CONSUMER
BEHAVIOR AND UTILITY
MAXIMISATION
TWO EXPLANATIONS OF THE
LAW OF DEMAND
Thomas Masese
Income Effect
Whenever a product’s price decreases, two things
happen to cause the amount demanded to increase
The income effect: this is the impact of a change in
the price of a product on a consumer’s real income
and consequently on the quantity of that product
demanded.
Whenever the price of a product falls, the real
income or purchasing power of anyone buying that
product increases.
This real increase in real income will be reflected in
increases in the purchase of many products
including the original product whose price fell.
Substitution Effect
The substitution effect is the impact a change in a product’s price
has on its relative expensiveness and consequently on the
quantity demanded.
The lower the price of a product means that it is now cheaper
relative to all other products
Consumers will substitute the cheaper product for other products
which are now relatively more expensive
A lower price increases the relative attractiveness of a product
and the consumer will buy more of it. This is the substitution
effect.
The income and substitution effect combine to make a consumer
able and willing to buy more of a specific good at a lower price.
Law of Diminishing Marginal
Utility
The second explanation of the downward
curve is that, although consumer wants in
general may be insatiable, wants for specific
commodities can be fulfilled.
In a given span of time, where buyers tastes
are unchanged, consumers can get as much
of a specific goods and services as they want
The more of a specific product consumers
obtain, the less they want more units of the
same product.
Law of Diminishing Marginal
Utility
Economists theorize that specific consumer wants can be fulfilled with
succeeding units of a commodity in the Law of Diminishing Marginal
Utility.
Utility is the want-satisfying power.
It must be emphasized that utility and usefulness are not the same. Also
utility of a specific product will vary widely from person to person i.e.
utility is a subjective notion.
By marginal utility we mean the extra utility or satisfaction a consumer
gets from one additional unit of a specific product.
In any short time wherein the consumer tastes do not change, the
marginal utility derived from successive units of a given product will
decline. A consumer will eventually become relatively saturated or filled
up with the product.
The fact that marginal utility will decline the consumer acquires
additional units of a specific product is known as the law of
diminishing utility
Law of Diminishing Marginal Utility
Because it is a Units of Marginal Total
subjective concept, Sausages Utility Utility
utility is not susceptible (Utils) (Utils)
to precise quantitative
First 10 10
measurement. But for
purposes of illustration Second 6 16
assume we can
measure satisfaction Third 2 18
with units we will call
“utils” Fourth 0 18
Fifth -15 13
Law of Diminishing Marginal Utility
How does the law of diminishing marginal utility explain why
the demand curve for a specific product is downward
sloping?
If successive units of a good yield smaller and smaller
amounts of marginal or extra utility, then the consumer will
buy additional units only if its price falls. This rationale
supports the notion of a downward sloping demand curve.
The amount by which marginal utility declines as more units
of a product are consumed will determine its price elasticity.
Ceteris paribus, if marginal utility falls sharply as successive
units are consumed, we would expect demand to be
inelastic.
Theory of Consumer Behavior
The situation of a typical consumer of the typical consumer is
something as follows:
1. Rational Behavior- the consumer is a rational person trying to
dispose his income so as to derive the greatest amount of
satisfaction or utility from it.
2. Preferences- the consumer has clear preferences for various
goods and services available on the market,
3. Budget Restraint- the consumer's money income is limited- all
consumers are subject to a budget restraint.
4. The goods and services available to customers have price
tags on them. Because consumers have limited income, the
consumer can only buy a limited amount of goods.
5. A consumer must choose among alternatives goods to obtain
with limited money income the most satisfying mix of goods
and services.
Utility Maximizing Rule
Of all the collections of goods and services a
consumer can obtain within his budget, which
specific collection will yield the maximum utility or
satisfaction?
The rule to be followed in maximizing satisfaction is
that the consumer’s income should be allocated
so that the last dollar spent on each product
purchased yields the same extra (marginal)
utility or satisfaction
The consumer will be in equilibrium. The utility
maximizing rule requires that MUX/PX = MUY/PY and
the consumer must use all his available income.
INDIFFERENCE
CURVE ANALYIS
THE BUDGET LINE: WHAT IS
ATTAINABLE
Budget Line- What is Attainable
A budget line shows the various combinations of two products which
can be purchased with a given money income.
Suppose you earn $12 and the are two products on which you can
spend your income, product X which costs $1.50 and product Y
which costs $1.00.
You can purchase all the combinations of X and Y shown in the
following table.
At one extreme you can spend all your income on 8 units of X and
have nothing left to spend on Y or you can buy 12 units of Y with
nothing left for X.
You can also have various combinations of X and Y in between.
In general the budget line (constraint) can be written as
I =PxQx +PyQy or Incme = Expenditure
BUDGET LINE
Income Changes- the location of the budget line varies with
money income. An increase in money income will shift the
budget line to the right; a decrease in money income will move it
to the left.
Price Changes- a change in product price will also shift a budget
line. A decline in the prices of both products will shift the budget
line to the right.
In general, the extra amount of good Y you can purchase by
sacrificing a unit of good X depends on the relationship between
the price of X and the price of Y. By giving up a one unit of X,
you will be able to purchase Px/Py units of Y. This represents the
extra Y you can add to your market basket for each unit of X you
remove, which is the slope of the budget line (∆Qy/∆Qx
multiplied by -1.
