Consumer Behavior

CONSUMER BEHAVIOR THEORY

LEARNING OBJECTIVES
After completing this topic, students should be able to:
explain the concept of utility, total utility, marginal utility and law of diminishing marginal
utility
describe the consumer equilibrium position by maximizing utility depends on the price of
the goods and services and budget constraint.
Derive demand curve
Explain the concept of consumer surplus
Theory of Consumer Behavior
Cardinal Utility Approach
Ordinal Utility Approach
Measuring utility in term of quantity
Measuring utility based on preference
I. CARDINAL UTILITY APPROACH

A. Concepts
Utility refers to the degree of satisfaction acquired as a result of consuming goods and
services.
It is impossible to measure utility, and it is impossible to compare the utilities of different
people. However, we can use the concept to better understand the process of choice.
Total utility (TU) refers to the total satisfaction as a result of consuming goods and
services.
Marginal utility (MU) refer to the additional satisfaction derived as a result of
consuming an additional unit of good or service
The law of diminishing marginal utility refers to the more of any one good
consumed in a given period, the less satisfaction (utility) generated by consuming each
additional (marginal) unit of the same good.
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The law of diminishing marginal utility states that as consumption increases, marginal
utility will always fall. Total utility will increase initially; reach a maximum and finally
fall. The rational consumer will only consume up to the point where marginal utility is
at zero or when total utility is at its maximum.
As the marginal utility falls, consumers do not want to buy as much.
Even if the product were free, consumers would eventually get so sick of it that there
would be a limit to the amount consumed.
Table: Total Utility and Marginal Utility
Quantity
Total Utility
Marginal Utility
22
22
40
18
50
10
50
40
-10
20
-20
Figure: Relationship between Total Utility and Marginal Utility

Utils
The relationship between

MU and TU
When TU increase, MU is
TU
4
Utils
positive
Quantity
When TU is at maximum,
MU is zero
When TU falls, MU is
negative
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MU
Quantity
52
A. Utility Maximizing Rule

A rational consumer will always try to maximize his/her satisfaction given his/her limited
income so as to reach consumer equilibrium.
For single product,
Condition for equilibrium is MUx = Px
Consumer will equate marginal utility with the price of the product to reach
equilibrium
For multiple products,
condition for equilibrium is MUx/Px = MUy/Py = MUz/Pz
The utility derived per RM spent on the last unit bought must be equal to the utility
derived per RM spent on last unit consumed of all other goods.
If the condition is not fulfilled, consumer does not achieve equilibrium position.
If MUx/Px > MUy/Py , consumer will increase consuming good x in order to
achieve equilibrium
If MUx/Px < MUy/Py , consumer will decrease consuming good x in order to
achieve equilibrium
Maximizing utility depend on budget constraint.
B. Derivation of Demand Curve

The law of diminishing marginal utility theory can explain why the demand curve is
downward sloping. The rational consumer will always try to be in equilibrium condition.
Example: Original equilibrium position of consuming 2 goods
MUx/Px = MUy/Py 10 / 2 = 40 / 8
If the price of good x increases from RM2 to RM4, the consumer will be in a state of
disequilibrium. In order to achieve equilibrium, the consumer will buy less of good x
such that marginal utility of good x rises to 20. Only then he is in equilibrium again.
MUx/Px = MUy/Py 20 / 4 = 40 / 8
This explains why the demand for good x falls as price increases and vise versa.
Refer question 3 for illustration
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Examples:
Question 1
Given quantity and total utility of good x and good y, if the price of x is RM2.00, price of y is
RM3.00, and total budget is RM20.00, determine which combination of good x and good y
yields the greatest utility?
Answer:
Quantity
TUx
TUy
MUx
MUy
MUx/Px
MUy/Py
10
24
10
24
5*
18
45
21
4 **
24
63
18
3 ***
28
78
15
5*
30
90
12
4 **
31
99
0.5
***
Combination of good x and y which yields maximum utility

Combination
Good x
Good y
MU/P
Total spending
( 1 X RM2) + ( 4 X RM3) = RM14
**
( 2 X RM2) + ( 5 X RM3) = RM 19
***
( 3 X RM2) + ( 6 X RM3) = RM 24
Given the budget equal to RM 20, the best combination will be 2 units of good x
and 5 units of good y.
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Question 2
Assuming the price of good x decrease from RM2 to RM1 with the price of good y and
given budget remaining the same, determine the combination of good x and y which yields
maximum utility.
Answer:
Quantity
TUx
TUy
MUx
MUy
MUx/Px
MUy/Py
10
24
10
24
10
8*
18
45
21
8*
24
63
18
6**
6**
28
78
15
30
90
12
4***
31
99
4***
Combination of good x and y which yields maximum utility

