Mr Sydney Armstrong

ECN 1100 Introduction to Microeconomics

Lecture Note (5)

Consumer Behaviour

Evidence indicated that consumers can fulfill specific wants with succeeding units of a commodity but

that each added unit provides less utility than the last unit purchased. A product has utility if it can

satisfy a want: Utility is want-satisfying power. The utility of a good or service is the satisfaction or

pleasure one gets from consuming it. Three characteristics of the concept must be emphasized:

“Utility” and “usefulness” are not synonymous. Paintings by Picasso may offer great utility to art

connoisseurs but are useless functionally (other than for hiding a crack on a wall).

Implied in the first characteristic is the fact that utility is subjective. The utility of a specific

product may vary widely from person to person. A “jack-up” truck may have great to someone

who drives off-road but little utility to someone too old to climb into the rig. Eyeglasses have

tremendous utility to someone who has poor eyesight but no utility at all to persons like Mr.

Armstrong with 20/20 vision.

Because utility is subjective, it is difficult to quantify. But for illustration purposes we assume

that people can measure satisfaction with units called utils.

Total Utility and Marginal Utility

It is important for us to distinguish between total utility and marginal utility. Total utility is the

total amount of satisfaction or pleasure a person derives from consuming some specific

quantity. Marginal utility is the extra satisfaction a consumer realizes from an additional unit of

that product. Alternatively, we can say that marginal utility is the change in total utility that

results from the consumption of 1 more unit of a product. Mu = ΔTU/ΔQ

Hot Dogs Consumed

Total Utility, Utils

Marginal Utility, Utils

0 0 1 10 10

2 18 8

3 24 6 4 28 4

5 30 2

6 30 0

7 28 -2

This information can be used to construct two graphs which are shown below.

Starting at the origin (from the graph or table), we observe that each of the first 5 units

increases total utility (TU) but by a diminishing amount. Total utility reaches a maximum with

the addition of the sixth unit and then decline. So in the graph and table above we find that

marginal utility (MU) remains positive but diminishes through the first 5 units (while total utility

increases but at a decreasing rate). Marginal utility is zero for the sixth unit (because that unit

doesn’t changes total utility). Marginal utility then becomes negative with the seventh unit and

beyond (because total utility is falling).

The table and graphs above tell us that each successive hot dog yield less extra utility, meaning

fewer utils, than the preceding one as the consumer’s wants for hot dog comes closer and

closer to fulfillment. The principle that marginal utility declines as the consumer acquire

additional units of a given product is known as the law of diminishing marginal utility. It is

important to note that diminishing marginal utility always steps in after the first unit.

0

5

10

15

20

25

30

35

1 2 3 4 5 6 7 8

Total Utility

Total Utility

-4

-2

0

2

4

6

8

10

12

1 2 3 4 5 6 7 8

Marginal Utility

Marginal Utility

Consumer Choice and Budget Constraint

In addition to explaining the law of demand, the idea of diminishing marginal utility explains

how consumers allocate their money incomes among the many goods and services available for

purchase.

The typical consumer’s situation has the following dimensions.

Rational behavior – The consumer is a rational person, who tries to use his or her

money income to derive the greatest amount of satisfaction, or utility from it.

Consumers want to get the most for their money or, technically, to maximize their

utility. They engage in rational behavior.

Preferences – Each consumer has clear cut preferences for certain of the goods and

services that are available in the market. We assume that buyers also have a good idea

of how much marginal utility they will get from successive units of the various products

they might purchase.

Budget constraint – At any point in time the consumer has fixed/ limited amount of

money income. Since each consumer supplies a finite amount of human and property

resources to society, he or she earns only limited income. Thus, every consumer faces

what economists called a budget constraint (budget limitation), even those who earn

millions of dollars a year. Of course, budget constraints are more severe for consumers

with average incomes than for those with extraordinarily high incomes.

Prices – Goods are scares relative to the demand for them, so every good carries a price

tag. We assume that the price tags are not affected by the amount of specific goods

each person buys.

