Chapter Three

THEORY OF CONSUMER BEHAVIOUR

2.1 Theory of Utility and Preferences

qsee how consumers allocate their limited

income among different number of goods and
services.

qlearn how consumer’s allocation decisions

determine quantity demand of goods and
services.
Compiled by Solomon Kebede (PhD Candidate)
Consumer preferences and choices
 A co n s u m e r : i s a n i n d iv i d u a l / h h wh o u s e s /
consumes final g+s with a primary objective of
maximizing utility.

UTILITY
is the level of satisfaction/ enjoyment derived
from consuming goods and services or undertaking
an activity.
Given any two consumption bundles, the consumer can
either decide that one of consumption bundle is
strictly better than the other, or decide that he is
indifferent between the two bundles.

Compiled by Solomon Kebede (PhD Candidate)

 Strict preference

Given any two consumption bundles (X1,X2) and

(Y1,Y2), if (X1,X2)>(Y1,Y2) or if he chooses (X1,X2)
when (Y1,Y2) is available the consumer definitely
prefers the X-bundle than Y.

Weak preference /indifferent/

Given any two consumption bundles(X1,X2) and

(Y1,Y2),if the consumer is indifferent between the two
commodity bundles or if (X1,X2) (Y1,Y2),the consumer
would be equally satisfied if he consumes (X1,X2) or
(Y1,Y2). Compiled by Solomon Kebede (PhD Candidate)
More is better than less
qConsumers always prefer more of any good to
less and they are never satisfied.

qHowever, bad goods are not desirable and

consumers will always prefer less of them.

qIn defining strict preference, the consumer

preferred bundle (X1,X2) to bundle (Y1,Y2) if
and only if the utility (X1,X2) is larger than
the utility of (Y1,Y2).
Compiled by Solomon Kebede (PhD Candidate)
 Approaches to measure
Utility
Ø Two approaches: Cardinal and ordinal approaches.

1. The Cardinal Utility theory

Utility can be quantitatively measured like weight,
height, & temperature with a unit of measurement of
satisfaction called utils.

A util is a cardinal number like 1,2,3 etc simply

attached to utility.

Compiled by Solomon Kebede (PhD Candidate)

Assumptions of Cardinal Utility theory
i. Rationality of Consumers
§ the objective of the consumer is to maximize
satisfaction given his/her limited budget or
income.

ii. Utility is cardinally Measurable

§ the satisfaction of each commodity is
measurable.
iii. Constant Marginal Utility of Money
§ The MU of money remain constant with the level
of income (wealth) of the consumer
Compiled by Solomon Kebede (PhD Candidate)
iv. Limited Money Income:
§ The consumer has limited money income to spend on
the g+s he/she chooses to consume.

v. Diminishing Marginal Utility (DMU):

§ the marginal utility of a commodity diminishes as the

consumer consumes more quantities of the commodity.
vi. The total utility of a basket of goods depends on the
quantities of the individual commodities.

§ If there are n commodities in the bundle with quantities, X1,

X2, … Xn, the total utility is given by:

TU = Compiled
f (X1,X2,…Xn )
by Solomon Kebede (PhD Candidate)
 Total and Marginal Utility
Total Utility (TU):
Is the total amount of satisfaction a consumer gets
from consuming or possessing some specific
quantities of a good at a particular time.

However, there is a saturation point for that

commodity in which the consumer will not be
capable of enjoying any greater satisfaction from it.

Compiled by Solomon Kebede (PhD Candidate)

Marginal Utility (MU):
refers to the additional utility obtained from
consuming an additional unit of a commodity.

is the change in TU resulting from the consumption

of one more unit of a product per unit of time.
Graphically, it is the slope of total utility.

Mathematically, the formula for MU is:

MU = ∆TU/∆Q
Where: TU is the change in Total Utility, and
Q is change in th e a m o u nt o f pro d u ct
consumed. Compiled by Solomon Kebede (PhD Candidate)
Table2.1 Hypothetical table showing TU and MU of
consuming apples (X)

Units of
Quantity(x)
consumed 0 1 s t 2 n d 3 r d 4th 5th 6th
Unit Unit unit unit unit Unit Unit

TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils

MUX 0 10 6 4 2 0 -2

Compiled by Solomon Kebede (PhD Candidate)

Graphically, MU is the slope of total utility.

Compiled by Solomon Kebede (PhD Candidate)

§ the total utility increases at an increasing rate (when
MU is increasing);
§ then increases at a decreasing rate (when MU
decrease);
§ reaches maximum (when MU is Zero).
§ decreases (when MU is negative)

Compiled by Solomon Kebede (PhD Candidate)

q This approach involves 3 weaknesses:

❶ It is doubtful because utility may not be

quantified.

❷ Utility cannot be measured absolutely (objectively).

❸ The assumption of constant MU of money is
unrealistic
v B/c: as income increases, the MU of money
changes.

Compiled by Solomon Kebede (PhD Candidate)

 The ordinalist school postulates that utility
cannot be measured absolutely but different
consumption bundles are ranked according to
preferences.

Consumer are assumed to be able to rank the

various baskets of g+s according to the
satisfaction that each bundle gives him/her.

Compiled by Solomon Kebede (PhD Candidate)

1. The Consumers are rational

2. Utility is ordinal i.e. utility is not absolutely (cardinally)

measurable.
§ Consumers are required only to order or rank their
preference

3. Diminishing Marginal Rate of Substitution (MRS):

§ It is the rate at which a consumer is willing to substitute one

commodity (x) for another commodity (y) so that his total

satisfaction remains the same.

