and when Px

decreases from P0 to P2, the quantity demanded increases from X0 to X2, which confirms the law of

demand.

Substitution effect and income effect for normal goods

Economists devide the impact of changes in the price of a good into two effects:

an income effect and substitution effect. The consequences of this change show a double influence

on consumer behavior. Respectively the derivation of the demand curve is based on the income

effect and substitution effect, as a  total effect of changes in price.

Substitution effect shows changes in consumer demand for a given good when its

price changes in order to maintain the same level of total utility. If the price of good X decreases,

the consumer  substitutes good Y by  good X ,  purchasing more of good X and less of the good

Y, transferring to another point on the same indifference curve.

Thus, the price change of good X from the consumption program changes price ratio of the

two goods. Good X whose price has decreased is relatively cheaper than good Y whose price has not

changed. As a result, consumers can get more additional units of good X per unit of good Y, which

they give up. In order to maintain the same level of total utility the individual will reduce the

expenditures for good Y, in exchange for increased consumption of good X. In other words, the

substitution of consumer goods always tends to modify the demand of the good whose value

changes in the opposite direction from its price change .

The income effect reveals the changes in consumer demand for acertain good, due to

changes in purchasing power and real income, caused by the change in price. The income effect

depends on the nature of the goods. This effect involves the transition from initial  indifference

curve to another curve.

Thus, a lower price of good X in the consumer program will allow consumers to increase

their total utility that can be achieved at the given income level, and to “climb” a higher indifference

curve. Iin case of normal goods consumer will purchase greater amounts of both goods, contributing

34

to increase in demand. Income effect is studied in terms of real income (I / P) rather than

nominal income (I).  The changing purchasing power of consumer regarding all goods in the

consumption program is taken into account

The total effect of reducing the price of good X is the outcome of the mentioned

two effects. In the case of normal goods this effect is positive because consumer is buying a larger

quantity of good X.  Both effects justify this behavior.

Box 4.14. Income and substitution effects for normal goods

Let us see how will react the consumer (student) in case of a price cut for access to the Internet from 6 lei /

hour to 3 lei / hour (Figure 4.24).

a) Since Internet access has become cheaper, the student can get more additional hours of access to Internet for

Xerox pages that he gives up. So as Xerox services are now relatively more expensive, the student will receive  

fewer Xerox services and more Internet access. This is the effect of substitution (ES). In this case, there is a

movement along the same indifference curve U1, from the initial equilibrium point b to point v, the amount of hours

of Internet access has increased from 2 hours to 4 hours. As a result, the structure of the consumption program of

student will change in favour of relatively cheaper good.

b) If the Internet access becomes cheaper, the purchasing power of student increase as real income increases

(student becomes richer). Accordingly, he can receive more Xerox services and Internet access. This is the income 

effect (EI).

Consumatorul va urca, deci, pe o curbă de indiferenţă U2 superioară celei iniţiale U1. Noul echilibru al

consumatorului ar putea fi în k, unde o curbă de indiferenţă U2 este tangentă cu linia bugetului imaginară AH, care va

fi paralelă liniei bugetului iniţială MN. În noul punct de echilibru, accesul la Internet este de 5 ore. Creşterea

numărului de ore de la 4 (punctul v) până la 5 ore (punctul k) caracterizează efectul de venit al studentului. Efectul de

venit este pozitiv (pentru bunurile normale).

The consumer will go up, to an indifference curve U2 higher than the original U1 . The

new consumer equilibrium could be in point  k, where indifference curve U2 is tangent to the imaginary budget

line  AH , which will be parallel to the original budget line MN. In the new equilibrium point, Internet access is

5 hours. Increas in the number of hours from 4 (point v) to 5 (point k) characterizes the income effectof of the

student. Income effect is positive (for normal goods).

The total effect (Et) of the price change will be:

Et = ES + EI or 3 hours (Et) = 2 hours (ES) + 1 hour (EI)

35

Figura 4.24.Total effect of changes in price of a good

In conclusion, the student shall beneficiate, of course, from several hours of Internet access, because both

effects (total effect) justify this behavior.

The given example regarding the substitution and income effects, and respectively, the total

effect of price change is only one version of the manifestation of both phenomena. In practice, there

are alternatives of substitution effects and income effects for inferior goods and Giffen goods.

Aspects of the new theory of consumer behavior

The traditional approach  of consumer behavior  is inefficient  in case of choosing the non-

trade goods. For example, what will determine a family decision regarding the number of children?

Or, what factors cause different behavior regarding marriage and divorce in different countries?

What explains the trend of decreasing birth rate in countries with a high level of development?

Solution to all these issues were found with the help of the "new theory of consumer

behavior", which emerged with the works of Gary S.Becker's, T.W. Schultz, G.J. Stigler, K.J.

