CONSUMER BEHAVIOUR

Reasons why demand curves slope down from left to right

a) Diminishing Marginal Utility
b) Income and Substitution Effects (Indifference Curves and Budget Lines)

Theory of Consumer Behaviour/ Consumer Equilibrium:

1. Marginal Utility Theory and Equi-marginal Principle (both are Cardinal measures)
2. Budget lines and Indifference Curves (Ordinal Measures)

CARDINAL MEASURES
 Assumptions/ constraints for reaching consumers equilibrium:
a) Utility can be measured in ‘Utils’.
b) Consumers aim to maximize total utility.
c) Rational consumer
d) Limited income
e) A given set of prices
f) Constant tastes
g) Continuous use of the commodity
h) Similar units of commodity in use
i) Marginal Utility (MU) of Money is constant
j) Price of substitutes remains unchanged
k) Does not apply to antiques or rare collection

Law of Diminishing Marginal Utility(LDMU) / Marginal Utility Theory

 Utility: another word for satisfaction. The pleasure or satisfaction derived by an individual from being
in a particular situation or from consuming goods or services.
 Marginal Utility (MU): is the extra satisfaction gained from consuming another unit of the good or
service.
MU = ∆TU = TUn-TUn-1
∆Q Qn-Qn-1

 Total Utility(TU): is the total satisfaction gained from consuming a given number of goods and
services. (Does not rise in line with quantity purchased).
TU = MU1+ MU2 + MU3+… MUn
 Law of Diminishing Marginal Utility (DMU, MU): a principle which states that as an individual
consumes a greater quantity of a product in a particular time period, the extra satisfaction (marginal
utility) derived from each additional unit will progressively fall as the individual becomes satisfied
with product. Eg. consumption of chocolate. (states that successive units of consumption will
eventually lead to a fall in their marginal utility).
OR
When a consumer continuously uses a commodity, the total utility derived from the consumption
rises with a decreasing rate.
 As consumption keeps increasing, MU can become negative indicating dissatisfaction or disutility.
 When MU becomes negative, TU falls.
  Example:
No. of cups of tea Total Utility Marginal Utility
1 80 80
2 150 70
3 210 60
4 250 40
5 275 25
6 280 5
7 280 0
8 278 -2

Downward Sloping demand curves and DMU: the demand curve is downward sloping because of the law
of diminishing marginal utility. Each extra unit of a good or service will eventually give less satisfaction
(utility); therefore the consumer will only be willing to pay less for more goods.

Note: although consumer gets less satisfaction from each additional unit, his/ her total satisfaction is rising.

Diagram:

 Relationship between TU and MU

When MU is positive TU rises
When MU = O TU maximum
When MU = negative TU falls
 Consumer Equilibrium given a single good: a rational consumer who compares the relative costs and
benefits of a decision to attain the maximum utility will consumer where MU = P for a single product.

MU/ MU
Price
When MU > P, consumption increases
When MU < P, consumption decreases
Hence rational consumer is in
MU
>P equilibrium where MU = P
P
MU
<P

Quantity
MU/
Price
If Price falls from P1 to P2, then at the
original price P1, MU > P, and
P1 consumption should increase.
MU
>P
If Price increases from P2 to P1, then
P2 consumption decreases to reach a new
equilibrium for MU= P
MU
Hence inverse relationship between Price
and MU, which is what is shown in a
Quantity demand curve as well

 Demand curve for a product is the same as its MU curve, measured in money terms, given a constant
MU of Money. This is based on the assumption that consumers are rational and do not consume when
MU falls to zero, hence demand curve is shown as
MU/ Price

Quantity
 Negative MU = Dis-utility or dissatisfaction.
 Price measures the sacrifice (other things that might have been obtained with the money).
 By assuming the sacrifice reflects utility, it is possible to obtain demand curve.
 Since MU diminishes, consumers are tempted to buy more of a product only if its price is lowered.
 As individuals derive different levels of satisfaction, hence have different individual demand curves.
 Market Demand Curve: the horizontal summation of individuals’ demand curves.

