Consumer theory

(Consumer behaviour and utility maximization)

Van Rensburg et al., chapter 3

Professor Corné van Walbeek

April 2025
 Learning outcomes

• Understand total utility, marginal utility and the law of

diminishing marginal utility
• Maximising total utility by comparing marginal utility-to-
price ratios of different products
• Deriving the demand curve by observing the impact of a
change in the price in the utility maximizing model
• Using indifference curves and budget lines to determine
consumer equilibrium
• Deriving the demand curve with indifference curve theory
• Identifying the income effect and the substitution effect
when there is a change in the price of a product
 Utility

• The pleasure or satisfaction that one gets from a

product
• Utility is subjective (e.g. eye-glasses)
• Measuring utility
• Cardinal utility- numerical value attached to the
comparison
• Ordinal utility – comparison eg the phone and grapes

• Distinguish between total utility and marginal

utility
 An example of total utility
and marginal utility
Number of pizza slices Total utility (utils) Marginal utility (utils)
0 0
10
1 10
8
2 18
6
3 24
4
4 28
2
5 30
0
6 30
 Presenting this
graphically
• Total utility increases, but at a decreasing rate
• Total utility can decrease, e.g. when you over-consume

• Marginal utility decreases as consumption increases

• Marginal utility can become negative; where?

• Law of diminishing/decreasing marginal utility

• As a consumer consumes more of a product, the MU
decreases
• Note: the law does not say that the MU will necessarily
become negative
 Theory of consumer
behaviour
• We make the following assumptions:
• Consumer is rational; wants to maximise total utility
• Consumer has clear-cut preferences and knows the
MU that they get from successive units consumed
• The consumer has limited income/resources; this is
the budget constraint
• The consumer uses up the full budget; cannot save or
borrow
• Prices of goods are not influenced by any individual
buyer
 Maximising utility given
the constraints
• What are the constraints?
• Income/budget
• Prices of the products
• How does a person decide what to purchase?
• Look at the MU per rand for each product
• Find the product with the largest MU per rand and
buy a unit of that
• Then buy the product with the second largest MU per
rand and buy that (it could be the same product)
• Continue with this process until the budget is
exhausted
 An example
Unit of Product A; price = R10 Product B; price = R20
product
MU MU/P MU MU/P
First 100 10 240 12
Second 80 8 220 11
Third 70 7 180 9
Fourth 60 6 160 8
Fifth 50 5 120 6
Sixth 40 4 60 3
Seventh 30 3 40 2
 The actions of the
consumer
Step Purchase Total Total Total utility
at this purchases expenditure
step
1 1B 1B R20 240
2 1B 2B R40 240 + 220 = 460
3 1A 1A+2B R50 460 + 100 = 560
4 1B 1A+3B R70 560 + 180 = 740
5 1A+1B 2A+4B R100 740 + 80 + 160 = 980
6 1A 3A+4B R110 980 + 70 = 1050
7 1A+1B 4A+5B R140 1050 + 60 + 120 = 1230
 The utility maximizing
position
• With R100 the analysis indicates that consumer
must buy 2 A + 4 B
• TU = 180 (from A) + 800 (from B) = 980 utils
• TU of 180 utils from A = 100 + 80 (i.e. the sum of the
MUs)
• TU of 800 utils from B = 240 + 220 + 180 + 160 (i.e.
the sum of the MUs)
• What about other combinations of A and B?
• 6 A + 2 B: TU = 400 + 460 = 860
• 4 A + 3 B: TU = 310 + 640 = 950
• 0 A + 5 B: TU = 0 + 920 = 920
 The rule in algebra

• Consumer will maximise utility where

and the budget is exhausted

 Revisiting our example
Unit of Product A; price = R10 Product B; price = R20
product
MU MU/P MU MU/P
First 100 10 240 12
Second 80 8 220 11
Third 70 7 180 9
Fourth 60 6 160 8
Fifth 50 5 120 6
Sixth 40 4 60 3
Seventh 30 3 40 2
 Applying the algebraic
rule
• At equilibrium, consumer consumes 2 A and 4 B:
 Applying the algebraic
rule
• If consumer consumes 4 A and 3 B:

• How to get to equilibrium?

• Decrease price of A and/or increase price of B? No
• Increase MUA and/or decrease MUB? Yes

• Increasing MUA and decreasing MUB

• Decrease consumption of A and increase consumption
of B
• Recall the law of diminishing marginal utility (increase in
 Deriving the demand
curve
• If price of product A increases, the equilibrium

is disturbed
• Consumer has to increase the MU of product A
• How?
• Decrease the quantity of product A
• Result:
• Price of A increases; quantity demanded (consumed) of
product A decreases
 An application: The
diamond-water paradox
• Also known as the paradox of value
• Adam Smith recognized this paradox in 1776

• Why is water, that is useful, so cheap, and diamonds,

that are largely useless, so expensive?

