ANALYSIS OF CONSUMER BEHAVIOUR

Consumer Objectives
· In the Neoclassical economics, the goal of
consumer behavior is utility maximization
[this is consistent with maximization of
Net benefits]
· Consumer choice among various
alternatives is subject to constraints:
· income or budget
· prices of goods purchased
· preferences
 Models of Consumer Behavior

· Marginal Utility approach

· cardinal measure of utility
· problem of related goods
· Indifference approach
· ordinal utility
· related goods
· observable behavior
Utility Approach to Consumer Behavior

· Need for cardinal measure of utility

· analysis is useful for explaining
behavior
· Total and Marginal utility
· “law of diminishing Marginal Utility”
· Equimarginal rule and utility
maximization
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
 Nature of Total Utility
· When more and more units of a good are consumed
in a specific time period, the utility derived tends
to increase at a decreasing rate
· Eventually, some maximum utility is derived and
additional units cause total utility to diminish. As
an example, think of eating “free” hot cakes.
· It is possible for total utility to initially increase
at an increasing rate.
 Marginal Utility
· Marginal utility [MU] is the change in total utility
associated with a 1 unit change in consumption.
· As total utility increases at a decreasing rate,
MU declines.
· As total utility declines, MU is negative
· When TU is a maximum, MU is 0 [This is
sometimes called the “Satiation point” or the point
of “absolute diminishing utility.”
 Marginal Utility [MU] is the change in total utility [DTU]
caused by a one unit change in quantity [DQ] ;
MU = DTU
DQ
The first unit consumed increases TU by 30.

..
Utility MU
The 2cd unit increases TU by 25.

..
Q TU MU 30
DQ=1

.. .
1 30 30 25
DQ=1 20
2 55 25
10

.
DQ=1
3 75 20 MU
4 90 15 1DQ2 3 4 5 6 7 Q/ut
5 100 10
Remember that the MU is associated with the
6 105 5 midpoint between the units as each additional
7 105 0 unit is added.
8 100 -5
TU
The first unit consumed, DQ The MU is the slope of TU or the

. . .
120 increases TU by 30, DTU.

100 max TU
. .
TU rate of change in TU associated
with a one unit change in quantity.
80 . [Using calculus, MU is the change in TU

.
as change in quantity approaches 0.]
60 between the 2cd and 3rd For the first unit:

.
DQ 30
40 units DTU = 20 or the DTU
slope of TU is 20. MU = =
DQ 1
20
DTU DTU
The slope of TU is = 30,
DQ
1 2 3 4 5 6 7 Q/ut

..
MU MU is the slope of the TU.

..
30 The second unit changes TU [ DTU] by
25, The slope of TU between the 1 and

. .MU
20 second unit is 25.

..
10
Where MU = 0, TU is a maximum.
1 2 3 4 5 6 7 Q/ut
 Consumer Preferences
· Both MU and TU are determined by the “preferences” or
utility function of the individual and the quantity consumed.
· Utility cannot be measured directly but individual choices
reveal information about the individual’s preferences
· Surrogate variables [age, gender, ethnic background,
religion, etc.] may be correlated with preferences.
· There is a tendency for TU to increase at a decreasing rate
[MU declines] as more of a good is consumed in a given time
period: i.e. “diminishing marginal utility”
 Diminishing Marginal Utility
· Initially, it may be possible for TU to increase at
an increasing rate. In which case MU will increase
[MU is the slope of TU which is increasing].
· Eventually, as more and more of a good are
consumed in a given time period, TU continues to
increase but at a decreasing rate; MU decreases.
· This is called the point of “diminishing marginal
utility.”
 Consumer Choices
· If there were no costs associated with choices,
the individual will consume a good until MU = 0 [this
maximizes TU or the total benefits, TB]
· Typically, individuals are constrained by a budget
[or income] and the prices they pay for the goods
they consume.
· Net benefits are maximized where MR= MC; as long
as the MU or MR of the next unit of good purchased exceeds the
Price or MC, it will increase net benefits
 Society and Individual
· The individual will purchase more of a good so long
as their perceived or anticipated MR exceeds the
price they must pay for the good: Buy so long as
MR > P, optimum where, P = MR
· From a social perspective that good should only be
produced and sold if the price is greater than or
equal to the MC: Sell so long as P > MC, optimum
where P = MC
· Social optimum when MR = P = MC
 Constrained Optimization
· Individual choices then become a function of the
price of the good, income [budget], prices of
related goods and preferences.
· QX = f (PX , Y, PY, Preferences, . . . )
· Where:
· PX = price of good X
· Y = income
· PY = prices of related goods
· “preferences” is the individual’s utility function
 Utility and Demand

