FOUNDATION

ECONOMICS
PART I :

PRINCIPLES OF
MICROECONOMICS
TOPIC 2 : CONSUMER BEHAVIOUR

OUT LINE

Introduction
Definitions
Define consumer theory
Distinguish between cardinal and ordinal utility
Explain how consumers maximize their utility
given their budget constrain
Derive individual Demand curve
Describe the characteristics of indifference curve.

INTRODUCTION
Consumer Theory is the study of the economic
behavior of the consumer. Consumer is one of
the basic economic units that determines which
commodities are purchased and in what quantity
Why do consumers purchase some commodities
and not others? How do they decide how much
to purchase of each commodity ? What is the
aim of a rational consumer in spending income?
In these unit we will attempt to seek answers to
these questions
The theory of consumer behavior and choice is the
first step in deriving the market demand curve.

What is Utility?
Utility

means the enjoyment consumers

derive from choices they make in choosing a
good or service.
Goods are desired because of their ability to
satisfy human wants. E.g. An individual
desired soft drinks because it satisfies his
thirst. The property of the good that enables it
to satisfy a want is called utility.
Util is the hypothetical unit of enjoyment that
a consumer derive from the consumption

Consumer Choice and Budget

Constrain

Rational Behaviour- a average consumer is rational, they want

to use their income in a way that will give them the greatest
amount of satisfaction or utility. A typical consumer wants to
obtain the most for their money or to maximise total utility.
Budget constrain The consumers money income is limited, all
consumers consumption activities are subject to a budget
constrain.
Prices the goods and services available to a consumer have
a price tag attached. Because of limited money income a
consumer can purchase only a limited amount of goods. This
brings us to the economic fact of scarcity. With limited income
the consumer have to choose amongst alternative goods , they
aim to obtain most utility in the collection of goods and services
the choose.

Utility Maximising Rule

Of all collection of goods and services a consumer

can afford within the limits of his or her budget
constrain, which collection will yield the maximum
utility?
The rule to follow in maximising satisfaction is that
the consumer should allocate money income so that
the last kina spent on each product bought yielded
the same amount of extra / marginal utility. This is the
utility maxisiming rule
When the consumer is buying in accordance with this
rule , there is no incentive to alter his/her expenditure
pattern. In this situation the consumer is said to be in
Equilibrium

Law of Diminishing Marginal

Utility
Economist use the law of diminishing marginal
utility. We all know that marginal utility means the
extra utility or satisfaction a consumer gets from one
additional unit of a specific good. However, it comes
to a point where this additional units of consumption
good yields less and less satisfaction until the
consumer is reluctant to consume any additional
unit of that particular good. When this situation is
reached (maximum point and declining satisfaction)
economist call it law of diminishing marginal utility

UTILITY ANALYSIS

A utility of a specific good is affected by consumers

preference based on needs, taste and Income.
To illustrate this, as Joe consumes more of a good
per time period, his Total Utility (TU) or satisfaction
correspondingly increases. E.g. TU of Joe increases
when he consumes more ice cream. While TU
generally increases his extra or Marginal Utility (MU)
decreases because the level of satisfaction
decreases. MU declines as Joe consumes more ice
cream per time period holding constant the quantity
consumed of all other goods.

The Laws of DMU as applied to

product A
Unit of Marginal Total
product
utility Utility
A
utils
utils

First
Second
Third
Fourth
Fifth
Sixth
Seventh

8
7
5
3
1
0
-2

8
15
20
23
24
24
22

Highest utility Joe can get

from consuming ice
cream is called a
saturation point. From the
table after consuming the
5th ice cream Joe reaches
its saturation point.
The second column
shows the law of
diminishing marginal
utility. Successive
consumption of ice cream
yield less utility

Total Utility & DMU Charts

12

0
-4

1 2 3

1 2

3 4

TU raises by smaller
amounts ( shaded areas)
and so MU declines.
Consumer reaches
saturation after 4x. Thus
TU remains unchanged
with consumption of 5x =0.
After 5x, TU declines and
MU becomes negative.
The negative slope or
down ward to- the right
inclination of the MU curve
reflects the law of DMU

Unique Individual Taste

Utility schedules refer to the tastes of a particular

individual. The schedule is unique to the individual
and reflects his or her own particular subjective
preferences and perceptions. Different individuals
have different tastes and therefore different
schedules. Utility will be unchanged if tastes are
unchanged. Utility schedules also refer to a specific
period of time.
For example, Joe consume all 6 ice cream in one
day

Marginal Utility in Kina / Money

Terms
The law of DMU depends

on the use to which the

good or service will be
put, e.g., paw paw can be
eaten straight, given to
pigs, as a salad etc.

Quantit (In Kina) T U ( In Kina) MU

y
(x)
(x)
(x)
0

10

10

16

20

22

22

20

-2

Optimal Purchase Rule.

(1).If MU > P it pays to
purchase more
(2).Buy when P = MU since
TU is maximized.
E.g., if P = K4.00/unit (x) TU
is maximized at 3(x)

P = K4.00

Numerical Example
MU y
MU x

Px
Py
Subject To

Utility Maximized

Px Qx P y Q y I

Where P = Price, I = Income

Q = Quantity
x = Product x
y = Product y

Numerical Example
Q

MUx

16

14

12

10

MUy

11

MU x

Px

MU y
Py

10

12
6
or

K 2 K1
Px Qx Px Q y
Px K 2

or

I or K 2 3 K1 6 K12

P y K1 I 12

The MU of the last kina spent on x is equal to the MU of the last

kina spent on Y and the amount of money spend on x plus the
amount of money spent on Y is equal to the individuals money
income (I) (K12). These two conditions must hold .

