Abay Minch College

Department of Management
MICROECONOMICS
 Chapter 1:Theory of Consumer Behaviour and Demand

1.1 consumer preference

A consumer is an individual or a household who uses/consumes final

goods and services to maximize utility.

Consumer preference is Given to any two consumption bundles, the

consumer can either decide that one of the consumption bundles is

strictly better than the other or decide that he is indifferent between the

two bundles.
 Cont’d…..

Suppose that given any two consumption bundles, (X1,X2) and (Y1,Y2)

denoted by X and Y respectively, the consumer can rank them as to

their desirability i.e. the consumer can determine that one of the
consumption bundles is strictly better than the other, or decide that
he/she is indifferent between the two bundles.
 (X1,X2) > (Y1,Y2) - the consumer strictly prefers bundle X to Y.

 (X1,X2) ~ (Y1,Y2) - the consumer is indifferent between the two bundles

of goods. (Each bundle gives him/her the same level of satisfaction)

 Cont’d….

Assumptions about Preferences

• There are certain axioms that are taken for granted regarding the consistency of
consumer’s preferences. They are called axioms of consumer’s theory. These are:-
 Completeness – consumer’s preferences are complete in a sense that a consumer
can compare and rank all the consumption possibilities. Given consumption bundles
X and Y, the consumer will either prefer A to B, or B to A, or will be indifferent
between A and B.
 Consistency: Consistency in a sense if at one time regards combination X is better
than of Y he/she will not consider combination Y is better than of X at another time.
 Cont’d….
 Transitivity of Preference – Given three bundles, X, Y and Z; if a
consumer Prefers X to Y and Y to Z, then the consumer prefers X to
Z.
1.2 Utility
 Utility is the level of satisfaction/pleasure that the consumer can derive from
consumption of goods and services or by undertaking a certain activity.
 It is the power of a good or service to satisfy a certain human need.

 In defining strict preference, we said that given any two consumption

bundles(X1,X2) and (Y1,Y2),the consumer definitely wants the X bundle than the Y
bundle if (X1,X2) > (Y1,Y2).This means, the consumer preferred bundle (X1,X2) to
bundle (Y1,Y2) if and only if the utility (X1,X2) is larger than the utility of
(Y1,Y2).

The concept of utility is characterized with the following properties:

 ‘Utility’ and ‘Usefulness” are not synonymous. For example, paintings by Picasso
may be useless functionally but offer great utility to art lovers.
 Cont’d….
 Utility is subjective. The utility of a product will vary from person to person. That
means, the utility that two individuals derive from consuming the same level of a
product may not be the same. For example, non-smokers do not derive any utility
from cigarettes.
 The utility of a product can be different at different places and time. For example,
the utility that we get from meat during fasting is not the same as any time else.
 A Consumer considers the following points to get maximum utility or level of
satisfaction:
 How much satisfaction he gets from buying and then consuming an extra unit of a
good or service (MU).
 The price he pays to get the good.
 The satisfaction he gets from consuming alternative products.
 The prices of alternative goods and services.
 Cont’d….
1.2.1 Approaches to measure Utility
o There are two major approaches of measuring utility. These are Cardinal and
ordinal approaches. This sub unit is divided into two Sections. In Section one the
Cardinal utility approach will be discussed while in Section two the concept of
ordinal Utility will be addressed.
Section 1: The Cardinal Utility theory
o Neoclassical economists argued that utility is measurable like weight, height,
temperature and they suggested a unit of measurement of satisfaction called utils.
o A util is a cardinal number like 1,2,3 etc simply attached to utility. Hence, utility
can be quantitatively measured.
 Cont’d….
Assumptions of Cardinal Utility theory
1. Rationality of Consumers. The main objective of the consumer is to maximize his/her
satisfaction given his/her limited budget or income. Thus, in order to maximize his/her
satisfaction, the consumer has to be rational.
2. Utility is Cardinally Measurable. According to this approach, the utility or satisfaction of
each commodity is measurable. Money is the most convenient measurement of utility. In
other words, the monetary unit that the consumer is prepared to pay for another unit of
commodity measures utility or satisfaction.
3. Constant Marginal Utility of Money. According to assumption number two, money is the
most convenient measurement of utility. However, if the marginal utility of money changes
with the level of income (wealth) of the consumer, then money can not be considered as a
measurement of utility.
 Cont’d….
4. Limited Money Income. The consumer has limited money income to
spend on the goods and services he/she chooses to consume.
5. Diminishing Marginal Utility (DMU).The utility derived from each
successive units of a commodity diminishes. In other words, the
marginal utility of a commodity diminishes as the consumer acquires
larger quantities of it.
6. 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 given by:
TU = f(X1,X2,…,Xn)
 Cont’d….
Total and Marginal Utility