Utility-Maximizing Rule

Of all the different combinations of goods and services a consumer can obtain within his or her

budget, which specific combination will yield the maximum utility or satisfaction? To maximize

satisfaction, the consumer should allocate his or her money income so that the last dollar spent

on each product yield the same amount of extra (marginal) utility. We call this the utility

maximizing rule. When the consumer has balanced his or her margins using the rule, there is no

incentive to alter the expenditure pattern. The consumer is in equilibrium and would be worse

off if there were any alteration in the bundle of goods purchased, providing there is no

change in taste, income, products or prices.

Utility Maximizing Rule:

MU of product A/ price of A = MU of product B/ Price of B…MU of product Z/ Price of Z

Base on the table above which combination of product A and product B will maximize the

consumer utility?

From the table above, the utility maximizing combination of goods attainable by John is 2 units

of A and 4 units of B Note that the marginal utility per dollar for both products is equal to 8. By

summing the marginal utility information from column 2 and column 4, we find that John is

obtaining 18 (10+8 =18) utils of satisfaction from 2 units of product A and 78 (24+20+18+16=78)

utils of satisfaction form the 4 units of B. His 10 dollars optimally spent (1*2 + 2*4 = 10),

yielding 96 utils of satisfaction (18+78 =96).

Assume that John’s income is $10

Product A: Price = $ 1

Product B: Price = $ 2

Unit of the product

Marginal utility (A)

Marginal Utility (B)

First (1) 10 24 Second (2) 8 20

Third (3) 7 18

Fourth (4) 6 16

Fifth (5) 5 12

Sixth (6) 4 6

Seventh (7) 3 4

Assume that John’s income is $10 Product A: Price = $ 1 Product B: Price = $ 2

Unit of the product

Marginal utility (A)

Marginal Utility per Dollar (MU/price) (A)

Marginal Utility (B)

Marginal Utility per Dollar (MU/price) (B)

First (1) 10 10 24 12

Second (2) 8 8 20 10

Third (3) 7 7 18 9

Fourth (4) 6 6 16 8

Fifth (5) 5 5 12 6

Sixth (6) 4 4 6 3

Seventh (7) 3 3 4 2

Note that there are two situations where the marginal utility per dollar for each product is

equal at 10 and 6. Why these outcomes are inferior to the one above?

First, when the marginal utility per dollar is equal to 10 for both products the first thing to note

is that John is not spending all of his income, because at this point he is purchasing only 1 unit

of product A with 2 units of product b which gives us 1*1 +2*2= 5. In this case he is only

spending 5 dollars of his income. Apart from this his total utility is 54 utils that is 10 utils from

the 1 unit of product A and 44 (24+20= 44) utils from the 2 units of product B which is less than

96 when compare to the combination above.

Second, when the marginal utility per dollar for both products is equal to 6 the combination of

product A and B at this point will produce a greater level of satisfaction than the previously

discussed combinations, but given John’s income of $10 this combination is unattainable. This is

so because when the marginal utility per dollar for both products is 6 he would be purchasing 4

units of product A with 5 units of product B which gives us 1*4 + 2*5= 14. In essence to get this

combination he would need an income of 14 dollars which he doesn’t have. What is total utility

at this point?

What needs to happen in the following case to put the consumer into equilibrium when:

MU of product A/ price A < MU of product B/ price B

MU of product A/ price A > MU of product B/ Price B

Indifference Curve Analysis

A more advance explanation of consumer behavior and equilibrium is based on:

Budget lines

Indifference curves

The Budget Line:

What is attainable

A budget line (or, more technically, the budget constraint) is a schedule or curve that shows the

various combinations of two products a consumer can purchase with a specific money income.

If the price of product A is $ 1.50 and the price for product B is $ 1, a consumer can purchase all

the combinations of A and B shown in the table below with the consumer money income being

$12. At one extreme, the consumer might spend all of his or her income on 8 units of A and

have nothing left to spend on B according to the table. Or, by giving up 2 units of A and thereby

“freeing up” $3, the consumer could have 6 units of A and 3 units of B. And so on to the other

extreme, at which the consumer could buy 12 units of B at $1 each, spending his or her entire

money income on B with nothing left to spend on A.

