Principles of

Micro
Economics
Module No. 006
Theory of Consumer
Behavior

By Muhammad
Shahid Iqbal
 Introduction
A consumer is an individual or a household composed
of one or more individuals. The consumer is the basic
economic unit that determines which commodities are
purchased and in what quantities. The study of
consumer behavior is guided by a number of
questions such as What guides individual consumer
decisions? 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?
A consumer usually decides his demand for a
commodity on the basis of utility that he derives from
it. Utility of a commodity is its want-satisfying capacity
Utility is subjective. Different individuals can get
different levels of utility from the same commodity.
 Introduction
The indifference approach is based on the notion
that satisfaction derived from consumption of
different bundles of goods can’t be objectively
measurable. Instead ( consumers are able to rank) or
order bundles of goods in line with their preferences(
from highest to lowest ( best to worst( most
satisfying to least satisfying (Ordinal utility).
It means that satisfaction obtained from consuming
different products or bundles of goods can be ranked
or ordered.
Consumers must be able to state their preferences
between different consumption combinations and in
this approach to utility their behavior can be
analyzed using indifference curves
 Introduction
The theory of consumer choice examines how
consumers facing these trade-offs make decisions and
how they respond to changes in their environment.
Most people would like to increase the quantity or
quality of the goods they consume—to take longer
vacations, drive fancier cars, or eat at better
restaurants. People consume less than they desire
because their spending is constrained by their income.
The theory of consumer choice can be examined by
studying the link between income and spending.
In today’s global economy millions of goods are
offered for sale, however to focus on essential aspects
of individual behavior and to keep things manageable,
we assumes that only two goods exist in the economy.
X and Y be any two goods i.e. Pizza and Pepsi.
 The Budget Constraint: What The
Consumer Can Afford
Suppose the consumer has an income of Rs.1,000 per
month and he spends his entire income on pizza and
Pepsi. The price of a pizza is Rs.10, and the price of a
pint of Pepsi is Rs.2
There are many combinations of pizza and Pepsi that
the consumer can choose. All the points on the line
from A to B are possible. This line, called the budget
constraint, shows the consumption bundles that
the consumer can afford. It shows the trade-off
between pizza and Pepsi that the consumer face
The slope of the budget constraint measures the rate at
which the consumer can trade one good for the other.
Notice that the slope of the budget constraint equals
the relative price of the two goods—the price of one
good compared to the price of the other.
The Consumer’s Budget Constraint
Active Learning Budget
Constraint
Humza’s income: Rs.1200, Prices: PF = Rs.4 per
fish, PM = Rs.1 per mango

If Humza spends all his income on fish, how

many fish does he buy?
If Humza spends all his income on mangos,
how many mangos does he buy?
If Humza buys 100 fish, how many mangos can
he buy?
Plot each of the bundles from parts A – C on a
graph that measures fish on the horizontal axis
and mangos on the vertical; connect the dots.
 PREFERENCES: What the
Consumer Wants
In chacterizing Consumer Behavior, there are two
important but distinct factors to consider:
Consumer opportunities (Possible Goods and
services consumer can afford to consume)
Consumer Preferences (which of these goods will
be consumed)
Assume a consumer is able to order his preferences
for alternatives bundles or combinations of goods
from best to worst i.e. Bundle A > B (A is preferred
to B), A ~ B (indifferent means equally satisfying).
A consumer’s preference among consumption
bundles may be illustrated with indifference curves.
An indifference curve shows the bundles of
consumption that make the consumer equally
happy.
 Representing Preferences with
Indifference Curves
An indifference curve is a locus of all combinations of two
goods which yield the same level of satisfaction (utility) to
the consumers.
Marginal rate of substitution: The rate at which a
consumer is willing to substitute one good for another
good and still maintain the same level of satisfaction.

