Chapter Three

Theory of Consumer Behaviour

 Consumer behavior can be best understood in
three steps.
1. Examining consumer‘s preference: how people
prefer one good to another.
2. Taking into account that consumers face budget
constraints: they have limited incomes that
restrict the quantities of goods they can buy.
3. Putting consumer preference and budget
constraint together to determine consumer
choice.
10/26/2023 LATI M, Lecturer, DaDU 1
3.1. Consumer Preference
Assumptions about the average consumer
1. Average consumer is rational
 clear cut and persistent preference
2. Consumer is not free in his/her choice
 A consumer makes choices by comparing bundle of
goods.
 Given any two consumption bundles, the consumer either
decides that one of the consumption bundles is strictly
better than the other, or decides that she is indifferent
between the two bundles.
 To tell whether one bundle is preferred to another, we see
how the consumer behaves in choice involving two
bundles.
10/26/2023 LATI M, Lecturer, DaDU 2
 If she always chooses X when Y is available, then
it is natural to say that this consumer prefers X to
Y. We use the symbol ≻ to mean that one bundle
is strictly preferred to another.
 So that X ≻Y should be interpreted as saying that
the consumer strictly prefers X to Y, in the sense
that she definitely wants the X-bundle rather than
the Y-bundle.
 If the consumer is indifferent between two
bundles of goods, we use the symbol∼ and write
X~Y.

10/26/2023 LATI M, Lecturer, DaDU 3

 Indifference means that the consumer would be
just as satisfied, according to her own
preferences, consuming the bundle X as she
would be consuming bundle Y.
 If the consumer prefers or is indifferent between
the two bundles we say that she weakly prefers X
to Y and write X ⪰ Y.
 The relations of strict preference, weak preference, and
indifference are not independent concepts; the relations
are themselves related.
 If X ⪰ Y and Y ⪰ X, we can conclude that X ~Y.
 If X ⪰ Y but we know that it is not the case that
X~ Y, we can conclude that X≻Y.
10/26/2023 LATI M, Lecturer, DaDU 4
3.2. The concept of utility
Utility: Is a pleasure/satisfaction that the consumer obtain by
consuming a product/service.
 It is the power of the product to satisfy human wants.
 Given any two consumption bundles X and Y, the
consumer definitely wants the X-bundle than the Y-
bundle if and only if the utility of X is better than the
utility of Y.
 It is important to bear in mind that;
1. Utility’ and ‘Usefulness’ are not synonymous.
 For example, paintings by Picasso may be useless
functionally but offer great utility to art lovers.
 Hence, usefulness is product centric whereas utility is
consumer
10/26/2023
centric. LATI M, Lecturer, DaDU 5
2. Utility is subjective.
 The utility of a product will vary from person to
person.
 The utility that two individuals derive from
consuming the same level of a product may not be
the same.
 Example: non-smokers do not derive any utility
from cigarettes.
3. Utility can be different at different places &time.
 Example, the utility that we get from drinking
coffee early in the morning may be different from
the utility we get during lunch time.
10/26/2023 LATI M, Lecturer, DaDU 6
3.3. Approaches of measuring utility
 There are two approaches to measure
consumer‘s utility:
Cardinal utility approach-
 utility is measurable and comparable
Ordinal utility approach-
 utility is not measurable but comparable.
 utility is not measurable in cardinal
numbers rather the consumer can rank or
order the utility from different goods and
services.
10/26/2023 LATI M, Lecturer, DaDU 7
3.3.1. Cardinal utility approach
 Utility is measurable by arbitrary unit of
measurement called utils in the form of 1, 2,
3 etc.
 Example: we may say that consumption of an
orange gives Bilen 10 utils and a banana
gives her 8 utils.
 From this, we can assert that Bilen gets more
satisfaction from orange than from banana.

10/26/2023 LATI M, Lecturer, DaDU 8

Assumptions of cardinal utility theory
1. Rationality of consumers. Consumer has to be
rational to maximize his/her satisfaction given his/her
limited budget or income.
2. Utility is cardinally measurable. Utility is measured
in subjective units called utils.
3. Constant marginal utility of money.
 A given unit of money deserves the same value at any
time or place it is to be spent.
 A person at the start of the month where he has received
monthly salary gives equal value to 1 birr with what he
may give it after three weeks or so.
10/26/2023 LATI M, Lecturer, DaDU 9
4. Diminishing marginal utility (DMU).
 The utility derived from each successive units of a
commodity diminishes.
 The marginal utility of a commodity diminishes as
the consumer acquires larger quantities of it.
5. The total utility of a basket of goods depends
on quantities of the individual commodities.
 If there are n commodities in the bundle with
quantities X1 , X 2 ,...X n , the total utility is given
by TU = f ( X1 , X 2 Xn ). Utility is additive
10/26/2023 LATI M, Lecturer, DaDU 10
Total and marginal utility
Total Utility (TU):
 is the total satisfaction a consumer gets from
consuming some specific quantities of a
commodity at a particular time.
 As the consumer consumes more of a good per
time period, his/her total utility increases.
 However, there is a saturation point for that
commodity beyond which the consumer will not be
capable of enjoying any greater satisfaction from it.

