Understanding how and why consumers behave the way they do in markets

1. 1
Consumer Theory

2. 2
What is Consumer Theory?
 Helps to understand the behaviour of individual customers.
How they decide which combination of goods and services
they should buy and in what quantity to maximise their
satisfaction.
Satisfaction has a name : UTILITY
Assumes that consumers are rational. Rational consumers
want to maximise utility, given budget constraints.
Is irrational buying possible?

3. 3
Consumer Theory - Why?
– to understand the foundations of market
demand
– These theories explain the story behind
the downward sloping demand curve

4. 4
Theories of Consumer Choice
The Cardinal Theory
– Utility is measurable in a cardinal sense
The Ordinal Theory
– Utility is measurable in an ordinal sense

5. 5
The Cardinal Approach:
Features
 Utility is the want satisfying ability of a
commodity
 Concept introduced by Alfred Marshal,
Jeremy Bentham
 Measured in “utils”

6. 6
Total utility
Total utility : sum of utility derived from
consumption
Marginal utility: rate of change of TU
from one more unit of extra
consumption.
MUn = TUn – TUn-1
MU= Δ TU/ Δ Q

7. 7
Understanding TU and MU
Unit of
mango
Total
utility
MU
1 10 10
2 20 10
3 29 9
4 37 8
5 43 6
6 48 5
7 51 3
8 52 1
9 52 0
10 50 -2

8. 8
Assumptions of Cardinal
Utility Analysis:
Rationality of consumer
Cardinal measurability of utility
MU of money is constant
Diminishing marginal utility
Utility is additive – TUn = Ux + Uy +
Uz+…. + Un

9. 9
LDMU: Carl Menger 1840
Irrefutably true.
The additional utility that a person
derives by consuming an extra unit of a
commodity diminishes, TU increases at
a decreasing rate.

10. 10
TU
No. of
mangoes
Max TU= saturation point
TU curve
No. of
mangoes
MU
MU curve
When TU = max, MU =0

11. 11
Applying The LDMU
LDMU is the basis of the downward
sloping demand curve.
The idea :
As consumer’s consume more of the
same commodity , they like less of it
and so will be willing to pay only a lower
price.

12. 12
Applying the LDMU : 2 good
case
Consumer rationally allocates his limited income
using the Law of equi-marginal utility which is :
Condition for utility maximisation=> decision
making rule for all rational consumers
MUx/ Px = MUy/ Py = MU m…. In a two commodity
world.
MUm = MU of money which is a constant.

13. 13
An example: Consumer
Equilibrium
Apple MUa Mua/Pa Banana MUb MUb/Pb
1 60 1 60
2 48 2 55
3 42 3 50
4 36 4 45
5 30 5 40
6 24 6 35
7 18 7 20
Pa= Rs3 Pb = Rs5
MU m = 10

14. 14
Criticisms:
Utility is not cardinally measurable
MU of money is not constant
Doesn’t explain inferior goods/ giffen
goods
Failure to distinguish between income
effects and substitution effects.

15. 15
Practical implications of
LDMU
What would happen if we had only one company
producing only one good of it’s kind?
Diversification in Production:
to overcome the resistance of the consumers and in
order to secure higher profits, the producers
continuously introduce newer varieties of the
products with new design, shape, color, technique
and presentation.

16. 16
Practical Implications for
LDMU
Basis for Progressive Taxation
As the rich have lower marginal utility of money as
compared to the poor people due to greater stock of
money, they should be taxed at a higher rate.
Household Expenditure: This law governs our daily
expenditure. Since larger purchases reduce marginal
utility, we restrict the purchase of a particular
commodity, as we cannot afford to waste our limited
resources.

