MASENO UNIVERSITY

BEC 211: INTERMEDIATE MICROECONOMICS

THEORY OF CONSUMER BEHAVIOUR

The traditional theory of demand involves the examination of the behaviour of the consumer, since
the market demand is assumed to be the summation of the demands of individual consumers.

Theories of Utility
There are two economic theories that exhibit how a person maximizes utility namely; the ordinal
and cardinal utility theory.

a) Cardinal Utility
The cardinalist school postulated that utility can be measured. Under certainty (complete
knowledge of market conditions and income levels over the planning period), some economists
have suggested that utility can be measured in monetary units, by the amount of money the
consumer is willing to sacrifice for another unit of a commodity. Others suggested the
measurement of utility in subjective units, called utils.
Assumptions
1. Rationality. The consumer is rational. He aims at the maximization of his utility subject to
the constraint imposed by his given income.
2. Cardinal utility. The utility of each commodity is measurable. Utility is a cardinal concept.
The most convenient measure is money: the utility is measured by the monetary units that
the consumer is prepared to pay for another unit of the commodity.
3. Constant marginal utility of money. This assumption is necessary if the monetary unit is
used as the measure of utility. The essential feature of a standard unit of measurement is
that it be constant. If the marginal utility of money changes as income increases (or
decreases) the measuring-rod for utility becomes like an elastic ruler, inappropriate for
measurement.
4. Diminishing marginal utility. The utility gained from successive units of a commodity
diminishes. In other words, the marginal utility of a commodity diminishes as the consumer
acquires larger quantities of it. This is the axiom of diminishing marginal utility.
5. The total utility of a 'basket of goods' depends on the quantities of the individual
commodities. If there are n commodities in the bundle with quantities  x1 , x2 .......xn  the
total utility is U  f  x1 , x2 ......xn  . In very early versions of the theory of consumer
behaviour it was assumed that the total utility is additive,
U  u1  x1   u2  x2   ..............  un  xn 
The additivity assumption was dropped in later versions of the cardinal utility theory. Additivity
implies independent utilities of the various commodities in the bundle, an assumption clearly
unrealistic, and unnecessary for the cardinal theory.

Equilibrium of the Consumer

Given a simple commodity x , The consumer can either buy x or retain his money income Y. Under
these conditions the consumer is in equilibrium when the marginal utility of x is equated to its
market price x
p 
MU x  Px
If the marginal utility of x is greater than its price, the consumer can increase his welfare by
purchasing more units of x . Similarly, if the marginal utility of x is less than its price the consumer
can increase his total satisfaction by cutting down the quantity of x and keeping more of his income
I
unspent. Therefore, he attains the maximization of his utility when mu x  px .
If there are more commodities, the condition for the equilibrium of the consumer is the equality of
the ratios of the marginal utilities of the individual commodities to their prices;
MU x MU y MU n
  .......... 
Px Py Pn

Mathematical Derivation of Consumer Equilibrium

Given utility function as
U  f  qx 
where utility is measured in monetary units.
If the consumer buys qx his expenditure will be qx px . The consumer would seek to maximize the
difference between his utility and his expenditure;
U  px q x
The necessary condition for maximum utility is that the partial derivative of the function with
respect
to qx be equal to zero. Thus

Rearranging we obtain

The utility derived from spending an additional unit of money must be the same for all
commodities. If the consumer derives greater utility from any one commodity, he can increase his
welfare by spending more on that commodity and less on the others, until the above equilibrium
condition is fulfilled.

Derivation of the Demand of the consumer

The derivation of demand is based on the axiom of diminishing marginal utility. The marginal
utility of commodity x may be depicted by a line with a negative slope (figure 2.2). Geometrically
U  f  qx 
the marginal utility of x is the slope of the total utility function . The total utility
increases, but at a decreasing rate, up to quantity x , and then starts declining (figure 2.1).
Accordingly, the marginal utility of x declines continuously, and becomes negative beyond
quantity x .
If the marginal utility is measured in monetary units the demand curve for x is identical to the
x MU1
positive segment of the marginal utility curve. At 1 the marginal utility is (figure 2.3). This
is equal to P1 by definition. Hence at P1 the consumer demands x1 quantity (figure 2.4). Similarly,
x MU 2 P P x
at 2 the marginal utility is , which is equal to 2 . Hence at 2 , the consumer will buy 2 ,
and so on.