Because the slope of the budget line is ∆Qy/∆Qx, it follows that
-∆Qy/∆Qx = Py/Px
INDIFFERENCE CURVE ANALYSIS
The Budget Line: Combinations of X and Y
Attainable With Income of $12 (Hypothetical data)
Units of X Units of Y Total
(price = $1.50) (price = $1.00) Expenditures
8 0 $12 (=$12 +$0)
6 3 $12 (=$9 +$ $3)
4 6 $12 (=$6 +$6)
2 9 $12 (=$3 +$9)
0 2 $12 (=$0 +$12)
Indifference Curves: What is
preferred
Budget lines reflect objective market data involving income and prices. It
reveals combinations of X and Y which are attainable given money income
and prices.
Indifference curves embody subjective information about consumer
preferences for X and Y
An indifference curve shows all combinations of products X and Y which
will yield the same satisfaction or utility to the consumer.
The basic assumption of indifference curve analysis is that consumers can
rank market baskets. Of any two market baskets, the consumer is assumed
to prefer one to the other or to be indifferent between the two.
The following table shows a hypothetical indifference curve involving X and
Y . The consumer’s subjective preferences are such that he or she will
realize the same total utility from each combination of X and Y. The
consumer will be indifferent as to which combination is actually obtained.
An indifference curve is a graph of various market baskets that provide a
consumer with equal utility.
An Indifference Schedule
(hypothetical data)
Combination Units of Y Units of X
I 10 4
II 6 5
III 3 6
IV 1 7
Characteristics of Indifference Curves
1. Downward Sloping- indifference curves for any two alternative products are negatively sloped.
This is because to remain on the same indifference curve, a reduction in the amount of Y,
measured on the vertical axis, by any amount, -∆Qy, from the market basket must be replaced
with the addition of a positive amount of good X, measured on the horizontal axis, ∆Q x. It follows
that the slope of an indifference curve ∆Q y/∆Qx will always be negative because the numerator
and denominator will always be opposite in sign.
2. Convex to the Origin- indifference curves become flatter as the good on the horizontal axis is
substituted for the good on vertical axis while the consume remains on the same indifference
curve. The marginal rate of substitution (MRSxy) of X for Y is the positive quantity of good Y
that a consumer would give up to obtain one more unit of good X while being made neither better
off nor worse off by the trade (i.e the consumer neither gains nor lose utility in the process)
• The marginal rate of substitution is defined as the positive amount of Y a consumer is willing to
give up for an additional amount of X. It is the slope of the indifference curve multiplied by -1. It
follows that MRSxy =-∆Y/∆X
• Diminishing Marginal Rates of Substitution- The curvature of the indifference curve implies
diminishing marginal rates of substitution of X for Y
• Diminishing marginal rate of substitution of X for Y constitute an important assumption about
shapes of indifference curves.
• As good X is substituted for good Y along the curve, the curve becomes flatter. Differences in
preferences imply differences in the amounts of one good they would be willing to exchange for
another while neither gaining nor losing satisfaction. However the marginal rate of substitution of
good X for Y will tend to decline as more X is substituted for Y along any consumer’s indifference
curve.
Indifference Map
Figure1 The fact that the consumer
is assumed to prefer more
to less of it can be used to
derive additional
indifference curves.
An indifference map is a
way of describing a
person’s preferences
An indifference curve can
be drawn for any market
basket on the graph.
Consumer Equilibrium
As a consumer you are assumed to choose quantities of X and Y
that maximize your utility given your budget constraint.
The consumer is in equilibrium when he chooses the
combination of goods X and Y that gives him the highest
possible utility given the prices and his income.
The consumer is in equilibrium when the budget line is just
tangent to an indifference curve.
The consumer equilibrium represents that combination of goods
purchased that maximizes utility subject to the budget constraint.
Geometrically, the equilibrium can be described as that
combination of goods corresponding to the point at which the
budget line is just tangent to the highest attainable indifference
curve in the consumer’s indifference map.
Consumer Equilibrium
Consumer Equilibrium
At that point the slope of the budget line is just equal
to the slope of the indifference curve.
The slope of the budget line is –Px/Py. The slope of
the indifference curve at any point is the marginal
rate of substitution of X for Y multiplied by -1.
The equilibrium condition can therefore be written as
: -Px/Py = -MRSxy or Px/Py = MRSxy
This condition means the consumer is maximizing
utility subject to the budget constraint.
How Changes in Relative Prices
Affect Consumer Choices
A change in the price of X relative to the price of Y
will change the slope of the budget line.
Suppose the price of declines. This will rotate the
budget line along the vertical axis without changing
its intercept on the horizontal axis.
The initial equilibrium, b, will no longer provide the
consumer with the greatest possible satisfaction.
Instead the consumer would be induced to move to
a new equilibrium, c, where the new budget line is
just tangent to a higher indifference curve.
Effects of Change in Price.
Marginal utility Analysis of
Consumer Prices
It is possible to relate the marginal rate of substitution along an indifference
curve to the marginal utilities of the goods on each axis.
Removing ∆Qy from a consumer’s market basket makes him worse off. The loss
of utility is ∆QyMUy, MUy is the marginal utility of Y to the consumer.
The consumer can be replaced with enough units of X to make him just as well
off as he was previously. The gain in utility is ∆QxMUx, where MUx is the
marginal utility of the added X.
If the consumer is to return to the same indifference curve, the gain in utility from
added X must exactly equal the loss in utility from Y removed from the market
basket.
Hence ∆QxMUx =-∆QyMUy
Therefore -∆Qy/∆Qx = MUx/Muy=MRSxy
The marginal rate of substitution of X and Y can therefore be thought of as the
ratio of marginal utility of X to marginal utility of Y
This also implies MRSxy =MUx/MUy =Px/Py
Or MUx/Px = MUy/Py
