Chapter 5: Demand and Consumer Behavior

Utility Theory
Utility: Utility means want satisfying Power. A good that gives you Utility is one that has the power to satisfy wants, or that gives you satisfaction. Example: A Pen has writing ability. Total Utility is the total satisfaction a person receives from consuming a particular quantity of good. Also, Total Utility is the summation of all individual utilities to be derived through the consumption of a commodity.

Marginal Utility
Marginal Utility is the additional utility gained from consuming an additional unit of some good. Marginal Utility is the change in total utility due to a one-unit change in the quantity of a good or service consumed.
change in total utility Marginal utility = change in number of units consumed

Relationship between Total Utility and Marginal Utility

Observations:
Marginal utility falls as more is consumed Marginal utility equals zero when total utility is at its maximum

Relationship between Total and Marginal Utility of Watching DVDs

20 18
Total Utility (utils per week) Total utility is maximized...

16
Marginal Utility (utils per week)

10 8 6 4 2 0 1 -2 -4 1 2 3 4 5 6 7
where marginal utility equals zero.
5

14 12 10 8 6 4 2 0

DVDs Watched per Week

DVDs Watched per Week

Relationship Between Total Utility and Marginal Utility

1. 2. With the rise in consumption of a product, total utility tends to be rising but marginal utility tends to be falling. Total Utility is the summation of all individual utilities to be derived through the consumption of a commodity. Marginal utility is the additional utility to be derived through the consumption of last unit of a product. With the rise in consumption total utility tends to be increasing but at a diminishing rate. Total utility is maximum when marginal utility is zero. Total utility tends to be falling when marginal utility is negative.

3. 4.

Basic assumptions of Marginal Utility Analysis

Cardinal measurement of utility:- It is assumed that utility can be measured and can be given definite quantity like 1,2 or 3.This means that a person can express the satisfaction derived from consumption of commodity in quantitative term. Utilities are independent:-Marginal utility assumes that utility of different commodities are independent to each other. Constant Marginal utility of money:-Another important assumption is that the marginal utility of money remains constant. Introspection:-The Marginal utility also assumes that from ones experience ,it is possible to draw inference about other person.

Law of Diminishing Marginal Utility

The law of Diminishing Marginal Utility states that for a given time period, the marginal utility gained by consuming equal successive units of a good will decline as the amount consumed increases.

The law of diminishing marginal utility is based on the idea that if a good has a variety of uses but only one unit of the good is available, then the consumer will use the first unit to satisfy his or her most urgent want.

Diminishing marginal utility curve

Assumptions: Goods are homogeneous. No time gap between the consumption of the different units. Consumers are rational. Taste, Preferences Fashions remain unchanged. Income of the consumer is constant.

This can also be shown by graph

Units of utility

Units of commodity consumed

Law of Diminishing Marginal Utility

It is generally accepted rule of consumption that total utility tends to be increasing and marginal utility tends to be gradually decreasing as with the rise of consumption. Because with the rise in stock of anything marginal utility of a particular product gradually diminishes. Therefore the relationship between rise in consumption of a product and gradual fall in marginal utility of that product is represented by the law often we called the diminishing marginal utility. For ex:- Suppose a person starts eating toast, the first toast gives him great pleasure. By the time he taking second he yield less satisfaction ;the satisfaction of third is less than that of second and so on. the additional satisfaction goes on decreasing with every successive toast till it drops down to zero; and if the consumer forced to take more the satisfaction may become zero.

LIMITATIONS OF THE LAW

Suitable units:- It is assumed that the commodity is taken in suitable units. Suitable time:-It is further assumed that the commodity is taken within a certain time, otherwise law will not apply. No change in consumers tastes:-Another assumption is that the character of the consumers does not change. Normal persons:- The law of diminishing marginal utility applies to normal persons and not to eccentric or abnormal persons like misers. Constant income:-it is also essential that the income remains the same. Any change in income will falsify the law. Rare collections:- In case of rare collections ,the law does not hold good. Fashion:- Further, fashion utility depends on fashion too.

