Chapter 3 Consumer Behavior PDF

Chapter 3. Theory of Consumer Behaviour Econ – Introduction to Economics (Econ 2012) Dr Seyoum Yunkura Hameso 1 Outline 3.1 Consumer preferences 3.2 The concept of utility 3.3 Approaches of measuring utility - 3.3.1 The cardinal ut...

Chapter 3. Theory of Consumer Behaviour Econ – Introduction to Economics (Econ 2012) Dr Seyoum Yunkura Hameso 1 Outline 3.1 Consumer preferences 3.2 The concept of utility 3.3 Approaches of measuring utility - 3.3.1 The cardinal utility theory - 3.3.2 The ordinal utility theory 2 Learning outcomes After successful completion of this chapter, you will be able to: explain consumer preferences and utility differentiate between cardinal and ordinal utility approach define indifference curve and discuss its properties derive and explain the budget line describe the equilibrium condition of a consumer 3 Consumer behaviour Consumer behaviour can be best understood in three steps. First, by examining consumer‘s preference, we need a practical way to describe how people prefer one good to another. Second, we must take into account that consumers face budget constraints – they have limited incomes that restrict the quantities of goods they can buy. Third, we will put consumer preference and budget constraint together to determine consumer choice. 4 Consumer preferences 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 s/he is indifferent between the two bundles. We use the symbol ≻ to mean that one bundle is strictly preferred to another, so that X ≻Y. If the consumer is indifferent between two bundles of goods, we use the symbol ∼ and write X~Y. If the consumer prefers or is indifferent between the two bundles we say that s/he weakly prefers X to Y and write X ⪰ Y. The relations of strict preference, weak preference, and indifference are not independent concepts. 5 The concept of utility Economists use the term utility to describe the satisfaction or pleasure derived from the consumption of a good or service. Utility 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. 6 The concept of utility … Points to bear in mind: - 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 centric. - Utility is subjective. The utility of a product will vary from person to person. That means, the utility that two individuals derive from consuming the same level of a product may not be the same. For example, non-smokers do not derive any utility from cigarettes. - Utility can be different at different places and time. For example, the utility that we get from drinking coffee early in the morning may be different from the utility we get during lunch time. 7 Approaches of measuring utility There are two major approaches to measure or compare consumer‘s utility: cardinal and ordinal approaches. - The cardinalist school postulated that utility can be measured objectively. - For the ordinalist school, utility is not measurable in cardinal numbers. Rather the consumer can rank or order the utility, and he derives from different goods and services. The cardinal utility theory Here utility is measurable by arbitrary unit of measurement called utils in the form of 1, 2, 3 etc. For example, consumption of an orange gives Bilen 10 utils and a banana gives her 8 utils, and so on. From this, we can assert that Bilen gets more satisfaction from orange than from banana. 8 Assumptions of cardinal utility theory The cardinal approach is based on the following major assumptions. Rationality of consumers. The main objective of the consumer is to maximize his/her satisfaction given his/her limited budget or income. Thus, in order to maximize his/her satisfaction, the consumer has to be rational. Utility is cardinally measurable. According to the cardinal approach, the utility or satisfaction of each commodity is measurable. Utility is measured in subjective units called utils. 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. Diminishing marginal utility (DMU). The utility derived from each successive units of a commodity diminishes. In other words, the marginal utility of a commodity diminishes as the consumer acquires larger quantities of it. The total utility of a basket of goods depends on the quantities of the individual commodities. If there are n commodities in the bundle with quantities X1,X2,...Xn, the total utility is given by TU = f ( X1 , X 2......X n). 9 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. Marginal Utility (MU) is the extra satisfaction a consumer realizes from an additional unit of the product. Graphically, it is the slope of total utility. Mathematically, marginal utility is MU = ∆TU/ ∆Q where, ∆TU is the change in total utility, and ∆Q is the change in the amount of product consumed. 10 11 Law of diminishing marginal utility (LDMU) The law of diminishing marginal utility 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. Assumptions - The consumer is rational - The consumer consumes identical or homogenous product. The commodity to be consumed should have similar quality, colour, design, etc. - There is no time gap in consumption of the good - The consumer taste/preferences remain unchanged 12 Law of diminishing marginal utility (LDMU)… 13 Law of diminishing marginal utility (LDMU)… 14 Law of diminishing marginal utility (LDMU)… 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. 15 The ordinal utility theory & Assumptions In the ordinal utility approach, the consumers can rank commodities in the order of their standard preferences as 1 , 2 , 3 and so on. Therefore, 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. Assumptions of ordinal utility theory 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. 16 Assumptions of ordinal utility theory 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 more and more of the good. 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. 17 18 Properties of indifference curves 1. Indifference curves have negative slope (downward sloping to the right). 2. Indifference curves are convex to the origin. 3. A higher indifference curve is always preferred to a lower one. 4. Indifference curves never cross each other (cannot intersect). 19 Marginal rate of substitution (MRS) A rate at which consumers are willing to substitute one commodity for another in such a way that the consumer remains on the 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. 20 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. 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. 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 and fixed money income (M). 21 22 The budget line or the price line … A budget is drawn for given prices and fixed consumer‘s income. Hence, the changes in prices or income will affect the budget line. Change in income: If the income of the consumer changes (keeping the prices of the commodities unchanged), the budget line also shifts (changes). BL shifts upward or downward. 23 The budget line or the price line … 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. 24 25 Equilibrium of the consumer 26 27 Thank you 28