AAE 211_2-Consumer Behavior PDF

Lilongwe University of Agriculture and Natural Resources Bunda College Campus Faculty of Development Studies Department of Agricultural and Applied Economics Course Name : Agricultural Economics I Course Code : AAE 32101 Offered to Year :...

Lilongwe University of Agriculture and Natural Resources Bunda College Campus Faculty of Development Studies Department of Agricultural and Applied Economics Course Name : Agricultural Economics I Course Code : AAE 32101 Offered to Year : 2 Academic Calendar : 2023/2024 1  Topic 2 Theory of Consumer Behaviour and Utility Maximization 2.0 Consumer Choice and Budget Constraint Theory of consumer behaviour is about decisions that a consumer makes in order to maximize satisfaction from the consumption of goods and services. – Ceteris paribus, to maximize satisfaction a consumer faces two main problems: (i) Consumption choices, and (ii) The budget constraint The typical consumer’s situation has the following dimensions. – Rational behaviour The consumer is a rational person, who tries to use his or her money income wisely to derive the greatest amount of satisfaction or utility, from it. – Preferences Each consumer has clear preferences for certain types of goods and services available in the market and the amount of marginal utility that can be obtained from successive units of the various products. 2  Dimensions of a typical consumer’s situation (cont’d) Budget constraint – At any point in time the consumer has a fixed, limited amount of money income. Since each consumer supplies a finite amount of human and property resources to society, he or she earns only limited income. – Thus, every consumer faces what economists call a budget constraint (budget limitation), even those who earn millions of Kwacha a year. Prices – Goods are scarce relative to the demand for them, so every good carries a price tag. – Since the consumer has a limited amount of money, he/she can buy only a limited amount of goods. This point drives home the reality of scarcity to each consumer. – So the consumer must compromise; he/she must choose the most satisfying mix of goods and services. 3  Approaches to the study of the Theory of Consumer Behaviour There are two ways of studying the theory of consumer bahaviour. (i) Marginal Utility Approach (Cardinal Utility Approach), (ii) Indifference Curves Approach (Ordinal Utility Approach) 4 2.1.1 Marginal Utility (Cardinal Utility) Approach  Marginal Utility approach Marginal utility approach is concerned with extra (additional) utility that consumers get from consuming successive units of commodities. For instance, how much utility (satisfaction) does one get from consuming one unit, two units, three units and so on of slices of bread?  The Concept of Utility The utility of a good or service is the satisfaction or pleasure one gets from consuming it. A product has utility if it can satisfy a want. 5  Characteristics of Utility Concept Three characteristics of this concept must be emphasized: (i) “Utility” and “usefulness” are not synonymous. Paintings by great artist may offer great utility to arts experts but useless functionally. (ii) Utility is subjective. The utility of a specific product may vary widely from person to person. (iii)Because utility is subjective, it is difficult to quantify. But for purposes of illustration we assume that people can measure satisfaction with units called utils (units of utility). For example, a particular consumer may get 100 utils of satisfaction from chocolate, 10 utils of satisfaction from a candy bar, and 1 util of satisfaction from a stick of gum. These imaginary units of satisfaction are convenient for quantifying consumer behavoiur 6  Total Utility (TU) and Marginal Utility (MU) Marginal utility or cardinal utility approach assumes an objective way of analyzing consumer behaviour through the hypothesized units (utils) of satisfaction. Total Utility and Marginal Utility – Total utility is the total amount of satisfaction or pleasure that a person derives from consuming some specific quantity – for example, 10 units - of a good or service. – Marginal utility is the extra satisfaction that a consumer realizes from an additional unit of that product – for example, from the eleventh unit. Alternatively, marginal utility is the change in total utility that results from the consumption of 1 more unit of a product. Algebraically, MU = Tun – TUn-1 or MU = TU2 – TU1 MU can also be expressed as change in TU divided by change in quantity consumed as follows: MU = ∆TU/∆Q; Thus, MU = ∂TU/∂Q. Note that ∂TU/∂Q is the slope of the point on TU curve or function. 