10/26/2023 LATI M, Lecturer, DaDU 11

Marginal Utility (MU):
 It is the extra satisfaction a consumer realizes from
an additional unit of the product.
 It is the change in total utility that results from the
consumption of one more unit of a product.
 Graphically, it is the slope of total utility.
Mathematically, marginal utility is:
 where, TU is the change in total utility, and Q is
the change in the amount of product consumed.

10/26/2023 LATI M, Lecturer, DaDU 12

 To explain the relationship between TU and MU, let us consider the
following hypothetical example.
Quantity Total utility (TU) Marginal utility (MU)
0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2

Total utility first increases, reaches the maximum (when the

consumer consumes 6 units) and then declines as the
quantity consumed increases.
The marginal utility continuously declines (even becomes
zero or negative) as quantity consumed increases.
10/26/2023 LATI M, Lecturer, DaDU 13
As it can be observed from the above figure,
When TU is increasing, MU is positive.
When TU is maximized, MU is zero.
When TU is decreasing, MU is negative.
10/26/2023 LATI M, Lecturer, DaDU 14
Law of diminishing marginal utility (LDMU)
states that as the quantity consumed of a commodity
increases per unit of time, the utility derived from
each successive unit decreases, consumption of all
other commodities remaining constant.
States that extra satisfaction that a consumer
derives declines as he/she consumes more and
more of the product in a given period of time.
This gives sense in that the first banana a person
consumes gives him more marginal utility than the
second and the second banana also gives him higher
marginal utility than the third and so on (see fig 3.1).
10/26/2023 LATI M, Lecturer, DaDU 15
 The law of diminishing marginal utility is
based on the following assumptions.
 The consumer is rational
 The consumer consumes homogenous
product. Similar quality, color, design, etc.
 No time gap in consumption of the good
 Taste/preferences remain unchanged

10/26/2023 LATI M, Lecturer, DaDU 16

 Equilibrium of a consumer
 The objective of a rational consumer is to
maximize total utility.
 As long as the additional unit consumed brings a
positive marginal utility, the consumer wants to
consumer more of the product because total utility
increases.
 However, given his limited income and the
price level of goods and services, what
combination of goods and services should he
consume so as to get the maximum total utility?

10/26/2023 LATI M, Lecturer, DaDU 17

A. The case of one commodity
 The equilibrium condition of a consumer that
consumes a single good X occurs when the
marginal utility of X is equal to its market
price. MU = P
X X

 Proof
 Given the utility function: U = f ( X )
 If the consumer buys commodity X, then his
expenditure will be Q P . X X

 The consumer maximizes the difference

between his utility and expenditure.
 Max(U - Q P )
10/26/2023
X X
LATI M, Lecturer, DaDU 18
 Max(U - Q P )
X X

 The necessary condition for maximization is

equating the derivative of a function to zero.
 Thus, *?
 =0
 =0
=

10/26/2023 LATI M, Lecturer, DaDU 19

 At any point above point C (like point A) where MUX > PX, it
pays the consumer to consume more.
 When MUX < PX (like point B), the consumer should consume
less of X.
 At point C where MUX = PX the consumer is at equilibrium.
10/26/2023 LATI M, Lecturer, DaDU 20
B. The case of two or more commodities
 For the case of two or more goods, the
consumer‘s equilibrium is achieved when
the marginal utility per money spent is equal
for each good purchased and his money
income available for the purchase of the
goods is exhausted.
 That is, = and + = M where, M is the
income of the consumer.

