Consumer Behaviour

Consumer Behaviour

● theory of consumer behaviour Description of how consumers

allocate incomes among different goods and services to maximize their
well-being.

Consumer behaviour is best understood in three distinct steps:

1. Budget constraints (determine what is possible given the

constraints they face, i.e. income and given prices)

2. Consumer preferences (utility and rate of substitution)

3. Consumer choices (given the defined opportunity set,

consumer selects the most preferred option within it)

We then derive the demand curve of a commodity for an individual and then
the market demand curve
Budget constraints
 BUDGET CONSTRAINTS

● The opportunity set is defined by Budget Constraint.

budget constraints Constraints that consumers face as a result of
limited incomes.

● budget line All combinations of goods for which the total

amount of money spent is equal to income.

Consider two goods, say Food and Clothing. Price for food
(say, pizza) is $1 per unit and Clothing (say, a t-shirt) is $2
per unit. Weekly budget/ income is $80.

• Budget set
• Trade-off between two commodities
 BUDGET CONSTRAINTS

● budget line All combinations of goods for which the total

amount of money spent is equal to income.

PF F + PC C = I
The table shows baskets associated with the budget line
F + 2C = $80

Baskets and the Budget Line

Market Basket Food (F) Clothing (C) Total Spending

A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
 BUDGET CONSTRAINTS
• The Budget Line

A budget line describes the

combinations of goods that
can be purchased given the
consumer’s income and the
prices of the goods.

The slope of the budget line

(measured between points B
and D) is −PF/PC = −10/20 =
−1/2.

Slope of the budget line is

the trade-off or the relative
price of one good in terms of
the other – gives us the
amount one has to give up to Slope or trade-off = Px/Py
have an extra unit of the
other good
 BUDGET CONSTRAINTS
• The Effects of Change in Income

Income Changes A change in

income (with prices unchanged)
causes the budget line to shift
parallel to the original line (L1).
When the income of $80 (on L1) is
increased to $160, the budget line
shifts outward to L2.
If the income falls to $40, the line
shifts inward to L3.
 BUDGET CONSTRAINTS
• The Effects of Change in Prices

Price Changes A change in the

price of one good (with income
unchanged) causes the budget line
to rotate about one intercept.
When the price of food falls from
$1.00 to $0.50, the budget line
rotates outward from L1 to L2.
However, when the price increases
from $1.00 to $2.00, the line rotates
inward from L1 to L3.
 Exercise 1
• The price of bread is Rs. 50 per pound and
butter is 25 per packet. Amrit spends all his
income buying 12 pounds of bread and 7
packets of butter.
– What is his income? Draw the budget constraint.
– If butter price is increased to 40 per packet, how
will the budget constraint change? In order to buy
the same amounts of both the goods, how much
income will he need?
 Exercise 1 continued……
• The price of DVDs is Rs 200 and the price of CDs is Rs
100. Ajay has a budget of Rs. 1000 to spend on the two
goods. Suppose that he has already bought one DVD
and one CD. In addition there are 3 more DVDs and 5
more CDs that he would really like to buy.
– Given the above prices and income, draw his budget line
with CDs on horizontal axis
– Considering what he already has purchased and what he still
wants to purchase, identify the three different bundles of
CDs and DVDs that he could choose. Assume that he cannot
purchase fractional units.
 Exercise 1 continued……
• Riddhi will have to buy five new college text books
during her first year at college at a cost of Rs. 400
each and she gets the money from her father. But,
she finds out that used books cost only Rs. 250
each. When the bookstore announces that there
will be a 10 per cent increase in the price of new
books and a 5 per cent increase in the price of
used books, her father offers her Rs. 200 extra.
• What happens to Riddhi’s budget line?
Preferences
 Preferences
• The process of identifying the budget constraint
and trade-off is same for any two people
• But which point they choose ultimately on the
budget constraint, depends on their preferences
• The choice depends on how better off you feel
by having an extra unit of a commodity by
sacrificing another good and this varies from
one person to another
• They look at marginal benefit and marginal cost
 Utility: a way of measuring preferences
• The benefit of consumption that individuals get
is called utility
• If a bundle of goods is preferred, one gets more
utility from it
• Willingness to pay comes from the utility
derived and it does not have any connection
with the market price that one actually has to
pay – this is purely a preference for the good
• Willingness to pay is not linked to ability to pay
– it is a measure of utility derived
 Principles of Decision Making
• Preferences (likes and dislikes)
• The Ranking Principle: A consumer can rank, in
order of preference, all potentially available
alternatives; allows for ties
• The Preference Principle: Among the available
alternatives, the consumer prefers the one
that he ranks the highest
 Consumer Preferences
• A consumption bundle is the collection of
goods that an individual consumes over a
given period