7  Relationship between TU and MU  Table 2.1 and the accompanying Figure 2.1 (on page 29 of the lecture notes) reveal the relationship between total utility and marginal utility.  Column 2 of Table 2.1 shows the total utility associated with each level of consumption of slices of bread.  Column 3 shows the marginal utility – the change in total utility – that results from the consumption of each successive slices of bread.  Notice that  when MU0, TU is increasing;  when MU 0, TU is decreasing;  when MU = 0, TU is maximum;  TU can also be calculated by summing up MU as follows: TU = MU1 + MU2 + MU3 +... Mun 8 Table 2.1: Total Utility and Marginal Utility (1) (2) (3) Slices of bread Total Utility (TU) Marginal Utility consumed per (utils) (MU) (utils) day 0 0 - 1 10 10 2 18 8 3 24 6 4 28 4 5 30 2 6 30 0 7 28 -2 9  The Law of Diminishing Marginal Utility  The principle that marginal utility (MU) declines as the consumer acquires additional units of a given product is known as the law of diminishing marginal utility.  Note that MU is always a decreasing function.  Evidence indicates that consumers can fulfill specific wants with succeeding units of a commodity but that each added unit provides less utility than the last unit purchased.  Consumers can get as much of a particular commodity as they can afford. But the more of that commodity they obtain, the less they want still more of it.  Consider the desire for durable goods such as cars for example;  the desire to have a car may be very strong. However, the desire for a 2nd, 3rd or 4th car is less intense; and gets weaker and weaker although their income would allow them to purchase a whole fleet of vehicles – MU diminishes. 10  Consumer Equilibrium and the Law of Equi-Marginal Utility  Of all the different combinations of goods and services a consumer can obtain within his/her budget, which specific combination will yield maximum satisfaction?  Utility maximizing rule states that to maximize satisfaction, the consumer should allocate his or her money income so that the last money unit spent on each product yields the same amount of marginal utility.  When the consumer has “balanced his or her margins” using this rule, there is no incentive to alter the expenditure pattern.  The consumer is in equilibrium and would be worse off – that is, total utility would decline, if there were any alteration in the bundle of goods purchased, providing there is no change in taste, income, products or prices.11  Conditions to achieving consumer  equilibrium There are two conditions to the consumer’s equilibrium:  Condition A: the consumer cannot increase his/her TU by reallocating his/her expenditure, and  Condition B: the constrained condition is the budget line.  Condition A: The consumer cannot increase his/her TU by reallocating his/her expenditure  Algebraically, this occurs when the following condition is satisfied: MUx/Px = MUy/Py = MUz/Pz. Where MUx is marginal utility of product X; Px is price of product X; MUy is marginal utility of product Y; Py is price of product Y; MUz is marginal utility of product Z; Pz is price of product Z.  This means that the utility to be derived from the consumption of last unit of money’s worth of commodity X is equal to the utility to be derived from the consumption of the last unit of money’s worth of commodity Y which is also equal to the utility to be derived from the consumption of the last unit of money’s worth of commodity Z. 12  Condition A: The consumer cannot increase his/her TU by reallocating his/her expenditure (cont’d)  In short, total utility is maximized when the ratios of marginal utility and price are equal for all commodities consumed with a given money income.  For example, given two products X (beef) and Y (pork),  Marginal Utility for beef (MUx) = 200 utils, and the unit price of beef (Px) = K400/kg; and  Marginal Utility for pork (MUy) = 250 utils, and the unit price of pork (Py) = K500/kg.  