Consumer Behaviour

Utility Analysis
UTILITY, INDIFFERENCE CURVE AND BUDGET
CONSTRAINT
How an Individual consumption decisions are made???
Consumer theoryisthestudyofhowpeopledecidewhattospendtheirmoney
ongiventheirpreferencesandtheirbudgetconstraints.

The Budget Constraint ???

TABLE 6.1 Possible Budget Choices of a Person Earning $1,000 per Month after Taxes

Monthly Other
Option Rent Food Expenses Total Available?
A $400 $250 $350 $1,000 Yes
B 600 200 200 1,000 Yes
C 700 150 150 1,000 Yes
D 1,000 100 100 1,200 No

choice set or opportunity setThesetofoptionsthatisdefinedandlimitedby

abudgetconstraint.
Ingeneral,thebudgetconstraintcanbewritten

PXX + PYY = I,

wherePX=thepriceofX, X=thequantityofXconsumed,PY=thepriceofY,
Y=thequantityofYconsumed,andI=householdincome.
If buyers are completely are aware about:
Range of products available
Prices of all products
Capacity of products to satisfy
Their income
consumers will rank all consumption bundles based on the level of satisfaction they
would receive from different units of consumption.

Assumptions
Emotional component to purchase
Consumer preferences
Availability of Quantity demanded
Utility: the Benefits what consumers obtain from goods & services
they consume is utility.

A numerical score representing the satisfaction that a consumer

gets from given consumption basket.

For example : If buying 3 copies of books give more happiness

than buying a shirt, it can be said that books give you more utility
than shirt

Utility function: an equation that shows an individual perception of

the level of utility that would be attained from consuming each
conceivable bundle of goods. U = F (X,Y)
Cardinal approach: Utility can be measured in subjective units.

Ordinal approach: Utility can not be measured , but can only

ranked in order of preference.

Goods Utility Rank Measuring utility in utils

Order
A 14 1 (Cardinal) Jack derives 10 utils from having one
slice of pizza but only 5 utils from having a burger.
B 03 4 Measuring utility by comparison
C 10 2
(Ordinal): Jill prefers a burger to a slice of pizza
D 08 3
and a slice of pizza to a sandwich.
Total utility (TU): Total utility is the total utility a consumer
derives from the consumption of all of the units of a good
or a combination of goods over a given consumption
period, ceteris paribus.
Total utility [TU] is defined as the amount of utility an
individual derives from consuming a given quantity of a good
during a specific period of time. TU = f(Q, preferences, . . .)

Utility TU
Q TU 120

. . . . . TU

.
1 30 100

.
2 55 80
3 75

.
60
4 90 40
5 100 20
6 105
7 105 1 2 3 4 5 6 7 Q/ut
8 100
 In other words, we can say that at a particular point of consumption, the consumer
maximizes his satisfaction which is known as satisfaction quantity.
Further consumption of that particular product decreases his satisfaction level.
In his estimation, the first apple is the best out of the lot available to him and thus
gives him the highest satisfaction, measured as 20 utils.
The second apple will naturally to be second best with lesser amount of utility than
the first and has 15 utils. The third apple has 10 utils and the fourth 5 utils.
This means that the consumption of a particular product gives satisfaction to a
person initially but after some time, utility starts diminishing.
Total utility is the sum total of utilities obtained by the consumer from different
units of a commodity 20, 35, 45, 50, 50, 45 and 35 utils.
The total utility of successive units of commodities increases initially, constant in
the middle and diminishes in the end.
 Marginal utility (MU): Marginal utility is the utility a consumer
derives from the last unit of a consumer good she or he
consumes (during a given consumption period), ceteris
paribus.

Marginal utility (MU) The additional satisfaction gained by

the consumption or use of one more unit of a good or service.
 Marginal utility (MU)
Marginal utility is the addition made to total utility by having an additional unit of the commodity.
In other words, marginal utility of a commodity is the additional utility derived by a consumer, by
consuming one more unit of that commodity.
Algebraically, the marginal utility (MU) of on units of a commodity is the total utility (TU) of n units
minus the total utility of n-1.
MU = TUn Tun - 1
Marginal utility can be defined as the change in the total utility resulting from a one-unit change in the
consumption of a commodity per unit of time.
Relationship between TU and MU
Units of Apple Total Utility (TU) Marginal Utility
MU = TU/Q
1 20 20
2 35 15
3 45 10
4 50 05
5 50 00
6 45 -05
7 35 -10
Diminishing Marginal Utility and Downward-Sloping Demand

The law states that as the quantity consumed of a commodity increases per unit
of time, the utility derived by the consumer from the successive units goes on
deceasing, provided the consumption of all other goods remains constant.

