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Today’s Discussion
• Fundamental Economic Questions revisited

• Consumer Preferences
Utility, Total Utility, Marginal Utility and
Law of Diminishing Marginal Utility

• Budget Constraints
• Consumer Choice/Consumer Equilibrium
Consumer Behaviour
• Why people buy goods and services?

Primary goal of consumers is maximization of satisfaction from

consuming the goods

Economists call this satisfaction “Utility”

• But how do we measure satisfaction???

Consumer Behaviour
• Can satisfaction you derive from consumption of a good be
measured in some units of measurement?

There are different opinions! Cardinal and Ordinal


To Cardinal Economists, the motivation to consume goods

is to gain utility which is measurable in some numerical
Consumer Behaviour
• There are three steps involved in the
study of consumer behavior.

1) To describe how and why people

prefer one good to another.
Consumer Behaviour
2) Then we will turn to budget constraints.
• People have limited incomes.
3) Finally, we will combine consumer
preferences and budget constraints to
determine consumer choices.
What combination of goods will consumers
buy to maximize their satisfaction?
Consumer Behaviour
It is assumed that consumers always
prefer more of any good to less. That is,
consumer is rational. This is called
economic rationality.
How can we determine the consumers

It is by looking at the Utility.

Utility is the satisfaction or pleasure derived from
consumption of a good or service.

Utility received from consumption varies from

person to person. It is subjective.

Actual measurement of utility is impossible! But

to Cardinalists believe it is possible
Ordinal Versus Cardinal Utility

The actual unit of measurement for utility is

not important- ordinal school of thought

Therefore, an ordinal ranking is sufficient

to explain how most individual decisions are
Total Utility

Total level of satisfaction derived from all

units of a good consumed.

Suppose Good X.

U = f (x1, x2, x3…)

U(x1, x2, x3),.. = U1 (x1) + U2 (x2)+…

Marginal Utility

Marginal utility measures the additional

satisfaction obtained from consuming one
additional unit of a good.
• Where ∂ U is change in utility
∂ Q is change in quantity consumed
Total Utility and Marginal Utility-
A Hypothetical data
Units of Food Total Utility Marginal
Consumed Utility
0 0 -
1 40 40
2 60 20
3 70 10
4 75 5
Total and Marginal Utility

• Example
– The marginal utility derived from increasing from 0
to 1 units of food might be 40
– Increasing from 1 to 2 might be 20
– Increasing from 2 to 3 might be 10

Observation: Marginal utility is diminishing

Law of Diminishing Marginal
• When more and more of a good is consumed,
consuming additional amounts will yield
smaller and smaller additions to utility.
• The extra satisfaction of a good declines as
people consume more and more.

This is a universal principle of human

consumption behavior
Utility Maximization in a world
of without Scarcity

• If a good is free, you increase

consumption as long as additional
units provide you positive utility.

• In our previous example, consumer will

consume 4 units. Thus his total utility
is maximixed (75 Utils)
Utility Maximization in a
World of Scarcity
• But Goods are not free!

• In the real world, consumption depends

on tastes, Prices, and your income.

• Now we will turn to Budget Constraints.

Budget Constraints

Preferences do not explain all of

consumer behavior.
• Budget constraints also limit an
individual’s ability to consume.

• Suppose you allocate your income for 2

goods, Food and Cloths
The Budget Line
• Price of Food is Rs. 100 per unit
• Price of Cloths is Rs. 200 per unit
• You have disposable income of Rs.800
• Given the price and income, you have different
consumption possibilities.
• Budget Line shows all combinations of two
commodities for which total money spent equals total
Pf. F + Pc. C = Total Income

Spending on food +Spending on Cloth =Total Budget

Budget Constraints
Market Basket Food (F) Clothing (C) Total Spending
Pf = (Rs.100) Pc = (Rs.200) PfF + PcC = Income

A 0 4 Rs.800
B 2 3 Rs.800
C 4 2 Rs.800
D 6 1 Rs.800
F 8 0 Rs.800
Budget Line-Graphically
Budget Line

3 B

2 C

1 D

0 E Food (per
2 4 6 8 week)
Shift in Budget Line
Due to Income Changes
An increase in income causes the budget line to shift outward,
parallel to the original line (holding prices constant).

A decrease in income causes the budget line to shift inward,

parallel to the original line (holding prices constant).
New Budget Line
when income
A increases

3 B

2 C
line when 1 D
decreases E
2 4 6 8 16
Food (per week)
Shift in Budget Line
Due to Price Changes

If the price of one good increases, the budget line shifts

inward, pivoting from the other good’s intercept.

If the price of one good decreases, the budget line shifts

outward, pivoting from the other good’s intercept.
Due to decrease
3 in the price of

2 4 6 8 16
Food (per week)
Price of Food Decreases
Market Basket Food (F) Clothing (C) Total Spending
Pf = (Rs.50) Pc = (Rs.200) PfF + PcC = Income

A 0 4 Rs.800
B 4 3 Rs.800
C 8 2 Rs.800
D 12 1 Rs.800
F 16 0 Rs.800

Due to
increase 2
in the
price 1
of food
2 4 6 8
Food (per week)
Consumer Choice
• How do you allocate our disposable
income between the two goods to
maximize utility?
Consumers choose a combination of goods that will
maximize the satisfaction they can achieve, given the
limited budget available to them.
• Consumers will consider their
Preferences (utility)
Market prices, and their Income
Marginal Utility and
Consumer Choice

Total utility is maximized when the total

budget is spent and the marginal utility for
the final unit consumed divided by that
good’s price is identical for each good
Consumer Choice- A
hypothetical example