Maximum Utility (Umax) is achieved when MUx/Px = MUy/Py; 200 utils MK400 = 0.5 util/MK 250 utils  MK500 = 0.5 util/MK  Thus, 200 utils  MK400 = 250 utils  MK500 = 0.5 util/MK 13  Application  Thoko may decide which combination of two products, A and B, she should purchase with a fixed daily income of $10 and maximize her satisfaction. Table 2.2. Utility Maximizing Combination of Products A and B with an Income of $10 A (Price = B (Price = B (Price = 1) Unit(s) $1) $2) MUA MUA/PA MUB MUB/ MUB’/pPB’ PB 1 10 10 24 12 24 2 8 8 20 10 20 3 7 7 18 9 18 4 6 6 16 8 16 5 5 5 12 6 12 6 4 4 6 3 6 14 7 3 3 4 2 4  Decision Making Process  From Table 2.2, the utility-maximizing combination of goods attainable by Thoko is 2 units of A and 4 units of B.  In terms of total utility (TU), this combination derives 96 utils.  By summing MU information from columns 2 and 3, Thoko obtains 18 (= 10 + 8) utils of satisfaction from 2 units of A and 78 (= 24 + 20 + 18 + 16) utils of satisfaction from the 4 units of B. Her $10, optimally spent, yields 96 (= 18 + 78) utils of satisfaction.  Remember!  In order to make the amounts of extra utility derived from differently priced goods comparable, marginal utilities must be put on a per-money-spent (such as per Dollar or Kwacha) basis as shown in columns 3 and 5 in Table 2.2. 15  Inferior Options  Thoko can as well obtain other combinations of A and B with $10, but none will yield as great utility as do 2 units of A and 4 units of B.  For example, she can obtain 4 units of A and 3 units of B for $10, thereby ensuring that all the available money income is used.  Thus, (4 units of A × $1) + (3 units of B × $2) = $4 + $6 = $10  However, this combination yields only 93 utils, clearly inferior to the 96 utils provided by 2 units of A and 4 units of B.  Note that we have implicitly assumed that Thoko spends her entire income.  She neither borrows nor saves. However, saving can be regarded as a “commodity” that yields utility and can be incorporated into our analysis. In fact, it is treated that way in Table 2.3 16  Further Application  In order to maximize his utility, Thom may decide which combination of four products, A, B, C and D he should purchase and the amount of money he should save with a fixed2.3: Table weekly income Utility of $118combination maximizing (Table 2.3).of products A , B, C, and D and money saved obtainable with an income of $118 A B C D Savings Uni (Price = (Price = (Price = (Price = ts 18) 6) 4) 2) MU MU/ MU MU/ M MU/p M MU/ Mone MU MU/ p p U U p y Saving Saved 1 72 4.0 24 4.0 15 3.75 36 18.0 1 5 5.0 2 54 3.0 15 2.5 12 3.0 30 15.0 2 4 2.0 3 45 2.5 12 2.0 8 2.0 24 12.0 3 3 1.0 4 36 2.0 9 1.5 7 1.75 18 9.0 4 2 0.5 5 27 1.5 7 1.67 5 1.25 13 6.5 5 1 0.2 6 18 1.0 5 0.83 4 1.0 7 3.5 6 0.5 0.08 17 7 15 0.83 2 0.33 3.5 0.875 4 2.0 7 0.2 0.04  Utility Maximization and the Demand Curve  Once you understand the utility maximizing rule, you can easily see why product price and quantity demanded are inversely related.  The basic determinants of an individual’s demand for a specific product are  preferences or tastes,  money income, and  prices of other goods.  The utility data in Table 2.2 reflect our consumer’s preferences.  We continue to suppose that Thoko’s money income is $10.  Concentrating on the construction of a simple demand curve for product B, we assume that the price of A, representing “other goods,” is still $1, while the price of product B has reduced from $2 to $1. 18 Deriving the Demand Schedule and Curve (1)  We can derive a single consumer’s demand schedule for product B by considering alternative prices at which B might be sold and then determining the quantity the consumer will purchase.  We have already determined one such price-quantity combination in the utility maximizing example:  Given tastes, income and prices of other goods, our rational consumer will purchase 4 units of B at $2 per unit.  Now let’s assume the price of B falls to $1.  The marginal utility per money (Kwacha) data for product B in last column of Table 2.2 will double, because the price of B has been halved.  But the purchase of 2 units of A and 4 units of B is no longer an equilibrium combination.  By applying the same reasoning we used in the initial utility maximizing example, we now find that Thoko’s utility maximizing combination is 4 units of A and 6 units of B. 19  Sketching the Demand Curve  As summarized in Table 2.2, Thoko will purchase 6 units of B when the price of B is $1. Using the data in this table, we can sketch the downward-sloping demand curve DB shown in Figure 2.2.  This exercise then clearly links the utility maximizing behaviour of a consumer and that person’s demand curve for a particular product. Price(P) $2 $1 DB 0 2 4 6 8 Quantity Demanded (Q) Figure 2.2 Deriving an individual demand curve for product B 20  Class Work  Key Question 1  Suppose Thoko’s income is $14 rather than $10.  