Consumer Choice or Behaviour Theory

Consumer behaviour theory concerns how consumers buy different goods and services. The
theory also describes how a consumer allocates its income in relation to the purchase of
different commodities and how price affects his or her decision. There are two theories that
explain consumer behaviour (i) The Utility Theory and (ii) The Indifference Preference
Theory.
Assumptions of consumer behaviour
These two theories are related. They are based on three assumptions.
The consumer is rational. First they seek to maximize the satisfaction they get from
consuming goods and services. Secondly, they think at the margin by considering the
satisfaction they will get from consuming the next unit of the good or service.
Consumers face a budget constraints. It means that there is a limit to how much they
can spend.
The consumer has preferences. He is able to tell the difference between goods and
services and he likes some more than others.
THE UTILITY THEORY
This theory was developed in 1870 by a British Economist, William Stanley Jevons.
In this theory, the behaviour of the consumer is explained in relation to the
satisfaction obtained from consuming a good or service.
Satisfaction is referred to as UTILITY.
Satisfaction can be measured by consumers. The unit of measure of utility is called
utils.
The Law of diminishing marginal utility: The utility a person derives in consuming a
particular product diminishes or declines as more and more of a good is consumed.
Therefore a consumer will consider the marginal utility (the utility in consuming the
next unit of a good) before making a choice.
The choice is continuously made so long as Marginal Utility is over and above the
price of the good.
INDIFFERENCE PREFERENCE THEORY
This theory was developed by Vilfredo Pareto.
Consumer behaviour is described in terms of the consumers preferences of various
combinations of goods and services (called a BUNDLE).
Preference depends both on marginal utility and total utility of consuming a certain
bundle.
Two tools are important in this decision making The budget constraint and the
indifference curves.
Tool 1: The Budget Constrain or Line
The limit on the bundle of goods and services that a consumer can afford. The main
determinants are the income of the consumer and the prices of the goods in his bundle
Let us consider a bundle of two goods Book and Beer.
o Suppose a consumer must choose between beer and books. He has an income
of 1000. The price of a book is 10 and a bottle of beer is 2.

o A. If the consumer spends all his income on books, how many books does he
buy?
o B. If the consumer spends all his income on beer, how many pints of beer does
he buy?
o C. If the consumer spends 400 on book, how many books and beers does he
buy?

The slope or the budget line (constraint) represents three things:

o The rate at which the consumer can trade or give up Beer for Books
o The opportunity cost of Books in terms of Beer
o The relative price of pizza:
o
price of Book
10

5 Beer per Books

price of Beer
2

Tool 2L Indifference curves

The indifference curves show consumption bundles (or combinations) that give the consumer
the same level of satisfaction.
Properties of indifference curves
There is more than one indifference curve.
Higher indifference curves are preferred to lower ones.
Indifference curves are downward sloping.
Indifference curves do not cross.
Indifference curves are bowed inward.
The slope of the indifference curve is called the Marginal rate of substitution (MRS). It
shows the rate at which a consumer is willing to trade one good for another
Making the choice

Now that we have the two tools (the budget line and indifference curve) we can now make
the choice.
The consumer will make a choice at the point when the satisfaction he derives from an extra
unit is the same or perhaps higher than the price.
So, the decision to consume is made at the point when
Marginal Rate of Substitution (From the Indifference Curve) = Relative Price (From
Budget Line)

The income effect is the change in consumption that arises because a lower price
makes the consumer better off. It is represented by a movement from a lower
indifference curve to a higher one.

The substitution effect is the change that arises because a price change encourages
greater consumption of the good that has become relatively cheaper. It is represented
by a movement along an indifference curve.