Lancaster and others, which  appeared in the 60s of the twentieth century. They do not reject the

traditional theory, but expand the area of research using specific tools of analysis.

i Xerox(pag)

100

90

80

70

60

50

40

30

20

k

A

b

F N

v

H

0 1 2 3 4 5 6 7 8 9 10

U2

U1

M

The substiutionntuţie

Incomeeffect de venit

Total effect of price preţului

I = 30 leiPx = 6 lei

I = 21 leiPx = 3 lei

Access to Internet (our)

I = 30 leiPx = 3 lei

36

In the new approach, it is assumed that the individual does not need food, but he fels the need

to feed himself; he  needs no car, but he need to move. Thus, the needs, preferences do not

change, but changes just the way we satisfy them, together with the general progress of society. We

can satisfy the need for travel using the  bicycle, car, train, plane, etc.. In conclusion, the same need

may be satisfied by different goods consumed independently or in various combinations with

other goods. Therefore, the utility function arguments are not goods but needs. It  can be written as:

U = U (food, information, travel, etc..)

Another completion to traditional theory, studied above, is the integration in the utility

function of the opportunity cost of time. Thus, low births rates in developed countries can be

explained from the opportunity cost of time spent raising children. The rapid growth of real

incomes (after 50s) resulted in a considerable increase in the cost of time, so every hour given up for

raising children has a higher opportunity cost then the one in the past.

Another element of the "new theory" is the integration of the human capital in the analysis.

Human capital is the whole experience, knowledge and skills acquired

by individuals, which allow different degrees of satisfaction obtained by consuming a given

quantity of goods and services.

For example, the satisfaction felt by two people who are reading the book of economic theory,

one is a student at the Faculty of Economics, and the other being a high school student. Of course, to

the first individual the book provides satisfaction, preparing him for the exam, while to the

second individual the book is a source of   dissatisfaction . Different degree of satisfaction is

given to the needs, abilities, skills acquired through training of human capital.

Another aspect in consumer theory was introduced by I. Neumann and O. Morgenstern . Using

the game theory, they examined consumer behavior under uncertainty (eg, participation in gambling,

lottery), when  the consumer compares not just alternatives with the determined results but also with

casual results.

In terms of risk and uncertainty, the theory of consumer behavior remains current and

continues to develop. In the information economy the changes of preferences, of the way of

consumption, of consumers' time budget, assume a new behavior which can not be addressed

by existing instruments and principles.

37

Conclusions

1. According to the theory of consumer behaviour, within financial income (available) and

prices on the market, consumers, based on their preferences tend

to make rational choice - to achieve a higher level of satisfaction of needs.

2. Utility reflects the consumer satisfaction expected to be obtained from consumption. Satisfaction

obtained by consuming a successive amount of a good in a given period is called the total utility.

3. Marginal utility represents the change in the total utility resulting from consuming additional

unit of the given good. According to cardinal approach, consumer satisfaction deriving

from consumption of additional quantities of good decreases (I-st Law of Gossen).

4. Marginal utility theory shows that whenever purchasing goods, we assign them a greater total

value than the amount we pay in the market. This difference represents consumer surplus.

5. The consumer goal is to maximize the total utility of goods purchased by the rational distribution

of income. Optimal choice assumes equality of marginal utility to price ratios, or such an income

distribution, that each unit of money spent to purchase various goods, brings the same level of

satisfaction (II-nd Law of Gossen).

6.  In consumer behaviour analysis are used such tools as: indifference curves, budget line, and

marginal rate of substitution.

7. Consumer preferences are represented graphically by indifference curves. Indifference curve

represents alternative combinations of goods, which allow the consumer to obtain the same level

of utility.

8. The slope of the indifference curve is called the marginal rate of substitution of goods (MRS).

Marginal rate of substitution indicates the ratio of the quantity of the good, which the

consumer is willing to give up in exchange for additional quantities of other goods, ensuring the

same level of total utility.

9. Budget line shows all combinations of goods that the consumer purchases within his income and

prices on the market. The slope of the budget line is expressed by the ratio of prices (- Px/Py).

10. Graphically rational consumer choice is determined by the point where the budget line is a

tangent to an indifference curve. At this point, the budget line and indifference curve have the

same slope, or MRS equals to price ratio. That point is the equilibrium point of the consumer.

Changes in income and prices change the position of the budget line, and respectively, change

the consumer optimum.

38

11. Dependence between income and consumption program may be reflected by income-

consumption curve, and respectively by the Engel curve. Dependence between price

and consumption program is reflected in the price-consumption curve and its derivative - the

demand curve.

