Consumer Behaviour

Behind the Demand Curve

 Explanation of Law of Demand
• Law of Diminishing Marginal Utility
• Income effect
• Substitution effect
Preferences
The law of Diminishing Marginal Utility
• Utility (TU)– Satisfaction derived from consuming a
given quantity of a good or service
• Utility can be measured in terms of money –
Marshallian Cardinal Utility theory
• Marginal Utility (MU) – Additional utility a consumer
derives from consuming one additional unit of a good
• First order derivative of TU= dTU/dQ =MU>0,
• Second order derivative of TU=dMU/dQ<0
• This implies diminishing MU
• Underlying assumption: MU of money constant
 Components of Price Effect:
The Substitution Effect

• Assuming that real income is constant:

– If the relative price of a good rises, then
consumers will try to substitute away from the
good. Less will be purchased.
– If the relative price of a good falls, then
consumers will try to substitute away from
other goods. More will be purchased.
• The substitution effect is consistent with
the law of demand.
 Components of Price Effect :
The Income Effect

• The real value of income is inversely related

to the prices of goods.
• A change in the real value of income:
– will have a direct effect on quantity demanded
if a good is normal.
– will have an inverse effect on quantity
demanded if a good is inferior.
• The income effect is consistent with the law
of demand only if a good is normal.
Utility from one commodity
How much a consumer demands for a
single commodity?
MU

PX

QX X
O
 Indifference Curves
• Locus of points with different combinations of
Qx and Qy having the same level of utility
• Utility Function: U = U(QX,QY)
• Marginal Utility > 0
– MUX = ∂U/∂QX and MUY = ∂U/∂QY
• Second Derivatives
– ∂MUX/∂QX < 0 and ∂MUY/∂QY < 0
– ∂MUX/∂QY and ∂MUY/∂QX
• This implies Marginal Utility is positive but
diminishing
 Marginal Rate of Substitution
• Rate at which one good can be substituted for
another while holding utility constant
• Slope of an indifference curve
– dQY/dQX = -MUX/MUY
 Indifference Curves:
Complements and Substitutes

Perfect Perfect
QY
Complements QY Substitutes

QX QX
 The Budget Line
• Budget = M = PXQX + PYQY
• Slope of the budget line
– QY = M/PY - (PX/PY)QX
– dQY/dQX = - PX/PY
 Consumer Equilibrium
• Combination of goods that maximizes utility
for a given set of prices and a given level of
income
• Represented graphically by the point of
tangency between an indifference curve and
the budget line
– MUX/MUY = PX/PY
– MUX/PX = MUY/PY
 Rule of Equal marginal utility per
rupee
• How consumer will allocate his/her
expenditure on two commodities
• Two conditions
MUX/ Px =MUy / Py => Equal marginal utility
per rupee
Expenditure on both X&Y = Amount available
for spending
 Mathematical Derivation
• Maximize Utility: U = f(QX, QY)
• Subject to: M = PXQX + PYQY
• Set up Lagrangian function
– L = f(QX, QY) + (M - PXQX - PYQY)
• First-order conditions imply
–  = MUX/PX = MUY/PY
X0 X1
Derivation of demand curve
 Applications of Indifference Curve
• Trade-off between present consumption and
future consumption (Present saving)
• Trade-off between income and leisure
• Trade-off between risk and return in financial
markets