17. 17
Ordinal Theory:
The actual level of utility generated from the consumption of a
good is irrelevant.
Consumers consume goods in bundles.
Only the ranking of preferences is important. The consumer will
try to reach equilibrium ,i.e. the most preferred commodity
bundle subject to his budget constraint.
This theory uses Indifference curves as a tool of analysis

18. 18
Ordinal Utility theory :
Assumptions
Consumer is rational.
Consumer Preferences are based on utility.
Consumer is clearly able to rank his preferences.
Among two bundles, the one with the higher utility is
the preferred bundle… More is better than less.
If two bundles have the same utility, we say that the
consumer is indifferent.
Preferences are transitive. If bundle A> bundle B and
bundle B > Bundle C then A>C.

19. 19
Indifference Curves
Is a contour of all combinations of two goods
among which the consumer is indifferent
The set of all indifference curves that describe
an individual’s preferences are referred to as
an indifference curve map.
An indifference curve connects all of the
bundles that a consumer likes equally.
We will assume only two goods when using
indifference curve analysis.

20. 20
Indifference Curve Map -
Properties
An indifference curve should not slope
up.
Indifference curves can not cross one
another.
Better bundles are to the northeast.
Indifference curves will not be “bowed
out.”

21. 21
Li’s Preferences in
Indifference Curves
An indifference curve connects
all the bundles that have the
same utility.
Higher indifference curves
indicate more utility (IC2 is
preferred to IC1).
Lower indifference curves
indicate less utility (IC1 is
preferred to IC0).
The indifference curve map is
FULL of indifference curves.
Li's Indifference Curves
0
5
10
15
20
25
30
0 10 20
Wheat
Rice
I2
I1
I0

22. 22
The Marginal Rate of
Substitution
The Marginal Rate of
Substitution(MRS) tells us
how much of one good Li
would willingly trade for an
incremental unit of the other
good and remain indifferent.
The MRS=|slope| of the
indifference curve at a
bundle.
Common to assume the MRS
declines as we move down
an indifference curve.
Li's Indifference Curves
0
5
10
15
20
25
30
0 10 20
Wheat
Rice
I2
I1
I0

23. 23
What is a Budget Constraint?
A budget constraint is a straight line
which shows all combinations of two
goods that the consumer can buy with
his given income.

24. 24
Example : Li’s Demand for
Wheat and Rice
Li’s demand for wheat and rice depends
upon the prices for these goods, her
income, and her preferences.
Suppose we look first at her budget
constraint:
– Wheat costs Rs 4/kg.
– Rice costs Rs2/kg.
-- Leena has Rs 40 of income.

25. 25
Li’s Budget Constraint
The mathematical expression for Li’s budget
constraint is:
I = PW W + PR R
R = I/PR - (PW / PR)W
the |slope| of the budget line is called the
MRS=Marginal Rate of Substitution
In this case it is PW / PR
For Li : PW=Rs4 PR=Rs2 I=Rs40 MRS=2
Try to construct the budget line!!

26. 26
Budget Line gymnastics
An increase in income only.
An increase in the price of wheat only.
A decrease in the price of rice only.
Income doubles as do the prices of wheat and
rice.
Note: Changes in the price of wheat relative to
the price of rice will change the MRS.

27. 27
How Much Wheat and Rice
Li’s optimal amount of wheat and rice to
consume is the amount that maximizes Li’s
utility subject to her budget constraint.
In the graph...
– Get to the highest indifference curve possible
– Stay on the budget constraint (b/c more is
better)

28. 28
How to Find Li’s Best
Combination
Wheat
Rice
20
10
IC0
IC1
IC2
W*
R*
The black bundle is best.
The pink bundle is not the
best. Li has spent all her
income but is not on the
highest indifference curve
possible.
Bundles n/e of IC0 are
better and some are
affordable.
At (W*, R*) she is doing the
best she can subject to her
budget constraint.