Critique of the cardinal approach

The following are the basic weaknesses in the cardinalist approach;
First, the very first assumption of cardinal utility approach that utility is cardinally (or objectively)
measurable is untenable. Utility is a subjective concept which cannot be measured objectively or
quantifiably.
Secondly, cardinal utility approach assumes that MU of money remains constant and serves as a
measure of utility. This assumption is unrealistic because the MU of money, like that of all other
goods, is subject to change. And, therefore, it cannot serve as a measure of utility derived from
goods and services.
Thirdly, the psychological law of diminishing MU has been established from introspection. This
law is accepted as an axiom without empirical verification.
Fourthly, cardinal utility approach and derivation of demand curve on the basis of this approach
are based on the ceteris paribus assumption which is unrealistic. It is for this reason that this theory
ignores the substitution and income effects which might operate simultaneously.
Finally, cardinal approach considers that the effect of price changes on demand curve is
exclusively price effect. This assumption is also unrealistic because price effect may include
income and substitution effects also.

b) Ordinal Utility
The ordinalist school postulated that utility is not measurable, but is an ordinal magnitude. The
consumer need not know in specific units the utility of various commodities to make his choice. It
suffices for him to be able to rank the various 'baskets of goods' according to the satisfaction that
each bundle gives him. He must be able to determine his order of preference among the different
bundles of goods. The main ordinal theories are the indifference-curves approach and the revealed
preference hypothesis.

Indifference Curve Approach

Indifference curves. An indifference curve is the locus of points- particular combinations or
bundles of goods-which yield the same utility (level of satisfaction) to the consumer, so that he is
indifferent as to the particular combination he consumes.

An indifference map shows all the indifference curves which rank the preferences of the
consumer. Combinations of goods situated on an indifference curve yield the same utility.
Combinations of goods lying on a higher indifference curve yield higher level of satisfaction and
are preferred. Combinations of goods on a lower indifference curve yield a lower utility.

Assumptions
i). Rationality. The consumer is assumed to be rational- he aims at the maximization of his
utility, given his income and market prices. It is assumed he has full knowledge (certainty)
of all relevant information.
ii). Utility is ordinal. It is taken as axiomatically true that the consumer can rank his
preferences (order the various 'baskets of goods') according to the satisfaction of each
basket. He need not know precisely the amount of satisfaction. It suffices that he expresses
his preference for the various bundles of commodities. It is not necessary to assume that
utility is cardinally measurable. Only ordinal measurement is required.
iii). Diminishing marginal rate of substitution. Preferences are ranked in terms of indifference
curves, which are assumed to be convex to the origin. This implies that the slope of the
indifference curves increases. The slope of the indifference curve is called the marginal
rate of substitution of the commodities. The indifference-curve theory is based, thus, on
the axiom of diminishing marginal rate of substitution.
iv). The total utility of the consumer depends on the quantities of the commodities
consumed

v). Consistency and transitivity of choice. It is assumed that the consumer is consistent in his
choice, that is, if in one period he chooses bundle A over B, he will not choose B over A in
another period if both bundles are available to him. The consistency assumption may be
symbolically written as follows:
 Similarly, it is assumed that consumer's choices are characterized by transitivity: if bundle
A is preferred to B, and B is preferred to C, then bundle A, is preferred to C. Symbolically
we may write the transitivity assumption as follows:

vi). Non-Satiety. Non-satiety means that consumers have not reached the point of saturation in
the case of a commodity and they are not oversupplied with the goods in question.
Therefore, a consumer always prefers a larger quantity of all the goods

Properties of Indifference Curves

1. Higher indifference curves are preferred to lower ones, since more is preferred to less (non-
satiation). A higher indifference curve that lies above and to the right of another
indifference curve represents a higher level of satisfaction and combination on a lower
indifference curve yields a lower satisfaction.
2. Indifference curves are downward sloping. If the quantity of one’s goods is reduced, then
you must have more of the other good to make up for the loss. The indifference curves
must slope down from left to right. This means that an indifference curve is negatively
sloped.
3. Indifference curves do not cross (intersect), since this would imply a contradiction. Given
the definition of indifference curve and the assumptions behind it, the indifference curves
cannot intersect each other. It is because at the point of tangency, the higher curve will give
as much as of the two commodities as is given by the lower indifference curve.
4. Indifference curves are bowed inward (in most cases). The slopes of indifference curves
represent the MRS (rate at which consumers are willing to substitute one good for the
other). They are convex to the origin (bowed inward). This is equivalent to saying that as
the consumer substitutes commodity X for commodity Y, the marginal rate of substitution
diminishes of X for Y along an indifference curve. People are usually willing to trade away
more of one good when they have a lot of it, and less willing to trade away goods, which
are in scarce supply. This implies that MRS must increase as we get less of a good.
5. One of the basic assumptions of indifference curves is that the consumer buys combinations
of different commodities. He is not supposed to buy only one commodity.
6. Perfect substitutes have straight-line indifference curves. As we get more of the good, we
trade off with the substitute at a constant rate because we are indifferent between them (i.e.,
Coke and Pepsi). Perfect complements have right-angled indifference curves. If goods can
only be used together, there is no satisfaction in having more of A without additional
amounts of B (i.e., left and right shoe). In general, the better substitutes goods are, the
straighter the indifference.