• How do people rank? …… More is Better.

 Utility Curves
Utility Curve
Marginal Utility

U
t
il
i
t
y

Number of Shirts Number of Shirts

Total Utility is increasing means he is having additional utility from having more shirts
Marginal Utility gives the extra utility from having an extra shirt; but with increase in
the number of shirts, the increase in utility is less
Diminishing Marginal Utility
 Understanding Utility
Total Utility
300

250

200

150

100

50

0
0 2 4 6 8 10 12

Marginal Utility
12

Diminishing Marginal Utility: 10

Each successive increment 8

increases her utility less 6

MU = change in total 2

utility/change in no. of units of 0

0 2 4 6 8 10 12
the good
 Case of Two Goods

• Willingness to give up one good to have more

of the other good, if your utility same = trade-
off
 Marginal Rate of Substitution
• Due to diminishing marginal utility for each good, when you have
more and more of one good, you will be less willing to sacrifice the
other good to get one unit of this good
• Marginal rate of substitution describes the trade-off in preferences
• If you are fond of ice cream, for having one extra ice cream you are
willing to sacrifice 3 packs of pop corn. But when you want to have
the 10th ice cream, you may be willing to give up only 1 packet of
pop corn
• MRS of x for y gives the rate at which you are willing to substitute
one good for the other

● marginal rate of substitution (MRS) Maximum amount of a good that a

consumer is willing to give up in order to obtain one additional unit of another
good.
MRSxy = MUx/MUy
Consumer Decision/Choice
 Choice of goods
• Budget Constraint
• Preferences
• Budget constraint defines your possible set that
you can afford (the rate at which you HAVE TO
substitute one good for purchasing the other)
• Preferences in terms of MRS gives you the rate
at which you are willing to give up one good for
having the other good
• CHOICE is made on the basis of the two
Choice of the Consumer
• Preferences are given by
utility
• Price per unit is Rs. 40.
• Equate marginal benefit
and cost
• MU = p implies he will
choose 2 shirts
• At p=18, one should
choose 7 shirts; if you
choose 5, then MU>p, so
you should increase your
purchase
 Choice with two goods
• Suppose the relative price of a shirt in terms of pizza is 2.
• Your MRS of shirt for pizza is 3.
• What will be the final choice of this consumer?
• Willingness to sacrifice pizza for a shirt (3 pizzas) > the relative
price of shirt in the market (2 pizzas) ; so you will go for more
shirts
• As you have more shirts, suppose your MRS now goes down to 2.
• Now, MRS = relative price. So you stop here and choose the
corresponding amounts of pizza and shirts on the budget line
• Consumer’s equilibrium choice is described by
MUx/MUy = Px/Py
• This can be applied to n number of goods
 CONSUMER CHOICE

Satisfaction is maximized (given the budget constraint) at the

point where

MRS = PF / PC

● marginal benefit Extra benefit from the consumption of one

additional unit of a good.
● marginal cost Extra cost of one additional unit of a
good.
Satisfaction is maximized when the marginal benefit—the
benefit associated with the consumption of one additional unit of
food—is equal to the marginal cost—the cost of the additional
unit of food. The marginal benefit is measured by the MRS.
 SUMMARY

