Module 4

Module 4

The theory of consumer behaviour

Introduction
This module develops tools that help a manager understand the behaviour
of individual consumers and the impact of alternative incentives on their
decisions. Despite the complexities of human thought processes,
managers need a model that explains how individuals behave in the
marketplace and in the work environment.

As we have illustrated, consumers’ efforts to get the most for their money
are reflected in their individual demand functions. Market-demand curves
are simply the aggregates of all individual consumer-demand curves.
Since utility is based on individual taste and preferences, each market-
demand curve reflects the aggregate market preferences of all consumers
in that market. Therefore, a market-demand curve is a powerful signal to
producers about what and how much to produce.

The utility approach offers useful insights into consumer behaviour. In

this context, consumer preferences, which are subjective, are connected to
changes in prices, incomes and other variables in the marketplace, which
are objective. This approach, which is referred to as the ordinal approach,
requires that combinations of products be ranked in order of preference.
The ordinal approach to consumer behaviour (demand analysis) assumes
that consumers are able to rank all conceivable bundles of commodities;
that is, when confronted with two or more bundles of goods and services,
consumers can determine an order of preference among them.

Order of preference does not require consumers to estimate how much

utility will be attained from a bundle of goods. Only the ability to rank is
fundamental. Furthermore, the degree of preference is irrelevant. It is
quite enough for the consumer to think, subjectively and
idiosyncratically, that one product or bundle of goods is better than
another. In more precise terms, we assume that the consumer’s preference
pattern possesses the following properties.

Property 1: Completeness. If an individual can rank any pair of bundles

chosen at random from all conceivable bundles, he or she can rank all
conceivable bundles. Put differently, for any two bundles, say A and B,
either A > B or B > A, or A ~ B.

Property 2: More is better than less. If bundle A contains at least as

many units of each good as bundle B, and more units of at least one
commodity, A must be preferred to B. If more is better than less, the
consumer must view the products under consideration as ‘goods’ instead
of ‘bads.’

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Upon completion of this module you will be able to:

 explain the essence of ordinal approach to utility analysis.

 explain the concept of utility maximisation and consumer’s
equilibrium.
 describe the applications of indifference curves analysis and
Outcomes apply the analysis to a variety of consumer situations.
 explain how individual demand curve is derived from the
indifference curve analysis.
 explain the concept of attribute approach to consumer choice.
 explain the difference between the traditional theory and the
attribute approach to consumer choice.
 describe the application of the attribute approach in the
marketing field and apply this approach to marketing situations.

Budget constraint: Determines the combinations of two products that

are affordable.

Indifference curve: Combinations of two goods that give the consumer

the same level of satisfaction.
Terminology
Law of diminishing Less additional satisfaction (utility) is obtained
marginal utility: from additional consumption of that product.

Indifference curves
Let us consider some implications of these assumptions about preference
orderings. Most important, they enable us to generate a graphical
description of consumers’ preferences. An indifference curve defines the
combinations of two goods (or two bundles of goods) that give the
consumer the same level of satisfaction – they are equally preferred.
Along an indifference curve, the consumer is indifferent between
alternative combinations of goods X and Y. This is shown as the curve
labelled I, in Figure 4-1. Bundles A, B, C, and D are all equally preferred
combinations of X and Y located on the indifference curve providing the
consumer with the same level of satisfaction.

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Figure 4-1

An indifference curve also allows us to compare the satisfaction implicit

in bundles that lie along it with those that lie either above or below it. The
completeness property of preferences implies that there is an indifference
curve that passes through every possible bundle. Therefore, we can
represent a consumer’s preference with an indifference map.

I1, I2, and I3, in Figure 4-2, are index values used to denote the order of
preference that corresponds to the respective indifference curves.
Figure 4-2

Property 3: Transitivity. Given three bundles of goods (A, B, and C), if

an individual prefers A to B and B to C, he must prefer A to C. Similarly,
if an individual is indifferent between A and B and between B and C, she
or he must be indifferent between A and C. Finally, if she or he is
indifferent between A and B and prefers B to C, she or he must prefer A
to C. This assumption obviously can be carried over to four or more
different bundles.

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Figure 4-3

The assumption of transitive preferences, together with the ‘more is better

than less’ assumption, implies that indifference curves (from the same
indifference map) cannot cross. To see why, since A and B are on the
same indifference curve (I2), A ~ B, in Figure 4-3, and since A and C are
on the same indifference curve (I1), A ~ C, the consumer must be
indifferent between B and C also. This, however, can happen if these
points are on the same indifference curve. This situation implies that the
consumer cannot make a choice.