Derivation of Individual Demand Curve

P
x

We combine the principle of DMU

and the concept of consumer
equilibrium to derive the demand
curve of an individual for a
particular commodity. Given that;
Px = K2, Py = K1, I = K12
x=3
y=6
Point A in the Figure .
If Px = K1, individual buys 6 (x) units,
no longer in equilibrium.
i.e., individual must buy more
units of x and MUx will fall (fall in
utils).
Point B in the Figure
Px Qx + Py Qy = Income
K1 (6) + K1(6) = 12
Therefore consumer equilibrium is
restored if 6 units of x and y are
consumed

Ordinal Utility:
Indifference Curve

Definition:
Consumers tastes can be examined with ordinal utility. An
ordinal measure of utility is based on 3 assumptions.

(1) Faced with 2 baskets of goods, the consumer can

determine whether he or she prefers A to B, B to A or
indifferent between the two.

(2) Assume that the tastes of the consumer are consistent or

transitive, i.e., if the consumer states that he prefers basket A
to B and also that he prefers B to C then he will prefer A to C.

(3) Assume that more of a commodity is a good rather than a

bad and the consumer is never satisfied with the commodity.

Indifference Curves

Q
y

Q
x

The above represent an

individuals tastes represented
by indifference curves. In
order to conduct the analysis
in plane geometry (or in a two
dimensional graph), we
assume only 2 goods x and y.
An indifference curve shows
the various combinations of
2 goods that gives the
consumer equal utility or
satisfaction. A higher
indifference curve shows a
greater amount of
satisfaction and a lower one,
less satisfaction.

Characteristics of Indifference
Curves (IC)

3 basic characteristics
(1) Indifference Curves
are negatively sloped and
convex to the origin. This
is because if one basket of
x and y goods contains
more of x, it will have to
contain less of y than
another basket for the two
baskets to give the same
level of satisfaction and be
on the same indifference
curve.
(2) Indifference Curves do
not intersect

Characteristics of Indifference Curves

(IC)
2) Indifference Curves can not intersect

Proof:

Baskets A and B are on indifference curve I so both yield equal satisfaction to the
consumer. In addition, baskets A and C are on indifference curve II and they also yield
equal satisfaction to the consumer. It follows that B and C are points of equal satisfaction,
so that, by definition, they should lie on the same indifference curve (not on 2 different
indifference curves as assumed). Thus, it is impossible for indifference curves to intersect.
(3) Convex to the origin
Points along the indifference curve lie above any tangency to the curve. Convexity results
from or is a reflection of decreasing marginal rate of substitution (MRS).

Marginal Rate of Substitution

Qx

Qy

MRSxy

Point

10

3/2

2/3

12

1
0

8
B

6
4

0
0

4
X

V1
8

MRS: Refers to the amount of

one good that an individual is
willing to give up for an
additional unit of another good
while maintaining the same
level of satisfaction or
remaining on the same IC, i.e.,
any amount of y that a
consumer is willing to give up
in order to gain one additional
unit of x (and still remain on
the same IC). As individual
moves down an IC,the
marginal rate of substitution
between x and y (MRSxy)
diminishes

Marginal Rate of Substitution

MRSxy measures the downward vertical distance (the
amount of y that the individual is willing to give up) per
unit of horizontal distance (i.e., per additional unit of X
required) to remain on the same IC.
i.e., MRSxy = - Y/X
(ignore minus sign)

MRSxy falls because as an individual is left with fewer

and fewer units of Y, each remaining unit of Y becomes
very valuable to him or her and so he is willing to give up
less and less of Y to obtain each additional unit of X.
Diminishing MRSxy is a reflection of the convexity of IC.

Budget constraint

Budget line shows all the different

combinations of the 2 commodities
that a consumer can purchase,
given his or her money income
and prices of the 2 commodities.
In other words, purchases are
limited by consumers income.
2 good case
Px Qx + Py Qy = I money
income
E.g., Px = Py = K1,
I = K10
all spent on x and y.

Since y is on the vertical axis it

becomes the dependent variable.
Rearranging the budget constraint
we get:
Budget line will change if I and P
changes.

Consumer Equilibrium

A consumer is in equilibrium when, given his or

her income and price constraints, the consumer

maximises the TU or satisfaction from his or her
expenditure. That is, given his budget line, the
consumer reaches the highest possible IC. This
occurs where IC is tangent to the budget line so
that the slope of IC (MRSxy) is equal to the slope
of the budget line Px/Py.

The condition for constrained utility maximization

occurs where the consumer spends all his
income and MRSxy = Px/Py.

Consumer Equilibrium

At point B, indifference curve V1 is tangent to budget line JK.

At point B, the consumer is on the budget line and his
MRSxy = Px/Py = 10/5 = 2. Indifference curve V1 is the
highest that the consumer can reach. Therefore to maximise
utility, he will spend
K4 to buy 2 x and K6 to buy 6 y. Any
other combination or below the budget line provides less
utility, such as points A and C because both are on lower IC.