Limitations of LDMU
  Tastes of consumers can change
 Incomes can change
 Not possible to measure utility in absolute terms
 Only a single good model [MU=P]

Consumers’ maximising behaviour (equilibrium)/ Maximizing Utility/ Equi-marginal Principle/ Law

of equi-marginal Utility:
 Also called the ‘Classical law of substitution’.
 Definition: consumers should distribute their expenditures among all available commodities until the
last penny spent on each commodity yields the same marginal utility.
 Example: if the last penny spent on ice creams yielded more utility than the last penny spent on
apples, then total utility could be increased by transferring a penny of expenditure from apples to ice
creams.
 Consumers will buy more of a commodity as long as the MU gained from the extra unit is greater
than the price paid.
 To maximize utility consumers will consume up to the point where they equate the marginal utility
over its price (or any other unit of money) they spend on the goods they buy:

MUA = MUB = MUC = …….. = MUN

PA PB PC PN

Where P = Price
MU = Marginal utility
A, B, C and N = individual products

Can also express as MUA = PA

MUB PB

 This is known as the Equi- Marginal Principle/ Condition.

 Means that the extra satisfaction per £ on the last unit of good A equals the extra satisfaction per £ on
the last unit of good B and that of C and D and so on. If it were not so, consumers would re-organize
their spending and increase their satisfaction. Eg. if the last A per £ was more satisfying than the last
B, consumers would buy more A’s and fewer B’s. Cannot have more of both as constrained by
income. (principle of substitution)
 Consumers fixed income and fixed prices of the goods they purchase are given by the budget
constraint :
APA + BPB + CPC+……. = I
Where A = Quantity of A consumed and so on
Pn = Price of good n (given n= A, B, C and so on)
I = Income of consumer

Example 1: given fixed prices and fixed income

I = 24
PA= 2 MUA= 32 A= 5
PB = 1 MUB = 16 B = 14
Applying Constraint: (5x2) + (14x1) = 24 = I
Applying Equi- marginal principle: 32/2 = 16/1 Consumer is in equilibrium
At any other level of MU, Quantity (A etc) change till equilibrium established once again.
Example 2:
Given Pa = $4; Pb = $3 and Income = $31
MUa/Pa Mua Units MUb MUb /Pb
11/4= 2.75 11 1 18 18/3=6
10/4=2.5 10 2 15 15/3=5
9/4=2.25 9 3 12 12/3=4
8/4=2 8 4 9 9/3=3
7/4=1.75 7 5 6 6/3=2
6/4=1.5 6 6 3 3/3=1

Applying Income Constraint:

Pa (Qa) + Pb (Qb) = 31
4 (4 ) + 3 (5) =31
16 + 15 =31
Hence consumer is in equilibrium when he consumes 4 units of Product A and 5 units of Product B. Here
MU/P is same for both products. It is not possible for the consumer with an income of $31 to obtain a
higher level of total utility.

Marginal Utility and changes in prices

 MU explains why a change in price causes a change in a person’s spending patterns.
 Example from Stanlake
Steak Trout Ratios: 12/6 for steak
Q=6 Q=4 and 8/4 for trout
P 1= £6 each P1 = £4 each
MU = 12 MU = 8
P2 = £8 each
Result: with P2: MU per £ spent on steak falls, Buy more trout.
As continues….MU from steak starts to rise till once again, and MU from trout starts to fall until MU per
£ spent on both is equal. (New Ratios: 14/8 for steak and 7/4 for trout). Substitute till marginal utility to
price ratios are equal.
 To summarise: consumers change the consumption of products when their prices change, until they
reach the point where the marginal utility to price ratio is equal for all products. This transition to a
new equilibrium gives a downward sloping demand curve. (For instance, in the above when the price
increases for steak, consumers consume less of it as the marginal utility per £ spent on steak falls, and
consumers substitute with the other good till equilibrium is established once again with new ratios.
Consumers’ change consumption depending on the marginal utility, while using all of their income.
Overall an inverse relationship with the price).
Law of Equi-marginal utility and the Demand Curve:

P
Pa X (MUa = MUb)
Pa Pb

Pa′ Y (MUa′ = MUb′)

Pa′ Pb

Qty

 If Pa↓, since MUa ; the Qd ↑ for product ‘a’. This causes MUa↓ as the consumption
Pa
increases while lower consumption of ‘b’ causes MUb↑. Process continues till a new
 equilibrium is reached at Y (MUa′ = MUb′) where the last dollar spent on each good gives the same
Pa′ Pb
utility.
This give the demand curve for Product ‘a’.
Market demand curve: horizontal summation of individual demand curves.