Property 4: Indifference curves are concave from above (convex to the

origin). In the preceding discussion, it was seen that indifference curves
are concave from above and downward sloping. These characteristics
arise from the assumption of diminishing marginal utility that was built
into the concept from which the indifference curves were derived; the
more of a product you consume, the less will be the additional satisfaction
(utility) obtained from additional consumption of that product. Since
diminishing marginal utility plays a crucial role in the consumer
behaviour model, it must be thoroughly understood.

As previously noted, different combinations of goods can provide equal

levels of total utility. When a consumer remains on a particular
indifference curve, one commodity can be substituted for the other so that
the consumer remains as well off as before. The rate at which a consumer
is willing to make such a substitution is a matter of great interest and
importance. We call it the marginal rate of substitution (MRSxy) of X for
Y, defined as the number of units of Y that must be given up to acquire
one additional unit of X while satisfying the condition of constant total
utility.

MRSxy, or simply MRS, is measured as the slope of the indifference

curve, which is different at each point along the curve. Since each point
represents a different combination of goods X and Y, it follows that each
combination has a different MRS. Is there a relationship between
marginal utility and the marginal rate of substitution? Indeed there is,
since the slope of the indifference curve is the direct result of the law of
diminishing marginal utility.

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Consider what happens when we move down the indifference curve

between any two points. Consumption of Y is reduced by DY unit
causing a loss of utility, which is equal to the change in Y, (DY), times
the loss of utility associated with this change in Y (marginal utility of Y =
MUy). That is, –DY x MUy. But, since total utility is unchanged as we
move down the curve, the loss of utility from consuming less Y is
precisely offset by a gain from consuming more X, ∆X x MUx:
 Y  MU y  X  MU x (1)

Rearranging this equation, we get

Y MU x
 
X MU y
(2)

The left hand side is the slope of an indifference curve, therefore,

MU x
MRS 
MU y
(3)

The continuously declining MRS is the logical result of the assumption

that the marginal utility of a product decreases as we obtain more of it. It
follows, then, that the more of a product one has, the more willing one is
to trade it for another product.

This willingness to exchange what we value less for what we value more
is true whether the owners of the commodities are individuals, firms, or
nations. Thus the marginal rate of substitution governs both domestic and
foreign trade.

Budget constraint
Indifference curves reflect the consumer’s personal feelings and the
relative values regarding the consumption of various combinations of any
two products. They show what combinations of X and Y the consumer is
willing to accept as equally satisfactory and they are totally independent
of the consumer’s income and market prices. Whereas indifference curves
show what the consumer is willing to do, income and market prices
determine what a consumer is able to do. In other words, the budget
constraint determines the combinations of X and Y that are affordable.
The consumer’s expenditure on X plus his or her expenditure on Y cannot
and does not exceed the consumer’s income. Assuming that the
consumer’s income is entirely spent on these two goods, we can write a
budget line relationship as follows:
Px  X  Py  Y  M
(4)

where PX and PY are the price of good X and Y, respectively, and M is the
income or the budget constraint. Suppose that the available money
income is $100, Px = $5, and PY = $10. If the entire $100 is spent on good

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X, a maximum of 20 units (100/$5) of X can be bought, whereas if the

entire $100 is spent on Y, as much as 10 units (100/$10) of Y can be
purchased. These combinations are illustrated in Figure 4-4. A straight
line joining these two points on the graph shows all the other
combinations of X and Y that the consumer’s income will allow him or
her to purchase at these prices.
Figure 4-4

M/PX=20 X

The points inside the budget line are attainable while those outside are
not. The slope of the budget line is given by –PX/PY (= the rise (M/PY
divides by the run M/PX) that represents the rate at which the X can be
exchanged for Y in the market place. In the example above, the slope
equals –1/2.

Changes in income
The consumer’s opportunity set depends on market prices and the
consumer’s income. As these parameters change, so will the consumer’s
opportunities. Let us now examine the effects on the opportunity set of
changes in income by assuming prices remain constant.

Suppose the consumer’s initial income in Figure 4-5 is M0. What happens
if M0 increases to M1 while prices remain unchanged? Recall that the
slope of the budget line is given by –PX/PY. Under the assumption that
prices remain unchanged, the increase in income will not affect the slope
of the budget line. However, the vertical and horizontal intercepts of the
budget line both increase as the consumer’s income increases, because
more of each good can be purchased at the higher income. Thus, when
income increases from M0 to M1, the budget line shifts to the right in a
parallel fashion. This reflects an increase in the consumer’s opportunity
set, because more goods are affordable after the increase in income than
before. Similarly, if income decreases to M2 from M0, the budget line
shifts toward the origin and the slope of the budget line remains
unchanged.