12. The total effect of price changes include: the income effect and substitution effect.

13.  The income effect implies that the price reduction leads to increase in consumer purchasing

power and reflects movement to a different indifference curve. Substitution effect implies

that good, whose price is reduced, substitutes other goods and corresponds to a displacement

along the same indifference curve.  Based on income and substitution effects the general law of

demand can be explained.

14. Each School of Economics has contributed to development of  the theory of consumer behavior.

Currently, cardinal and ordinal approaches are interposed. Thus, the cardinal approach involves

comparing the total utility of the different consumption programs. In its turn, the ordinal

approach of utility assesment does not exclude the posibility to sum the utility of consumption

programs in numerals sizes.

15. The theory of consumer behaviour has practical value in various aspects of consumer choice.

Basic notions

Alegerea raţională a consumatorului – rational choice of consumer Utilitate – utility Utilitate cardinală – cardinal utility Utilitate ordinală – ordinal utility Utilitate totală - total utility Utilitate marginală – marginal utility Legea utilităţii marginale descrescânde (legea I a lui Gössen) – law of diminishing of marginal

utility (the first law of Gössen) Regula maximizării utilităţii (legea a II-a a lui Gössen) – utility maximizing rule (the second

law of Gössen) Curba de indiferenţă – indifference curve Harta curbelor de indiferenţă – indifference map Rata marginală de substituire – marginal rate of substitution, MRS Linia bugetului – budget line Optimul (echilibrul) consumatorului – consumer equilibrium Curba „venit-consum” – „Income-consumption” curve Curba lui Engel – Engel curve Curba „preţ-consum” – „Price-consumption” curve Efect de venit – income effect Efect de substituţie – substitution effect Efect total de preţ – total effect of price Surplusul consumatorului – consumer surplus

39

True/False:

Total utility represents the satisfaction deriving from all units of the consumed good.

The ordinal approach is based on a quantitative assessment of the utility of a good.

The indifference curve is linear and the budget line is convex to the origin.

The consumer balance does not mean the market balance.

The demand curve of a good can be created on the base of "price-consumption" curve.

Marginal utility assumes full satisfaction obtained by consuming a certain amount of a good.

The Ist Law of Gossen states: as the quantity of a consumed good increases, its marginal utility will still increase.

The II nd Law of Gossen states: to maximize total utility, the consumer must distribute income in such a way that the utility-to-price ratio of the good to be equal.

Any change in prices leads to changes in the slope of budget line.

Consumer Equilibrium represents a state in which the consumer experiences maximum total utility in conditions of full use of income.

Multiple Choice Tests

1. The theory of consumer behavior assumes that the consumer:a) has tastes and preferences;b) has limited income;c) aims to maximize the utility when consuming some goods;d) all answers are correct.

2. Marginal utility is:a) the maximum level of utility that receives the consumer;b) the utility obtained by consuming an additional unit of the good;c) the maximum utility that can be obtained by consuming the given volume of the good;d) maximum possible utility obtained by spending some amount of money.

3. The law of diminishing marginal utility states that:a) for individuals all goods have different utility, and due to this feature they cannot be

arranged in an decreasing order of those utilities;b) initially, are required to be consumed most important goods for individuals, then all the

others;c) utility obtained from the consumption of the next portion of good is less that the one

obtained from the previous portion ; d) only the total utility can be calculated and not the margianl one.

4. An increase in consumers income graphicly is represented in:a) changes in the slope of budget line;b) parallel shift to the right of the budget line;

40

c) parallel shift to the left of the budget line;d) their is no right answer.

5. Changes in the price of one good , other things equal will cause:

a) parallel shift of the budget line;b) changes in the slope of budget line; c) no changes in the budget line;d) there is no right answer.

6. Which of the following equations represent the right relation? a) I=Px X – Py Y;b) MRSxy = - y/x; c) TU=f(U);d) TU<MU.

7. Which data regarding total utility reflects the law of decreasing marginal utility?a) 200  300  400  500;b) 200  450  750 1100;c) 200  400 1600 9600;d) 200  250  270  280; e) 200  350  450  600.

8. If the margianl utility of a good is zero, then the total utility is: a) zero; b) negativ; c) increasing; d) decreasing; e) maxim.

9. In the optimum point of the consumer:a) the slopeof the budgetline is equal to the slope of the consumption possibilities curve;b) indifference curve overlaps the budget line;c) the indifference curves intersect;d) the slopes of the budget line and indifference curve are equal.

10. If the consumer budget and the prices of goods X and Y doubles, the budget line:a. shifts to the  right;b. shifts to the left;c. remains unchanged;d. no correct answer.