The unit of consumption must be a standard one.

Consumption must be continuous
The tastes and preferences of the consumer should remain unchanged during
the course of consumption
The goods should be Normal and not Addictive in nature
Limitation of Law of Diminishing Marginal Utility
1. Homogeneous units
2. No change in Tastes
3. Continuity
4. Suitable size units
5. Constant Prices
6. Indivisible Goods
7. Rational Consumers
 1. Homogeneous Units
There should be a single commodity with homogeneous units wanted by an individual consumer.
All units of the commodity should be of the same weight and quality.
If for example, the first apple is sour and the second sweet, the second will give greater satisfaction than
the first.
2. No change in Tastes and habits
There should be no change in the tastes, habits, customs, fashions and income of the consumer.
A change in any one of them will increase rather than diminish utility.
3. Continuity
There should be continuity in the consumption of the commodity.
Units of the commodity should be consumed in succession at one particular time. Pieces of bread taken
at random may increase utility.
4. Suitable size units
Units of the commodity should be of a suitable size. Giving water to a thirsty person by spoons will
increase the utility of the subsequent spoons of water.
 5. Constant prices
Prices of the different units and of the substitutes of the commodity should remain the same.
6. Individual goods (Durable goods)
The commodity should not be indivisible. In the case of durable consumer goods it is not
possible to calculate their utility because their use is spread over a period of time.
Moreover, a consumer does not buy five scooters, six television sets or even three sewing
machines for his personal consumption.
7. Rational Consumers
The consumer should be an economic man, who acts rationally.
If he is under the influence of an intoxicant, say wine or opium, the utility of the later
units will rise.
But this exception is not wholly true. In the beginning the marginal utility of each peg rises
but ultimately it starts falling and even becomes negative when a drunkard starts vomiting.
 8. Ordinary Goods
Goods should be of an ordinary type. If they are commodities, like diamonds and jewels or
hobby goods like stamps, coins or paintings, the law does not apply.
The utility of the additional coins or jewels may be greater than the earlier pieces.
But this view is not correct. For the law also applies in their case.
The collector of coins or jewels will never like to have innumerable pieces of the same coin or
jewels.
Similarly, the marginal utility of the second set of a particular issue of stamps will diminish for
the stamp collector if he already possesses one.
 Ordinal Utility Analysis - Indifference Curve Analysis

The consumer can only compare his levels of satisfaction in terms of degrees
good, better, best or bad, worse and worst and cannot measure it in terms of
numbers as assumed by Marshallian analysis.
The Indifference curve analysis is a technique for explaining how
choices between two alternatives are made.

Locus of points representing different bundles of goods, each of which yields

the same level of total utility

A curve that defines the combinations of 2 or more goods that give a consumer
the same level of satisfaction.

Negatively sloped & convex

 Y IC1 = 20
Anindifference
curveisagraph
showingcombination 9 A
oftwogoodsthat

Commodity Y
givetheconsumer Indifference Curve
equalsatisfactionand
utility.Eachpointon B
6
anindifference 4 C
curveindicatesthata 3 D IC1 = 200
consumeris
indifferentbetween
thetwoandallpoints 0 1 2 3 4 X
givehimthesame Commodity X
utility.
Assumptions of Ordinal Utility Theory

1. Rationality and full information

2. Ordinal Utility
3. Transitivity and Consistency of Choice
4. Non-satiety
5. Diminishing Marginal Rate of Substitution
1. Rationality the consumer is a rational being. He aims at maximising his total satisfaction,
given his income and prices of goods and services he consumes. He has full knowledge of his
circumstances.
2. Ordinal Utility Indifference curve analysis assumes that utility can be expressed only
ordinally scale of preference
3. Non-satiety consumer always prefers a larger quantity of all the goods
4. Transitivity and Consistency of Choice
Consumers choices are transitive. Transitivity of choice means that if a consumer prefers A
to B and B to C, he must prefer A to C. Or, if he treats A= B and B = C, he must treat A = C.
Consistency of choice means that, if he prefers A to B in one period, he will not prefer B to A
in another period or treat them as equal.
The transitivity and consistency in consumers choices may be symbolically expressed as
follows
Transitivity If A > B, and B > C, then A > C and
Consistency If A > B, in one period, then B > or B = A
 5. Diminishing Marginal Rate of Substitution
The marginal rate of substitution means the rate at which consumer is willing to
substitute one commodity (X) for another (Y)
i.e., the units of Y he is willing to give up for one unit of X so that his total satisfaction
remains the same.
This rate is given by Y/X. The assumption is the Y/X goes on decreasing, when
a consumer continues to substitute X for Y.
Indifference Curve properties
IC will be downward sloping : If they sloped upward, they would violate the assumption that
more is preferred to less