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Figure 4-5

M2/PX M0/PX M1/PX X

Changes in price
Now suppose the consumer’s income remains fixed at M, but the price of
good X decreases to P1 from P0. Furthermore, suppose the price of good
Y remains unchanged. Since the slope of the budget line is given by –
PX/PY, the reduction in the price of good X changes the slope, making it
flatter than before. Since the maximum amount of good Y that can be
purchased is M/PY, a reduction in the price of good X does not change the
Y intercept of the budget line. But the maximum amount of good X that
can be purchased at the lower price (the X intercept of the budget line) is
M/PX1, which is greater than M0/PX0. Thus, the effect of a reduction in the
price of good X is to rotate the budget line anticlockwise, as in Figure 4-
6.
Figure 4-6

M/PX0 M1/PX1 X

Similarly, an increase in the price of good X leads to a clockwise rotation

of the budget line.

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Consumer equilibrium
The principal assumption upon which the theory of consumer behaviour
rests is that consumers attempt to allocate their limited money incomes to
purchase available goods and services so as to maximise their satisfaction
(utility). In other words, consumers’ indifference map provides a
diagrammatic representation of a consumer’s taste and intensity of desire
for different product combinations while the consumer’s purchasing
power (and thus ability to satisfy material wants) is reflected by the line
of attainable combinations. Putting the two together shows all the desired
product combinations on the indifference curves that are also attainable.

As illustrated in Figure 4-7, the point of equilibrium can be located by

drawing the budget line on the indifference map for goods X and Y. Since
the number of indifference curves upon the indifference map is infinite,
one curve will be tangent to the budget line regardless of where the
budget line lies. The point of tangency is the point of equilibrium,
representing the attainable combination of X and Y that gives the highest
level of utility. As indicated in this Figure, the budget line is tangent to
the indifference curve, I2, at point E, where the consumer acquires YE
units of Y and XE of X. Since indifference curves may not intersect, it is
clear that I2 represents the highest level of utility that can be obtained
with the budget available. An indifference curve representing a higher
level, I3, does not touch the budget line, and hence is unattainable,
whereas an indifference curve representing a lower level, I1, intersecting
the budget line at two places is inferior to I2. It should not be difficult to
see why point E is preferable to any other point on the budget line. For
example, point B also exhausts the income, but it clearly offers less utility
than point E because it lies on a lower indifference curve.
Figure 4-7

XE X

Note, at the point of tangency between the indifference curve and the
budget line, the slope of the indifference curve equals the slope of the
budget line, that is,
Px
MRS 
Py
(5)

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The condition for maximising satisfaction requires that the consumer

allocate his or her purchasing power so that the marginal rate of
substitution of X for Y is equal to the ratio of the price of X to the price of
Y. The interpretation of this condition is straightforward. The MRS
defines the rate at which the consumer is willing to exchange X for Y.
The price ratio (PX/PY) shows the rate at which the consumer can
exchange X for Y. Unless the two rates are equivalent, it is possible for
the consumer to alter purchases of X and Y and achieve a greater degree
of satisfaction.

Suppose that at the current purchase combination, MRS = 4, meaning that

the consumer is willing to exchange four units of Y for one more unit of
X. If PX = $6 and PY = $2, then the consumer need only give up three
units of Y at $2 each to obtain the dollars needed to buy another unit of
X. This situation is reflected by point B in Figure 4-7, where the slope of
the indifference curve is steeper than the slope of the budget line. This
means the consumer is willing to give up more of good Y to get an
additional unit of good X than he or she actually has to give up, based on
the market. Confronted with these circumstances, it is in the consumer’s
interest to consume less of good Y and more of good X. This substitution
continues until ultimately the consumer is at point E, in Figure 4-7, where
the MRS is equal to the ratio of prices.

In general, then, consumer maximization of satisfaction requires equality

between the marginal rate of substitution for any pair of products and the
ratio of their prices, otherwise some exchange can be made which will
increase consumers’ overall satisfaction.

Demonstration problem
Suppose an individual uses exactly two pats of butter on each piece of
toast. If toast costs $0.20/slice and butter costs $0.10/pat, find this
individual’s best affordable bundle if she has $12 per month to spend on
toast and butter.
Answer:

The individual is willing to exchange one piece of toast for two

pats of butter, i.e., MRS = 2. At the same time, the price ratio
(Ptoast/Pbutter) = 2. Therefore the individual is already
maximising her satisfaction since MRS = (Ptoast/Pbutter).
Therefore her $12 budget should be allocated in such a way that
for every piece of toast that she consumes she will consume two
pats of butter – 60 pats of butter and 30 toasts.

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Price changes and consumer behaviour

A change in the price of a good will lead to a change in the equilibrium
consumption bundle. To see this, assume that the price of X is reduced.
This, as explored earlier, results in an anticlockwise rotation of the budget
line. The consumer responds by moving from point A to point B on a
higher level of utility.

