CONSUMER BEHAVIOUR

How do consumers make their spending decisions? Answering this question will strengthen our understanding of the law of demand.

Marginal utility and consumer choice

Economist assume that in making choices consumers are motivated to maximize their utility. Utility-satisfaction or well-being that a consumer receives from consuming some good or service. Utility cannot be measured directly but our inability does not mean it is not a useful concept.

Two important distinction of utility:

total utility total satisfaction resulting from the consumption of a given commodity by a consumer Marginal utility additional satisfaction obtained by a consumer from consuming one additional unit of a commodity

Diminishing Marginal Utility

Central hypothesis of utility theory often called the law of diminishing marginal utility: The utility that any consumer derives from successive units of a particular product consumed over a period of time diminishes as total consumption of the product increases

Illustration of these concepts:

Two simplifying assumptions: Utility can be measured Different amounts of utility received from consuming different products can be compared. Example: Allans daily consumption of cocacola

Utility schedules and graphs

No of Drinks (per day) TU MU

0 1 2

0 30 50

30 20 15

3
4 5 6 7

65
75 83 89 93

10
8 6 4 3

Total utility curve

120 100
total utility

80 60 40 20 0 1 2 3 4 5 6 7 8 9 10 11 Quantity of drinks per day

Total utility rises but increases at a diminishing rate, reaches a maximum and then declines

Marginal utility curve

marginal utility

40 30 20 10 0 1 2 3 4 5 6 7 8 9 10 11 Number of drinks per day

Marginal utility declines as consumption increases Each successive drink yields less and less extra utility than the previous one, as Allans desire for coca-cola comes closer and closer to fulfillment

Importance of DMU
Help to explain the law of demand Also explain how consumers should allocate their money income among products available for purchase

Maximizing Utility
Consumers seek to maximize their total utility subject to the constraints they face Constraints:- income and markets prices of various goods

Consumers decision
How should consumers decide to allocate their consumption of coca-cola and beer in such a way to maximize their utility? To maximize utility the consumer must satisfy the equimarginal principle : A utility maximizing consumer must allocates expenditures so that the utility obtained from the last dollar spent on each product is equal. Consumers money income should be allocated so that the last dollar spent on each and every product purchased yields the same amount of extra satisfaction.

Algebraic Representation
MU = MU P p

The Equimarginal Principle: Illustration

Suppose Allan buys beer for $3 each and cocacola for $1each. Buying beer represents a poor use of his money if the marginal utility from the last beer equals the marginal utility from the lat cocacola. Why? Because Allan would be spending $3 on beer to get additional utility equal to what he could have acquired for only $1 by buying coca-cola.

Example
The ratio must be equal if not satisfied there will be reallocation of consumers expenditures between coca-cola and beer, i.e. from the low to the high marginal utility per $ product. Suppose the mu per $ of coca-cola is 3 times mu per $spent on beer, what is expected: Rational consumer- consumes more of coca cola and less of beer. TU of coca cola increases but mu from units of coca is lowered. This switching reduces qty of beer consumed, and given the law of DMU, raises mu of beer.

Example continues
Switching stops when the mu per $spent is the same for all goods. At this condition the consumer cannot increase utility further by reallocating expenditure.

The Consumer Demand Curve

Marginal utility and the demand curve Recall why does the demand curve slopes downward? Deriving the demand curve To derive we need to ask what happens when there is a change in the price of the product?

Deriving Allans Demand Curve: Law of diminishing marginal utility and slope of demand curve
Let X represent coca-cola, Y all other products taken together. What will Allan do if, with all other prices remaining constant, there is an increase in the price of coca-cola? Equimarginal principle is violated, hence need for adjustments in consumption to restore equality. The hypothesis of diminishing marginal utility tells us that as he buys fewer coca-cola, mu of coke will rise and thereby increase the ratio on the left side.

continued
Thus in response to an increase in the price of coke, ceteris paribus, Allan reduces his consumption of of coke until mu of coke rises sufficiently that equation 2 is restored. Analysis leads to the basic prediction of demand theory: A rise in the price of a product (with all other determinants of demand held constant) leads each consumer to reduce the quantity demanded of the product. Thus the theory of consumer behaviour predicts a negatively sloped demand curve

Income and Substitution Effect of Price Changes

An alternative method for thinking about the slope of the demand curve. Discuss: Lets consider Winnie a student who loves to eat ice cream and assume that the price of ice cream falls, ceteris paribus This fall in price will affect Winnie in two ways:

 a) provides an incentive to buy more be (and less of other things) because eating ice cream is now cheaper. Thus a reduction in the price of ice cream which, with all other prices constant, means a fall in the relative price of ice cream leads Winnie to substitute away from other products towards ice cream. b) more purchasing power available to spent on all products. Eg price fall $5 to $4 and if she eat 1 per day for a 30 day month, she will save $15 money available for any purchase

continued
Price fall generates an increase in Winnies real income:-quantity of goods and services that can be purchased with a given amount off money income This rise in income provides an incentive to buy more of all normal goods (recall determinants of demand)

The Substitution Effect

When purchasing power is held constant, the change in quantity demanded of a given good whose relative price has changed is called the substitution effect of the price change. The substitution effect increases the quantity demanded of a good whose price has fallen and reduces the quantity demanded of a good whose price has risen

The Income Effect

Effect of the change in purchasing power, holding relative prices constant at the new value. The increase in purchasing power imply more will be bought. A change in quantity demanded as result of consumers reaction to increased real income is called the income effect. The income effect leads consumers to buy more of a product whose price has fallen, provided that the product is a normal good.