o Total Utility (TU):It refers to the total amount of satisfaction a consumer gets
from consuming or possessing some specific quantities of a commodity at a
particular time.

o As the consumer consumes more of a good per time period, his/her total utility
increases. However, there is a saturation point for that commodity in which the
consumer will not be capable of enjoying any greater satisfaction from it.

o Marginal Utility (MU): It refers to the additional utility obtained from

consuming an additional unit of a commodity. In other words, marginal utility is
the change in total utility resulting from the consumption of one or more unit of
a product per unit of time. Graphically, it is the slope of total utility.
 Cont’d….

Law of diminishing marginal Utility (LDMU)

 The utility that a consumer gets by consuming a commodity for the first time is not the
same as the consumption of the good for the second, third, fourth, etc.
 The Law of Diminishing Marginal Utility States that “as the quantity
consumed of a commodity increases per unit of time, the
utility derived from each successive unit decreases,
consumption of all other commodities remaining constant”.
 The LDMU is best explained by the MU curve that is derived from the relationship
between the TU and total quantity consumed.
Units of
Cont’d….
Quantity(x) 0 1st 2nd 4th 5th 6th
consumed Unit Unit unit . 3rd unit
unit Unit Unit

TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils

MUX - 10 6 4 2 0 -2
 Cont’d….
o As indicated in the above figures, as the consumer consumes more of a good per
time period, the total utility increases, at an increasing rate when the marginal utility
is increasing and then increases at a decreasing rate when the marginal utility starts
to decrease and reaches maximum when the marginal utility is Zero.

Equilibrium of a consumer
o A consumer that maximizes utility reaches his/her equilibrium position when
allocation of his/her expenditure is such that the last birr spent on each commodity
yields the same utility.
Symbolically, the equilibrium of the consumer can be represented as:
Mux = Px
Where: MUx is the marginal utility of the commodity (X), and Px is the price of the
commodity (X)
 Cont’d….
o If the marginal utility of X is greater than its price (MUx > Px), the consumer
can increase his/her welfare by purchasing more units of the commodity X.
o Similarly, if the marginal utility of the commodity is less than its price, the
consumer can increase his/her total satisfaction by cutting down the quantity
of the commodity X and keeping more of his/her income unspent.
Therefore, the consumer attains the maximum level of satisfaction (utility)
when MUx = Px.
o If there are more commodities, the condition for the equilibrium of the
consumer is the equality of the ratios of the marginal utilities for the
individual commodities to their prices.
 Cont’d….
Example: Suppose Hirut has 20 Birr to be spent on two goods: orange
and banana. The unit price of orange is 2 Birr and the unit price of a loaf
of banana is 4 Birr. The total utility she obtains from consumption of
each good is given below.
 Cont’d….

Derivation of the Cardinalist Demand

• We discussed that marginal utility is the slope of the total utility function. The derivation of
demand curve is base don the concept of diminishing marginal utility. If the marginal utility is
measured using monetary units the demand curve for a commodity is the same as the positive
segment of the marginal utility curve.
Cont’d….
,
 Cont’d….
Limitation of the Cardinalist approach
The Cardinalist approach involves the following three weaknesses:

1. The assumption of cardinal utility is doubtful because utility may not

be quantified.
2. Utility cannot be measured absolutely (objectively). The satisfaction
obtained from different commodities cannot be measured objectively.
3. The assumption of constant MU of money is unrealistic because as
income increases, the marginal utility of money changes.
 Cont’d….
Section 2: The Ordinal Utility Theory
 In the ordinal utility approach, utility cannot be measured absolutely
but different consumption bundles are ranked according to
preferences.
 The concept is based on the fact that it may not be possible for
consumers to express the utility of various commodities they consume
in absolute terms, like, 1 util, 2 util, or 3 util, but it is always possible
for the consumers to express the utility in relative terms.
 It is practically possible for the consumers to rank commodities in the
order of their preference as First, second, third and soon.
 Cont’d….
Assumptions of Ordinal Utility theory

1. The Consumers are rational: they aim at maximizing their satisfaction or utility given
their income and market prices.
2. Utility is ordinal, i.e. utility is not absolutely (cardinally) measurable. Consumers are
required only to order or rank their preference for various bundles of commodities.
3. Diminishing Marginal Rate of Substitution (MRS): The marginal rate of substitution is
the rate at which a consumer is willing to substitute one commodity (x) for another
commodity (y) so that his total satisfaction remains the same. When a consumer
continues to substitute X for Y the rate goes decreasing and it is the slope of the
Indifference curve.

4. The total utility of the consumer depends on the quantities of the commodities consumed,
i.e U = f(X1,X2,…,Xn)
 Cont’d….
5. Preferences are transitive or consistent:

 It is transitive in the senses that if the consumer prefers market basket X to market
basket Y, and prefers Y to Z, and then the consumer also prefers X to Z.
 When we said consistent it means that If market basket X is greater than market basket
Y (X>Y) then Y not greater than X (Y not >Y).
o The ordinal utility approach is expressed or explained with the help of indifference
curves.

o An indifference curve is a concept used to represent an ordinal measure of the tastes

and preferences of the consumer and to show how he/she maximizes utility in
spending income.

o The ordinal utility theory is also known as the Indifference Curve Analysis.
 Cont’d….
Indifference Set, Curve and Map

o Indifference Set/ Schedule: It is a combination of goods for which the consumer is indifferent,
preferring none of any others. It shows the various combinations of goods from which the
consumer derives the same level of utility.

Table 2: Indifference Schedule

Bundle (Combination) A B C D

Orange(X) 1 2 4 7

Banana (Y) 10 6 3 1

o Each combination of good X and Y gives the consumer equal level of total utility. Thus, the
individual is indifferent whether he consumes combination A, B, C or D.
 Cont’d….
Indifference Curves: an indifference curve shows the various
combinations of two goods that provide the consumer the
same level of utility or satisfaction.
 It is the locus of points (particular combinations or bundles
of good), which yield the same utility (level of satisfaction)
to the consumer, so that the consumer is indifferent as to
the particular combination he/she consumes.
 Cont’d….
o By transforming the above indifference schedule into graphical
representation, we get an indifference curve.
 Cont’d….
Indifference Map: To describe a person’s preferences for all
combinations potato and meat, we can graph a set of indifference curves
called an indifference map.
 In other words it is the entire set of indifference curves is known as an
indifference map, which reflects the entire set of tastes and
preferences of the consumer.
 A higher indifference curve refers to a higher level of satisfaction and
a lower indifference curve shows lesser satisfaction. IC2 reflects
higher level of utility than that of IC1.Any consumer has lots of
indifference curves, not just one.
 Cont’d….
Properties of Indifference Curves:

1. Indifference curves have negative slope (downward sloping to the right).

Indifference curves are negatively sloped because the consumption level of one
commodity can be increased only by reducing the consumption level of the other
commodity. Hence, in order to keep the utility of the consumer constant, as the
quantity of one commodity is increased, the quantity of the other must be
decreased.
2. Indifference curves do not intersect each other. Intersection between two
indifference curves is inconsistent with the reflection of indifference curves.
 If they did, the point of their intersection would mean two different levels of
satisfaction, which is impossible.
 Cont’d….
3. A higher Indifference curve is always preferred to a lower one. The further away from the
origin an indifferent curve lies, the higher the level of utility it denotes: baskets of goods on a
higher indifference curve are preferred by the rational consumer, because they contain more of
the two commodities than the lower ones.
4. Indifference curves are convex to the origin. This implies that the slope of an indifference
curve decreases (in absolute terms) as we move along the curve from the left downwards to the
right. This assumption implies that the commodities can substitute one another at any point on an
indifference curve, but are not perfect substitutes.
The Marginal rate of substitution (MRS)

o 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 of X so that the consumer
maintains the same level of satisfaction.
 Cont’d….