• Suppose you want to consume Apple and

• Price of Apple is Rs.8 per one.
• Price of Orange is Rs. 4 per one
• You have Rs. 40 with you.
• Then, how do you allocate your limited
budget to maximize your total utility
given the prices and preferences?
Consumer Equilibrium- Example
Units of TU MU MU/P Units of TU MU MU/P
Apple P= Orange P=4

0 0 - - 0 0 - -
1 56 56 7 1 40 40 10
2 88 32 4 2 68 28 7
3 112 24 3 3 88 20 5
4 130 18 2 1/4 4 100 12 3
5 142 12 1 1/2 5 108 8 2
6 150 8 1 6 114 6 1 1/2
Marginal Utility and
Consumer Choice
Condition for Consumer equilibrium if we choose two
goods, Food and Cloths

M UFood / PFood = M UCloth / PCloth

This is referred to as the equal marginal principle.
• People behave rationally in an attempt to maximize satisfaction
from a particular combination of goods and services.

• Consumer choice has two related parts: the consumer’s

preferences and the budget line.

• Consumers make choices by comparing bundles of commodities.

• Consumers maximize satisfaction subject to budget constraints
Topics of Discussion

• What is behind the Law of Demand?

• Income Effect
• Substitution Effect
• Ordinal Approach to Consumer Behavior
• Consumer Surplus
• Types of Demand
What is behind the Law of Demand?
Any logic from
behavior point of

Why do you purchase less at higher
price and more at lower price?
Price changes alter your real income
Money Income Vs eal Income
A rise in prices decreases purchasing power, and a fall in
prices increases purchasing power.

Recent rise in Petroleum

It causes an increase/decrease in the consumer’s
willingness and ability to purchase a good.
This income effect is one of the reasons for law of demand.
Any other explanation?

Suppose the price of a good rises, then you will consume

less of that good. Why?

When the price of a good rises, consumers may switch

to more affordable substitutes. This is substitution effect.

This is second reason behind the law of demand

Ordinal Approach to
Consumer Behavior

• Ordinal approach to Consumer Behaviour

• Indifference curves
• Properties of ICs
• Consumer equilibrium using IC analysis
Ordinal Approach
• Economic rationality is assumed

• Consumers are able to rank their preferences for various

combinations of goods

• A is preferred to combination B or both combinations A and B

are equally preferred.
• If A is preferred to B, then A gives him more utility/satisfaction
Indifference Curve
• Ordinal approach use indifference curves to
analyze consumer preferences

• An indifference curve shows all combinations of

goods that provide the consumer with the same
satisfaction, or the same utility.

• Numerical measure of utility is not required

Indifference Curve

• All combinations on an IC are equally preferred.

• Total utility is same at all combinations on an IC

• So consumer is indifferent about which

combination to choose.
Properties of IC
• IC slope downward

• Higher IC represent higher levels of utility

• IC will not intersect

Indifference Map
• An indifference map is a graphical representation of
a consumer’s tastes for two goods

• Each curve in the map reflects a different level of


• Then how we will decide given a consumer’s

indifferent map, how much of each good will be
consumed? This is a consumer choice problem
Consumer Choice/Equilibrium
We need to consider

• the relative prices of the goods and

• the consumer’s income

Consumer Equilibrium
• The indifference curve indicates what you
are willing to buy

• The budget line shows what you are able

to buy

• Now find out what quantities of each good

you are both willing and able to buy.
Consumer Equilibrium
• In equilibrium - that is, when the
consumer maximizes utility- the last
rupee spent on each good (Food and
Cloth for instance) yields the same
marginal utility.

MUFood / PFood = MUCloth / PCloth

The Concept of Consumer
• The demand curve can be viewed as a willingness-to-
pay curve.

• It shows the value that consumers place on extra units

of the good.

• Consumer Surplus is the difference between what a

person is wiling to pay for a commodity and the
amount that he actually is required to pay
Consumer Surplus
• Consumer surplus = total willingness to pay for a good -
the total amount consumers actually do pay.

• Consumer enjoys consumer surplus if he pays the same

amount of money for each unit of good he buys.
Consumer Surplus (CS)
• It is a measure of the net benefits
received by the consumer.

• CS occurs when people are able to

buy a good for less than they would
be willing to pay. They enjoy more
utility than they had to pay for.
Application of Consumer
• This concept has more public policy relevance.

• Since it is a measure of the net benefits

received by the consumer, government can
estimate the loss or increase in consumer
welfare due to any policy change.
Types of demand

• Individual and Market Demand

• Direct and Derived Demand
• Total Market and Segmented Market Demand
• Domestic and Industrial Demand
Types of demand
• Company and Industry Demand
• Final and Intermediate Demand
• Perishable and Durable goods demand
• New and replaceable Demand
• Autonomous and Induced Demand
• Short run and Long run Demand
When the price of a good increases, one effect Quiz Time
of this price increase is that consumers of that
good experience a decline in their purchasing
power that is like a decline in income. For
normal goods, this contributes to the law of
demand. What is this effect called?

A. The substitution effect.

B. The income effect.

The law of diminishing marginal
utility states that as more and
more units of a good or service are
consumed, total utility becomes
smaller and smaller.

a. True.

b. False.
In a consumer equilibrium, which of the following is

a. The marginal utility from the last unit of each good

consumed is equal.

b. The price of each unit consumed is equal.

c. The total utility derived from consuming all the units of

each good is equal.

d. The marginal utility per rupee spent is equal for the last
unit of each good consumed.