Combination
Good x
Good y
MU/P
Total spending
( 2 X RM1) + ( 1 X RM3) = RM 5
**
( 3 X RM1) + ( 3 X RM3) = RM 12
***
( 4 X RM1) + ( 5 X RM3) = RM 19
Given the budget equal to RM 20, the best combination will be 4 units of good x
and 5 units of good y.
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Question 3
Derive the demand curve for good x based on the answer from question 1 and question 2
Price x
Answer:
When price of x =RM2.00, Qd = 2 units
2.00
When price of x =RM1.00, Qd = 4 units
1.00
Quantity
of good
x
Question 4
Aminah spends her disposable income on food and clothing. When her weekly income is
RM200, she buys 10 units of food at a price of RM2. Her marginal utility from food
consumption is 20. If the price of a clothing unit is RM4, Aminahs marginal utility from
clothing is:
Answer:
Condition for equilibrium:
MU food / Price food = MU clothing / Price clothing 20 / 2 = MU clothing / 4
MU clothing = 40 utils
Question 5
If MUx = 20 utils, Px = RM2.00, MUy = 12 utils and Py = RM4.00, which good should be
consumed more?
Answer:
Condition for equilibrium: MUx / Px = MUy / Py
MUx / Px = 20 / 2 = 10
MUy/Py = 12 / 4 = 3
Since MUx / Px > MUy / Py
the consumer will then consume more of good x and less of good y
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II. ORDINAL UTILITY APPROACH

A. Indifference Curve (IC)
An indifference curve (IC) is a set of points, each point representing a combination of
two goods, all of which yield the same level of satisfaction
Characteristics of Indifference Curve (IC)
IC is downward sloping from left to right (negatively sloped)
The points along the curve represent the combination of 2 goods which will give the
same level of satisfaction.
Example: consuming 14Y and 5X yield the same satisfaction as consuming 9Y and 7X.
Point a, b and c represents the same level of satisfaction

Figure: Indifference Map
Good Y
Good Y
14
IC3
IC
IC2
IC1
5
15
Good X
Good X
IC that lie farther from the origin represent higher levels of satisfaction IC3
represents the highest level of satisfaction relative to IC2
IC cannot intersect another IC, due to the principle of transitivity.
Example: If A, B, and C are bundles of goods, and a consumer prefers A to B, and B

to C, then the consumer prefers A to C (rationality).
Marginal rate of substitution (MRS) represents the slope of IC
MRSxy = Y / X = - MUx / MUy
IC convex to origin due to the principle of diminishing marginal rate of

substitution.
As the point move to the right, quantity of good y falls, hence marginal utility for y
increases; while quantity of x increase, hence marginal utility for x decrease.
Because the slope is MUx/MUy, the slope must therefore be decreasing as the point
move to the right along the curve.
(Convex to the origin means that the slope decreases as we move down the curve
from left to right.)
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B. Budget Line
A line that shows the combinations of any two goods, given the level of income and
the price of both goods.
Given : Price of x = RM10; Price of y = RM5;
The slope of budget line = - Px / Py
Good y
Figure: Budget Line
Income = RM100
The equation of the budget line:
20
10
10x + 5y = 100
5y = -10x + 100
y = -2x + 20
BL
5
10
Good x
Possible combination: 5 good x and 10 good y, 10 good x and 0 good y, and 0 good
x and 20 good y
Change in the budget line

Good y
If price of good x falls to RM5.00 while
Figure:
Budget line- Change in price
20
price of y is RM5 and income is RM100
5x + 5y = 100
5y = -5x + 100
y = -x + 20
10
BLo
5
If income increase to RM140 while

10x + 5y = 140
5y = -10x + 140
y = - 2x + 28
10
20
Good x
Good y
price of x is RM10 and price of y is RM5
BLn
Figure:
Budget line- Change in income
28
20
10
BLn
BLo
10
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14
Good x
C. Consumer Equilibrium
Consumer equilibrium is at the tangential point of the budget line and indifference curve.
The conditions to achieve consumer equilibrium:
fully spend the income given
achieve maximum satisfaction
the slope of indifference curve (MRS) equal with the slope of budget line (-Px/Py)
MRSxy = - Px/Py
Consumer equilibrium single indifference curves with multiple budget lines

