The Consumer TheoryHow they make the choice

What is behind a consumers demand curve? How do consumers choose from among various consumer goods? What determines the value of a consumer good?

The principle assumption upon which the theory of consumer behavior and demand is built is: a

consumer attempts to allocate his/her limited money income among available goods and services so as to maximize his/her utility (satisfaction).

The value a consumer places on a unit of a good or service depends on the satisfaction he or she expects to derive from consuming it at the point of making a consumption (consumer) choice. economics the satisfaction or pleasure consumers derive from the consumption of consumer goods is called utility. however, cannot have every thing they wish to have. Consumers choices are constrained by their incomes & other factors. the limits of their incomes, consumers make their consumption choices by evaluating and comparing goods with regard to their utilities.

In

Consumers,

Within

Consumption & Utility

A households consumption choices are determined by Budget constraint Preferences.

Utility is the benefit or satisfaction that a person gets from the consumption of a good or service. Utility can also be regarded as the ability of a product to satisfy demand. It also refers to an individuals expected level of satisfaction in consuming a product or service.

 It

is subjective Depends on the mental attitude & emotions of consumers. Has no physical or material existence. Higher the price, greater the utility. {eg: buying an original movie DVD and buying a pirated movie CD}

 Total

utility - The total benefit or satisfaction that a person gets from the consumption of goods and services. utility - The change in total utility resulting from a one-unit increase in the quantity of a good consumed. equilibrium - A situation in which a consumer has allocated his or her income in the way that, given the prices of goods and services, maximizes his or her total utility.

Marginal

Consumer

( s T R .) U 111

( s M R .) U - -

Utility
Refers

Satisfaction
Refers

to expected satisfaction in consumption of product. Related to the pre -purchasing stage Measured by the price paid for the product.

to the contentment realized after consuming a product. Related to the stage after purchasing Cannot be measured by the price paid to the product.

 The

Cardinal Theory

Utility

is measurable in a cardinal sense i:e utility can be quantifiable. (Measurable). Also known as Marshallian utility analysis.

The

Ordinal Theory
is measurable in an ordinal sense

Utility

19th century economists assumed that utility was measurable in a cardinal sense, which means that the difference between two measurement is numerically significant. UX = f (X), UY = f (Y), .. eg: my utility for 1 glass of coffee as 20 units compared to 10 units of utility for a glass of Pepsi. U coffee = f (20), U Pepsi = f (10), ..

 Consumers

are utility maximizers Consumers prefer more of a good (thing) to less of it. Facing choices X and Y, a consumer would either prefer X to Y or Y to X, or would be indifferent between them. Transitivity: If a consumer prefers X to Y and Y to Z, we conclude he/she prefers X to Z Diminishing marginal utility: As more and more of good is consumed by a consumer, ceteris paribus, beyond a certain point the utility of each additional unit starts to fall.

According to Marshall, the additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has. we could say: over a given consumption period, as more and more of a good is consumed by a consumer, beyond a certain point, the marginal utility of additional units begins to fall.

Alternatively,

 The

consumer is a rational person. Successive units consumed are identical. The unit of consumption is of specific standard. Eg: no. of biscuits Consumption is simultaneous without time interval. Utility is measurable objectively. Taste & Preference do not undergo change. Income of the consumer remains constant.

Total Utility

(Marginal Utility
- -

(R s ) TU(R s ) M U 111 - -

Law of demand Consumer surplus Value paradox (the value in use & the value in exchange are different. Diamond has great value in exchange coz of its limited ss, value is high as it offers greater utility. But water has greater value in use as it is abundantly available but no value in exchange.) Taxation

The law suffers from the criticism that utility is subjective in nature and can not therefore be measured objectively. Money gives consumer increasing marginal utility but not constant marginal utility. Continuous consumption may not be possible in practice. Limited physical capacity of human.

 Consumer

equilibrium can be defined as a consumption bundle that is feasible given a particular budget constraint and maximizes total utility. can also be defined as the point of consumption that equates the marginal utility of a product or service to the price of the product or service.

It

In order to maximize satisfaction a consumer tries to equalize marginal utilities of all the last units of various goods purchased by him. Every consumer has a limited income, which he has to spend on various goods. A consumer is said to be in equilibrium when his marginal utility is 0.

 Equi

marginal utility state that the consumer will distribute his money income between the goods in such a way that the utility derived from the last rupee spent on each good is equal. Consumer gets equilibrium when his marginal utility of money expenditure on each good is the same.

Following table explains consumption behaviour.