Indifference Maps
A set of indifference curves constitute the indifference map.
An indifference curve shows various combinations of two goods or services which yield the same
level of satisfaction or total utility to a particular consumer. For each level of satisfaction there will
be a unique indifference curve, showing the various combinations which yield that particular level
of satisfaction to the consumer. In principle it is therefore possible to draw an infinite number of
indifference curves for any consumer’s choice between two goods. Such a collection of
indifference curves is called an indifference map.

OTHER TYPES OF INDIFFERENCE CURVES

The other types of consumer goods are classified under the following two categories;
 Perfect substitutes
 Complementary goods

i). Perfect Substitutes

Generally, two goods are considered perfect substitutes for one another when the utility derived
from either of the goods is the same. For example, wheat and rice, tea and coffee, electricity and
cooking gas for the kitchen, petrol and diesel, and so on are perfect substitutes for some, if not for
all, consumers. In the case of two goods (X and Y) being perfect substitutes for one another, the
MRS between them (i.e., ΔX/ΔY and ΔY/ΔX) remains constant and the indifference curve assumes
the shape of a straight line, as shown by the line MN in the Figure below;

Complementary goods
The indifference curve for complementary goods takes the shape of a right triangle or an L-shape
as illustrated in the Figure below.

The indifference curve has a sharp convexity only at one point, giving it a rectangular shape. The
rectangular shape of the indifference curve implies that an increase in the quantity of X without an
increase in the quantity of Y (or an increase in the quantity of Y without any addition to the quantity
of X) leaves the consumer at the same level of satisfaction. It means that an additional quantity of
one commodity without a corresponding increase in the quantity of the other does not yield
additional satisfaction.

GOODS, BADS AND NEUTERS

Bads are the things that yield disutility to the people, for example, environmental pollution, water
pollution, noise pollution, adulterated commodities, unhygienic sanitation, industrial toxins,
atomic radiation, passive smoking and social insecurity. Because bads give negative utility to the
people, less of bads is always preferable to having more of them. Some ‘bads’ are produced directly
for a profit motive and are consumed willingly e.g., cigarettes and drugs. However, most bads are
by-products of goods e.g., environmental pollution is the by-product of industrial production; air
pollution is the by-product of thermoelectricity; air and noise pollution are the by-products of
transportation facilities in the city; the growth of slums and slum-borne diseases are the by-
products of industrial growth; risk and return in the choice of asset portfolio; and so on. Most bads
are associated with some goods.
Goods turn into bads when they begin to yield disutility beyond a certain level of consumption i.e.,
goods become bads when they begin to yield negative marginal utility. This happens in the case
of almost all normal consumer goods. For example, food is good but eating food beyond a limit is
bad because it is dangerous for health.

Neuters are the things that yield neither utility nor disutility to their consumers e.g., old furniture
and paintings, old newspapers etc. Objects whose disutility cancels out their utility also fall in this
category. The neuters may turn bads beyond a certain level.
While there are definitely certain goods, bads and neuters, some goods may turn neuters and then
bads, beyond a certain level of consumption and with a change in consumers’ tastes and
preferences.

Indifference Maps for Goods, Bads and Neuters

Indifference Map for a Good and a Bad - more of a good is always preferable to less of it
and less of bad is always preferable to more of it. Therefore, if people have the option, they will
opt for all goods and no bads. However, consuming some bad is often unavoidable. Therefore,
people combine the unavoidable minimum of bad and any amount of good they can afford.
In this case, an indifference curve will be a straight line - vertical or horizontal.