Point
a, b, c, d and
e
c
a and e
f
Description
Same level of satisfaction
Consumer is in equilibrium position: maximum
satisfaction with minimum budget
High level of satisfaction but consumer need to spend
more than budget
Though cheaper, the satisfaction level is low.
Good y
a
b
c
f
BL1
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BL2 BL3
59
IC
BL4
Good x
Consumer equilibrium single budget line with multiple indifference curve

Point
e
Description
Consumer is in equilibrium position: maximum satisfaction with minimum budget
a and b Lower level of satisfaction compared to IC2

c
Lower level of satisfaction and not fully used the budget given
High satisfaction but not attainable given the budget line.
Good y
d
IC3
b
BL
IC2
IC1
Good x
EXERCISES
Structure
1. If a rational consumer is in equilibrium, then,
A. marginal utility obtained from one product is equal to the marginal utility obtained
from any other product.
B. a reallocation of income would increase the consumers total utility.
C. marginal utility per last ringgit spent is the same for all goods consumed.
D. total utility becomes zero.
2. If Mux/Px < Muy/Py, a consumer who spend all of his income on these two goods
A. can never maximize utility
B. has maximized their total utility
C. can increase utility by buying more of good y and less of good x
D. can increase utility by buying more of good x and less of good y
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3. Lia spends RM150 on movie tickets and pizza. The price of a pizza is RM10 and a movie
ticket is RM7.50. If Lia buys 9 movie tickets, how many pizzas can he afford?
A. 7
B. 10
C. 9
D. 8
Sue consumes apples and bananas. Suppose Sues income doubles and the prices of
apples and bananas do not change. Sues budget line will:
A. shift rightward and its slope will not change
B. remain unchanged
C. shift rightward and become steeper
D. shift leftward and its slope will not change
Apples (number per month)
4.
5.
10
20
40
oranges (number per month)
The figure above shows Sallys budget line and one of her indifference curves. At point
a, Sallys marginal rate substitution is ______
A.
B. 40
C. 10
D. 4
6. The marginal rate of substitution is defined as the

A. relative price of the two goods
B. magnitude of the slope of the indifference curve
C. inverse of the slope of the budget line
D. marginal cost of each slope
7. An indifference curve shows combinations of goods ____
A. that are inside or on the budget line
B. that are affordable
C. which the consumer prefers equally
D. that have the same relative price
8. All points above a given indifference cure are
A. definitely affordable
B. preferred to any point on the indifference curve
C. definitely not affordable
D. inferior to any point on the indifference curve
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Structure questions
1. The following is the price of two goods, A and B and the total utility for consumer Z.
Price of good A = RM30 ; Price of good B = RM20
Quantity
TU A
29
50
68
83
93
101
TU B
20
35
49
61
71
78
a. If the budget given is RM170, calculate how many of good A and good B will be
bought by consumer Z to maximize utility from both goods.
b. Calculate the total utility gained by consumer Z
2. The schedule below shows the marginal utility of shoes and cloth bought by Alina.
Quantity
Marginal utility for shoes
20
18
14
10
Marginal utility for cloth
40
30
25
20
15
a. If the price of shoes is RM40 and the price of cloth is RM60 and Alinas income is
RM460, calculate how many shoes and cloth will be bought by Alina to maximize her
utility.
b. Calculate the total utility gained by Alina.
c. If the price of shoes is reduce to RM20 and Alinas income increase to RM480,
calculate how many shoes and cloth will she bought to maximize her utility.
d. Based on question c, calculate the total utility gained by Alina.
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3. The diagram below shows the equilibrium position of a consumer who has spent RM600
on good Y and good X. The budget line and indifference curves are shown in the
diagram. BLo is the original budget line and BLn is the new budget line.
Good X
60
A
Qx
E
D
33
I3
I2
I1
C
BLo
Qy 20
BLn
40
75
Good Y
a. Calculate the original price of good Y and good X

b. Determine the value of Qy.
c. What is the new price of the good Y?
d. Determine the value of Qx.
e. Referring to a new budget line (BLn), which combination will give the highest possible
utility to the consumer? Why?
f.
Is utility maximum at combination C
g. State the condition for maximizing utility from the ordinal approach.
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63

Consumer Behavior

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CONSUMER BEHAVIOR THEORY