Problems to solve:

1. Calculate the total and marginal utility of the good and plot the respective curves. What trends do you observe?

Consumed Quantity (Qx)

Total Utility(TUx)

Marginal Utility (MUx)

41

12345678

25--

8290--

50

-2220--0

-10-

2. Let’s assume that a student can spend 70 lei on pizza and Fanta. The price of one pizza is 20 lei, and the price of a bottle of Fanta – 10 lei.

Consumed Quantity (Qx)

Marginal Utility of Pizza (MUx)

Marginal Utility of Fanta (MUy)

1234567

10875431

6543210

Based on data presented in the table: 1) Determine the optimal consumption program of the student.2) Determine the total utility of the given consumption program.3) How the increase of students’ income with 80 lei will influence the consumption  program?

3. Total utility function of consumer for goods X and Y is represented by the equation: TU=X2Y4. The price for good X is 6 m.u., the price for good Y – 8 m.u. Consumer income is 200 m. u. What quantity of goods X and Y will buy the consumer to achieve equilibrium?

4. A consumer buys 20 units of good X and 15 units of good Y. The utility function has the following form: U = Qx 6Qy.1) Determine the total utility of the consumer.2) Calculate the marginal utilities for both goods for this situation.

5. The monthly income of a consumer is 1500 m. u. and it is used for the purchase of goods X şi Y. The prices for those goods are respectively 20 m.u. and 30 m.u. per unit. At the same time the consumer has an additional monthly income in amount of 200 m.u. which can be used exclusively for the purchase of the good X. Plot the consumers’ budget line.

6. For a consumer the total utility function has the following form: U = 2Qx 3Qy, and the budget line is described by the equation: 15Qx + 30Qy = 1200.Determine the combination of goods that maximizes the consumers’ utility.

7. Preferences of a consumer  are expressed using the following utility functions: U (x, y) = x + y, where x and y indicate the quantities consumed of two goods that make up his consumer basket.

a) Plot 3 indifference curves, for the following utility levels: 40,50, 60.b) Assuming that the consumers’ income is 50 m. u. and the price for good x is 5 m.u., and for

y - 1 m.u., plot on the same graph the budgetary constraint.

42

c) What would be the consumers’ choice?

Case study:

1. During the winter holiday season a student received a bonus in „Puma” store for the

purchase of two homogeneous goods, and another student received a gift certificate in the

amount of 1000 lei (cash). What is your opinion regarding the efficiency of the bonus and

the gift certificate according to the rational choice theory?

2. Living blocks are usually provided with gas, water, and s.o. How can be explained this

phenomenon:

According to the rational consumption?

Which laws explain the reduction in consumption of these services?

3. Show common features and differences between the map of indifference curves and a

topographic map. What unites the climber who conquers heights and a rational consumer?

4. In Chisinau, the introduction of monetary compensation for urban transport for some groups

of people (pensioners, invalids, etc..), caused dissatisfaction of some consumers. How can be

explained this situation according to rational choice theory?

5. Rational choice requires to be insured through an adequate institutional framework. Thus, in

conditions of development of modern economics, consumer and consumer's choice must be

protected. What are the causes, objectives, and domains of consumer protection?

The promotion of equal rights, economic freedom, and health protection are core values of

the European Union, reflected in its legislation. R. Moldova has also adopted „Law on

Consumer Protection 'N105-XV of 13. 03. 2003.” Based on the analyzed information,

determine the basic consumers rights and the degree of their compliance with consumer

rights in the U. E.

Analytical Tasks:

1. Analyze the structure of consumption expenditures based on the income of population of R Moldova in 2009 (Figure 4.25).

43

Figure 4.25. Structure of total consumption expenditures of householdsof R Moldova in 2009

Source: www.statistica.md

According to you:1) What factors influence the structure of expenditures?2) How to explain the low level of education expenditures?3) What explains the fact of equal level of expenditures for entertainment and alcoholic beverages?4) How the national character is reflected in consumption?

2. Using the National Bureau of Statistics data (www. Statistics. md) analyze the dynamics and structure of consumption expenditures for the past 10 years, according to respective criteria (*average per person, *by groups of quintiles, *by area of residence). Identify the trends in the development of consumption.

3. Consumption expenditures are not only differentiated between consumers, but also between nations. According to World Bank (Figure 4.26), we can confirm that in some countries, the share of food expenditure in the budget of households is significant. Does this reflect a higher level of food consumption?

44

Figure 4.26. The share of food expenditure in the budget of households (%)

Source: World Bank, World Development indicators [ www.wolrdbank.com]

Proposed themes for economic presentations and essays: The impact of electronic commerce upon consumers choice Analysis of consumer behavior under conditions of  risk and uncertainty Limitations of the traditional consumer theory and the main elements of the "new theory" Choosing gifts: the rational approach. Consumer behavior of students and its characteristics .

45