30-Jan-21

Consumer Behaviour: Utility Analysis

• Utility is the sense of pleasure, or satisfaction, that comes
Theory of Consumer Behaviour from consumption
• The utility that a person derives from consuming a
particular good depends on person’s tastes or preferences
for different goods and services  likes and dislikes
• Utility is subjective
Dr. Muhammad Shahadat Hossain Siddiquee • Generally have little to say about the origin of tastes or
Professor, Department of Economics why tastes differ across individuals, households, regions,
University of Dhaka
Email: shahadat_eco@yahoo.com or countries
Contact: +8801719397749 • We generally assume simply that tastes are given and are
relatively stable  different people may have different
tastes but an individual’s tastes are not constantly in flux.

Total and Marginal Utility

• Choice and Utility Theory, • Total utility (TU) is the total satisfaction a person derives
• Marginal Utility and the Law of Diminishing Marginal from consumption
Utility, • Marginal utility (MU) is the change in total utility
• Relationship of Total and Marginal Utility, resulting from a one-unit change in consumption of a good
• History of Utility Theory,
• Cardinal Versus Ordinal Utility Approaches, Law of Diminishing Marginal Utility
• Equimarginal Principle, • The more of a good an individual consumes per time
• Budget line, Indifference Curve and Consumer period, the smaller the increase in TU from additional
Equilibrium. consumption
– That is, the smaller the marginal utility of each
additional unit consumed
• Applies to all consumption

Model of Rational Choice Utility Derived from Water

• Consumer Behavior Units of Water
Utility Analysis Consumed Total Marginal
Consumer Preference Ordering (8 ounce glass) Utility Utility
-what the consumer wants to do 0 0 -
1 40 40
Indifference Curve Analysis
2 60 20
• Constraints 3 70 10
Budget Constraint 4 75 5
• what the consumer can afford to do 5 73 -2
• The Rational Decision
• the optimum decision given preferences and budget The first column lists possible quantities of water a person might
constraint consume after running on a hot day. The second column
consumer equilibrium presents the total utility derived from that consumption and the
third column presents the marginal utility of each additional
glass of water consumed  change in total utility from
consuming an additional unit.

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 30-Jan-21

Total and Marginal Utility Consumer Behavior: Indifference

Because of
diminishing
Curve Analysis
Total Utility
marginal, each glass
Indifference Curve
adds less to total
• Indifference curves are a graphical Good Y
utility  total utility representation of a consumer’s tastes for
increases for the first the two goods III.
four glasses but at a
decreasing rate II.
• A curve that defines the combinations I.
of 2 or more goods that give a
consumer the same level of
In our example, satisfaction.
diminishing Marginal Utility Since each of the alternative bundles of
marginal utility goods yields the same level of utility, the
begins with the first consumer is indifferent about which
unit as seen by the combination is actually consumed
pattern of marginal
utility Good X

Consumer Behavior: Consumer Preference An Indifference Curve

Ordering
•Suppose there are only two goods
• Consumer Opportunities available: pizzas and movie videos
• The possible goods and services consumer can afford •Point a shows the consumption 10
bundle consisting of 1 pizza and 8
to consume. video rentals
8 a
• Consumer Preferences •Moving from point a to point b, we
• The goods and services consumers actually consume. are willing to give up 4 videos to get a
second pizza (total utility is the same at
• Given the choice between 2 bundles of goods a points a and b, so is point c and d). 5
consumer either 4 b
c
• Prefers bundle A to bundle B: A  B Points a, b, c, and d can be connected to 3
d
form the indifference curve, I, which 2 I
• Prefers bundle B to bundle A: A  B represents possible combinations of
• Is indifferent between the two: A  B pizza and videos that would keep the
person at the same level of total utility. 0
1 2 3 4 5 10
Pizzas per week

Consumer Preference Ordering (contd.)

