PRINCIPLE OF ECONOMICSECO1013

CHAPTER 4

THEORY OF CONSUMER BEHAVIOUR

ELEVENIE JOHN BAPTIST (13012236)

FELYSITA BT SAMUDIN (13012246)

JACQULYN ANNABELLA JAMILUS (13012256)

INTRODUCTION

- How a consumer choose to spend his/her limeted

income to purchase available goods in the market to

achieve maximum utility.

- Two approaches – the cardinal approach and the ordinal

approach.

DEFINITION OF CONSUMER BEHAVIOR

- Consumer behaviour refers to the study of consumer

while he/she is engaged in the prosess of consumption.

UTILITY APPROACH-Utility means the satisfaction obtained from consuming a commodity. Utility is the ability or the power of goods or services

ORDINAL APPROACH –-Utility is not measurable but it can be compared.-Uses the ranking of alternatives as first, second, third and so on.

CARDINAL APPROACH -Utility is measurable and by placing a number of alternatives where the utility can be added. The index used to meansure utility is called utils.

CARDINAL APPROACH

TOTAL UTILITY AND MARGINAL UTILITY. Total utility is the total satisfaction that a person

derives from the consumption of certain goods and services. As quantity increases, total utility increases.

Marginal utility is the additional total utility derived from consuming one more unit of the same kind of goods or services.

Marginal utility (MU) = CHANGE IN TOTAL UTILITY

CHANGE IN TOTAL QUANTITY

LAW OF DIMINSHING MARGINAL UTILITY

States that as consumption increase more and more, marginal utility will decrease.

=10 

UNITS OF APPLES TOTAL UTILITY MARGINAL UTILITY1 20 202 35 153 45 104 50 55 50 06 45 -57 35 -108 20 -15

The total utility and marginal utility in table 4.1 can be illustrated by figure 4.1 below.

utility

maximum

TU

Quantity

50

Utility

Quantity

This figure illustrates the general relationship between total utility and marginal utility. The total utility curve shows how total utility increase, reaches a maximum and then decreases. The marginal utility curve shows that marginal utility decrease, reaches zero and then becomes negative.

Law of Equi – Marginal Utility (EMU)

States that a consumer maximizes satisfaction when the marginal utility derived from the last unit of money spent on each item of expenditure is equal.

Indifference schedules and curve

An indifference schedules is a list of combinations of two goods that given equal satisfaction to the consumer. An difference schedules may be defined as a schedules of various combinations of goods that will equally satisfy the individual. Table below shows all the five combinations which give an equal level of satisfaction to the consumer.

Combination Y X

A 12 2B 6 4C 4 6D 3 8E 2 12

2 4 6 8 120

2

4

6

8

10

12

14

A

B

C

D

E

GOOD Y

Each indifference curve represent only one particular level of satisfaction. If there are a number of indifference curve showing different levels of satisfaction, called indifference map. An indifference map shows a set of indifference curves. The higher the indifference curve from the origin , the higher the utility.

GOOD X

Good y Ic3 Ic2 Ic1 Good x

Marginal Rate Of Substitution.Marginal rate of substitution refers to the

rate at which goods are substituted for other goods.

5-3Y : 4-3X=2Y :1X

 

COMBINATION Y X MARGINAL RATE OF SUBSITUTION

A 12 1 -

B 8 2 4Y : 1X

C 5 3 3Y : 1X

D 3 4 2Y : 1X

E 1 5 1Y : 1X

Characteristics of an difference curve.

1.Indefference curve slope downward from left to right

Indifference curves must have a negative slope.

2.Indifference curves are convex vis-a-vis the origin.

They are convex to vis-a-via the origin because of diminishing marginal rate of substitution.

3.Higher indifference curves represent a higher level of satisfaction.

An difference curve that lies above and to the right of another indifference curve shows a higher level of substitution.

4.Indifference curve never intersect each other

Indifference curves can never meet or intersect each other.