Compiled by Solomon Kebede (PhD Candidate)
4. The
total utility of the consumer depends on the
quantities of the commodities consumed, i.e.,
U=f ( X1, X2,…Xn)

5. Preferences are transitive or consistent:

i.e. if the consumer prefers good X to good Y, and
prefers Y to Z, and then the consumer also prefers X
to Z.

qThe ordinal utility approach is explained with the

help of indifference curves to study the consumer’s
behavior.

Compiled by Solomon Kebede (PhD Candidate)

 Indifference Set, Curve and
Map

Indifference Set/ Schedule

shows the various combinations

of goods from which the consumer
derives the same level of utility.

Compiled by Solomon Kebede (PhD Candidate)

Table2.4 Indifference Schedule

Bundle A B C D
(Combination)
Orange(X) 1 2 4 7

Banana (Y) 10 6 3 1

Compiled by Solomon Kebede (PhD Candidate)

Indifference Curves:
§ is the locus of points shows the various
combinations of two goods that provide the
consumer the same level of satisfaction;

• so that the consumer is indifferent as

to the particular combination he/she
consumes.

Compiled by Solomon Kebede (PhD Candidate)

By transforming the above indifference schedule into
graphical representation, we get an indifference curve.

10 A

Banana Good B
(Y) Indifference
B
Curve (IC)
6

C
2 IC3
D IC2
1
IC1

1 2 4 7 Good A

OrangeX)) (X)

Indifference curve Indifference map

Fig2.4 indifference curves and indifference map.
Compiled by Solomon Kebede (PhD Candidate)
Indifference Map:
It is the entire set of ICs, which reflects the
entire set of tastes and preferences of the
consumer.

Compiled by Solomon Kebede (PhD Candidate)

 Properties of ICs
a) are negatively sloped

b) do not intersect to each other

§ If they did, the point of their intersection would
mean two different levels of satisfaction,
which is impossible.

Compiled by Solomon Kebede (PhD Candidate)

c. A higher IC is always preferred to a lower
one.

§ The further away from the origin an IC lies,

the higher the level of utility it denotes:
d. are convex to the origin

the slope of an indifference cur ve

decreases as we move along the curve from
the left downwards to the right.

Compiled by Solomon Kebede (PhD Candidate)

positively sloped and intersected ICs

Banana B
Banana
E
D
IC2
C
A
IC1

Orange Orange X

Compiled by Solomon Kebede (PhD Candidate)

 The Budget Line
ØIs a graph indicating d/t combinations of two goods
that a consumer can buy with a given income at a
given prices.

Assumptions to use budget line

§ Only two goods, X and Y, bought in quantities X
and Y;
§ two prices of goods (Px and Py) of good X and good
Y respectively;
§ Fixed income; the consumer has a known and fixed
money income (M).
Compiled by Solomon Kebede (PhD Candidate)
Budget Line Equation
qwe can express the budget constraint as:

M  PX X  PY Y
Where, PX = price of good X
PY = price of good Y
X = quantity of good X
Y= quantity of good Y
M= consumer’s money income

qThis means that consumer’s money income is the

amount of money spent on X plus the amount spent
on Y. Compiled by Solomon Kebede (PhD Candidate)
Example:
Suppose a household with 30 Birr per day to
spend on banana(X) at 5 Birr each and Orange(Y)
at 2 Birr each.

o Given: Px = 5, Py = 2 and M = 30birr

o Therefore, our budget line equation will be:

5X + 2Y = 30
qFrom this equation we can have d/t alternative
purchase possibilities of the two goods
Compiled by Solomon Kebede (PhD Candidate)
 5X + 2Y = 30
Consumption
A B C D E F
Alternatives
Kgs of banana (X) 0 1 2 3 4 6

Kgs of Orange(Y) 15 12.5 10 7.5 5 0

Total Expenditure 30 30 30 30 30 30

At pt A, the consumer is using all of his /her

income for good Y. Mathematically it is the y-
intercept (0, 15).

And at pt F, the consumer is spending all his

income for good X. It is the x-intercept (6, 0).
Compiled by Solomon Kebede (PhD Candidate)
Fig.2.7. Derivation of the Budget Line

M/PY

B


A 

M/PX

Compiled by Solomon Kebede (PhD Candidate)

Factors Affecting the Budget Line
1. Changes in consumer income
qIf the income of the consumer changes (keeping the
prices of the commodities unchanged), the budget
line shifts (changes).
§ upward shift of the budget line if increase in
income;
§ downward shift of the budget line if decrease in
income; that leads the consumer to buy less
quantity of the two goods.
§ but the slope of the budget line does not
changes when income changes.
Compiled by Solomon Kebede (PhD Candidate)
Fig.2.8 Effects of change in income

M2/Py
Where M2>M>M1

M/Py

B B2
M1/Py

B1

M1/PX M/PX M2/PX

Compiled by Solomon Kebede (PhD Candidate)

2. Changes in Price of the commodities

Y Y

B1 B1

B
B

X X

Fig.a Fig.b

Fig.2.9 Effects of change in price

Compiled by Solomon Kebede (PhD Candidate)
q Changes in the prices of X and Y ;
§ shifts the budget line
§ changes the intercept of budget
line
§ changes slope of the budget
line

qBut, the proportional change in the

price of the two commodities do not
change the slope of the budget line
if it is in the same direction.
Compiled by Solomon Kebede (PhD Candidate)
Equilibrium of the
Consumer
A ra t i o n a l co n s u m e r s e e k s to m a x i m i z e h i s
utility/satisfaction by spending his/her income.
This occurs where an IC is tangent to the budget
line so that the slope of the IC is equal to the
slope of the BL

(PX / PY ). =
MRSXY

Compiled by Solomon Kebede (PhD Candidate)

Figure2.14 Consumer equilibrium

Compiled by Solomon Kebede (PhD Candidate)

1

Compiled by Solomon Kebede (PhD Candidate)