An IC must be convex to the origin :As more of one good is consumed, a consumer would
prefer to give up fewer units of a second good to get additional units of the first one. As food
becomes less scarce, he/she would give up less of clothing for an additional food.

Two ICs can not intersect each other.

Higher Indifference curve gives higher level of satisfaction

 Indifference Map

To describe preferences for all combinations of goods/services, we have a set of

indifference curves an indifference map is a set of a indifference curves
shifting to the right.
Marginal Rate of Substitution : MRS shows the rate at which one
good can be substituted for another while keeping utility constant

Negative of the slope of the indifference curve

Diminishes along the indifference curve as X increases & Y

decreases

Ratio of the marginal utilities of the goods

 Diminishing Marginal Rate of Substitution

X Y DMRS
Combination Commodities Commodities of X for
Y
L 1 9 -
M 2 6 3:1
N 3 4 2:1
O 4 3 1:1
 FIGURE 6A.2 A Preference
Map: A Family of Indifference
Curves
Eachconsumerhasaunique
familyofindifferencecurves
calledapreferencemap.
Higherindifferencecurves
representhigherlevelsoftotal
utility.

MU X X ( MU Y Y )

WhenwedividebothsidesbyMUY
andbyX,weobtain

Y MU X

X MU Y

TheslopeofanindifferencecurveistheratioofthemarginalutilityofXtothe
marginalutilityofY,anditisnegative.
 Consumers Budget Line

A budget line describes the limits to consumption choices and

depends on a consumers budget and the prices of goods and
services.

Shows all possible commodity bundles that can be purchased

at given prices with a fixed money income
Consumer Equilibrium :A consumer behaves rationally and would
always aim to maximize utility , given income and prices of goods in
the consumption basket.

Is at a point where the budget line is tangent to the highest attainable

indifference curve by the consumer subject to budget constraint.

Consumer Equilibrium :
Consumers objective: to maximize his/her utility subject to income
constraint

2 goods (X, Y) Prices Px, Py are fixed Consumers income (I) is

given
Consumer Choice
FIGURE 6A.3 Consumer Utility-Maximizing
Equilibrium

Consumerswillchoosethecombinationof
XandYthatmaximizestotalutility.
Graphically,theconsumerwillmovealong
thebudgetconstraintuntilthehighest
possibleindifferencecurveisreached.
Atthatpoint,thebudgetconstraintandthe
indifferencecurvearetangent.
ThispointoftangencyoccursatX*andY*
(pointB).

MU X PX

MU Y PY
slopeofindifferencecurve=slopeofbudget
constraint
Bymultiplyingbothsidesofthis
equationbyMUYanddividingboth
sidesbyPX,wecanrewritethis
utility-maximizingruleas

MU X MU Y

PX PY
 The Utility-Maximizing Rule

In general, utility-maximizing consumers spread out their

expenditures until the following condition holds:
MU X MU Y
utility - maximizing rule : for all goods,
PX PY
where MUX is the marginal utility derived from the last unit of
X consumed, MUY is the marginal utility derived from the last
unit of Y consumed, PX is the price per unit of X, and PY is the
price per unit of Y.

utility-maximizing rule Equating the ratio of the marginal

utility of a good to its price for all goods.
diamond/water paradox A paradox stating that (1) the things with the greatest value in use
frequently have little or no value in exchange and (2) the things with the greatest value in
exchange frequently have little or no value in use.
 Water is the most essential and precious resources for
human being as well as other lives beings such as plants and
animals etc.
All living things could be die if there is no water.
We use water for drinking, washing, cleaning, bathing and
making of food as well as many other activities such as
agriculture and industries.
Nothing is more useful than water, but it will purchase
scarce anything can be had in exchange for it.
 A diamond on the contrary, has scarce any use, value but a very great quantity of other goods may frequently
he had in exchange for it.
Diamond & Water paradox perplexing observation
Price Even though water is obviously important to human activity (life cannot exist without water). The
price of water is relatively low.
Alternatively, diamonds are clearly much less important to human existence, but the price of diamonds is
substantially higher.
Utility - the utility obtained from water is obviously very great, while the utility obtained from diamonds is
substantially less.
However, because it is so plentiful, the marginal utility of water is relatively low. An extra ounce of water
provides very little additional satisfaction.
 Water Diamond Paradox
Objectives Water Diamonds
Value in Use Very high Low/very low
Value in Exchange Very low/zero Very high