Precisely where the new equilibrium point lies along the new budget line
after a price change depends on whether the two goods are substitutes or
complements. Recall from Module 3 that goods X and Y would be called
substitutes if an increase (decrease) in the price of X leads to an increase
(decrease) in the consumption of Y. On the other hand, they would be
called complements if an increase (decrease) in the price of good X leads
to a decrease (increase) in the consumption of good Y.

Figure 4-8 shows the case of two substitutes. A reduction in the price of
X would lead the consumer to move from point A in to a point such as B,
where less of Y is consumed than at point A.
Figure 4-8

If goods X and Y were complements, a reduction in the price of X would

have led the consumer to move from point A in Figure 4-8 to a point such
as C, where more of Y is consumed than before. Please note that this
would require a new set of indifference curves (showing a different
consumer’s preferences), which is not shown here.

Price changes alter consumer incentives to buy different goods, thereby

changing the mix of goods they purchase in equilibrium. The primary
advantage of indifference curve analysis is that it allows a manager to see
how price changes affect the mix of goods that consumers purchase in
equilibrium. These changes may be the result of other firms initiating
price changes, or due to a change in the firm’s own strategy.

Income changes
Indifference curve analysis also allows us to see how changes in income
affect the mix of goods purchased by consumers. When the consumer’s
income changes, the consumer will respond by changing his or her

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optimal bundle of goods (X and Y). Normally, increases in income, all

else remaining constant, will lead to increased demand for the products
available to the consumer. We show such a situation in Figure 4-9, where
the consumer’s income has increased and that consumer subsequently
purchases more of both products available. Note that at the initial prices
and income level (M0), and given the consumer’s taste and preference
pattern (indicated by the indifference curves), the consumer maximises at
point A.

Now suppose the consumer’s income increases to M1 so that his or her

budget line shifts out in a parallel fashion. Clearly the consumer can now
achieve a higher level of satisfaction than before. This particular
consumer finds it in his or her interest to choose bundle B in Figure 4-9,
where the indifference curve through point B is tangent to the new budget
line.
Figure 4-9

In this case, the quantity demanded of both products has increased as a

result of the increase in the consumer’s income. Since income and
quantity demanded moved in the same direction, we say that the income
effect was positive for both goods. We call such products normal goods.

For some products the income effect is negative, meaning that if income
increases, the quantity demanded of those products actually declines. This
may happen to a product that is an inferior substitute for some superior
product. As people become richer, they tend to switch away from inferior
goods to superior substitutes. Conversely, as incomes fall (in a recession,
for example), people tend to switch back to the inferior substitutes as they
find themselves unable to afford the superior substitutes.

In Figure 4-10 we show the income effect for an inferior good. The
product on the horizontal axis, travel by train, is an inferior good, and
travel by air is a superior substitute for this particular consumer. Note that
when the consumer’s income increases and the budget line moves
outward, the quantity demanded of travel by train actually decreases
while travel by air increases. This consumer, now able to afford more air
travel, substitutes away from the inferior good and in favour of the

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superior good. Looking at this from the opposite perspective, if the

consumer’s income were to fall from the higher level to the lower level,
the consumer would reduce consumption of the superior good and
increase consumption of the inferior good.
Figure 4-10

For any particular product at any particular point in time, some consumers
may regard that product as a superior good while others may regard it as
an inferior good. This difference in attitude toward a particular product
stems from a difference in income levels and/or a different pattern of
tastes and preferences.

The income and substitution effects of a price change

We can combine our analysis of price and income changes to gain a better
understanding of the effect of a price change on consumer behaviour. The
effect of the price change can be thought of as comprising two separate
effects, known as the income effect and the substitution effect. When a
product’s price falls (and all other things remain unchanged), the
consumer experiences an increase in his or her real income. Real income
is the purchasing power of money income. When the price of a particular
good falls, the consumer can buy the same combination as before and
have some money left over. This additional real income can then be spent,
both on the product whose price has fallen and on other products.
Normally, the income effect of a price reduction causes the consumer to
buy a little more of the product in question, but if the product in question
is an inferior substitute for some other product, the consumer may reduce
purchases of the inferior product (whose price fell) in favour of the other
product.

The second part of the price effect is the substitution effect. When the
price of a product falls, consumers will tend to substitute in favour of that
product because it is now cheaper relative to other substitute products that
serve the same need. Thus, when the price of a product falls, all else
being kept constant, the consumer would normally buy more of that
product, first because his or her real income has increased, and second

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because he or she substitutes toward that product and away from other
substitutes that are now relatively more expensive.