• Consider the marginal utility of the products, not the

total utility
• Water has much total utility, but because it is abundant, it
has low marginal utility
• Diamonds have little total utility, but because it is scarce, it
 The diamond-water
paradox (cont.)
• Remember that equilibrium is determined by the
MUx/Px = MUy/Py

• Presenting this graphically:

• Total utility curve vs. marginal utility curve
Consumer theory using an
ordinal approach
 The cardinal approach
has constraints
• Cardinal approach assumes that consumers can
quantify the utility (in utils)
• Not very realistic
• Indifference curve analysis does not require this
• Only requires consumers to rank different bundles of
goods
 A small digression: scales
of measurement
• Ratio scale
• Where, if the number is divided by something, it still makes sense; true zero exists
• E.g. mass, height, distance, income
• You can’t use a ratio scale because it does not have an absolute zero
• Interval scale
• Where the distance between two numbers makes sense, but the ratio does not
• E.g. temperature (Celsius vs. Fahrenheit)

• Ordinal scale
• Where things can be ranked, but the differences between them are not meaningful
• E.g. education, ranking of athletes, ranking of utility
• We rank but we do not know the difference in which one is better or one is worser

• Nominal scale
• Where things are categorized; ranking is not meaningful
• E.g. sex, race, eye colour, car brands
 Indifference curves
• What it is
• Different combinations of (two) products that give the
consumer the same level of total utility
• Example
• Combinations of meat and rice that give the consumer the
same amount of utility
Combination Rice (kg) Meat (kg)
A 1 8
B 2 5
C 3 3
D 4 2
E 5 1.5
 Indifference curves
• Graphical presentation of the indifference curve

• Things to note
• Indifference curves are downward sloping
• To increase the quantity of one thing I have to give up
something else
• Convex with respect to the origin
• Decreasing marginal rate of substitution (MRS)
• Indifference curves do not cross
• See explanation on the board
• Indifference maps
- All these indifference curves
make an indifference map
 The budget line

• Different quantity combinations of (two) products

that can be purchased with a given budget
• Three things are required to draw up a budget
line:
• Income (budget)
• Price of good X
• Price of good Y
 An example

• If the price of meat is R100/kg and the price of

rice is R50/kg, calculate the combinations of rice
and meat that a person can buy with budget of
R400
Combination Meat (kg) Rice (kg)
V 4 0
W 3 2
X 2 4
Y 1 6
Z 0 8
 The budget line

• Presenting the budget line graphically

• Note: the axes indicate the quantity, not the price, of
the two products

• Slope of the budget line

• From M = Py Y + Px X follows
Y = M/Py – Px/Py X
• How to interpret this equation
 Movements of the
budget line
• If income changes:
• Parallel shift of the budget line

• If the price of product X or Y changes:

• Pivoting of the budget line
• Change in the slope (slope = - Px/Py)
• Opportunity cost changes
 Consumer equilibrium

• Aim of the consumer:

• Maximise utility, subject to the budget constraint

• Doing this within our framework:

• Given a budget line, find the highest possible
indifference curve

• Presenting this graphically

• See the blackboard
 At equilibrium

• Slope of the indifference curve = slope of the

budget line
• MRS = Px/Py
• At equilibrium the rate at which the consumer is
willing to give up product Y for one extra unit of X (the
MRS) is equal to the opportunity cost (i.e. the number
of units of Y given up for one unit of X, which is Px/Py)

• Point of disequilibrium
• MRS ≠ Px/Py
• Showing this graphically
 Deriving the demand
curve
• Start with a point of consumer equilibrium, using
indifference curve analysis
• The price of X and the quantity of X demanded at that
price (given income and Py) is a point on the demand
curve
• Allow the price of product X to change
• Find a new point of equilibrium
• The new Px and Qx is another point on the demand
curve
• Present this graphically
• See blackboard
 Income and substitution
effects
• Important:
• This is not in the textbook
• Please watch the following YouTube video:
https://www.youtube.com/watch?
v=pLhh_D5b_Lg&ab_channel=Economicsfun

• If the price of product X decreases, there are two

effects:
• Product X becomes relatively cheaper than product Y
• The real income (purchasing power) of the consumer
increases
 Disentangling these two
effects
• Start with a point of consumer equilibrium (point A)
• Determine the quantity of product X consumed at
equilibrium (QxA)
• Reduce the price of X
• Pivot the budget line (slope becomes flatter)
• Find a new point of equilibrium (point B) on the
new budget line
• Determine the quantity of product X consumed at
the new equilibrium (QxB)
• This quantity will be more than QxA
 Disentangling these two
effects (cont.)
• Take the new budget line, and push it back to the
original indifference curve, till it forms a tangent
at point C
• This budget line is an artificial (“compensated”)
budget line that represent the new price ratio (i.e. the
new Px/Py), but where the consumer experiences the
same utility as at point A
• The difference in the quantity of X between point
A and point C is the substitution effect
• The difference in the quantity of X between point
C and point B is the income effect
 Income and substitution
effects
• See the board for a graphical exposition

• Note: When the price of X decreases, the

substitution effect is always to increase the
consumption of product X

• The income effect can be positive or negative

• Positive income effect: Normal product
• Negative income effect: Inferior product
 Consumer theory

END OF THIS SECTION