What now is the utility maximizing combination of products A and B?  Are A and B normal or inferior goods? Explain your answer. Working Table 1. Utility Maximizing Combination of Products A and B with an Income of $14 A (Price Mu/p B (Price = $2) Mu/p Unit( = $1) s) MU MU 1 10 10 24 12 2 8 8 20 10 3 7 7 18 9 4 6 6 16 8 5 5 5 12 6 6 4 4 6 3 21  Class Work Working Table 2 Further Application of Decision making Rule and Demand Curve Units of X MUx Units of Y MUy 1 10 1 8 2 8 2 7 3 6 3 6 4 4 4 5 5 3 5 4 6 income is $9 and (a)If your 2 the prices of6 X and Y are $23and $1 respectively, what quantities of each will you purchase to maximize utility? (b)What total utility will you realize? (c)Assume that ceteris paribus, the price of X falls to $1, what quantities of X and Y will you now purchase? (d)Using the two prices and quantities for X, derive a demand schedule and plot the demand curve for X. 22  Condition B: The constrained condition is the budget line  A more advanced explanation of consumer behaviour and equilibrium is based on budget line and the so-called indifference curve.  Budget Line: What is Attainable  A budget line or, more technically, the budget constraint is a schedule or curve that shows various combinations of two products X and Y that a consumer can purchase with available money income given the prices of X and Y.  Algebraically, the budget line is expressed as M = Px(X) + Py(Y) Where M is money income, X and Y are quantities of the two different products that a consumer can buy, Px and Py are prices of X and Y, respectively. 23  Example of a budget line (Budget constraint) If the price of X is K200 and that of Y is K100, a consumer could purchase all the combinations of X and Y shown in Table 2.4 below with K1000 of money income. Table 2.4: The Budget Line: Whole unit combinations of X and Y attainable with an income of MK1000 Units of X Units of Y Total Expenditure [Px(X) + Py(Y)] (Price = (Price = MK200) MK100) 5 0 MK,1000 (=MK1,000 + MK0) 4 2 MK,1000 (=MK800 + MK200) 3 4 MK,1000 (=MK600 + MK400) 2 6 MK,1000 (=MK400 + MK600) 1 8 MK,1000 (=MK200 + MK800) 0 10 MK,1000 (=MK0 + MK1,000) At one extreme, the consumer might spend all of the income on 5 units of X and have nothing left to spend on Y. On the other extreme, the consumer could buy 10 units of Y at K100 each, spending the entire money income on Y with nothing left to spend on X. 24  Example of a budget line (Budget constraint) Figure 2.3 shows the same budget line graphically. Note that the graph is not restricted to whole units of X and Y as is the table. Every point on the graph represents a possible combination of X and Y, including fractional quantities. QX 5 A Income = MK 1,000; PX = MK200 4 The budget line 3 2 1 Income = MK1,000 PY = MK100 0 θ B 2 4 6 8 10 QY Figure 2.3: A consumer’s budget line 25 The slope of the Budget Line The slope of the graphed budget line measures the ratio of the price of Y (PY) to the price of X (PX); – more precisely, the absolute value of the slope is Py/Px = K100/K200 = ½. – This is the mathematical way of saying that the consumer must forgo 1 unit of X to buy 2 units of Y. – In moving down the budget or price line, 1 unit of X (at K200 each) must be given up to obtain 2 units of Y (at K100 each). This yields a slope of ½. – The slope of the budget line can also be calculated trigonometrically: tan = OA/OB = (M/Px)  (M/Py) i.e Opposite over Adjacent = [1000/200]÷ 1000/100 = [5/10] = ½ OR = Py/Px = K100/K200 = ½ 26 Characteristics of the budget line The budget line shows all the combinations of any two products that can be purchased, given the prices of the products and the consumer’s money income. The budget line has other two significant characteristics: (i) Income changes. The location of the budget line varies with money income. An increase in money income shifts the budget line to the right; a decrease in money income shifts it to the left. In order to verify this, recalculate Table 2.3, assuming that money income is (a) K2000 and (b) K600, and plot the new budget lines. (ii) Price changes. A change in product prices also shifts the budget line. A decline in prices of both products – the equivalent of an increase in real income – shifts the curve to the right. (Verify this by assuming that Px = K150 and Py = K50). Conversely, an increase in the prices of X and Y (the equivalent of a decrease in real income) shifts the curve to the left. (Verify this). 