Water Diamonds
Abundance in Supply Shortage in supply
Total utility is large Total utility is less or zero
Marginal utility is less or Marginal utility is high
equal to zero
Low price High price
Price Change:
Income and
Substitution
Effects
THE IMPACT OF A PRICE CHANGE

Economists often separate the impact of a price

change into two components:
the substitution effect; and
the income effect.
THE IMPACT OF A PRICE CHANGE

The substitution effect involves the

substitution of good x1 for good x2 or vice-
versa due to a change in relative prices of the
two goods.
The income effect results from an increase or
decrease in the consumers real income or
purchasing power as a result of the price
change.
The sum of these two effects is called the price
effect.
THE IMPACT OF A PRICE CHANGE

The decomposition of the price effect into the income and

substitution effect can be done in several ways
There are two main methods:
(i) The Hicksian method; and
(ii) The Slutsky method
THE HICKSIAN METHOD
Sir John R.Hicks (1904-1989)
Awarded the Nobel Laureate in Economics (with Kenneth
J. Arrrow) in 1972 for work on general equilibrium theory
and welfare economics.
THE HICKSIAN METHOD
Optimal bundle is Ea, on indifference
X2 curve I1.

Ea

I1

xa
X
1
THE HICKSIAN METHOD
A fall in the price of X1
X2 The budget line pivots out from P

P *

Ea

I1

xa
X
1
THE HICKSIAN METHOD
The new optimum is Eb on I2.
X2 The Total Price Effect is xa to
xb

Eb
Ea I2

I1

xa xb
X
1
THE HICKSIAN METHOD

To isolate the substitution effect we ask.

what would the consumers optimal bundle
be if s/he faced the new lower price for X1 but
experienced no change in real income?
Thisamounts to returning the consumer to the
original indifference curve (I1)
THE HICKSIAN METHOD
The new optimum is Eb on I2.
X2 The Total Price Effect is xa to
xb

Eb
Ea I2

I1

xa xb
X
1
THE HICKSIAN METHOD
Draw a line parallel to the new
X2 budget line and tangent to the old
indifference curve

Eb
Ea I2

I1

xa xb
X
1
THE HICKSIAN METHOD
The new optimum on I1 is at Ec. The
X2 movement from Ea to Ec (the increase
in quantity demanded from Xa to Xc)
is solely in response to a change in
relative prices

Eb
Ea I2
Ec I1

xa xc xb
X
1
THE HICKSIAN METHOD
This is the substitution effect.
X2

Eb
Ea I2
Ec
I1

X
Xa Substitution Xc
Effect 1
THE HICKSIAN METHOD

To isolate the income effect

Look at the remainder of the total price effect
This is due to a change in real income.
THE HICKSIAN METHOD
The remainder of the total effect is
due to a change in real income. The
X2 increase in real income is evidenced
by the movement from I1 to I2

Eb
Ea I2
Ec
I1

X
Xc Income Effect
Xb 1
THE HICKSIAN METHOD
X2

Eb
Ea I2
Ec
I1

xa xc xb
X
Sub Income
1
Effect Effect
HICKSIAN ANALYSIS and DEMAND CURVES
P
A fall in price from p1 to p1*

M 1 p1 x1 p2 x2
B
AC
M 1 p1 x1 p2 x2

P X1
Marshallian Demand Curve (A
P1 A & B)

P1*
B Hicksian Demand Curve (A
& C)
C
X1
HICKSIAN ANALYSIS and DEMAND CURVES

Hicksian (compensated) demand curves cannot be upward-sloping

(i.e. substitution effect cannot be positive)
 NORMAL GOODS

Since both the substitution and income effects increase demand

when own-price falls, a normal goods ordinary demand curve
slopes downwards.
The Law of Downward-Sloping Demand therefore always
applies to normal goods.
 INFERIOR GOODS

Some goods are (sometimes) inferior (i.e. demand is reduced by

higher income).
The substitution and income effects oppose each other when
an inferior goods own price changes.