This information can be represented graphically as shown below, however the graph is not

restricted to whole units of A and B as in the table. Every point on the graph represents a

possible combination of A and B, including fractional quantities.

Mathematically the budget line is derived by the following equation:

Income = Px*Qx + Py*Qy

The Budget Line: whole-Unit Combination of A and B Attainable with an Income of

$12

Units of A (Price= $1.50)

Units of B (Price= $1)

Total Expenditure

8 0 $ 12 (= 12+0)

6 3 $12 (= 9+3)

4 6 $12 (=6+6)

2 9 $12 (=3+9) 0 12 $12 (=0+12)

Product A

Product B

The slope of the budget line measures the ration of the price of B to the price A; more precisely,

the absolute value of the slope is PB/PA = $1/$1.50 = 2/3 or 0.67. This is the mathematical way

of saying that the consumer must forego 2 units of A (measured on the vertical axis) to buy 3

units of B (measured on the horizontal axis). In moving down the budget line, 2 units of A (at

$1.50 each) must be given up to obtain 3 more units of B (at $1 each). This yields a slope of 2/3.

The Budget line has two other significant characteristics:

Income changes – The location of the budget lines varies with money income. An

increase in money income shifts the budget line to the right; a decrease in money

income shifts the curve to the left. To verify this recalculate the table above, assuming

that income is (a) $24 and (b) $6 and plot the new budget lines.

Price changes – A change in product price also shifts the budget line. A decline in the

price of both products- equivalent of an increase in real income- shifts the curve to the

right. Conversely, an increase in the prices of A and B shifts the curve to the left. Note

what happens if the price of B changes while the price of A and income remain the

same. If the price of B drops, the lower end of the budget line fans outward to the right.

The opposite will happen if the price of B increases in this case the lower end of the

budget line fans inwards to the left. In both instances the line remains “anchored” at 8

units on the vertical axis because the price of A has not changed.

0

1

2

3

4

5

6

7

8

9

0 2 4 6 8 10 12 14

Budget Line

Income increase Income Decrease

QA QA

QB QB

Price A and B Decreases Price A and B Increases

QA QA

QB QB

Price of B Decreases Price of B increases

QA QA

QB QB

Price of A Decreases Price of A Increases

QA QA

QB QB

Indifference Curves

What is preferred

Budget lines reflect “objective” market data, specifically what income and prices. They reveal

combinations of product A and product B that can be purchased, given current money income

and prices.

Indifference curves, on the other hand reflect “subjective” information about consumer

preferences for A and B. An indifference curve shows all the combination of two products A and

B that will yield the same level of satisfaction or total utility to a consumer. The table and graph

below presents a hypothetical indifference curve for product A and B. The consumer’s

subjective preferences are such that he or she will realize the same total utility from each

combination of A and B shown in the table or on the curve. So the consumer will be indifferent

(will not care) as to which combination is actually obtained.

An Indifference Schedule (Whole Units)

Combination Units of A Units of B

I 12 2

K 6 4 L 4 6

M 3 8

Product A

Product B

Indifference curves have three important characteristics:

Indifference curves are Downwards sloping – An indifference curve slopes downward

because more of one product means less of the other if total utility is to remain

unchanged. Suppose the consumer moves from one combination of A and B to another,

say from J to K in the table and graph above. In so doing, the consumer obtains more of

product B, increasing his or her total utility. But because total utility is the same

everywhere on the curve, the consumer must give up some of product A, to reduce total

utility by a precisely offsetting amount. Thus more of B necessitates less of A and the

quantity of A and B are inversely related. A curve that reflects inversely related variables

is downwards-sloping.