Indifference Curve
An Indifference curve is the locus of points indicating particular combinations of goods or the baskets of two commodities from which the consumer derives the same level of utility or satisfaction. The I.C. is the locus of successive indifferent points or combinations which yield equal level of satisfaction. This curve is also known as Iso Utility curve and the different point on the curve represents the same level of satisfaction. The equation Indifference curve can be written as : U = f(x,y)

Indifference Curves: An Example

Market Basket A B D E G H Units of Food 20 10 40 30 10 10 Units of Clothing 30 50 20 40 20 40

Graph the points with one good on the x-axis and one good on the y-axis Plotting the points, we can make some immediate observations about preferences -More is better

Indifference Curves: An Example

Clothin 50 g

B H A D E

40 30 20

The consumer prefers A to all combinations in the yellow box, while all those in the pink box are preferred to A.

G 10 10 20 30 40

Food

Indifference Curves: An Example

Clothin g

50 H 40 30 20 10 10

B E A D G

Indifferent between points B, A, & D E is preferred to points on U1 Points on U1 are preferred to H&G

U1

20

30

40

Food

Indifference Curve
Properties of Indifference Curve: 1. 2. 3. 4. 5. Indifference curve is down wards sloping. It is Convex to the origin. Higher Indifference curve represents higher level of satisfaction. Two Indifference curves never intersect each other. The collections of Indifference curves is known as indifferent Map.

Assumptions of Indifference Curve: Existence of two products X and Y in a commodity space where both the products are normal and the consumption combinations are positive definite. The utility function are dependent which can be written as U = f (x,y) and I.C considers related product where both the products are substitute to each other.

Indifference Curve

X1

((X1/ (X2) X1

Io X2 X1 I1 Io X2 X1 A B C X2 B>A B=C A= C X2

Indifference Curve
Assumptions of Indifference Curve:

The level of satisfaction is ordinarily measurable which means ranking of different combinations is possible according to the preference of the consumer. The relationship may be indifferent, i.e. if the combinations on A & B or B & C is equally preferable then the combination of A & C must be equally preferable to the consumer. The relation may be transitive. Application of the diminishing marginal rate of substitution. (The marginal rate of substitution of X for Y (MRSx,y) is defined as the no of units of good Y that must be given up in exchange for an extra unit of good X, so that the consumer maintains the same level of satisfaction.)

Indifference Map
To describe preferences for all combinations of goods/services, we have a set of indifference curves an indifference map. Each indifference curve in the map shows the market baskets among which the person is indifferent.
Clothing Market basket A is preferred to B. Market basket B is preferred to D.

D B A

U3 U2 U1
Food

Budget Constraints
Preferences do not explain all of consumer behavior Budget constraints also limit an individuals ability to consume in light of the prices they must pay for various goods and services. The Budget Line Indicates all combinations of two commodities for which total money spent equals total income We assume only 2 goods are consumed, so we do not consider savings Let F equal the amount of food purchased, and C is the amount of clothing Price of food = PF and price of clothing = PC Then PFF is the amount of money spent on food, and PCC is the amount of money spent on clothing

The Budget Line

The budget line then can be written:

PF F  PC C ! I
All income is allocated to food (F) and/or clothing (C)

Different choices of food and clothing can be calculated that use all
income. These choices can be graphed as the budget line Example: Assume income of $80/week, PF = $1 and PC = $2 Assumptions: Existence of 2 products which are close substitute and divisible in small nos. Income (M) of the Consumer is constant. Price of the products (Px and Py) are constant and market determined. Total income spend on 2 products so, No savings and No Loan demand.