10/26/2023 LATI M, Lecturer, DaDU 21

 Example: Suppose Saron has 7 Birr to be spent on two goods:
banana and bread. The unit price of banana is 1 Birr and the unit
price of a loaf of bread is 4 Birr.
 The total utility she obtains from consumption of each good is
given below.
Income = 7 Birr, Price of banana = 1 Birr, Price of bread = 4 Birr
Banana Bread
Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 6 1 12 12 3
2 11 5 5 2 20 8 2
3 14 3 3 3 26 6 1.5
4 16 2 2 4 29 3 0.75
5 16 0 0 5 31 2 0.5
6 14 -2 -2 6 32 1 0.25
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 Recall that utility is maximized when the condition
of marginal utility of one commodity divided by its
market price is equal to the marginal utility of the
other commodity divided by its market price.
 =
 In table 3.2, there are two different combinations of
the two goods where the MU of the last birr spent
on each commodity is equal.
 However, only one of the two combinations is
consistent with the prices of the goods and her
income.
 Saron will be at equilibrium when she consumes 3
units of banana and 1 loaf of bread.
10/26/2023 LATI M, Lecturer, DaDU 23
 At this equilibrium,
1. = = = = = = 3
2. +=M
(1*3)+(4*1) = 7
 The total utility that Saron derives from this
combination can be given by:
 TU= TU1 + TU2
 TU= 14 + 12
 TU= 26
 Given her fixed income and the price level of the
two goods, no combination of the two goods will
give her higher TU than this level of utility.
10/26/2023 LATI M, Lecturer, DaDU 24
Limitation of the cardinal approach
 The assumption of cardinal utility is doubtful
because utility may not be quantified. Utility
cannot be measured absolutely (objectively).
 The assumption of constant MU of money is
unrealistic because as income increases, the
marginal utility of money changes.

10/26/2023 LATI M, Lecturer, DaDU 25

Exercise:
 Consider that Asefa has birr 12 and he
consumes two goods X and Y. the Px=2 birr
and Py= 1 birr. The Tu he gets from the
consumption of the goods are given below
i. Fill the Mu and Mu/P for good x and good y
ii. Find the best combination of x and y that
maximizes utility
iii. Find the maximum utility

10/26/2023 LATI M, Lecturer, DaDU 26

10/26/2023 LATI M, Lecturer, DaDU 27
The ordinal utility theory
 The ordinal theory suggests that utility is only
relatively discernible but not quantifiable
 Utility can only be ranked by an order or a scale of
preference to show the degree of willingness of a
consumer
 The consumers can rank commodities in the order of
their preferences as 1st, 2nd, 3rd and so on.
 The consumer need not know in specific units the
utility of various commodities to make his choice.
 It suffices for him to be able to rank the various
baskets of goods according to the satisfaction that
each bundle gives him.
10/26/2023 LATI M, Lecturer, DaDU 28
Assumptions of ordinal utility theory
The ordinal approach is based on the following assumptions.
1. Consumers are rational - they maximize their
satisfaction or utility given their income and market
prices.
2. Utility is ordinal - utility is not absolutely (cardinally)
measurable. Consumers are required only to order or rank
their preference for various bundles of commodities.
3. Diminishing marginal rate of substitution: The
marginal rate of substitution is the rate at which a
consumer is willing to substitute one commodity for
another commodity so that his total satisfaction remains
the same. The rate at which one good can be substituted
for another in consumer‘s basket of goods diminishes as
the consumer consumes
10/26/2023
more and more of the good. 29
LATI M, Lecturer, DaDU
4. The total utility of a consumer is measured by the
amount (quantities) of all items he/she consumes from
his/her consumption basket.
5. Consumer’s preferences are consistent. For example, if
there are three goods in a given consumer‘s basket, say,
X, Y, Z and if he prefers X to Y and Y to Z, then the
consumer is expected to prefer X to Z. This property is
known as axioms of transitivity.
 The ordinal utility approach is explained with the help of
indifference curves. Therefore, the ordinal utility theory is
also known as the indifference curve approach.

10/26/2023 LATI M, Lecturer, DaDU 30

Indifference set, curve and map
Indifference set/ schedule:
 is a combination of goods for which the consumer
is indifferent.
 It shows various combinations of goods from
which consumer derives the same level of utility.
 Consider a consumer who consumes two goods X
and Y (table 3.3).
Table 3.3: Indifference schedule
Bundle (Combination) A B C D
Orange 1 2 4 7
Banana 10 6 3 1