Indifference Curve for a Good and a Good-Turning-Bad

Certain goods remain goods for any level of consumption, such as money, gold, jewellery, house,
car etc.
In general, however, most consumer goods retain the property of being a good only up to a certain
point, i.e., the point of satiety.
Beyond the point of satiety, such goods become bads if consumed or are forced to be consumed
beyond that level e.g., eatables and drinks, such as, ice cream, fruits, sweets, tea, coffee, etc.
These are all goods. However, eating or drinking these things beyond the point of satiety results
in discomfort or displeasure. They become bads as they begin to yield disutility.
This also applies to clothes and other consumer durables. Such goods create a storage problem,
occupy space and involve cost of maintenance. This is their disutility. Therefore, beyond the point
of satiety, lesser amounts of such goods are preferable to more of them. However, if one has to
consume more of a bad, then a much larger quantity of good will be required to offset the disutility
of the bad. In such cases, the indifference curve takes the shape of a bowl.
Indifference Curves for a Good and a Neuter
A neuter is a commodity that gives neither utility nor disutility. The consumer is, therefore,
indifferent to the level of its consumption. In the figure below, the commodity X is a neuter and
commodity Y is a normal good. Whatever the consumption level of Y, the consumers do not care
whether they have more or less of the commodity X, the neuter. In this case, the indifference curve
takes the form of a straight horizontal line.

Budget Constraint
The budget constraint defines the set of baskets that a consumer can purchase with a limited
amount of income. The budget line indicates all of the combinations of food (x) and clothing (y)
that can be purchased if he spends all of his available income on the two goods.
The consumer has a given income which sets limits to his maximizing behaviour. Income acts as
a constraint in the attempt for maximizing utility. The income constraint, in the case of two
commodities, may be written

We may present the income constraint graphically by the budget line, whose equation is derived
from by solving for q y :
Assigning successive values to qx (given the income, Y and the commodity prices, Px , Py we may
find the corresponding values of q ,. Thus, if qx  0 (that is, if the consumer spends all his income
on y ) the consumer can buy Y P units of y . Similarly, if q  0 (that is, if the consumer spends
y y

all his income on x ) the consumer can buy Y Px units of x . These results are shown by points A
and B. If we join these points with a line, we obtain the budget line, whose slope is the ratio of the
prices of the two commodities. Geometrically the slope of the budget line is;

Mathematically the slope of the budget line is the derivative

Equilibrium of the consumer

To define the equilibrium of the consumer (i.e., his choice of the bundle that maximizes his utility)
the concept of indifference curves and of their slope (the marginal rate of substitution), and the
concept of the budget line are introduced. These are the basic tools of the indifference curves
approach.
According to the ordinal utility approach, two conditions must be satisfied for the consumer to be
in equilibrium. These are;
i. necessary or first-order conditions
ii. supplementary or second-order condition.

The negative of the slope of an indifference curve at any one point is called the marginal rate of
substitution of the two commodities, x and y, and is given by the slope of the tangent at that point:

It is assumed that the commodities y and x can substitute one another.

The marginal rate of substitution of x for y is defined as the number of units of commodity y that
must be given up in exchange for an extra unit of commodity x so that the consumer maintains the
same level of satisfaction.

Symbolically an indifference curve is given by the equation;

where k is a constant.
The concept of marginal utility is implicit in the definition of the MRS, since it can be proved that
the marginal rate of substitution (the slope of the indifference curve) is equal to the ratio of the
marginal utilities of the commodities involved in the utility function:

The necessary condition for maximum utility requires that the MRS must be equal to the price
ratio. Considering a two-commodity model, the necessary condition may be expressed as:

Graphical presentation of the equilibrium of the consumer

Given the indifference map of the consumer and his budget line, the equilibrium is defined by the
point of tangency of the budget line with the highest possible indifference curve (point e in the
graph below);

The indifference curves IC1 , IC2 and IC3 represent a hypothetical indifference map of a consumer
and the corresponding budget line is given by the line AB. The budget line AB is tangential to IC2
at point E. This point fulfils both the necessary and the supplementary conditions. At point E, the
slopes of the indifference curve IC2 and the budget line AB are equal. This fulfils the first-order
condition.
The slope of an indifference curve is on the other hand given by:

The slope of the budget line is given by;

Py
Point E marks the consumer’s equilibrium because at point E, MRS y , x  . This satisfies the
Px
necessary condition. Therefore, the consumer is in equilibrium at point E. The tangency of IC2
with reference to the budget line, AB, indicates that IC2 is the highest possible indifference curve
that the consumer can reach, given their budgetary constraint. Point E satisfies, therefore, also the
second-order condition. At the equilibrium point E, the consumer consumes OQx of X and OQy of
Y, which yield the maximum satisfaction for the consumer, given the constraints.

At the point of tangency, the slopes of the budget line  Px Py  and of the indifference curve

 MRS x, y  MU x MU y  are equal:

The second-order condition is implied by the convex shape of the indifference curves. The
consumer maximizes his utility by buying Qx and Qy of the two commodities.
The second-order or supplementary condition requires that the necessary condition must be
fulfilled at the highest possible indifference curve. Consumers attain their equilibrium at a point
where both these conditions are satisfied.