• Completeness Indifference Curves
• The consumer is capable of expressing a preference for all
bundles of goods.
• A preferred to B, B preferred to A, or indifferent between • Along an indifference curve, there is an inverse
A and B relationship between the quantity of one good
consumed and the quantity of another
• Non-satiation consumed  indifference curves slope down
More is Better (always prefer more goods to less)

• Consistency (Transitivity)
• Given 3 bundles of goods: A, B & C.
• If A  B and B  C, then A  C.
• If A  B and B  C, then A  C.

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 30-Jan-21

Marginal Rate of Substitution Indifference Map

Qy
MRS 
Qx • An individual’s preferences can be illustrated by
a set of indifference curves - an indifference
• The marginal rate of substitution (MRS) measures the map
amount of one product a consumer must be given to
compensate for giving up one unit of the other. • Each curve in the map reflects a different level
of utility
• The marginal rate of substitution quantifies the
amount of one good a consumer will give up to obtain
more of another good.
• It is measured by the slope of the indifference curve.
• MRS is the absolute value of the ratio of ΔQy to ΔQx

An Indifference Map
Marginal Rate of Substitution

• The marginal rate of substitution, or MRS, Because both goods yield

marginal utility, the
between pizza and videos indicates the number of

Video rentals per w eek

consumer prefers more of
videos that the consumer is willing to give up to get each, rather than less 10
one more pizza, while maintaining the same level of  curves farther from the
total utility origin represent greater
consumption levels
 total utility along I2 is
• The MRS measures the consumers willingness to higher than I1, I3 higher than 5
I4
trade videos for pizza I2, etc
I3
I2
The combination on each I1
successive indifference curve
reflects greater amounts of
both goods 0 5 10
Pizzas per week

Marginal Rate of Substitution (MRS)

Constraint: Budget Constraints
• The law of diminishing marginal rate of
substitution says that as a persons consumption of • Preferences do not explain all of consumer behaviour.
pizza increases, the number of videos that they are
willing to give up to get another pizza declines • Budget constraints also limit an individual’s ability to
• This implies that the indifference curve has a consume in light of the prices they must pay for
diminishing slope various goods and services.
As we move down the indifference curve, the
consumption of pizza increases and the marginal
utility of additional pizza declines (i.e., Indifference
curves are also convex to the origin  they are
bowed inward toward the origin).

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 30-Jan-21

Budget Constraints A Budget Line

Clothing
(units
per week)
• The Budget Line
• The budget line indicates all combinations of (I/PC) = 40 A
Budget Line F + 2C = $80
two commodities for which total money is
B
spent. 30
10 1
D Slope C /F  -  - P F/P C
2
20
20
E
10
G
Food
0 20 40 60 80 = (I/PF) (units per week)

The Budget Line Budget Constraints

• LetF equal the amount of food purchased, and C is the

amount of clothing.
• The Budget Line
• Then PFF is the amount of money spent on food, and
• As consumption moves along a budget line
PCC is the amount of money spent on clothing. from the intercept, the consumer spends
• The budget line then can be written: less on one item and more on the other.

PFF  PCC  I

Alternative Market Baskets Budget Constraints

Market Basket Food (F) Clothing (C) Total Spending • The Budget Line
($1) ($2) • The slope of the line measures the relative cost
of food and clothing.
A 0 40 $80 • The slope is the negative of the ratio of the
B 20 30 $80 prices of the two goods.
D 40 20 $80
E 60 10 $80
G 80 0 $80

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 30-Jan-21

Budget Constraints Changes in the Budget Line

• The Budget Line Quantity of Good Y Quantity of Good Y

• The vertical intercept (I/PC), illustrates the maximum
20
amount of C that can be purchased with income I. 15

• The horizontal intercept (I/PF), illustrates the maximum

15 Decrease
amount of F that can be purchased with income I. Increase in in Income
Price of X
10
Decrease in Increase
Price of X in Income

0 8 12 20 0 8 12 16
Quantity of Good X Quantity of Good X
(a) (b)