IE, SE and The slope of the demand curve

When price changes, Winnie moves directly from the initial consumption pattern to the final one, we do not observe any halfway consumption pattern. SE leads consumers to increase their demand for goods whose prices fall. IE leads consumers to buy more of all normal goods whose prices fall.

continued
Combined effect of IE and SE gives the following statement of the law of demand: Because of the combined operation of the I and S effects the demand for any normal commodity will be negatively sloped. Thus, a fall in the price will increase quantity demanded. For normal goods I and S effects work in the same direction.

CONSUMER SURPLUS
The market forces consumers to reveal a great deal about their preferences . CS - difference between the total value that consumers place on all units consumed of a commodity and the payment that they actually make to purchase that amount of the commodity. the market demand curve shows the valuation that consumers place on each unit of the product. For any given quantity, CS is the area under the demand curve and above the price line (up to that quantity)

Illustration
Consumer surplus

Applications of the concept of consumer surplus

The paradox of value Early economists, struggling with the problem of what determines the relative prices of products, encountered what they called the paradox of value. Many necessary products such as water, have prices that are low compared to the prices of luxury products like diamonds. Diamond is not in any way essential to life.

CS continued

Indifference Curves Analysis

The history of demand have seen two major breakthroughs: Marginal utility theory - based on strong assumption utility is measurable in absolute terms (utils). - measurement of utility using utils is called the cardinal measure. Indifference curve theory - weaker assumption that consumers can always say which of two consumption bundles they prefer without having to say by how much they prefer it. - rely on the consumers ability to state his rank order of preference of goods. i.e. ordinal measure

Indifference Curves Theory: What is preferred?

Shows all combinations of products that yield the same level of satisfaction to the consumer. Captures the subjective information about consumer preferences. Indifference schedule:

Alternative bundles giving Mark equal utility

Bundle a b c d clothing 30 18 13 10 food 5 10 15 20

e f

8 7

25 30

Indifference curve
35 30 25 20 15 10 5 0 0 10 20 food per week 30 40

clothing per week

characteristics
Any point above the IC is preferred to any point along the IC (because have more of everything) Any point on the curve is preferred to any point below it (less of everything) Illustrate use IC map. The law of transitivity-IC cannot cross or touch (illustrate).

 Downsloping: - : marginal rate of substitution - how much clothing is Mark willing to give up to get one more unit of food but to keep his utility unchanged? MRS amount of one product that a consumer is willing to give up to get one more unit of another product. - slope of IC is negative, MRS is ve 1st basic assumption: to increase consumption of one product , Mark is prepared to decrease consumption of the second product. formula

Diminishing MRS
Second basic assumption of the IC theory IC are convex to the origin: any IC becomes flatter as the consumer moves downward and to the right along the curve The rationale is that consumers subjective willingness to substitute clothing for food will depends of the amounts of commodities being currently consumed by the individual.

 The less of one product, A, and the more of a second product, B, that the consumer has already , the smaller the amount of A the consumer will be willing to give up to get one additional unit of B. Thus the decreasing steepness of the curve means that Mark is willing to sacrifice less and less clothing to get each additional unit of food.

MRS for Mark

movement From a to b From b to c Change in clothing -12 -5 Change in food 5 5 MRS -2.4 -1.0

From c to d
From d to e From e to f

-3
-2 -1

5
5 5

-0.6
-0.4 -0.2

The indifference map

A set of ICs

Special cases
Perfect substitutes: MRS is constant goods can be exchanged one on one IC is a straight line.

Perfect complements
Goods needed in fixed proportions eg left socks and right sock No additional level of only one of them raises consumers satisfaction, only more of both raises consumer satisfaction

Homework
Goods which gives zero utility eg meat to a vegetarian

Budget line
IC illustrate consumers tastes To develop a complete theory of their choices, we must also illustrate the available alternatives. These are shown by a budget line Budget line: what is attainable Shows all combinations of products that are available to the consumer given his money income and the prices of the goods that he purchases. Eg Mark income $720, price clothing $12 and food $24.

Properties of budget line

Points on BL indicates bundles that can use up consumers income Attainable and unattainable Slope of BL measures the opportunity cost of one product interms of the other Slope is equal to the relative price ratio, Pf/Pc

Mark example
Slope = 24/12 = 2 Has to forgo 2 units of clothing to acquire one extra unit of food. Mathematical formula: M = PxX + PyY

EFFECTS OF CHANGES IN INCOME AND PRICES

What happens to BL when income changes, holding prices constant. What happens to BL when price changes Illustrate.

Consumers Utility-Maximizing Choices

IC curve describes the preferences of a consumer, and a budget line describes the possibilities available to a consumer. To predict what a consumer will actually do, both sets of information must be combined. The consumers utility is maximized at the point where an BL is tangent to the highest attainable IC.

Graphical analysis

Consumers reaction to a change in income

Income consumption line: shows how the consumers purchases react to a change in money income with relative prices being held constant. Money income cause a parallel outward shift of his BL Graphical

The Consumers Reaction to a Change in Price

Price consumption line: shows how the consumers purchases react to a change in one price with money income and other prices being held constant. Pivot BL showing that Mark purchase more of cheaper good and less that good whose price has not changed.