03 - Theory of Consumer Behavior
03 - Theory of Consumer Behavior
Behaviour
ECONOMICS – CLASS 3
Contents
Utility theory
Utility Maximizing Choice
Consumer Surplus
Indifference Curves
Income, Substitution and Price Effects
Normal Goods, Inferior Goods and Giffen Goods
Consumption
“Consumption means the act of using goods and services to satisfy
human wants during a given period of time”
If we had unlimited income we would satisfy unlimited wants: But
income is limited!
◦ A. What should be buy amongst all the goods and services?
◦ B. How much to allocate to each good and service?
It is not from the benevolence of the butcher, the brewer, or the baker
that we expect our dinner, but from their regard to their own interest.
Adam Smith
Total Utility and Marginal
Utility
Qty Consumed Marginal Utility Total Utility
0 0 0
1 25 25
2 20 45
3 15 60
4 10 70
5 5 75
6 0 75
7 -5 70
80
70
60
50
40
Axis Title
30
20
10
-10
0 1 2 3 4 5 6 7
Marginal Utility 0 25 20 15 10 5 0 -5
Total Utility 0 25 45 60 70 75 75 70
Economic Surplus
Consumer Surplus is the utility for consumers by being able to purchase
a product for less than the highest price that they would be willing to
pay.
Problem 1
Nelum purchases 4 chocolates for the price of Rs.15 per bar. She is willing
to pay 25 for the bar 22 for the second 18 for the third and 15 for the 4th
How much consumer surplus is derived from the 4 bars?
Problem 2
Show graphically the change in consumer surplus resulting from a rise in
product price.
Indifference Curve Analysis
Indifferent means you do not care.
Lets use Nelum again – Over the course of the year she likes 300 candy
bars and 25 CD’s
Budget constraints – This defines the opportunity set she can choose
any point on or below the line.
Indifference Curves cannot cross!
Marginal Rate of Substitution
The technical term of the slope of the Indifference Curve is the Marginal
Rate of Substitution.
It tells how much of one good one is willing to give up to get the second
good.
If Nelum is willing to give up 15 candy bars for a 1 CD. Her marginal rate
of substitution for candy bars to CDs is 1 to 15
Substitution Effect and Income
Effect
The rise in quantity demanded due to a rise in purchasing power of real
is called the income effect. (Price effect)
The fall of the price of a good will induce the consumer to purchase
more of it and less of the other good this is called the substitution
effect.
Normal Good – Are goods that we buy more of when the price falls
Inferior Good – We buy less when their price falls.
Thank You! See You Next
Week!