The consumer is
indifferent among
combinations D, E and
F because they are all
on the same curve.
The slope at any point
on an indifference
curve equals the rate
at which the consumer
is willing to substitute
 Assumptions of ordinal utility approach
The preference ordering is assumed to satisfy some basic
Assumptions.
1. Rationality: The consumer is assumed to be rational
meaning that he aims at maximizing total utility given
his limited income and the prices of goods and
services.
2. Utility is Ordinal: According to this assumption,
utility is assumed not to be measurable but can only
be ranked according to the order of preference for
different kinds of goods.
3. Preferences are complete: For any two bundles say
A and B, either A>B, B<A or A ~ B, prefer A to B’ or
prefer B to A’ or prefer both equally’
4. More is Better: The indifference curve analysis
assumes that consumer always prefers more goods to
less.
 Assumptions of ordinal utility approach
1.

1. Diminishing MRS: the rate by which a person

substitutes X for Y diminishes more and more
with each successive substitution of X for Y.
2. Preferences are transitive: If the consumer
prefers A to B and B to C, obviously, he must
prefer A to C. Symbolically, it is written as: If A >
B and B > C; then A > C.
 Properties of Indifference
Curves Property 1
Higher indifference curves are preferred to
lower ones. Consumers usually prefer more of
something to less of it. Higher indifference curves
represent larger quantities of goods than lower
indifference curves. Thus, the consumer prefers
being on higher indifference curves.
 Properties of Indifference
Curves Property 2
Indifference curves are downward sloping: A
consumer is willing to give up one good only if he or
she gets more of the other good in order to remain
equally happy.
If the quantity of one good is reduced, the
quantity of the other good must increase. For this
reason, most indifference curves slope
downward.
 Properties of Indifference
Curves Property 3
Indifference curves do not cross: suppose that two
indifference curves did cross, point A is on the same
indifference curve as point B, the two points would make
the consumer equally happy. Point B is on the same
indifference curve as point C, these two points would make
the consumer equally happy. But these conclusions imply
that points A and C would also make the
consumer equally
happy, even though
point C has more of
both goods. This
contradicts our
assumption that the
consumer always
prefers more of both
goods to less. Thus,
indifference curves
 Properties of Indifference
Curves Property 4
Indifference are convex to the origin: People are more willing to
trade away goods that they have in abundance and less willing to
trade away goods of which they have little.
 Two Extreme Examples of
Indifference Curves
Perfect Substitutes: Two goods are perfect
substitutes when the marginal rate of substitution of
one good for the other is constant. The indifference
curves are straight lines.
Perfect Complements: if you are offered bundles of
shoes. Some of the shoes fit your left foot, others your
right foot. How would you rank these different bundles?
you would judge a bundle based on the number of pairs
you could assemble from it. The indifference curves for
Pe goods are shaped as right angles.
the
psi

Co
ke
 Optimization: What The
Consumer Chooses
Consumers want to get the combination of goods on
the highest possible indifference curve. However,
the consumer must also end up on or below his
budget constraint.
Combining the indifference curve and the budget
constraint determines the consumer’s optimal
choice. The point at which this indifference curve
and the budget constraint touch is called the
optimum. The consumer chooses consumption of
the two goods so that the marginal rate of
substitution equals the relative price.
at the optimum, the slope of the indifference curve
equals the slope of the budget constraint. We say
that the indifference curve is tangent to the budget
constraint.
The Consumer’s Optimal Choices
The consumer would prefer point A, but he cannot
afford that point because it lies above his budget
constraint. The consumer can afford point B, but
that point is on a lower indifference curve and,
therefore, provides the consumer less satisfaction.
How Changes in Income Affect the
Consumer’s Choices
An increase in income shifts the budget constraint
outward. The consumer is able to choose a better
combination of goods on a higher indifference curve.
 How Changes in Income Affect the
Consumer’s Choices
Normal versus Inferior Goods: If a consumer buys more of
a good when his or her income rises, the good is called a
normal good. If a consumer buys less of a good when his
or her income rises, the good is called an inferior good.
Budget Constraints: Prices Change
If the two goods increase (decrease) in price, but the ratio
of the two prices is unchanged, the slope will not change.
However, the budget line will shift inward (outward) to a
point parallel to the original budget line.
Budget Constraints: Prices Change
If the price of a good increases, then there will be two
different effects – known as the income and substitution
effect.
If a good increases in price.
The good is relatively
more expensive than
alternative goods, and
therefore people will
switch to other goods
which are now relatively
cheaper. (substitution
effect) – The increase in
price reduces disposable
income and this lower
income may reduce
demand. (income