Microeconomics: Chapter 4

Theory of Consumer Behavior

 Consumer behaviour refers to the study of consumer while engaged in the process of consumption.
 This chapter we will look how a consumer choose to spend his/her limited income to purchase available goods
in the market, so as to achieve maximum utility.

UTILITY APPROACH

 Definition
– ‘Utility’ means the satisfaction obtained from consuming a commodity.
 Two Types of Approach
– Cardinal Approach
• The cardinal utility theory says that utility is measurable and by placing a number of
alternatives so that the utility can be added.
• The index used to measure utility is called utils.
– Ordinal Approach
• The ordinal utility theory says that utility is not measurable but it can be compared.
• Ordinal approach uses the ranking of alternatives as first, second, third and so on.

CARDINAL APPROACH

 TOTAL UTILITY (TU) - The total satisfaction that a person gets from the consumption of goods and
service.

 MARGINAL UTILITY (MU) -The additional to total utility as a result of consuming one more units
of the same good or services.
Marginal Utility (MU) = Change in Total Utility
Change in Total Quantity

LAW OF DIMINISHING MARGINAL UTILITY

 Definition
The additional benefit which a person derives from a given increase of a stock of a thing diminishes, other
things being equal, with every increase in the stock that he already has.
OR
Law of Diminishing Marginal Utility states that as consumption increases more and more, marginal utility will
be less and less.

Assumptions:
 homogeneous units (same goods)
 consumption within same time frame (continuous)
 No change in taste (remain constant)
 No change in price (price of goods, complementary goods and substitute good are not change)
 suitability quantity of consumption (not consumed in small amount)

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RELATIONSHIP BETWEEN TU AND MU
 When TU is increasing, MU will be positive.
 When TU is at its maximum, MU will be zero.
 When TU is decreasing, MU will be negative.

LAW OF EQUI-MARGINAL UTILITY (EMU)

 Definition
The Law of Equi-Marginal Utility (EMU) states that other things being equal, a consumer gets maximum
satisfaction when he allocates his limited income to the purchase of different goods, where the marginal utility
derived from the last unit of money spent on each item of expenditure tends to be equal.
– This is also known as conditions for maximum utility or satisfaction.

 Conditions for Equilibrium

For consumer equilibrium, this condition must be fulfilled.

Condition 1: Every ringgit spent on every commodity must yield the same marginal utility.

Marginal Utility of X = Marginal Utility of Y

Price of X Price of Y

Condition 2: Total expenditure of all goods must be equal to the total budget allocated to maximize utility.
P1Q1 + P2Q2 + … + PnQn = Total budget

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Theory of Consumer Behaviors

EXAMPLE: Arwin has an income of RM37 and the prices of goods P, Q and R are RM5, RM1 and RM4
respectively

Quantity Product P (RM5) Product Q (RM1) Product R (RM4)

TU MU MUP/PP TU MU MUQ/PQ TU MU MUR/PR

1 21 21 21/5=4.2 7 7 7/1=7 16 16 16/4=4

2 41 41-21=20 20/5=4 13 6 6 30 14 14/4=3.5
3 59 59-41=18 18/4 =3.6 18 5 5 42 12 3
4 74 74-59=15 15/4 = 3 22 4 4 50 8 2
5 85 85-74=11 11/4 =2.2 25 3 3 55 5 1.25
6 91 91-85=6 6/4=1.2 27 2 2 58 3 0.75
7 91 91-91=0 0/4=0 28 1 1 60 2 0.5

Condition 1 : Every ringgit spent on every commodity must yield the same marginal utility.

Fulfilling condition 1, two combination of goods are obtained:

Combination 1 : 2P, 4Q and 1R

Combination 2 : 4P, 5Q and 3R

Condition 2 : Total expenditure of all goods must be equal to the total budget allocated to maximize utility.

Combination 1 : 2P + 4Q + 1R
2(5) + 4(1) + 1(4) = 10 + 4 + 4 = RM18
2(RM5) + 4(RM1) + 1(RM4) = RM18

Combination 2 : 4P + 5Q + 3R
4(5) + 5(1) + 3(4) = 20 + 5+ 12 = RM37
4(RM5) + 5(RM1) + 3(RM4) = RM37

So, 4 units of Product P, 5 units of Product Q and 3 units of Product R will be purchased by Arwin because the
total expenditure is equal with his budget – RM37

Exercises
Chapter 4, Section B, Page 106-107 : Question 1, 3, 4, and 5.
Tutorial 4

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Exercises
Q1. Suppose the consumer is interested in buying only three goods, A, B, and C, and that we somehow
know that this consumer would derive the amounts of total utilities (TU) from the quantities of these
goods shown in the table below:

Quantity TU of Good A TU of Good B TU of Good C

X Y Z
1 50 400 70
2 120 700 130
3 200 900 180
4 240 1000 225
5 258 1020 265
6 268 1030 300
7 275 1038 328
8 280 1044 348
9 285 1048 360
10 289 1050 366
11 293 1051 370
12 296 1052 373

(a) Calculate the marginal utility for each of the goods at each of the quantities shown and complete the
next three columns of the table. (7 marks)

(b) Calculate the amount of utility the consumer gets from each of the quantities of the three goods
purchased per RM of expenditure on each good if the price of X is RM1 per unit, the price of Y is RM2
per unit, and the price of Z is RM4 per unit. (7 marks)

(c) State the satisfaction maximizing rule that is relevant to the decision the consumer has to make here.
Write down all the combinations of X, Y, and Z that might satisfy this rule? (4 marks)

(d) If the consumer has a budget of RM52 to spend on these three goods, which of the combinations
identified in (c) will be chosen? (2 mark)

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Q2. The table below shows the marginal utility that Raj obtains from consuming chicken burger,
hotdogs and fried chicken.
Quantity MU for chicken MU for hotdogs MU for fried
burger chicken
0 - - -
1 100 80 40
2 80 75 36
3 68 70 32
4 58 65 28
5 50 60 24
6 40 55 20
7 38 50 16
8 28 45 14
9 20 40 8
10 10 35 4

a) Based on the information above, calculate his total utility at each quantity for the three types
of food. (6 marks)

b) How much food would Raj purchase to maximize utility if the price of burger and hotdogs are
RM5 respectively while the price for fried chicken is RM4 each? Raj has an allowance of RM64
to spend on foods. (8 marks)

c) If his allowances increase to RM87, what is his new consumption bundle? (1 marks)

d) What is utility? Explain the relationship between Total utility and Marginal utility. (5 marks)

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 ORDINAL APPROACH:

INDIFFERENCE CURVE
 Definition
– An indifference curve represents all the possible combinations of two goods which will give the
same level of satisfaction.
 Assumptions
– Scale of preferences
– Consumers’ preferences are transitivity
– Rationality
– Diminishing marginal rate of substitution
– Concept of ordinal utility

Combinations Good X Good Y

A 2 12
B 4 6
C 6 4
D 8 3
E 12 2
The table above shows all the five combinations, which will give the equal level of satisfaction.

An indifference curve represents all those combinations of two goods; X and Y which yield the same level of
satisfaction to a consumer.

Indifferent map - shows a set of indifference curve.

The higher the indifference curve from the origin, higher will be the utility. IC3 has the higher satisfaction.

 Marginal Rate of Technical Substitution

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 – Refers to the rate at which one good is substituted for another good.
– Its shows that as a consumer get one more unit of X, he/she has to sacrifice some units of Y to
maintain his/her satisfaction.

Characteristics of Indifference Curve

1. Indifference curve slopes downward from left to right.
2. Indifference curve are convex to the origin.
3. Higher indifference curves represent higher level of satisfaction.
4. Indifference curve never intersect each other.
5. Indifference curve does not touch the Y axis or X axis.

BUDGET LINE
A budget line represents various combinations of two goods, which can be purchased with a given amount of
money at the given price of each unit.

CHANGES IN BUDGET LINE

1. Change in Consumer’s Income – ↑ income , budget line shift to right. ↓income , budget line shit to left.

2. Change in Price of Good X

Price of good X increase Price of good X decrease

3. Change in Price of Good Y

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Price of good Y increase Price of good Y decrease

CONSUMER EQUILIBRIUM
A consumer is in equilibrium when he or she is consuming the best possible combination of two goods with the
given amount of income.

INCOME, PRICE AND SUBSTITUTION EFFECT

 INCOME EFFECT
– The income effect is defined as the effect on the purchases of the consumer caused by changes in
income with prices of goods remaining constant.

 PRICE EFFECT
– Price effect explains what happens to the consumers’ equilibrium position when the price of one
good changes while the price of another good and other factors remains constant.

 SUBSTITUTION EFFECT
– Substitution effect explains what happens to the consumers’ equilibrium position when the price
of both good changes—price of one rises and price of another falls while other factors remains
constant.

CONSUMER SURPLUS
Consumer surplus is defined as the excess of what a consumer is willing to pay and what he/she actually pays.

Example : Suppose Sally who is fond of chocolates is ready to pay for each successive bar of chocolate as shown
in table below. Assume that Sally is willing to pay lower price for the successive bar of chocolates. Assume the
market price of one bar of chocolate is RM1.00.

CONSUMER SURPLUS = TOTAL VALUE – (MARKET PRICE x NUMBER OF UNITS CONSUMED)

Bars of chocolate 1 2 3 4 5
Price (RM) 2.50 2.00 1.50 1.00 0.80

Consumer surplus = (2.50 + 2 + 1.50 + 1) – (1 x 4)

= RM3.00

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