Suppose a consumer initially is in equilibrium at point A in Figure 4-11,

along the budget line connecting points J and K. Suppose the price of
good X decreases so that the budget line rotates anti-clockwise, and
becomes the budget line connecting points J and L. The consumer now
maximises his or her satisfaction at point C. The movement from A to C
is referred to as the total effect. The total effect, however, is composed of
substitution and income effects. The substitution effect reflects a
movement along an indifference curve, from A to B, thus isolating the
effect of a relative price change on consumption: XB – XA. The income
effect results from a parallel shift in the budget line; thus it isolates the
effect of increases of ‘real income’ on consumption and is represented by
the movement from B to C: XC – XB. The total effect of a price decrease,
which is what we observe in the marketplace, is the movement from A to
C: XC – XA. Therefore, the total effect of a change in consumer behaviour
results not only from the effect of a lower relative price of good X (the
movement from A to B) but also from the increased real income of the
consumer (the movement from B to C).
Figure 4-11

Demonstration problem
Suppose your product is a cyclical product, that is, sales vary directly
with the economy. How can this information be useful to you when
considering alternative products to include in your store?
Answer:

If you expand your offerings to include more normal goods, you

will continue to have an operation that sells more during an
economic boom than during a recession. However, if you include
in your operation some inferior goods, the demand for these
products will increase during bad economic times for normal
goods. This is not to say that the optimal mix of products

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involves a 50-50 mix of normal and inferior goods; indeed, the

optimal mix will depend on your own risk preference. Therefore,
you may be better off diversifying, at least to a degree.

Demonstration problem
Does running a gourmet food store involve a higher level of risk of going
out of business than running a supermarket, or vice versa, when the
economy heads for a recession?
Answer:

Note that gourmet shops sell almost exclusively normal goods,

while supermarkets have a more ‘balanced portfolio’ of normal
and inferior goods. This explains why, during recessions, many
gourmet shops go out of business while supermarkets do not.
This is the case because the outlet that sells low, or even perhaps
negative, income elastic products tends to survive and in fact do
well in a recession.

Corner solutions
In all the examples considered so far, the optimal consumer basket has
been interior, meaning that the consumer consumes positive amounts of
both goods. In reality, though, a given consumer will not purchase
positive amounts of all available goods. For example, not all consumers
own a car or a house. Some consumers may not spend money on tobacco
or alcohol. If the consumer cannot find any interior basket at which the
budget line will be tangent to an indifference curve, then he or she may
find an optimal basket at a corner point, that is, at a basket along an axis,
where one of the goods is not purchased at all. If an optimum occurs at a
corner point, the budget line may not be tangent to an indifference curve
at the optimal basket.

Let’s consider again our consumer who chooses between just two goods,
food and clothing. If the consumer’s indifference map is as illustrated in
Figure 4-12, no indifference curve is tangent to his or her budget line. At
any interior basket on the budget line, such as basket B, the slope of the
indifference curve is steeper (more negative) than the slope of the budget
line. This means that MRS > PX/PY. In this case, our consumer is willing
to exchange more Y for an additional unit of X than he or she has to,
based on the market. This is true not only at basket B, but at all baskets on
the budget line. The consumer would continue to substitute X for Y,
moving along the budget line until he or she reaches the corner point
basket C. At basket C the slope of the indifference curve I2 is still steeper
than the slope of the budget line; he or she would like to substitute more
X for Y if that were possible. But no further substitution is possible
because no more X can be purchased beyond basket C. Therefore the
optimal choice for this consumer is basket C, because that basket gives
the consumer the highest utility possible on the budget line.

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Figure 4-12

CX

Application of indifference curves

Quantity discounts
In many instances sellers offer consumers quantity discounts. We can use
indifference curve analysis to understand how such discounts work. Here
is an example. Suppose a video/DVD store sells its products according to
the following formula. For the purchase of the first eight videos/DVDs
the seller charges a price of $15 for each video/DVD. However, a hefty
discount is offered on purchase of each additional unit, $10 per
video/DVD. Figure 4-13 shows how the quantity discounts affect the
consumer’s behaviour assuming that the buyer starts with a fixed budget
of $300 to be spent on all goods including video/DVD.
Figure 4-13

As shown in Figure 4-13, in the absence of a quantity discount, each unit

sells for $15 and the budget line facing the consumer is represented by
JK. The slope of this line is (–15). Point J, the vertical intercept is a point
where the buyer buys no video/DVD, and keeps his or her money for
other products. The vertical axis can hence be regarded as a composite
good (all other goods). Point K, on the other hand, is a point where all
$300 is spent on video/DVD. The consumer, however, would choose

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point A, where eight video/DVDs are purchased. Suppose the discount

kicks in. The budget line is now represented by the line JAL, a broken
line. The upper segment of the budget line (JA) has the slope of (15),
whereas the bottom segment (AL) has the slope of (–10), and the
consumer will buy the total of 12 videos/DVDs, point B. The quantity
discount scheme has induced the consumer to purchase an additional four
units.