Indifference Curves are Convex to the Origin – A downward-sloping curve can be

concave (bowed outwards) or convex (bowed inwards) to the origin. A concave curve

has an increasing slope (steeper) slope as one move down the curve, while a convex

curve has a diminishing (flatter) slope as one move down the curve. Note that the

indifference curve is convex to the origin. Its slope diminishes or become flatter as we

move from J to K to L, and so on down the curve. The slope of the indifference curve at

each point is called the Marginal Rate of Substitution (MRS). The MRS shows the rate at

which the consumer is willing to substitute one good foe another (in this case B for A) to

remain equally satisfy. The diminishing slope of the indifference curve means that the

willingness to substitute B for A diminishes as one move down the curve. MRS = Δ Y/ΔX

0

2

4

6

8

10

12

14

0 2 4 6 8 10

Indifference Curve

Indifference Curves Never Intersect – Indifference curves identify a given level of

satisfaction. Higher indifference curve mean higher level of satisfaction, lower

indifference curves means lower levels of satisfaction. So when indifference curves

intersect it would be difficult to identify on which curve the consumer is having a

greater level of satisfaction.

Indifference Map

The single indifference curve as the one above reflects some constant (but unspecified) level of

total utility or satisfaction. It is possible and useful to sketch a whole series of indifference

curves or an indifference map, as shown below. Each curve reflects a different level of total

utility. Specifically, each curve to the right of our curve (labeled I) reflects combinations of A

and B that yield more utility than I. Each curve to the left of I reflects less total utility than I. As

we move out from the origin, each successive indifference curve represents a higher level of

utility.

Quantity of A

I

Quantity of B

Special Indifference Curves

Perfect Substitutes Perfect Complements

Quantity of A Quantity of A

Quantity of B Quantity of B

Equilibrium at Tangency

Since the axes for the budget line and indifference map are the same we can superimpose a

budget line on the consumer’s indifference map as shown below. By definition, a budget line

indicates all the combinations of A and B that the consumer can attain with his or her money

income, given the price of A and B. Of these attainable combinations, the consumer will prefer

the combination that yields the greatest satisfaction or utility. Specifically, the utility-

maximizing combination will be the combination lying on the highest attainable indifference

curve. It is called the consumer’s equilibrium position.

Quantity of A

Y W

QA1 X

Quantity of B

In the graph above the consumer’s equilibrium position is at point X, where the budget line is

tangent to I. Why not point Y? Because Y is on a lower indifference curve I2. By moving down

the budget line (by shifting dollars from purchases of A to purchases of B) the consumer can

attain an indifference curve farther from the origin and thereby increase the total utility derived

from the same income. Why not Z? For the same reason: Point Z is on a lower indifference

curve I2. By moving up the budget line (by reallocating dollars from B to A) the consumer can

get to higher indifference curve I and increase total utility.

How about W on the indifference I3? While it is true that W would yield a greater total utility

than X, point W is beyond (outside) the budget line and hence is not attainable by the

consumer. Point X represents the optimal attainable combination of product A and B. Note

that, according to the definition of tangency, the slope of the highest attainable indifference

curve equals the slope of the budget line. Because the slope of the indifference curve reflects

the MRS (marginal rate of substitution) and the slope of the budget line is PB/PA, the

consumer’s optimal or equilibrium position is the point where

MRS = PB

. PA

I

I

I

I

I3

I2

2

Z QB1

The Derivation of the Demand Curve

The budget line determining the above equilibrium position assumes that money income is $12

and that PA = $1.5 and PB = $1. Let’s see what happens to the equilibrium position when we

increase PB to $1.5 and hold both money income and the price of A constant.

The result is shown in the graph below. The budget line fans to the left, yielding a new

equilibrium point X1 where it is tangent to the lower indifference curve I2. At X1 the consumer

buys QB2 units of B and QA2 units of A. our interest is in B, and we now have sufficient

information to locate two points on the demand curve for product B. We know that at

equilibrium point X the price of B is $1 and the quantity purchased is QB1 units; at equilibrium

point X1 the price of B is $1.5 and QB2 are purchased.

By simple manipulation of the price of B in an indifference curve-budget line context, we have

obtained a downward-sloping demand curve for B. We have thus again derived the law of

demand assuming “other things equal,” since only the price of B was changed.

Quantity of A

QA2 X1 X

QA1

QB2 QB1 Quantity of B

Price of B

1.5

1

D

QB2 QB1 Quantity of B

The notes came from McConnell &Brue, Economics, 15th edition, 2002.

You are required to supplement this with additional reading.

I

I

I

I

I3

I2

2