Limitations of Law of Equi-marginal utility

 Difficult to measure utility
 In reality, not easy to arrive at MU and prices and their equilization
 The law fails to consider factors such as customs, traditions etc, which also influence the consumers’
purchase.
 Consumers might be lacking knowledge of substitutes available.
 MU of durables is not possible to assess.
 Impulsive buying like ‘buy one get one free’, leads to irrational behaviour by the consumer
 Where payment can be deferred eg. Use of a credit card allowing consumers to purchase beyond their
ability to pay.
 Emotional attachment to a brand, or prejudice against a brand.
 Role of advertising
 Incomes change

Past Paper Questions

Q.

Answer = A
Q.

Answer = B

Q.

Answer = B
Paradox of Value
 Definition: the proposition that the value (price) of a good is determined by its relative scarcity rather
than by its usefulness. Water is extremely useful and its total utility is high, but because it is generally
so abundant, its marginal utility (and hence, price) is low. Diamonds, by contrast, are much less
useful than water but their great scarcity makes their marginal utility (and hence price) high. Hence
people are willing to pay more for diamonds.
 Marginal utility for diamonds is high (as few of them available) but their total utility is quite low.
 Marginal utility for water is low (abundant) but its total utility is high.
ORDINAL MEASURES

Assumptions:
 Does not require consumers to measure utility in absolute terms
 Consumers can simply state their ‘order’ of preference but cannot tell exactly how much is the
satisfaction being obtained.
 The consumer can make comparisons in order to substitute between the goods.
 Consumer will always prefer more to less, which maximises their utility.
Budget Lines
 Budget Lines: also called Consumption Possibility Line: a line showing alternative combinations of
goods that can be purchased by a consumer with a given income and fixed prices.
 Any point along the line shows an outcome where consumption is maximised for that particular level
of income.
 Points within the budget line are achievable but the consumer can afford more, while those outside
are not. Any point on the budget line is affordable for the consumer and utilises his total income.
 Downward sloping showing buying more of one product requires buying less of the other.
 The slope of the budget line reflects the relative price of any good i.e. price in terms of the other
good, its opportunity cost. It shows how much of one good must be given up to attain more of the
other.
 Money Income divided by price of the good gives the particular intercept showing the amount
purchased.
 Budget lines shows the real income of the consumer i.e the purchasing power (how much the
consumer can buy given his fixed money income and prices of the products).

Shifts in the Budget Line

 The budget line shifts if money income changes or price of the product/ products change. (the ceteris
paribus assumptions change)
 Budget line undergoes a shift inward (decrease in income as shown below). An increase in income
would cause an outward shift.

Product A

BL2 BL1
Product B
  If change in price for one product, with constant income then budget line pivots as seen in the
diagram below. Price decreases for Product B in the first diagram and Product A in the second
diagram.
→Pivotal Shift Real income ( i.e. the purchasing power)
has increased as now can buy more with
the same fixed income.
Product B has become relatively cheaper
and Product A has become relatively more
expensive.
Product A
The slope has changed: relative prices
have changed i.e. the price of a product
expressed in terms of the other product
(its opportunity cost)

BL1 BL2
Product B

BL1

BL2

Product A

Product B

 If change in price for both products

→ Parallel shift. Eg. price increases for both products as seen in the diagram below.