● marginal utility (MU) Additional satisfaction obtained

from consuming one additional unit of a good.
● diminishing marginal utility Principle that as more of a good is
consumed, the consumption of additional amounts will yield
smaller additions to utility.
MRS = MU /MU
F C

Equilibrium implies:

MRS = P / P
F C
MU / MU = P / P
F C F C
MU / P = MU / P
F F C C
● equal marginal principle Principle that utility is maximized
when the consumer has equalized the marginal utility per dollar of
expenditure across all goods.
 Example
Budget equation:
2X + Y = 10

The following
points are on the
budget line:
(1,8)
(2,6)
(3,4)
(4,2)
(5,0)

Which one should

he choose?
• At (1,8), MRS=90/6 = 15 > Px/Py; hence will have more of Clothing.
• Equilibrium occurs at X=4 and Y=2, budget is also satisfied and MRSxy
= Px/Py
 Exercise 2
1. Based on his preference, Feroz is willing to trade four movie
tickets for one ticket to the basketball game. If movie tickets
cost Rs. 80 each and basketball ticket costs Rs. 400, should
Firoz make the trade? Why or why not?

2. Sachin and Saurabh each plan to spend Rs. 2,00,000 on the

styling and gas mileage features of a new car. They can each
choose all styling, all gas mileage or some combination of the
two. Sachin does not care at all about styling and wants the
best gas mileage possible. Saurabh likes both equally and wants
to spend an equal amount on each. For styling and gas mileage,
they have to pay more or less the same amount. What can you
infer about the choice that each person will make.
Exercise 2 continued…..
 Solution to Problem 5

• Points on budget line 10x+30y=150 are:

• (0,5), (3,4), (6,3), (9,2), (12,1), (15,0)
• Consumer eqm occurs at MUx/MUy = Px/Py, i.e. at (6,3)
 Other Topics

• Derivation of Individual Demand

• Derivation of Market Demand

• Network Externalities

• Consumer Surplus
 Demand for a Single Good
• Hirschey, Chapter 4, Page 150, ST 4.1
 INDIVIDUAL DEMAND

Px X + Py Y = M;
• For given M and Py, if Px changes, how the
quantity of X changes may be obtained from
the consumer’s equilibrium.
• In fact, since the budget line changes, the
amount of X are obtained from the old and
the new equilibria corresponding to old Px
and the new Px.

This gives us the consumer’s demand curve for

good x.

• Similarly, by varying only Py, while Px and M

remain the same, one may obtain the
amount of Y the consumer chooses from the
 Pizzas
12.0
Deriving Individual Demand Curve:
Price Changes and the demand curve

Price-consumption curve
A reduction in the price of e3
food, with income and the 5.2
e2
4.3
price of clothing fixed, e1 I3
2.8
causes this consumer to I2

choose a different market L 1 (pb = $12) I1 L2 (pb = $6) L 3 ( pb = $4)

basket. 0 26.7 44.5 58.9 Wine
, Pizzas, $ per unit
(b) Demand Curve

12.0 E1
● individual demand curve Curve
relating the quantity of a good that
a single consumer will buy to its
E2
price. 6.0
E3
4.0
D1, Demand for wine

0 26.7 44.5 58.9 Wine, Gallons per year

 Explaining the Price Effect
• With a change in price, two effects operate, viz.
substitution effect and income effect
• For a normal good, if Price of good 1 falls, one has a
natural tendency to substitute more of the cheaper
good, so quantity for good 1 increases
• On the other hand, due to this price change, effective
purchasing power also increases; so you tend to buy
more
• So, with fall in price, quantity demanded for good 1
increases.
 Key Learning
• Why is the demand curve for a good for a
consumer negatively sloped?