Budget Constraints
Market Basket A B D E G Food PF = $1 0 20 40 60 80 Clothing PC = $2 40 30 20 10 0 Income
I = P F F + P CC

$80 $80 $80 $80 $80

The Budget Line

Clothing

(I/PC) = 40

A B

(C 1 PF Slope ! ! - !(F 2 PC
D 20 E

30 10 20

10 G
0 20 40 60 80 = (I/PF) Food

The Budget Line

As consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other The slope of the line measures the relative cost of food and clothing The slope is the negative of the ratio of the prices of the two goods The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent We can rearrange the budget line equation to make this more clear

I ! PX X  P Y Y I  PX X ! P Y Y I PX  X !Y P P Y Y

Budget Constraints
The Budget Line The vertical intercept, I/PC, illustrates the maximum amount of C that can be purchased with income I The horizontal intercept, I/PF, illustrates the maximum amount of F that can be purchased with income I As we know, income and prices can change As incomes and prices change, there are changes in budget lines We can show the effects of these changes on budget lines and consumer choices

The Budget Line - Changes

The Effects of Changes in Income An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant). Can buy more of both goods with more income Clothing (units per week)

80

An increase in income shifts the budget line outward

60
A decrease in income shifts the budget line inward
L3 (I = $40) L1 (I = $80) L2 (I = $160)

40

20
0

Food
(units per week)

40

80

120

160

The Budget Line - Changes

Clothing (units per week) A decrease in the price of food to $.50 changes the slope of the budget line and rotates it outward.

40

L3
(PF = 2)
40

L1
(PF = 1)
80

L2
120 160

An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward.

(PF = 1/2)
Food
(units per week)

The Budget Line - Changes

The Effects of Changes in Prices If the price of one good increases, the budget line shifts inward, pivoting from the other goods intercept. If the price of food increases and you buy only food (x-intercept), then you cant buy as much food. The x-intercept shifts in. If you buy only clothing (y-intercept), you can buy the same amount. No change in y-intercept. If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change However, the budget line will shift inward parallel to the original budget line If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change However, the budget line will shift outward parallel to the original budget line

Consumers Equilibrium
Consumer shall be in equilibrium where he / she can maximize his / her utility subject to his budget constraint. Occurs when the consumer has spent all income and the marginal utilities per dollar spent on each good purchased are equal. This equilibrium considers 3 basic problems of the consumer behaviour: Equilibrium satisfaction level. Equilibrium commodity combination. Distribution of income between two products. Conditions:
Necessary Condition:

At the equilibrium point, Slope of I.C. = Slope of B.L. i.e. MUx / Px = MUy/Py
Sufficient Condition:

At equilibrium I.C must be convex to the origin.

Consumers Equilibrium: Consumer Choice

Clothing (units per week)

40 A 30 D C

A, B, C on budget line D highest utility but not affordable C highest affordable utility Consumer chooses C

20

U3 B
0 20 40 80

U1
Food (units per week)

Consumers Equilibrium
Assumptions: Existence of the 2 products in the commodity space say X and Y, where both the products are normal, close substitutes, divisible in small units and consumption combinations are positive definite. Utility levels are ordinarily measurable and ranking of the different combinations are possible where the utility functions are dependent, i.e. U = f ( X,Y ) Level of income (M) and prices of the products (Px and Py) are constant. Consumer spends his entire income for the 2 products represents the Income Expenditure equality. Consumers taste and preference is constant. The relationship or the choice of the product combinations may be indifferent or transitive. Application of diminishing marginal rate of substitution and principle of substitution.

Consumers Surplus
Consumers surplus is the difference between the total amount of money the consumer would be willing to pay for a quantity of a commodity and the amount he /she actually had to pay for it and this concept is based on DMU. CS = TU (P * Q), otherwise, CS = Price prepared to pay Actual price paid.

Unit MU MP CS s 1 70 20 50 2 60 20 40 3 44 20 24 4 20 20 00 4 194 Units 80 114

Income and Substitution Effects

A persons real income, or purchasing power, rises if with a given absolute income, he or she can purchase more goods and services. A fall in the relative price of a good will, and a rise in real income can, lead to greater purchases of the good. The portion of the change in the quantity demanded that is attributable to a change in its relative price is referred to as the Substitution Effect. The portion of the change in the quantity demanded that is attributable to a change in real income, brought about by a change in absolute price, is referred to as the Income Effect.

Income and Substitution Effects