Situation MU exceeds price MU is less than the price MU equates the price

Consumer behaviour Consumes the product Does not consume the product Consumes the product but decides not to consume further.

 To

consumers for allocating financial resources among various needs. To producers, to allocate various factors of production towards producing product. Also to the channel members. To government, for the purpose of promoting entrepreneurial activities in the state.

 Consumers

are not rational & calculative. Not possible to measure utility in cardinal terms for all the products & services. Indivisibility of goods.

 Here,

it is stated that utility is subjective and hence cannot be measured. But utility for different products can be compared by assigning ranks in the order of preference of the consumer.

 Consumer

possess all relevant information about the product & market. They aim at maximizing their total satisfaction through rational consumption decisions. They rank goals on a continuous manner.

 Consumer

surplus is a measure of the difference between the amount of money a person was willing to pay to buy a quantity of good and the actual price they paid. This measure is used as a tool in policy analysis. Consumer surplus is represented graphically as the area underneath the demand curve above the price paid for the goods.

 Consumer

Surplus - the difference between the price buyers pay for a good and the maximum amount they would have paid for the good.

Example:

Im willing to pay Rs.60 for a bottle of Diet coke Diet coke is on sale for Rs.50 per bottle Consumer surplus = Rs.10

 Enables

the manager to fix the right price for the products. Helps in taking investment decisions. Import decisions Taxation decisions

 As

consumers, all of us has unlimited wants and desires. All our desires cannot be fulfilled coz of the reason that we have less money at our disposal. A consumers consumption is routed through his income capabilities. The limited income limits us from buying whatever we want to buy is called Budget constraint. Budget line is a downward sloping line.

Units of Product X 0 5 10 15 20 25 30 35 40

Units of product Y 8 7 6 5 4 3 2 1 0

Exp on X 0 1000 2000 3000 4000 5000 6000 7000 8000

Exp on Y 8000 7000 6000 5000 4000 3000 2000 1000 0

Total exp 8000 8000 8000 8000 8000 8000 8000 8000 8000

Y Income = Px .Qx + Py. Qy I/Py

X O I/Px

 Budget

constraint explains the limit on the affordability of consumer. Consumers choice depends on his set of preferences between diff goods. Indifference curves An indifference curve is a line drawn in a twodimensional space showing different combinations of two goods from which the consumer draws the same amount of utility and therefore he/she is indifferent about.

 Indifference

curves for two goods are generally negatively sloped The slope of an indifference curve reflects the degree of substitutability of two goods for one another Indifference curves are generally convex, reflecting the principle of diminishing returns Indifference curves never cross Indifference curves that are farther from the origin represent higher levels of utility Indifference curves never intersect each other.

U4 U3 U2 U1 O X

 In

ordinal study, consumers utility is a function of budget constraints and preferences . Hence, he obtains equilibrium at that consumption bundle for which the consumers indifference curve is tangent to his budget line.

x2
Consumption of pepsi

10

5 1 Budget line 1 2.5 5 Consumption of pizza

U = 25 U = 12.5 U=1 x1

 Here,

consumer obtains equilibrium at utility level 12.5 as the budget line becomes tangent to the this indifference curve. But when consumers income increases, his budget line also shifts to right and become tangent to higher level of indifference curve. When his income decreases, his budget line moves towards left and become tangent to lower level indifference curve.

 Substitution
It

Effect

is the change in the quantity consumed due to a change in the price of the good, while holding other prices for goods constant and utility constant.

Income
It

Effect

is the change in the quantity consumed due to a relative increase in a change of income while holding prices constant.

 Assume

that the price for soda has decreased. To find the substitution effect graphically, we examine what quantities would be consumed if the consumer had to stay on her original indifference curve facing the new prices.
This

is equivalent to taking a parallel line to the new budget line and setting it tangent, i.e., just touching at one point, to the old utility level.

Quantity of Chips

Original consumption level

Original Budget line

New consumption level

I2 I1 New Budget Line Quantity of Soda

Substitution Effect

Income Effect

 Prof.

Samuelson has propounded this theory. It provides behaviorist explanation of consumer demand. This theory state that utility can be analyzed by observing the behavior of consumers in the market, where as the other two theories are psychological models. When a consumer reveals his preference by selecting one product, he rejects others as they are inferior.

 RISK

in economics means variations in the outcome of an event. No two individual has same risk bearing ability. We classify the consumers into: 1. Risk averters doesn't like to take risk. 2. Risk seekers willing to bare with high returns. 3. Risk neutrals change in income should be equal to change in utility of money income.