29. 29
How to Find the Best
Combination
Utility is maximized when:
– the indifference curve is just tangent to the budget
line.
Utility is maximized when:
– you are on the budget line and
– the slope of the indifference curve equals the
slope of the budget line

30. 30
The “bang per buck” story
Let MUW = Li’s marginal utility of wheat
– it measures the change in utility as we change wheat
consumption by an incremental unit while holding rice
constant
Let MUR = Li’s marginal utility of rice
– it measures the change in utility as we change rice
consumption by an incremental unit while holding
wheat constant
Common to assume that marginal utilities decline
as we increase consumption - the law of
diminishing marginal utility

31. 31
The “bang per buck” story
The MRS = MUW / MUR
The ERS = PW / PR
At an optimal bundle: MRS=ERS
Rewritten we have:
» MUW / MUR = PW / PR
» MUW/PW = MUR/PR
» bang/buck in wheat = bang/buck in rice

32. 32
Handling a change in PW
Li wants to achieve the
highest indifference curve
that the budget constraints
permit.
The points A, B, and C
represents the best that Li
can do at prices of $4, $2,
and $1 for wheat.
The equation MRS=ERS is
satisfied at each of the
points.
Li's Demand for Wheat
0
5
10
15
20
25
30
0 5 10 15 20
Wheat
Rice
I2
I1
I0
4
2
1
C
B
A

33. 33
Li’s Demand for Wheat
The table shows the
amount of wheat
that Li demands at
each price.
These are the points
of tangency from the
previous slide.
Quantity Price Point
6 4 A
10 2 B
16 1 C
Li's Demand for Wheat

34. 34
Graph of Li’s Demand for
Wheat
When we connect the
points from the table in
the previous slide we
get Li’s demand for
wheat.
The points A, B, and C
correspond to the
tangencies of the
budget constraint and
the indifference curves.
Li's Demand for Wheat
0
1
2
3
4
0 2 4 6 8 10 12 14 16 18 20
Quantity
Price
A
B
C

35. 35
Li’s Best Choice
Reconsidered
Consider the choice at PW=Rs 2/ kg.
The point B is optimal.
The point A is feasible but inferior to
all points on the red budget line
between E and F.
The point C is preferred to B but
cannot be purchased with Li’s $40
income at the given prices; it is
above the red budget line.
The point E is feasible but Li prefers
more wheat and less rice (B).
The point F is feasible but Li prefers
less wheat and more rice (B, again).
There is no combination that Li
prefers to B that she is able to buy.
Li's Best Choice of Wheat and Rice
0
5
10
15
20
25
30
0 5 10 15 20
Wheat
Rice
I2
I1
I0
2
A
E
F
B
C

36. 36
Handling a change in PW
Li wants to achieve the
highest indifference curve
that the budget constraints
permit.
The points A, B, and C
represents the best that Li
can do at prices of $4, $2,
and $1 for wheat.
The equation MRS=ERS is
satisfied at each of the
points.
Li's Demand for Wheat
0
5
10
15
20
25
30
0 5 10 15 20
Wheat
Rice
I2
I1
I0
4
2
1
C
B
A

37. 37
Li’s Demand for Wheat
The table shows the
amount of wheat
that Li demands at
each price.
These are the points
of tangency from the
previous slide.
Quantity Price Point
6 4 A
10 2 B
16 1 C
Li's Demand for Wheat

38. 38
Graph of Li’s Demand for
Wheat
When we connect the
points from the table in
the previous slide we
get Li’s demand for
wheat.
The points A, B, and C
correspond to the
tangencies of the
budget constraint and
the indifference curves.
Li's Demand for Wheat
0
1
2
3
4
0 2 4 6 8 10 12 14 16 18 20
Quantity
Price
A
B
C

39. 39
Income and Substitution Effects:
Price Decline, “X” normal
When the price of a good falls, the quantity
demanded rises for two reasons.
The income effect: real income is higher because the
same money income buys more at the lower prices.
For normal goods, then, the income effect of a price
fall is positive.
The substitution effect: consumers substitute the now
cheaper good for ones whose price has not fallen,
real income held constant. This increase in demand
is called the substitution effect of a price decline.

40. 40
General effect of a price fall
Income effect - you feel richer
“X” normal
Substitution Effect
X now looks relatively cheaper
PX falls
Quantity demanded increases Quantity demanded increasesQuantity demanded decreases
Total effect is the substitution effect AND the income effect
working at the same time.
“X” inferior