Real income ( i.e. the purchasing

power) has decreased as now can
buy less with the same fixed
income.
Relative prices have remained the
Product A same i.e. the price of a product
expressed in terms of the other
product (its opportunity cost). The
price ratios have not changed.
Price for both products fell by the
same proportion.
BL2 BL1
Product B
 → Non – parallel shift
Real income ( i.e. the purchasing
power) has decreased as now can
buy less with the same fixed
income.
Product A Relative prices have changed i.e.
the price of a product expressed in
terms of the other product (its
opportunity cost ratios). The price
ratios have changed.
Product A became relatively
cheaper as compared to Product B
BL2 BL1
Product B

→Intersecting shift
Real income ( i.e. the purchasing
power) remains uncertain as can
buy more of Product A but less of
Product B.
Product A Relative prices have changed i.e.
the price of a product expressed in
terms of the other product (its
opportunity cost ratios). The price
ratios have changed.
Product A became relatively
cheaper and Product B became
BL2 BL1
relatively more expensive.
Product B

 The above change in the price and/ or income causing changes in the BL can have effect on the real
income and on the relative prices 1
 Real income changes whenever the purchasing power of the consumer is affected. This can occur if
money changes or the price of the good itself changes as seen above.
 Absolute price changes are ‘as expressed’ in terms of Rs, $ and £. Relative prices are expressed in
terms of opportunity cost (in comparison to the price of other). The following can be associated with
changes in the BL:
– Parallel shift : relative prices remain the same
– Non Parallel shift: relative prices change.

Substitute effect and income effect applied to BL.

 Rational consumers substitute towards the product that has become cheaper.

Indifference Curve: a curve that shows all combinations of goods that yield the same satisfaction to the
consumer. (consumer is indifferent; total utility is constant along the curve).

1
Money Income: money value or face value represented in the terms of units of the currency such as Rs, $, £ etc
Real income: income in terms of its purchasing power. Income that has been adjusted for inflation.
Example:
Reference Eggs Chicken
Point
A 30 5
B 13 15
C 10 20
D 7 30

 All point on the IC curve yield the same level of satisfaction. Point above the curve are considered
superior, and those below are considered inferior.
 Characteristics of IC curves:
― Slopes downward to the right, i.e. has negative slope. This is because of opportunity cost, in
order to increase consumption of one commodity, the consumer is prepared to reduce
consumption of a second.
― Slope gets flatter and flatter as slope downward to the right.
― It is convex to the origin because marginal rate of substitution declines. [Marginal rate of
substitution (MRS) = the amount of one commodity a consumer could give up to get one more
unit of another commodity while leaving the level of satisfaction unchanged].
― MRS declines as a consumer would be willing to give up lesser and lesser amounts of good Y to
gain more of good X as additional units of good X give progressively lower levels of
satisfaction as given by LDMU.
― Slope of the indifference curve given the marginal utility ratios i.e MUX/MUY
― More of any good is preferred to less of that good.
― Never intersect because of the principle of transitivity (it is illogical to have the same
combination yet different levels of satisfaction)

IC1, IC2 and IC3 (in the diagram below) show an INDIFFERNCE MAP. On each the level of satisfaction
remains constant, but at a different level from every other curve.

Good Y

IC3
IC2
IC1

Good X
CONSUMER EQUILIBRIUM: achieved when the budget line is tangent to the indifference curve i.e. the
slope of the indifference curve (or the marginal rate of substitution MRS) is equal to the slope of the budget
line i.e MUX = PX
MUY PY

Good Y

IC3
IC2
IC1

Good X

Equilibrium changes: a new equilibrium established whenever income changes or price changes.

Income Changes and Consumer Equilibrium

Normal Goods: when income increases, demand increases.

Y
ICC (Income consumption curve)

IC2

IC1

0
X

 Due to a rise in income, new equilibrium at E, with a rise in both X and Y, due to a rise in income.
Inferior Goods: as income rises, demand decreases

ICC (Income consumption curve)

Y
Good X is an inferior good,
Good Y is a normal good
IC2

IC1

0
X

Would be a downward sloping ICC if good Y was inferior and good X normal.

