Consumer Behavior and

Utility Analysis
Dr. Mukta Mukherjee
Reading
 2.1.3. S_N_Chapter05
 2.2.2.P_R_Chapter03

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Consumer Behavior
 Theory of consumer behavior
◦ Description of how consumers allocate incomes among different goods and
services to maximize their well-being

 Consumer is rational – seeks to maximize utility obtained by

consuming goods and services

 Utility is the total satisfaction received by the consumers from

consuming goods and services

 Two Schools of Thought

◦ Cardinal Approach
◦ Ordinal Approach

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Cardinal Utility Approach
 Assumptions
◦ Utility is measurable and quantifiable, i.e. cardinal
 Utilities can be compared
 Measured in monetary unit – some economists suggested a subjective
measure ‘utils’
◦ Marginal Utility of Money is Constant
◦ Introspection Method
 Judging others with self-observation

 Marginal Utility is the additional utility obtained by

consuming an additional unit of a commodity holding
consumption of all other commodities constant
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 Cardinal Utility Approach

“The law of diminishing marginal

utility states that as the amount of a
good consumed increases, the marginal
utility of that good tends to decline”

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Cardinal Utility Approach
 Law of Equimarginal Principle
◦ The fundamental condition of maximum satisfaction or utility

 Based on the following assumptions

◦ Consumers’ income is fixed
◦ Prices are fixed
◦ Tastes and Preferences do not change
◦ Consumers can perform utility calculations

“The law states that a consumer will achieve maximum

satisfaction or utility when the marginal utility of the last dollar
spent on a good is exactly the same as the marginal utility of the
last dollar spent on any other good”

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Cardinal Approach: Equimarginal
Utility: Numerical Example
QA UA MUA QB UB MUB MUA /PA MUB /PB Step Inc. Balance
Consumed Inc.
0 0 - 0 0 - - -
1 (A-1) 5 55
1 100 100 1 180 180 20 18
2 (B-1) 10 45
2 170 70 2 330 150 14 15
3 (B-2) 10 35
3 220 50 3 420 90 10 9 4 (A-2) 5 30
4 250 30 4 480 60 6 6 5 (A-3) 5 25
5 260 10 5 510 30 2 3 6 (B-3) 10 15
7 (A-4) 5 10
• PA= $5; PB= $10; Income = $60
8 (B-4) 10 0

Note: Choose the commodity that

provides highest MU per $ 𝑀𝑈 𝐴= 4 𝑀𝑈 𝐵=4
=
𝑃𝐴 𝑃𝐵

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Cardinal Utility Approach – Derivation of
Demand Curve Demand curve shows the
relationship between
𝑀𝑈 𝑥 quantity demanded and
=𝑀𝑈 𝑖𝑛𝑐𝑜𝑚𝑒 price ceteris paribus
𝑃𝑥

The marginal utility of x declines continuously. If the marginal utility is measured in

monetary units the demand curve for x is identical to the positive segment of the marginal
utility curve. At x1 the marginal utility is MU1. This is equal to P1. Hence at P1 the
consumer demands x1 quantity. Similarly at x2 the marginal utility is MU2 , which is equal
to P2. Hence at P2 the consumer will buy x2 , and so on. The negative section of the MU
curve does not form part of the demand curve, since negative quantities do not make sense
in economics.

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Cardinal Utility Approach
 Limitations
◦ Measuring utility in cardinal terms is not feasible – state of psychological
feeling, no objective units

◦ Marginal utility of money is not constant – elastic measuring rod

◦ Law of diminishing marginal utility is established through introspection –

psychological law taken for granted

◦ Consumers are governed by habits and customs leading to allocation of

expenditure that may not necessarily maximize satisfaction

◦ Indivisibility of goods may not allow marginal utility of good to be equal

to marginal utility of money

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Ordinal Approach
 Consumer behavior is best understood in three distinct
steps:
◦ Consumer preferences
◦ Budget constraints
◦ Consumer choices

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Consumer Preferences
 Market Baskets
◦ Market basket (or bundle) - List with specific quantities of
one or more goods
TABLE 3.1 Alternative Market Baskets

Market Basket Units of Food Units of Clothing

A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
To explain the theory of consumer behavior, we will
ask whether consumers prefer one market basket to
another
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Consumer Preferences
 Some Basic Assumptions about Preferences
◦ Completeness
 Preferences are assumed to be complete
 Consumers can compare and rank all possible baskets
 for any two market baskets A and B, a consumer will prefer A to B, will
prefer B to A, or will be indifferent between the two
 Indifferent: person will be equally satisfied with either basket
 Preferences ignore prices

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Consumer Preferences
 Transitivity
◦ Preferences are transitive
◦ Consumer prefers basket A to basket B and basket B to basket C, then the
consumer also prefers A to C
◦ Transitivity is normally regarded as necessary for consumer consistency
◦ Implications: Indifference do not intersect

 More is better than less

◦ Goods are assumed to be desirable – Consumers always prefer more of any
good to less
◦ Consumers are never satisfied or satiated – more is always better, even if
just a little better
◦ Some goods, such as air pollution, may be undesirable, and consumers will
always prefer less – We ignore these “bads”

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Consumer Preferences
 Indifference Curves

Describing Individual Preferences

Because more of each good is

preferred to less, we can compare
market baskets in the shaded areas.
Basket A is clearly preferred to
basket G, while E is clearly
preferred to A. However, A cannot
be compared with B, D, or H without
additional information.