• Budget, Preferences, CHOICE – choice is what

is observed as a final consumption
Applications
 Application 2
• Why Don’t Students Study More?
• See handout
 Exercise 2 continued…..
• Stiglitz and Walsh, Chapter 5, page 122
• Problem 1
 FROM INDIVIDUAL TO MARKET DEMAND

● market demand curve Curve relating

the quantity of a good that all consumers
in a market will buy to its price.

From Individual to Market Demand

TABLE 4.2 Determining the Market Demand Curve

(1) (2) (3) (4) (5)
Price Individual A Individual B Individual C Market
($) (Units) (Units) (Units) (Units)
1 6 10 16 32
2 4 8 13 25
3 2 6 10 18
4 0 4 7 11
5 0 2 4 6
 MARKET DEMAND

From Individual to Market Demand

Summing to Obtain a Market Demand

Curve

At each price, the

quantity of coffee
demanded by the
market is the sum of
the quantities
demanded by each
consumer.

It is addition of
quantitites
 MARKET DEMAND

From Individual to Market Demand

Two points should be noted as a result of this analysis:
1. The market demand curve will shift to the right as more
consumers enter the market.
2. Factors that influence the demands of many consumers will also
affect market demand.

For example, we might obtain information about the demand for

home computers by adding independently obtained information about
the demands of the following groups:
• Households with children
• Households without children
• Single individuals
 EQUATION OF MARKET DEMAND
Aggregate Demand for Wheat in US

Domestic demand for wheat is given by the equation

QDD = 1430 – 55P

where QDD is the number of bushels (in millions) demanded

domestically, and P is the price in dollars per bushel. Export
demand is given by

QDE = 1470 − 70P

where QDE is the number of bushels (in millions) demanded

from abroad.

To obtain the world demand for wheat, we set the left side of
each demand equation equal to the quantity of wheat. We
then add the right side of the equations, obtaining
 NETWORK EXTERNALITIES

● network externality Situation in which each individual’s demand depends

on the purchases of other individuals.

A positive network externality exists if the quantity of a good demanded by a typical

consumer increases in response to the growth in purchases of other consumers.

If the quantity demanded decreases, there is a negative network externality.

The Bandwagon Effect The Snob Effect

● bandwagon effect Positive ● snob effect Negative
network externality in which a network externality in which a
consumer wishes to possess a consumer wishes to own an
good in part because others do. exclusive or unique good.

The Veblen Effect

● veblen effect If the good
becomes more expensive,
people buy more.
 CONSUMER SURPLUS
●consumer surplus Difference between what a consumer is willing to pay
for a good and the amount actually paid.

Consumer Surplus Generalized

For the market as a whole,

consumer surplus is
measured by the area
under the demand curve
and above the line
representing the purchase
price of the good.

Applying Consumer Surplus

When added over many individuals, it measures the aggregate benefit that
consumers obtain from buying goods in a market.
When we combine consumer surplus with the aggregate profits that producers
obtain, we can evaluate both the costs and benefits not only of alternative
market structures, but of public policies that alter the behavior of consumers
and firms in those markets.
Consumer Surplus Example
 Consumer Surplus: Example
• Q = 60 – 2P. Find out consumer surplus at P=0,
P=10 and P = 24.
 Exercise 3
• Demand for books for young adults and adults
are given by two demand equations, Q1 = 20 –
2P and Q2= 80 – P. Find out the market
demand equation for books.
• Demand equation is given by Q=14000 – 500P.
Find out consumer surplus at the price where
elasticity is 1.
 Exercise 3 continued…….
• The in charge of a toll bridge that costs nothing to
operate estimates the demand for bridge crossings
Q
• given by: P = 15 – 1/2Q.
– How many people would cross the bridge if there is no
toll? Find out consumer surplus.
– What is the loss of consumer surplus associated with
the bridge toll of Rs 5?
– Find the lost consumer surplus associated with the
increase in price of the toll from Rs 5 to Rs 7.
 Ref
• Stiglitz and Walsh, Chapter 5