10/26/2023 LATI M, Lecturer, DaDU 31

 In table 3.3 above, each combination of good X
and Y gives the consumer equal level of total
utility. Thus, the individual is indifferent whether
he consumes combination A, B, C or D.
 Indifference curve: When the indifference
set/schedule is expressed graphically, it is called an
indifference curve. An indifference curve shows
different combinations of two goods which yield
the same utility (level of satisfaction) to the
consumer.
 A set of indifference curves is called indifference
map.
10/26/2023 LATI M, Lecturer, DaDU 32
10/26/2023 LATI M, Lecturer, DaDU 33
Properties of indifference curves
1. Indifference curves have negative slope (downward sloping to the
right).
 The consumption level of one commodity can be increased only by
reducing the consumption level of the other commodity.
 To keep utility constant, as the quantity of one commodity is increased
the quantity of the other must be decreased.
2. Indifference curves are convex to the origin.
 The slope of an indifference curve decreases (in absolute terms) as we
move along the curve from the left downwards to the right.
 Convexity is the reflection of diminishing marginal rate of substitution.
 Commodities can substitute one another at any point on an indifference
curve
10/26/2023but are not perfect substitutes.
LATI M, Lecturer, DaDU 34
3. A higher indifference curve is always preferred to a
lower one.
 The further away from the origin an indifferent curve
lies, the higher the level of utility it denotes.
 Baskets of goods on a higher indifference curve are
preferred by the rational consumer because they contain
more of the two commodities than the lower ones.
4. Indifference curves never cross each other (cannot
intersect).
 The assumptions of consistency and transitivity will rule
out the intersection of indifference curves.

10/26/2023 LATI M, Lecturer, DaDU 35

 Figure 3.4 shows the violations of the assumptions of
preferences due to the intersection of indifference curves.

 In the above figure, the consumer prefers bundle B to bundle C.

 On the other hand, following indifference curve 1 (IC1), the consumer is
indifferent between bundle A and C, and along indifference curve 2 (IC2) the
consumer is indifferent between bundle A and B.
 According to the principle of transitivity, this implies that the consumer is
indifferent between bundle B and C which is contradictory or inconsistent
with the initial statement where the consumer prefers bundle B to C.
Therefore, indifference curves never
10/26/2023 crossDaDU
LATI M, Lecturer, each other. 36
Marginal rate of substitution (MRS)
 Is a rate at which consumers are willing to substitute
one commodity for another in such a way that consumer
remains on same indifference curve.
 It shows a consumer‘s willingness to substitute one good
for another while he/she is indifferent between the bundles.
 Marginal rate of substitution of X for Y is defined as the
number of units of commodity Y that must be given up
in exchange for an extra unit of commodity X so that the
consumer maintains the same level of satisfaction.
 Since one of the goods is scarified to obtain more of the
other good, the MRS is negative.
 Hence, usually we take the absolute value of the slope.
10/26/2023 LATI M, Lecturer, DaDU 37
 ==
 To understand the concept, consider the following
indifference curve.

 From the above graph, MRSX,Y associated with the movement from point A
to B, point B to C and point C to D is 2.0,1.6, and 0.8 respectively.
 That is, for the same increase in the consumption of good X, the amount of
good Y the consumer is willing to scarify diminishes.
 This principle of marginal rate of substitution is reflected by the convex
shape of the indifference curve and is called diminishing marginal rate of
substitution.
10/26/2023 LATI M, Lecturer, DaDU 38
 It is also possible to derive MRS using the concept
of marginal utility. is related to and as follows:
 =
 Proof: Suppose the utility function for two
commodities X and Y is defined as: U = f ( X ,Y )
 Since utility is constant along an indifference
curve, the total differential of the utility function
will be zero.

10/26/2023 LATI M, Lecturer, DaDU 39

 =+=
+ = =-
= =.
similarly, = =
 Example:
 Suppose a consumer‘s utility function is given by
U ( X ,Y ) = . Find MRSX,Y
 Solution:
 MRSX,Y = = =

10/26/2023 LATI M, Lecturer, DaDU 40

 The budget line or the price line
 Indifference curves only tell us about consumer
preferences for any two goods but they cannot
show which combinations of the two goods will be
bought.
 In reality, the consumer is constrained by his/her
income and prices of the two commodities.
 This constraint is often presented with the help of
the budget line.

10/26/2023 LATI M, Lecturer, DaDU 41

 The budget line is a set of the commodity
bundles that can be purchased if the entire
income is spent.
 It is a graph which shows the various
combinations of two goods that a consumer can
purchase given his/her limited income and the
prices of the two goods.
 In order to draw a budget line facing a consumer,
we consider the following assumptions.
 There are only two goods bought in quantities, say, X and Y.
 Each consumer is confronted with market determined prices,
PX and PY.
 The consumer has a known
10/26/2023 andDaDUfixed money income (M).42
LATI M, Lecturer,
 Assuming that the consumer spends all
his/her income on the two goods (X and Y),
we can express the budget constraint as:
+
 By rearranging the above equation, we can
derive the following general equation of a
budget line.
 -