Voucher versus cash subsidies

Governments in most countries often employ a wide range of publicly
subsidised ‘assisted housing’ programmes. One of the main objectives of
all of these programmes is to provide access to a primary human
requirement for those most in need. For instance in Canada, the current
annual cost of housing subsidies is estimated at more than $5 billion.
Increasingly, in the allocation of the limited stock of subsidised housing
units, the focus is on those high-need, low-income families who have to
spend more than 30 per cent of their family income to rent adequate
accommodation.

Suppose the consumer (household’s) preferences for housing and other

goods are represented by the indifference curves as in Figure 4-14. Let
the Y-axis denote the composite good (measured in dollars per month)
and X represents the housing units. Assume that this household has a
monthly budget of $M and must pay PX for each unit it rents. The budget
line is represented by JK. Given the budget line and the indifference
curves, equilibrium is found at point A with XA units of housing. The
consumer spends ($M – YA) on housing and the rest, YA, on other goods.

Now suppose the government steps in to increase the housing

consumption. There are two types of programmes that might be
implemented to increase the consumer’s purchases of housing: (a) the
subsidy as an additional amount of housing the family receives, coupon
(housing voucher) or (b) the subsidy as an additional income, cash
subsidy.
Figure 4-14

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If the consumer receives a cash subsidy of $S from the government, the

budget line shifts from JK to LN. If the government gives the consumer a
voucher also worth $S that can only be spent on housing, the budget line
will be represented by JHN. Because the consumer cannot apply the
voucher to purchase other goods, the maximum he or she can spend on
other goods is still $M, whereas in the case of a cash (income) subsidy,
the consumer is free to allocate whatever amount he or she wishes to
allocate to housing and other goods. Assuming that the consumer’s
preferences are represented by the set of indifference curves I1 and I2, he
or she will be indifferent between a cash subsidy and a voucher, and the
choice of the programme does not matter. The consumer’s choice will be
point B in either case.

However, if the consumer’s preferences are represented by a different set

of indifference curves, Figure 4-15, the choice of the programme does
matter. Under the policy of cash subsidy, the consumer will select the
bundle at point C, on I4, whereas under the voucher, the consumer will
choose the bundle at point H, on a lower indifference curve, I3. Clearly,
the consumer is worse off under the voucher scheme than under the cash
subsidy.
Figure 4-15

If such strong conclusions can be drawn from such a simple model, then
why do governments spend billions of dollars to provide subsidised
housing, instead of just making cash grants? One political reason is that
earmarking the subsidy for housing guarantees that resources used will
put roofs over people’s heads rather than being spent in frivolous or illicit
ways. An economic reason the likelihood of the consumer finding
housing is less under cash subsidy than voucher. This is the case because
the landlord may perceive the risk of non-payment to be greater when the
entire rental payment is made by the tenants themselves than when a
portion of it is guaranteed by the government.

Relationship between indifference curve analysis and demand curves

The indifference curve approach developed in this module is, in fact, the
basis for the demand functions we studied in Module 3. We have seen
how the consumption patterns of an individual consumer depend on

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variables that include the prices of substitute goods, the prices of

complementary goods, tastes (the shape of indifference curves), and
income. We conclude by examining the link between indifference curve
analysis and demand curves.

Individual demand
Recall from Module 3 that a market demand curve is a relationship that
tells how much of a good the market as a whole wants to purchase at
various prices. Suppose we want to generate a demand schedule for a
good, X, not for the market as a whole but for only a single consumer.
Holding income, preferences, and the prices of all other goods constant,
how will a change in the price of shelter affect the amount X the
consumer buys? To answer this question, we begin with this consumer’s
indifference map, with X on the horizontal axis and the composite good Y
on the vertical axis, Figure 4-16(a). The consumer initially is in
equilibrium at point A, where income is fixed at M, and prices are PXA
and PYA. But when the price of good X falls to the lower level, indicated
by PXB (PXB < PXA ), the consumer reaches a new equilibrium at point B.
The important thing to notice is that the only change that caused the
consumer to move from A to B was a change in the price of good X;
income and the price of good Y are held constant in the diagram. When
the price of good X is PXA the consumer consumes XA units of good X;
when the price falls to PXB, the consumption of X increases to XB.

The panel (b) in Figure 4-16 shows this relationship between the price of
good X and the quantity consumed of good X. This consumer’s demand
curve for good X indicates that, holding other things constant, when the
price of good X is PXA the consumer will purchase XA units of X; when
the price of good X is PXB, the consumer will purchase XB units of X.