To summarise:

 Both normal goods if new IC

Y curve between points 2 and 3
1  Good Y normal, good X
inferior if new IC curve is
between points 1 and 2
2
 Good Y inferior, good X
normal if new IC is between
3 points 3 and 4

IC1

0
X

Price Changes and Consumer Equilibrium

Demand curve with the Indifference Curve analysis:
 Y
IC1
IC2

IC3

Price Consumption line

0
A B C X

Price of X

PA

PB

PC

Quantity of X

Price Changes and Consumer Equilibrium

 The Price effect consists of: income effect and substitution effect. It is the effect of a change in price
upon the quantity demanded of a product.

Income and Substitution Effect

The price effect is divided into:
 An income effect: with lower price of good A, consumer has more real income. A rise in purchasing
power as good A becomes cheaper, so can now buy more of the lower priced product. Can be positive
or negative in effect depending on the good being normal or inferior.
 Substitution effect: with fall in price of good A, A becomes relatively cheaper than other goods and
inevitably there is a desire to buy more. Consumers inevitably switch to the cheaper good. Always
positive effect.
 A price effect (P.E) = Income effect (I.E) + substitution effect (S.E).

Diagrammatically:
The substitution remains the same for all goods. The income effect varies. The final outcome depends on
whether income effect is greater or the substitution effect is greater than the income effect. Both can even
more in the same direction as in the case of normal goods.
Normal Goods
- If Normal good: consumer will want to buy more because of the income effect. Means both income
and substitution effects make the consumer want to buy more. (same direction, buy more)

Diagram shows price effect of a normal good i.e good X when its price falls.
BL pivots
Dotted BL = Compensating Budget line, which removes any change in real income of consumers (real
income is held constant to measure the substitution effect)
To estimate income effect, relative prices (substitution effect) is held constant.
Normal Good

Good
Y Original
position

I2
I1

Good X
S.E I.E

P.E

P.E = rise in Qd as price falls

What happens if price of good X were to increase?

Inferior Good
Given that the price for Good B decreases.
- If Inferior good: the consumer will want to buy less, have more real income buying more luxurious
goods. The income effect works against the substitution effect. However, substitution effect is larger,
so overall consumers do buy more.(opposite direction where the substitution effect > income effect,
buy more).
 Good B: Inferior Good

Good
A Original
position

X
I2

I1

S.E Good B
I.E

P.E

― The substitution effect is dampened by the income effect, though overall there is still a rise in the
quantity of Good B due to its price fall, but rise is less than what it could have been.
― As the substitution effect is greater than the income effect, with the result that the demand curve is
negatively sloped.
― Decrease in Qd is due to the income effect, but S.E. more than offsets it.
― P.E = small rise in Qd as price falls

Giffen Goods
- Giffen Good: a commodity for which quantity demanded increases as its price increases and falls at
lower prices. Eg. staple foods such as wheat, rice.
- If Giffen good: income effect works against substitution effect and outweighs it. Overall Qd falls
when Price falls and hence have upward sloping demand curve. (opposite direction where the
substitution effect< income effect , buy less)
 Giffen Good (price decreases)

Good X Original
position

I2

I1

S.E Giffen
I.E
good
P.E

― Income effect is greater than substitution effect so that the demand curve has a positive slope
― P.E = fall in Qd as price falls

Giffen

Anywhere within this

dotted region would be
Good B inferior goods

Original
Position
X

Normal Goods

Good A

IC’s and Demand curves

 Good X Original position X,
with original price P0

Good Y

Price of Y
X

P0

P1
Normal Goods

Giffen Inferior QY
goods goods

There are three income effects: positive, negative and zero.

 If an increase in real income is accompanied by an increase in quantity demanded, then there is a
positive income effect.
 If an increase in real income and the quantity demanded remain unchanged, then there is a zero
income effect.
 If an increase in income is accompanied by a decrease in the quantity demanded, then there is a
negative income effect.
The substitution effect is always positive with respect to the good which is cheaper now (P↓). For a
normal good, the substitution effect is reinforced by the positive income effect. As for an inferior good, the
substitution effect and the negative income effect move in opposite directions and the substitution effect
outweighs the income effect. Finally, for a Giffen good, the negative income effect is stronger than the
substitution effect (and they both move in opposite directions)
All Giffen goods are inferior goods but not all inferior goods are giffen goods.

MARKET DEMAND: horizontal summation of individual demand curves.