10/26/2023 LATI M, Lecturer, DaDU 43

 The slope of the budget line is given is by -the ratio of
the prices of the two goods).
 Any combination of the two goods within the budget line
(such as point A) or along the budget line is attainable.
 Any combination of the two goods outside the budget
line (such as point B) isLATIunattainable
10/26/2023 M, Lecturer, DaDU
(unaffordable). 44
 Example: A consumer has $100 to spend
on two goods X and Y with prices $3 and $5
respectively. Derive the equation of the
budget line and sketch the graph.
 Solution: The equation of the budget line can
be derived as follows.
+
+


10/26/2023 LATI M, Lecturer, DaDU 45

 When the consumer spends all of her income
on good Y, we get the Y- intercept (0,20).
Similarly, when the consumer spends all of
her income on good X, we obtain the X-
intercept (33.3,0). Using these two points we
can sketch the graph of the budget line.
 Recall that a budget is drawn for given prices
and fixed consumer‘s income. Hence, the
changes in prices or income will affect the
budget line.

10/26/2023 LATI M, Lecturer, DaDU 46

 Change in income:
 If the income of the consumer changes (keeping
the prices of the commodities unchanged), the
budget line also shifts (changes).
 Increase in income causes an upward/outward
shift in the budget line that allows the consumer
to buy more goods and services and decreases in
income causes a downward/inward shift in the
budget line that leads the consumer to buy less
quantity of the two goods. It is important to note
that the slope of the budget line (the ratio of the
two prices) does not change when income rises or
falls.
10/26/2023 LATI M, Lecturer, DaDU 47
10/26/2023 LATI M, Lecturer, DaDU 48
Change in prices: An equal increase in the
prices of the two goods shifts the budget line
inward. Since the two goods become
expensive, the consumer can purchase the
lesser amount of the two goods. An equal
decrease in the prices of the two goods, one the
other hand, shifts the budget line out ward.
Since the two goods become cheaper, the
consumer can purchase the more amounts of
the two goods

10/26/2023 LATI M, Lecturer, DaDU 49

10/26/2023 LATI M, Lecturer, DaDU 50
 An increase or decrease in the price of one of the two
goods, keeping the price of the other good and income
constant, changes the slope of the budget line by affecting
only the intercept of the commodity that records the
change in the price.
 For instance, if the price of good X decreases while both
the price of good Y and consumer‘s income remain
unchanged, the horizontal intercept moves outward and
makes the budget line flatter.
 The reverse is true if the price of good X increases. On the
other hand, if the price of good Y decreases while both the
price of good X and consumer‘s income remain
unchanged, the vertical intercept moves upward and
makes the budget line steeper. The reverse is true for an
increase
10/26/2023 in the price of good Y. DaDU
LATI M, Lecturer, 51
10/26/2023 LATI M, Lecturer, DaDU 52
Equilibrium of the consumer
 The preferences of a consumer (what he/she wishes to
purchase) are indicated by the indifference curve. The
budget line specifies different combinations of two
goods (say X and Y) the consumer can purchase
with the limited income.
 Therefore, a rational consumer tries to attain the highest
possible indifference curve, given the budget line. This
occurs at the point where the indifference curve is
tangent to the budget line so that the slope of the
indifference curve () is equal to the slope of the budget
line (). In figure 3.10, the equilibrium of the consumer
is at point ‗E‘ where the budget line is tangent to the
highest
10/26/2023 attainable indifference curve (IC2).
LATI M, Lecturer, DaDU 53
10/26/2023 LATI M, Lecturer, DaDU 54
 Mathematically, consumer optimum ( equilibrium)
is attained at the point where:

=
=
 At equilibrium point
1. BL and IC are tangent at each other
2. slope of BL= slope of IC

10/26/2023 LATI M, Lecturer, DaDU 55

 Example:
 A consumer consuming two commodities X
and Y has the utility function U (X ,Y ) = XY +
2X . The prices of the two commodities are 4 birr
and 2 birr respectively. The consumer has a total
income of 60 birr to be spent on the two goods.
A. Find the utility maximizing quantities of good X and Y.
B. Find the at equilibrium.

10/26/2023 LATI M, Lecturer, DaDU 56

Solution
a. The budget constraint of the consumer is given by:
 +
 + …………………1
 Moreover, at equilibrium
 = =
 …………………..2
 Substituting equation (2) into (1), we obtain Y = 14
and X = 8.
b. = = =2
 (At the equilibrium, MRS can also be calculated as the
ratio of the prices of the
10/26/2023 LATI M,two
Lecturer, goods)
DaDU 57