 It is the negative of the slope of an indifference curve at any point of

any two commodities such as X and Y, and is given by the slope of the
tangent at that point:

 In other words, MRS refers to the amount of one commodity that an

individual is willing to give up to get an additional unit of another
good while maintaining the same level of satisfaction or remaining on
the same indifference curve.
 The diminishing slope of the indifference curve means the willingness
to substitute X for Y diminishes as one move down the curve.
Cont’d….
,
Cont’d….
,
 Cont’d….
The Budget Line or the Price line
 Indifference curves only tell us about the consumer’s preferences for any
two goods but they can not tell us which combinations of the two goods
will be chosen or bought..
 The budget line is a line or graph indicating different combinations of
two goods that a consumer can buy with a given income at a given prices.
 In other words, the budget line shows the market basket that the consumer
can purchase, given the consumer’s income and prevailing market prices.
 Cont’d….
Assumptions for the use of the budget line
 In order to draw the budget line facing the consumer, we consider the
following assumptions:
 there are only two goods, X and Y, bought in quantities X and Y;
 each consumer is confronted with market determined prices, Px and
Py, of good X and good Y respectivley; and
 the consumer has a known and fixed money income (M).
Cont’d….
,
 Cont’d….
,
Unattainable(unaffordable)

attainable(affordable)

 Therefore, the budget line is the locus of combinations or bundle of goods that can be
purchased if the entire money income is spent.
Factors Affecting the Budget Line
The Effect of Change in Income on the Budget Line
 increase in income, assuming that Px and Py are constant, will increase the vertical intercept
and the horizontal intercept, and does not affect the slope of the budget line. thus, an increase
in income will result in a parallel outward shift of the budget line.
 Cont’d….
 similarly, a decrease in income will reduce both the vertical and the
horizontal intercepts and as a result it will cause a parallel inward
shift of the budget line
 Cont’d….
The Effect of Changes in Price on the Budget Line

 increase in Px will not change the vertical intercept (I/Py), since I and Py are
constant. But it will make the budget line steeper since Px/Py (slope of the
budget line in absolute terms) will become larger. That means, increase Px
shifts the horizontal intercept inward, as a result the budget line rotates
inward with constant vertical intercept and a steeper slope.
 Similarly, if we consider the effect of decline in Px while holding Py and I
constant, the vertical intercept remains constant but the slope becomes flatter
and the horizontal intercept increases and shift outward, as a result the budget
line rotates outward with a constant vertical intercept and a flatter slope.
 Cont’d….
,

Read the effect of change in price of Y commodity on the budget line???????????

 Cont’d….
Numerical Example

A person has $ 100 to spend on two goods(X,Y) whose respective prices

are $3 and $5.

a) Draw the budget line.

b) What happens to the original budget line if the budget falls by 25%?
c) What happens to the original budget line if the price of X doubles?
d) What happens to the original budget line if the price of Y falls to 4?
 Cont’d….
o Optimum of the Consumer
o A rational consumer seeks to maximize his utility or satisfaction by
spending his or her income.
o It maximizes the utility by trying to attain the highest possible
indifference curve, given the budget line.
o This occurs where an indifference curve is tangent to the budget line
so that the slope of the indifference curve (MRSx,y) is equal to the
slope of the budget line (Px/Py)
o Thus, the condition for utility maximization, consumer optimization,
or consumer equilibrium occurs where the consumer spends all
income (i.e. he/she is on the budget line) and the slope of the
indifference curve equals to the slope of the budget line MRSx,y
Px/Py
 Cont’d….

The equilibrium of the consumer is attained at the tangency

point of the budget line (BL) and the indifference curve (I 2),
consuming Y*amount of commodity Y and X* amount of
commodity X (Figure 6).
 Cont’d….
 This is because, the consumer cannot consume on the third
indifference I3 curve as it is not attainable given his/her income.
 And, the consumer does consume on the first indifference curve (I1)
as he/she can consume more given his/her income.