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Figure 4-16

The line connecting point A to point B in panel (b) represents the demand
curve for our consumer. An individual consumer’s demand curve is like
the market demand curve in that it tells the quantities the consumer will
buy at various prices.

Market demand
The market demand curve is the horizontal summation of individual
demand curves and indicates the total quantity all consumers in the
market would purchase at each possible price. This concept is illustrated
graphically in Figures 4-17(a) and 4-17(b). The curves D1 and D2
represent the individual demand curves of two hypothetical consumers:
Individual 1 and Individual 2. When the price is $500, Individual 1 and
Individual 2 buy 0 units. Thus, at the market level, 0 units are sold when
the price is $500, and this is one point on the market demand curve
(labeled DM in Figure 4-17(b)). When the price is $400, Individual 1 buys
50 units (point A) and Individual 2 buys 0 units (point B). Thus, at the
market level 50 units are sold when the price is $400, and this is another
point (point A + B) on the market demand curve. When the price of good
is $200, Individual 1 buys 150 units and Individual 2 buys 80 units; thus,
at the market level, 230 units are sold when the price is $200.

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Figure 4-17

(a) Individual demand (b) Market demand

The attribute approach to consumer choice

Our discussion of consumer behaviour so far has failed to explain why
some customers opt to purchase brand A over brand B for the same
general good or service. To analyse consumer choice criteria for
competing brands, we can study the modern consumer theory known as
Attribute analysis. The attribute model of consumer behaviour holds that
consumers derive utility not from the products themselves but from the
characteristics or attributes provided by the products. It is a product’s
characteristics, performance features, or attributes that create utility; thus,
what causes a buyer to prefer one brand over another has to do with the
different attributes of rival brands. For instance, what business travellers
care about in their notebook computers are low weight, long battery life,
and high computing power, rather than the logo on the case. There are
trade-offs among these good things; what differentiates one notebook
from another is where in this ‘attribute space’ or ‘characteristics space’
they are located.

Therefore, the major contribution of the attribute model is its ability to

explain that a consumer’s preference for brand A over brand B is rooted
in the fact that the consumer attaches more utility or satisfaction to some
attributes than to others. Thus, the attribute approach greatly facilitates
the explanation of consumer choice within groups of substitutes.

Depicting products in attribute space

For the purposes of our graphical analysis here, consider the situation of
buying a notebook computer assuming that a prospective buyer is familiar
enough with its two most important attributes (other than price), that is.,
‘low weight’ and ‘high computing power.’ To demonstrate how a
consumer might choose among products to maximise utility derived from
the two attributes, suppose there are three notebook brands. After a
careful evaluation, the buyer ranks each notebook on a scale of 1 to 10,
with 1 being the lowest and 10 the highest, and comes up with the
following information, Table 4-1 below. We shall assume that each
product supplies both attributes in a particular ratio.

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Table 4-1: Attributes and Prices of Three Brands of Notebook

Computers

Attribute Rating

Notebook Notebook Low High Ratio of

Brand Price Weight Computing Low Weight
Power to High
Computing
Power
A $2,500 9 4 2.25

B 2,800 7 6 1.16
C 3,200 5 9 0.55

In Figure 4-18, below, each notebook brand is shown in the attribute

space as a ray drawn from the origin. Graphically, the slope of each ray is
determined by the ratio of low weight to computing power, as listed in the
last column in the table. If the buyer buys notebook A, he or she will
travel out along the steepest ray, absorbing the two attributes in the ratio
2.25. The other notebook computers are indicated by the lower rays
because these offer the two attributes at lower ratios. If the traveller buys
notebook B, he or she will travel along the second steepest ray with the
slope of 1.16. Finally, for brand C, the ratio is 0.55.

What determines how far along each ray the buyer could go and how
much of each product the buyer can purchase depends on the buyer’s
budget (budget constraint). In the case of an indivisible purchase, such as
purchase of a car or a notebook computer – the products that are, on the
one hand, available only in discrete units and, on the other hand, the price
of which are large in relation to the consumer’s income – the consumer is
expected to stop at purchasing just one unit of the product: one car and
one notebook computer. This, of course, implicitly assumes the buyer’s
budget is large enough to permit the purchase of all three brands despite
the price differences.

Following this logic, the efficiency frontier, which is the outer boundary
of the attainable combinations of attributes, is obtained. It is called
‘efficient’ because only combinations on this frontier allow the consumer
to maximise utility. This frontier consists of the points joining the limit
points – points A, B, and C – on each product ray. Each point is found by
first dividing the buyer’s income by the price of the respective product in
order to determine the number of the units of the product, and then
multiplying the outcome by the attribute content of each unit. The point
depicted along each ray shows the maximum intake of the two attributes
that can be obtained by consuming each notebook.