· Individual choice is influenced by:

· QX = f (PX , Y, PY, Preferences, . . . )
· These are the same variables in the
demand function
· The forces that shape the demand
function can be analyzed with utility
analysis
The budget constraint can be expressed: B > PxQx + PyQy
The amount of good Y that can be purchased
is the budget divided by the price of good Y, B
The amount of good X
Py
that can be purchased For a B = $80,
is, and Py = $5
B
Px For a B = $80,
80 B C and PX = $3
= 16 =
5 Py
Any combination
Connecting the two intercepts inside area 0AC
identifies all combinations of can be purchased
goods X &Y that can be for less than $80.
purchased for a budget of $80,
Py = $5, and PX = $3. A
0 80 B
= 26.7 =
3 Px
Consider an individual’s utility preference for 2 goods, X & Y;
If the two goods were “free,”
Good X [ or no budget constraint], Good Y
the individual would consume
Utility X each good until the MU of Utility Y
Qx TUx MUx that good was 0, 7 units Qy TUy MUy
of good X and 6 of Y.
1 30 30 1 60 60
2 55 25 2 90 30
Once the goods have a price
3 75 20 and there is a budget 3 110 20
4 90 15 constraint, the individual 4 120 10
10 will try to maximize the
5 100 5 128 8
utility from each additional
6 105 5 dollar spent. 6 128 0
7 105 0 7 120 -8
8 100 -5 8 100 - 20
 Given the budget constraint, Individuals will attempt to
gain the maximum utility for each additional dollar spent,
“the marginal dollar.”
For PX = $3, the
Utility X MUX MUX per dollar MUY Utility Y
PX spent on good PY
Qx TUx MUx Qy TUy MUy
X is;
1 30 30 10. 12 1 60 60
2 55 25 8.33 6 2 90 30
For PY = $5, the
3 75 20 6.67 MUY per dollar 4 3 110 20
4 90 15 5.00 spent on good 2 4 120 10
10 Y is;
5 100 3.33 1.6 5 128 8
6 105 5 1.67 0 6 128 0
7 105 0 0 7 120 -8
8 100 -5 8 100 - 20
Now the preferences of the individuals and the relative prices
of the two goods are displayed in the tables.

Utility X MUX MUY Utility Y

PX PY
Qx TUx MUx Qy TUy MUy
If the objective is
1 30 30 10. 12 1 60 60
to maximize utility
2 55 25 8.33 given prices, 6 2 90 30
3 75 20 6.67 preferences, and 4 3 110 20
4 budget, spend each 4
90 15 5.00 2 120 10
additional $ on the
5 100 10 3.33 good that yields 1.6 5 128 8
6 105 5 1.67 the greater utility 0 6 128 0
7 105 0 0 for that 7 120 -8
expenditure.
8 100 -5 8 100 - 20
 Given the preferences of the individual and the relative
prices of the goods [PX = $3, PY = $5], the MU’s for
each dollar spent are:
To maximize TU given a budget of $30,the first
MUX expenditure would logically be for good Y since MUY
PX the MUY for each dollar is 12. PY

$3 The second expenditure is for good X, $5

10.  [MUX $ is greater than MUY $]
 12
8.33 $3   $5 6
The third & fourth expenditures are for
6.67 $3  good X since the MU per dollar spent is  $5 4
$3 greater for X than Y.
5.00  2
The fifth expenditure is for is for good Y.
3.33 $3  1.6
Continue to maximize the MU per $ spent.
1.67 0
AT THIS POINT YOU HAVE SPENT THE BUDGET OF $30.
0
MUX
PX
>P
MUY , BUY X ! MUX MUY
PX
<P Y
, BUY Y !
Y
MUX
PX
>MU
P
Y says that the marginal utility of an additional
Y dollar spent on good X is greater than that of
a dollar spent on good Y.

MUX
PX
<MU
P
Y indicates that the MU per dollar spent on good
Y Y exceeds that of a dollar spent on good X.

If the amount spent on the two goods is equal to the budget

then
PX
>
MUX MUY suggests that the individual should buy
PY less of Y in order to buy more of X.

MUX
PX
<MU
P
Y says to purchase less X to pay for additional
Y
amounts of Y.

MUX MUY
PX = PY
is an equilibrium condition!
MUX MUY subject to the constraint:
P X = PY
PX X + PY Y = B
insures the individual has maximized their total utility and
has not spent more on the two goods than their budget.