5.Indifference curve do not touch the Y-axis or X-axis.

Indifference curve operate under the assumption that the consumer purchases a combination of goods.

GOOD Y 12 11 A 10 9 4 units of Y 8 B 7 3 units of Y 6 5 C 2 units of Y 4 3 D 1 units of Y 2 1 0 1 2 3 4 5 GOOD X

GOOD Y 8 6 IC1 GOOD X 0 4 6

FIGURE 4.4(a)

Indifference curve slope Down from Left to Right

FIGURE 4.4(b)

Indifference curve are convex to the Origin

GOOD Y

IC3 IC 2 IC1 GOOD X

FIGURE 4.4(C)HIGHER INDIFFERENT CURVES REPRESENT HIGHER LEVELS OF

SATISFACTION

GOOD Y

IC 2

IC 1

GOOD X

FIGURE 4.4(D) INDIFFERENCE CURVES NEVER INTERSECT EACH

OTHER

X

24 B

BUDGET LINE

A Y 12

BUDGET LINEBudget line represents various combinations of two goods, which can be purchased with a given amount of money and given the price of each unit.

CHANGES IN THE BUDGET LINE.

X

B1 B B2

Y A2 A A1

Change in consumer’s incomeThe budget line depends on the consumer’s income and prices of the goods that a consumer buys in the market. If the prices remain the same, then an increase in the consumer’s income will lead to a shift of the budget line to the right.

Y

When price of x deccreases from RM1 to RM 0.50

24 point A2= 𝟏𝟐𝟎.𝟓 = 𝟐𝟒

X 12(A) 24 (A2)

Y

When price of x deccreases from RM1 to RM 0.50

24 point A2= 𝟏𝟐𝟎.𝟓 = 𝟐𝟒

X 12(A) 24 (A2)

Y 24 when price of Y increase from RM 0.50 to RM Pont B1 =

𝟏𝟐𝟏 = 𝟏𝟐

12 (B1)

x 12

Y 30 (B1) when price of x decreases from RM0.50 to RM 0.4.point B2 =

𝟏𝟐𝟎.𝟒 = 𝟑𝟎

24

12(A)

Figure 4.7(B) price of x is constant and price of Y Changes

Y

30

24

6 12

Price of x increases from RM 1 to RM 2 =

Figure 4.7(c) price of x increases and price of y

decreases

Consumer equilibrium

- Consumer equilibrium is achieved when the consumer the best

possible combination of two goods with a given amount of income.

- The difference curve represents different combinations of two

goods, which give the consumer the same level of statisfaction.

While the budget line represents the various combination of two

goods, which can be purchased with a given amount of money at a

given price.

- The position of consumer equilibrium will be indicated by the point

at which the budget line is tangent to the indifference curve.

GOOD Y a

b c d e

Ic0 Ic1

Ic2

GOOD X

Y

X

 

- From figure 4.8 the possible combinations are a,b,c and e. The consumer equilibrium will be at point C. This is obtained when the indiffrence curve is tangent to the budget line.

- Consumer equilibrium is reached when the indifference curve is tangent with the budget line which represents the best combination of two goods with a limited income. The points a,b,d and e lie on the budget line where the incomes are the same but satisfaction at IC2 with the same amount of income. A consumer will choose the best combination of goods which give him/her maximum satisfaction.

INCOME EFFECT : PRICE EFFECT AND SBSTITUTION EFFECT

 Income effect

- The incomes effect is defined as the effect on the purchases of the

consumer caused by changes in income where prices of goods

remain constant.

- Every increase in the consumer’s income will lead to a higher

indifference curve because the consumer has greater disposable

income. An increase in income will also cause the budget line to

shift to the right due to the fact that the consumer can obtain more

of X and Y. The new budget line will be parallel to the old budget

line, the new budget line wil be tangent to the higher indifference

curve. This is illustrate in figure 4.9 below. 