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Consumer Preferences
 Indifference Curves: Curve representing all combinations of market baskets
that provide a consumer with the same level of satisfaction

An Indifference Curve

The indifference curve U1 that

passes through market basket A
shows all baskets that give the
consumer the same level of
satisfaction as does market basket
A; these include baskets B and D.
Our consumer prefers basket E,
which lies above U1, to A, but
prefers A to H or G, which lie
below U1.

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Consumer Preferences
 Indifference Maps: Graph containing a set of indifference curves showing
the market baskets among which a consumer is indifferent

An Indifference Map

An indifference map is a set of

indifference curves that describes
a person's preferences.
Any market basket on indifference
curve U3, such as basket A, is
preferred to any basket on curve
U2 (e.g., basket B), which in turn
is preferred to any basket on U1,
such as D.

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Consumer Preferences
 Indifference Maps

Indifference Curves Cannot Intersect

If indifference curves U1 and U2

intersect, one of the assumptions
of consumer theory is violated.
According to this diagram, the
consumer should be indifferent
among market baskets A, B, and
D. Yet B should be preferred to D
because B has more of both
goods.

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Consumer Preferences
The Marginal Rate of Substitution: Maximum amount of a good that a consumer is
willing to give up in order to obtain one additional unit of another good.

The Marginal Rate of Substitution

The magnitude of the slope of an

indifference curve measures the
consumer’s marginal rate of substitution
(MRS) between two goods.
In this figure, the MRS between clothing
(C) and food (F) falls from 6 (between A
and B) to 4 (between B and D) to 2
(between D and E) to 1 (between E and G).
Convexity The decline in the MRS
reflects a diminishing marginal rate of
substitution. When the MRS diminishes
along an indifference curve, the curve is
convex.

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Consumer Preferences
 Perfect Substitutes and Perfect Complements

● perfect substitutes Two goods for which the marginal rate of

substitution of one for the other is a constant.

● perfect complements Two goods for which the MRS is zero or

infinite; the indifference curves are shaped as right angles.

Bads
● bad Good for which less is preferred rather than more.

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CONSUMER PREFERENCES
Perfect Substitutes and Perfect Complements

In (a), Bob views orange juice and In (b), Jane views left shoes and right
apple juice as perfect substitutes: He is shoes as perfect complements: An
always indifferent between a glass of additional left shoe gives her no extra
one and a glass of the other. satisfaction unless she also
obtains the matching right shoe.

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Consumer Preferences
● Utility Numerical score representing the satisfaction that a consumer gets
from a given market basket.

● Utility function Formula that assigns a level of utility to individual

market baskets.

Utility Functions and Indifference Curves

A utility function can be

represented by a set of
indifference curves, each
with a numerical indicator.
This figure shows three
indifference curves (with
utility levels of 25, 50, and
100, respectively)
associated with the utility
function FC.

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Budget Constraints
 Budget constraints
◦ Constraints that consumers face as a result of limited incomes

 Budget Line
◦ All combinations of goods for which the total amount of money spent is equal to income

Market Baskets and the Budget Line

The table shows market baskets Market Food Clothing Total
associated with the budget line Basket (F) (C) Spending
F + 2C = $80 A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80

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Budget Constraints Budget Line: F + 2C = $80
i.e. C = 80/2 – (F/2)
A Budget Line
i.e. C = 40 – (F/2)
A budget line describes the
combinations of goods that can be
purchased given the consumer’s
income and the prices of the goods.
Line AG (which passes through points
B, D, and E) shows the budget
associated with an income of $80, a
price of food of PF = $1 per unit, and a
price of clothing of PC = $2 per unit.
The slope of the budget line (measured
between points B and D) is −PF/PC =
−10/20 = −1/2.

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Budget Constraints
Budget Line (I = 80): C = 40 – (F/2)
Budget Line (I = 40): C = 20 – (F/2)
Effects of a Change in Income on the
Budget Line Budget Line (I = 160): C = 80 – (F/2)
Income Changes A change in income
(with prices unchanged) causes the
budget line to shift parallel to the
original line (L1).
When the income of $80 (on L1) is
increased to $160, the budget line shifts
outward to L2.
If the income falls to $40, the line shifts
inward to L3.