This model can be expanded to include as many goods as

necessary:

MUX MUY MUZ

PX = PY
= P = . . . = MUN
Z PN
subject to;

PX X + PY Y + Pz Z + . . . + PN N = B
From this information a demand for the goods can be
constructed.
Given the preference functions for goods X and Y,
and the prices of the two goods: PX = $3, PY = $5.
the MU of derived
from each dollar
Utility X MUX of expenditure MUY Utility Y
PX can be calculated. PY
Qx TUx MUx Qy TUy MUy
1 30 30 10. 12 1 60 60
If the individual is
2 55 25 8.33 maximizing utility, 6 2 90 30
3 75 20 6.67 their choices, 4 3 110 20
4 constrained by 4
90 15 5.00 2 120 10
their preferences,
5 100 10 3.33 the prices and 1.6 5 128 8
6 105 5 1.67 their budget can 0 6 128 0
7 105 0 0 be shown: 7 120 -8
8 100 -5 8 100 - 20
 Given preferences, prices [PX = $3, PY = $5] and
budget [$30], the individual’s choices were:

MUX Five units of X and 3 units of Y were purchased MUY

PX
These choices can be shown in the context of PY
a demand model:
10. $3   $5 12
PX 5

.
8.33 $3   $5 6
6.67 $3  4  $5 4
5.00 $3  PX = 3 2
$3 This point lies on the 1.6
3.33  2 demand for good X.
1.67 0
At PX = $3, 1
0 given budget,
Py and preferences, 1 2 3 4 QX/ut
5 units of X are purchased.
55 6 7
 Given the individual’s preferences, the price of Y [PY]
and the budget [B = $30], the individual purchased
5 units of X when the price of X [PX ] was $3.

MU Raise the price of X [PX ] to $5 and the MUX per

MUXX MUX MUY
$ spent is reduced.
PPXX PX PY

.
[$3]
[$5] [$5] Choices about spending the $30 are now:
10. 6 $5 6  The $30 is now spent.  $5 12
PX

.
8.33
5 $5 5  5  $5 6
6.67 4
Demand 4
4 $5 4  That  $5
portion
5.00
3 3 3 At PX = $5, 2
of demand
3.332 2 between $3 and $5 ceteris paribus, 1.6
2
1.671 is mapped! 3 units of X are 0
1
1 purchased.
0 0 MU
0X MUY
PX = PY 1 2 3 4 5 6 7 QX/ut
 Demand
· By continuing to change the price of good X
[and holding all other variables, PY , budget or
income and preferences constant,] the rest of
the demand for good X can be mapped.
· All price and quantity combinations on the
demand for X are equilibrium points for
the consumer [They are maximizing utility;
holding all other variables, PY , budget or income
and preferences constant]
By changing the price of the good [in this case, good X] and
holding all other variables [PY , budget or income and
preferences] constant, the demand for the good can be
mapped.

The demand function

is a schedule of the P
X
quantities that
individuals are willing 5
and able to buy at a 4
schedule of prices
3
during a specific
period of time, 2
ceteris paribus. 1

1 2 3 4 5 6 7 QX/ut
 The demand function has a negative slope because of the
income and substitution effects.
Income effect: As the price of a good that you buy increases
and money income is held constant, your real income decreases
and you can not afford
to buy as much as you
could before. PX
Substitution effect: As 5
the price of one good rises
relative to the prices of 4
other goods, you will tend 3
to substitute the good
that is relatively cheaper 2
for the good that is 1
relatively more expensive.
1 2 3 4 5 6 7 QX/ut
 Income effects
· As the price of a good that you buy
increases, you will have less real income.
· This is the basis of price indices that
measure changes in real income as prices
rise or fall.
· The consumer price index is one of the
indices that is used [currently there is a
debate about how it is calculated].
 Substitution Effects
· As the price of a good increases
[decreases] while the prices of other
goods is constant, it becomes
relatively more [less] expensive.
· Individuals would substitute relatively
less expensive goods for relatively
more expensive ones even if their
real income were constant.
 CONSUMER SURPLUS
Notice that someone is willing and able to pay $6.80 for the
first unit. If the market price [established by S and D]
were $3, the buyer would purchase at $3 even though they
were willing to pay
$6.80 for the first unit. PX
7
They receive utility 6.80
that they did not have 6

.
to pay for [6.80-3.00].
This is called consumer 5 consumer
surplus. 4 surplus
3
At market equilibrium,
Consumer surplus will be 2
the area above the market 1
price and below the demand
function. 1 2 3 4 5 6 7 QX/ut
 Demand
· Demand functions can be derived from utility
[cardinal measures] or indifference functions
[ordinal measures]
· Normally, demand functions show and inverse
relationship between price and quantity
· a change in price “causes” a change in “quantity
demanded”
· a change in any other variable [income, prices of
related goods, population, preferences, . . .] will
“cause a change in demand” or shift of demand