Y B1 B C1 B2 C C3 IC1 ICo IC2 GOOD X A2 A A1 - In figure 4.9 points C is the original equlibrium posisition. C1, and C2 are

the new equlibrium positions with an increase and decrease income respectively. By joining all the equlibriium points C,C1 and C2, this curve known as the income consumption curve (ICC). The income consumption curve shows relationship between changes in the level of income and corresponding changes in thelevel of consumption and the equlibrium level.

- An increase in income will increase the demand, applies only to normal goods. Normal goods are goods that a consumer purchases more of as income increase.

- An increase in income has a different impact on inferio goods and necessity goods. Inferior goods are goods that consumers purchase less of as income increase such as lw – grade potatoes, secondhand items and salted fish.

- Necessity goods are goods which are consumed in the same amount at all levels of

income or in other words, independent of income consumption curve for inferior goods

and necessity goods.

B3 ICC If ICC bends back on itself to the verticle axis, Y is an inferior

B2 C3 axis, Y is an inferior good

B1 C2

B C1

Co A A1 A2 A3 x

FIGURE 4.10(A) INCOME CONSUMPTION CURVE FOR INFERIOR GOODS

Y

B3 B2 C3 B1 C2 IC3 C1 IC2 B Co IC1

ICo X A A1 A2 A3

Y ICC B2

B1 C2 IC2

B C1 IC1

Co ICo X A A1 A2

IC3 IC3

FIGURE 4.10(B) INCOME CONSUMPTION CURVE FOR

NECESSITY GOODS

PRICE EFFECT

- Price effect explains what happena to the consumers’s equilibrium

position when the price of one of the goods changes while the price

of X will shift the budget line outward to a new intercept on the X

axis.

- In figure 4.11, points C is the original equilibrium position. C21 and

C2 are new the equilibrium position.A decrease in a price of X will

cause the budget line to shift to the right.

- By joining together all the all equilibrium points,C, C1 and C2, this

curve known as price consumption curve (PCC).The price

consumption curve show the changes of consumption as price

changes.

GOOD Y

PCC B C3 C2 IC3 C1 IC2 Co IC1 GOOD X A A1 A2 A3 PRICE OF GOOD X P1 P2 P3 P4

QUANTITY OF GOOD X DD

FIGURE 4.11 DERIVATION OF INDIVIDUAL DEMAND

CURVE FROM PPC

SUBSTITUTION EFFECT

- Substitution effect explains what happens to the consumer

equilibrium position when the price of both goods changes-price

of one rises and price of the other fall while the other remain

constant.

- In figure 4.12, point C is the original equilibrium position.When

the Y increases and the price of X decrease, there will be a new

budget line A1B1.Point C1 will be a new equilibrium position on

the same indifference curve.The combination of two goods may

change but the level of satisfaction remains unchanged if the price

of both gooda change.

GOOD Y B B1 C IC1 C1

GOODX A A1

CONSUMER SURPLUS

- The law of equi-marginal utility states that the price paid for a goods

should be equal to its marginal utility.

- A consumer may get more satisfaction compared to the money he

spends or lesser satisfaction.The excess of satisfaction the consumer

obtains above the price paid of the goods is known as a consumer

surplus.

- Consumer surplus is defined as the excess of what a consumer is

willing to pay and what he/she actually pays. Other words, consumer

surplus, is the diffrence between whta the consumer is ready to pay

minus what he actually pays for a product. 

CONSUMER SURPLUS=TOTAL VALUE - (MARKET PLACE × NUMBER OF UNITS

CONSUMED).

As a conclusion, consumer behaviour defined as the study of a consumer while engaged in the process of consumption.Consumer has a limited resources or income purchases various goods and services that compare the price and utilities of different alternatives.In other words, a consumer chooses to spend the limited income to purchase available goods in the market as to achieve maximum utility.

In this chapter, we can know the characteristics of an Indifference curve, budget line, consumers’ equilibrium, the income and substitution effects of a price change, the effect of price changes on quantity demanded and the consumer surplus.