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Budget Constraints
Budget Line (PF= 1): C = 40 – (F/2)
Budget Line (PF= 0.5): C = 40 – (F/4)
Effects of a Change in Price on the
Budget Line
Budget Line (PF= 2): C = 40 – F
Price Changes A change in the price
of one good (with income unchanged)
causes the budget line to rotate about
one intercept.
When the price of food falls from $1.00
to $0.50, the budget line rotates
outward from L1 to L2.
However, when the price increases
from $1.00 to $2.00, the line rotates
inward from L1 to L3.

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Consumer Choice
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.
2. It must give the consumer the most preferred combination
of goods and services.
Maximizing Consumer Satisfaction

A consumer maximizes satisfaction by

choosing market basket A. At this
point, the budget line and indifference
curve U2 are tangent.
No higher level of satisfaction (e.g.,
market basket D) can be attained.
At A, the point of maximization, the
MRS between the two goods equals the
price ratio. At B, however, because the
MRS [− (−10/10) = 1] is greater than
the price ratio (1/2), satisfaction is not
maximized.

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Consumer Choice
Satisfaction is maximized (given the budget constraint) at the point
where

MRS PF / PC

● marginal benefit Benefit from the consumption of one additional

unit of a good.
● marginal cost Cost of one additional unit of a good.
The condition given above illustrates the kind of optimization
conditions that arise in economics. In this instance, satisfaction is
maximized when the marginal benefit—the benefit associated with
the consumption of one additional unit of food—is equal to the
marginal cost—the cost of the additional unit of food. The marginal
benefit is measured by the MRS.

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Consumer Choice
● corner solution Situation in which the marginal rate of
substitution of one good for another in a chosen market basket
is not equal to the slope of the budget line.
A Corner Solution

When the consumer’s marginal rate

of substitution is not equal to the
price ratio for all levels of
consumption, a corner solution
arises. The consumer maximizes
satisfaction by consuming only one
of the two goods.
Given budget line AB, the highest
level of satisfaction is achieved at B
on indifference curve U1, where the
MRS (of ice cream for frozen
yogurt) is greater than the ratio of
the price of ice cream to the price of
frozen yogurt.

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Consumer Choice

A College Trust Fund

When given a college trust

fund that must be spent on
education, the student
moves from A to B, a corner
solution.
If, however, the trust fund
could be spent on other
consumption as well as
education, the student
would be better off at C.

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Marginal Utility and Consumer Choice
● marginal utility (MU) Additional satisfaction obtained from
consuming one additional unit of a good.
● diminishing marginal utility Principle that as more of a good is
consumed, the consumption of additional amounts will yield smaller
additions to utility.
0 MU (F )  MU (C )
F C
 (C / F ) MU / MU
F C
MRS MU /MU
F C
MRS P / P
F C
MU / MU P / P
F C F C
MU / P MU / P
F F C C
● equal marginal principle Principle that utility is maximized when the
consumer has equalized the marginal utility per dollar of expenditure
across all goods.

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Marginal Utility and Consumer Choice

Inefficiency of Gasoline Rationing

When a good is rationed, less is
available than consumers would
like to buy. Consumers may be
worse off. Without gasoline
rationing, up to 20,000 gallons of
gasoline are available for
consumption (at point B).
The consumer chooses point C on
indifference curve U2, consuming
5000 gallons of gasoline.
However, with a limit of 2000
gallons of gasoline under
rationing (at point E), the
consumer moves to D on the
lower indifference curve U1.

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Marginal Utility and Consumer Choice
Comparing Gasoline Rationing to the Free
Market
If the price of gasoline in a competitive
market is $2.00 per gallon and the
maximum consumption of gasoline is
10,000 gallons per year, the woman is
better off under rationing (which holds
the price at $1.00 per gallon), since she
chooses the market basket at point F,
which lies below indifference curve U1
(the level of utility achieved under
rationing).
However, she would prefer a free
market if the competitive price were
$1.50 per gallon, since she would select
market basket G, which lies above
indifference curve U1.

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From Indifference Curves to Demand
Curve
Demand Curve shows the
relationship between quantity
demanded and price ceteris
paribus
Effect of Price Changes

A reduction in the price of food,

with income and the price of
clothing fixed, causes this
consumer to choose a different
market basket.
In (a), the baskets that maximize
utility for various prices of food
(point A, $2; B, $1; D, $0.50) trace
out the price-consumption curve.
Part (b) gives the demand curve,
which relates the price of food to
the quantity demanded. (Points E,
G, and H correspond to points A,
B, and D, respectively).
Ordinal Approach
 Limitations
◦ Fails to provide a clear explanation of consumer behavior
◦ Provides combinations that are not based on the principles of
economics
◦ Ignores risk and uncertainty while analyzing the consumer
behavior

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