Constrain: The Budget Constraint Budget Constraints

• The Effects of Changes in Income and Prices

• Opportunity Set Y
• The set of consumption bundles The Opportunity Set • Income Changes
that are affordable. • An increase in income causes the budget line to shift
• PxX + PyY  I. outward, parallel to the original line (holding prices
• Budget Line Budget Line constant).
• The bundles of goods that • A decrease in income causes the budget line to shift
exhaust a consumers income. inward, parallel to the original line (holding prices
• PxX + PyY = I. Px
constant).
• Market Rate of Substitution Py
• The slope of the budget line
• -Px / Py X

Market Rate of Substitution (Contd.)

Budget Constraints
• The Effects of Changes in Income and Prices
• The slope (gradient) of the budget line can be deduced as • Price Changes
follows:
• If the price of one good increases, the budget line
shifts inward, pivoting from the other good’s intercept.
I
Y PY P
( Absolute ) Slope  (  ) 
I
 X • If the price of one good decreases, the budget line
X PY
PX shifts outward, pivoting from the other good’s
• i.e. the slope of the budget line equals the relative price of intercept.
good X to good Y.
• In other words, the slope tells us the rate at which the
individual can trade off one good for the other without
changing the amount of money spent - e.g. the amount of Y
that has to be foregone in order to purchase one more unit
of X

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 30-Jan-21

Budget Constraints Consumer Choice

• The Effects of Changes in Income and Prices The maximizing market basket must satisfy two
• Price Changes conditions:
• If the two goods increase in price, but the ratio of the 1. It must be located on the budget line.
two prices is unchanged, the slope will not change.
• However, the budget line will shift inward to a point
2. The maximizing market basket must give the
parallel to the original budget line. consumer the most preferred combination of
goods and services.

Budget Constraints Consumer Choice

• The Effects of Changes in Income and Prices • Recall, the slope of an indifference curve is:
• Price Changes C
• If the two goods decrease in price, but the ratio of
MRS  
F
the two prices is unchanged, the slope will not
change. • Further, the slope of the budget line is:
• However, the budget line will shift outward to a
PF
point parallel to the original budget line. Slope  
PC

Consumer’s Equilibrium Consumer Choice

Consumers seek to maximize total satisfaction, Therefore, it can be said that satisfaction is
which means reaching the highest possible maximized where:
indifference curve
PF
MRS 
Consumers choose a combination of goods that will PC
maximize the satisfaction they can achieve, given the
limited budget available to them.

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 30-Jan-21

Maximizing Consumer Satisfaction

Consumer Choice
Clothing
(units per
week) Market basket D
It can be said that satisfaction is maximized when cannot be attained
marginal rate of substitution (of F and C) is equal to 40 given the current
budget constraint.
the ratio of the prices (of F and C). D
30

20
U3

Budget Line
0 20 40 80 Food
(units per week)

Maximizing Consumer Satisfaction Maximizing Consumer Satisfaction

Clothing Clothing
(units per (units per
week) week) At market basket A
the budget line and the
40 40 indifference curve are
tangent and no higher
B level of satisfaction
30 30 can be attained.

A A
20 20

U1 U2
Budget Line Budget Line
0 20 40 80 Food 0 20 40 80 Food
(units per week) (units per week)

Maximizing Consumer Satisfaction Equilibrium Conditions

Looking at the diagram it is clear that two conditions
Clothing characterise the optimum point A:
(units per
week) Point B does not All income is spent - the individual must choose a point
40
maximize satisfaction on the budget line not within it.
because the
MRS (-(-10/10) = 1 The slope of indifference curve (U2) equals the (absolute)
B is greater than the slope of the budget line: i.e.
30 price ratio (1/2).
PX
-10C
A
MRSY , X 
20 PY
In other words, at the equilibrium bundle, the rate at
+10F U1 which the consumer is willing to trade good X for good Y
Budget Line (MRS) is exactly equal to the rate at which he/she can
trade good X for Y (relative price).
0 20 40 80 Food
(units per week)