Consumer Behaviour/Choice

Theory
BY
HOPKINS KAWAYE
(BscoEco,[Link])
• This chapter provides a more detailed examination of the theory of
consumer choice.
• The theory of demand is derived from this theory of choice.
Utility

• The economic theory of choice is based on the concept of utility.

• Utility is defined as the level of happiness or satisfaction associated
with alternative choices.
• Economists assume that when individuals are faced with a choice of
feasible alternatives, they will always select the alternative that
provides the highest level of utility.
Total and marginal utility

• The total utility associated with a good is the level of happiness

derived from consuming the good.
• Marginal utility is a measure of the additional utility that is received
when an additional unit of the good is consumed.
• The table below illustrates the relationship that exists between total
and marginal utility associated with an individual's consumption of
pizza (in a given time period).
 Total Marginal
# of slices
utility utility
0 0 -
1 70 70
2 110 40
3 130 20
4 140 10
5 145 5
6 140 -5
• As the table above indicates, the marginal utility associated with an
additional slice of pizza is just the change in the level of total utility
that occurs when one more slice of pizza is consumed.
• Note, for example, that the marginal utility of the third slice of pizza is
20 since total utility increases by 20 units (from 110 to 130) when the
third slice of pizza is consumed.
• More generally, marginal utility can be defined as:
• The table above also illustrates a phenomena known as the law of
diminishing marginal utility.
• This law states that marginal utility declines as more of a particular
good is consumed in a given time period, ceteris paribus.
• In the example above, the marginal utility of additional slices of pizza
declines as more pizza is consumed (in this time period).
• In this example, the marginal utility of pizza consumption becomes
negative when the 6th slice of pizza is consumed.
• Note, though, that even though the marginal utility from pizza
consumption declines, total utility still increases as long as marginal
utility is positive.
• Total utility will decline only if marginal utility is negative.
• This law of diminishing marginal utility is believed to occur for
virtually all commodities.
• A bit of introspection should confirm the general applicability of this
principle.
Consumer equilibrium
• How can the concept of marginal utility be used to explain consumer
choice?
• As noted above, economists assume that when an individual is faced
with a choice among feasible alternatives, he or she will select the
alternative that provides the highest level of utility.
• Suppose that an individual has a given income that can be spent on
alternative combinations of goods and services.
• A utility maximizing consumer will select the bundle of goods at
which the following two conditions are satisfied:
1. MUA/PA = MUB/PB = ... = MUZ/PZ, for all commodities (A-Z), and

2. all income is spent.

• The first of these conditions requires that the marginal utility per
dollar of spending be equated for all commodities.
• To see why this condition must be satisfied, suppose that the condition
is violated.
• In particular, let's assume that the marginal utility resulting from the
last dollar spent on good X equals 10 while the marginal utility
received from the last dollar spent on good Y equals 5.
• Since an additional dollar spent on good X provides more additional
utility than the last dollar spent on good Y, a utility-maximizing
individual would spend more on good X and less on good Y.
• Spending MK1 less on good Y lowers utility by 5 units, but an
additional dollar spent on good X raises utility by 10 units in this
example.
• The first condition listed above is sometimes referred to as the
"equimarginal principle."
• The reason for the assumption that all income is spent is because this
relatively simple model is a single-period model in which there is no
possibility of saving or borrowing (since there are no future periods in
this simple model).
• When the two conditions above are satisfied, a state of consumer
equilibrium is said to occur.

• This is an equilibrium because the individual consumer has no reason

to change the mix of goods and services consumed once this outcome
is achieved. (Unless, of course, there is a change in tastes, income, or
relative prices.)
Consumer equilibrium and demand
• The concept of consumer equilibrium can be used to explain the negative
slope of a consumer's demand curve. Suppose that an individual is initially
buying only two goods, X and Y. At a point of consumer equilibrium:

• and all income is spent. Let's consider what happens if the price of good X
rises.
• An examination of the equation above indicates that the marginal utility
per dollar spent on good X will fall when the price of good X rises.
• To restore a consumer equilibrium, the individual will increase his or
her consumption of good Y and reduce his or her spending on good X.

• This change in the mix of goods consumed is called the substitution

effect.

• When good X becomes relatively more expensive, the quantity of

good X demanded falls as a result of the substitution effect.
• In addition to this substitution effect, there is also an income effect
that occurs when the price of a good changes.

• Since good X has become more expensive in this example, the

individual can no longer afford the original combination of goods X
and Y.

• This income effect results in a reduction in the quantity demanded for

all normal goods.

• If good X is a normal good, the substitution and income effects both

work together to reduce the quantity of good X demanded.
Indifference curves
• Consumer choice can also be explained through the use of indifference
curves.
• An indifference curve is a graph of all combinations of goods that
provide a given level of utility.
• The diagram below contains an indifference curve for two goods, X
and Y.
• Any two points on an indifference curve generate the same level of
utility.
• Thus, the diagram below indicates that this person would be
indifferent if faced with a choice between the combinations of goods
represented by points A and B.
• Points that lie above and to the right of an indifference curve provide a
higher level of consumption of each good than points on an
indifference curve.

• Because of this, such points provide a higher level of utility than

points on the indifference curve.

• Thus, point C would be preferred to either point A or B (or any other

point on the indifference curve Uo).

• Points that lie below and to the left of the indifference curve (such as
point D) provide a lower level of utility.
• Therefore, this individual would prefer the bundle of goods
represented by point A if faced with a choice between the bundles of
goods represented by points D and A.

• An indifference curve crosses through each and every point in this

diagram.

• Thus, an infinite number of indifference curves exist for these two

goods.

• Two additional indifference curves, corresponding to the levels of

utility received at points C and D have been added to the diagram
below.
• It is assumed that individuals attempt to place themselves on the highest
level of utility that they can achieve, given the constraints that they face.

• Let's examine the budget constraint facing individuals.

Budget constraint
• Let's consider the budget constraint facing an individual who has a
fixed level of income (I) that can be used to buy two goods (X and Y)
at fixed prices (PX and Py). The budget constraint facing this individual
can be expressed as:

• A graph of this budget constraint appears below.

• The intercepts of this budget constraint on each axis equals income

divided by the price of the good represented on the axis (this can be
demonstrated quite easily using basic algebra).
• Changes in income will result in a parallel shift in the budget
constraint while changes in the prices of goods X and Y will affect the
slope of the budget constraint.
Consumer equilibrium and indifference curves
• Individuals maximizing utility subject to their budget constraint attain
the highest possible level of utility at a point of tangency between their
budget constraint and an indifference curve.
• In the diagram below, this occurs when the individual consumes X*
units of good X and Y* units of good Y.
• While other points on the budget constraint, such as point A, are
feasible, they provide a lower level of utility.
• Points such as point B provide a higher level of utility, but are not
feasible.
• It is not possible to attain a higher level of utility than U” without
violating the budget constraint (and there are laws that prevent people
from acquiring more goods than they can pay for...).
• END OF THE COURSE