Utility maximisation from attributes

Just as consumers can express preference or indifference between
combinations of products, they can express preference of indifference

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between combinations of attributes. At any particular combination of

‘light weight’ and ‘high computing power’, our buyer will be able to
express a marginal rate of substitution between the two attributes: at any
point, an extra unit of ‘low weight’ will be worth giving up some amount
of ‘high computing power.’ These evaluations produce a set of
indifference curves expressing the buyer’s tastes and preferences at each
possible attribute combination. Since our buyer cannot mix brands but
rather needs to choose one notebook brand or another, he or she must be
content with the constrained point: A, B, or C, Figure 4-18. Therefore, the
efficient frontier is represented by the kinked line ABC. The buyer
maximises utility by choosing the notebook brand with the attribute
combination on the highest indifference curve attainable, I*.

Of these options, point B allows the buyer to attain the highest

indifference curve, I*.
Figure 4-18

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Module summary
The utility approach to consumer behaviour is grounded upon
psychological principles, and is best explained in terms of utility.
Conceptually, utility can be measured in cardinal units, as in Module 2, or
ordinal approach, as discussed in this module, in which case the
Summary consumer is able to rank products in order of preference. Consumer
equilibrium is reached when the marginal utility per dollar is the same for
all products, or when the slope of the indifference curve and the slope of
the budget line are the same. The consumer’s demand curve for a
particular product is directly related to the marginal utility of that product.
The downward sloping demand curve is due to the law of diminishing
marginal utility. In general, the individual’s demand curve consists of two
effects, the substitution effect and the income effect. The income effect
may be positive or negative depending on the taste and preferences of the
consumer. Changes in the consumer’s income will change the quantity
demanded at a given price level. The quantity demanded of normal goods
will move in the same direction as income, whereas the quantity
demanded of inferior goods will move in the opposite direction to
income.

The attribute approach to consumer behaviour gives several valuable

insights into consumer choice, which are not readily apparent using the
product approach. This approach allows the entire range of substitutes
available to the consumer to be depicted on the same graph. It is,
therefore, able to explain why a consumer buys one brand of a product
over another one. Furthermore, this approach can explain why a
consumer will purchase combinations of substitute products.

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Assignment
1. A consumer has an income of $50. He can choose any combination of
product X and product Y for consumption. If price of X (Px) is $5
and price of Y (Py) is $2.50, draw the budget line of the consumer.
Find the market rate of substitution. What is the maximum quantity of
Y that he can purchase? If the income goes up to $75, then how will
the budget line change? Find the maximum quantity of Y that he can
Assignment purchase with the new budget.
2. A consumer can choose any combination of apples and oranges. A,
B, and C are three different points on his indifference curve. If he
moves from A to B he gives up two oranges for one apple. If he
moves from B to C then he gives up one orange for one apple. Do the
consumer’s preferences comply with the diminishing marginal rate of
substitution? Explain.

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Assessment
1. Consider the problem in question 2. If the price of apples is $0.50 per
unit and the price of oranges is $0.25 per unit, then with an income of
$10 at which point (among points A, B, and C) will he maximise his
welfare? Explain. If welfare is not maximised at any of these points,
Assessment then explain how he should change his consumption.
2. Prices of food and clothing are currently $10 per unit and $25 per unit
respectively. With an income of $500, find the market rate of
substitution. Suppose that the consumer’s preference shows that
marginal rate of substitution at some point is two units of food for
one unit of clothing. Given that the consumer’s indifference curve
shows a diminishing marginal rate of substitution, how should the
consumer adjust his consumption to maximise utility given the
budget constraint?

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Assessment answers
1. Market rate of substitution = 0.5/0.25 = 2, MRS at A = 2
At A the consumer maximises welfare.

2. Market rate of substitution = 25/10 = 2.5

MRS = 2
The consumer can improve welfare by increasing
consumption of food and reducing consumption of clothing.
Given that her preferences show diminishing MRS, with this
change she can reach a point where her preference will be to
give up 2.5 units of food for 1 unit of clothing, at which point
MRS will be equal to the price ratio, maximising her utility.

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References
Baumol, W. J. (1967). Business Behavior, Value and Growth, Rev. Ed.
New York: Harcourt Brace Johanovich.
Besanko, D., & Braeutigam, R. (2002). Microeconomics: An Integrated
References Approach. New York: Wiley & Sons.
Douglas, J. E. (1992). Managerial Economics: Analysis and Strategy.
Upper Saddle River, NJ: Prentice Hall.
Lancaster, K. (1971). Consumer Demand: A New Approach. New York:
Columbia University.
Pindyck, R. S., & Rubinfeld, D. (2001). Microeconomics, 5th Edition.
Upper Saddle River, NJ: Prentice Hall.

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