27 Characteristics of the budget line (cont’d) Note what happens if Py changes while Px and money income (M) remain constant. – In particular, if Py drops, from K100 to K50, for example, the lower end of the budget line fans outward to the right. – Conversely, if Py increases, from K100 to K150, for example, the lower end of the budget line fans inward to the left. – In both instances the line remains “anchored” at 5 units on the vertical axis because the price of X (P x) has not changed (as depicted below). QX 5 When price of Y increases When price of Y decreases 0 10 QY 28 2.1.2 Indifference Curve (Ordinal Utility Approach): What is preferred Budget lines reflect “objective” market data, specifically income and prices. – They reveal combinations of products that can be purchased, given current money income and prices. Indifference curves, on the other hand, reflect “subjective” information about consumer preferences for different products, A and B, for example. – An indifference curve shows all possible combinations of two products A and B that will yield the same total satisfaction or total utility to a consumer. 29  Indifference Schedule (Table)  Table 2.4 presents a hypothetical indifference schedule for products A and B. Table 2.4: An Indifference schedule (Table), (Whole units) Combination Units of product Units of Product B A C 12 2 D 6 4 E 4 6 – F The consumer’s subjective3 preferences are such 8 that he or she will realize the same total utility from each combination of A and B shown in the table. » So the consumer will be indifferent (will not care) as to 30 which combination is actually obtained.  Indifference Curve  Figure 2.4 presents a hypothetical indifference curve for products A and B. QA 12 C 11 10 9 8 7 6 D 5 4 E 3 F 2 I 1 31 0 2 4 6 8 10 QB  Indifference Curve (cont’d) Every point on indifference curve (I ) represents some combination of products A and B, and all those combinations are equally satisfactory to the consumer. – That is, each combination of A and B on the curve yields the same total utility. Characteristics of Indifference Curves – Indifference curves have several important characteristics. The following are probably most notable characteristics. (i) Indifference curves are downward sloping. An indifference curve slopes downward because more of one product means less of the other if total utility is to remain unchanged. Thus “more of B” necessitates “less of A” and the quantities of A and B are inversely related. A curve that reflects inversely related variables is 32 downward sloping.  Characteristics of Indifference Curves (cont’d) (ii) Indifference Curves are convex to the Origin. – A downward sloping curve can be concave (bowed outward) or convex (bowed inward) to the origin. A concave curve has an increasing (steeper) slope as you move down the curve, while a convex curve has a diminishing (flatter) slope as one moves down the curve. – The slope of the indifference curve shown in Figure 2.4 diminishes or becomes flatter as we move from c to d to e, and so on down the curve. Technically, the slope of the indifference curve at each point measures the marginal rate of substitution (MRS) of the combination represented by that point. The slope or MRS shows the rate at which the consumer who possesses that combination will substitute one good for the other (B for A, for example) to remain equally satisfied. The diminishing slope of the indifference curve means that the willingness to substitute B for A diminishes as one moves down the curve. 33 Rationale for convexity of the indifference curve The rationale for the convexity – (a diminishing MRS ) – is that a consumer’s subjective willingness to substitute B for A (or A for B) will depend on the amounts of B and A he or she has to begin with. In Table 2.4 and Figure 2.4, at point c the consumer has a substantial amount of A and very little of B. – Within this combination, a unit of B is very valuable (that is, its marginal utility is high), while a unit of A is less valuable (its marginal utility is low). – The consumer will then be willing to give up a substantial amount of A to get 2 more units of B, for example. – In this case, the consumer is willing to forgo 6 units of A to get 2 more units of B; the MRS is 6/2, or 3/1. 34  Rationale for convexity of the indifference curve (cont’d) At point d the consumer has less A and more B. Here A is somewhat more valuable, and B less valuable, “at the margin.” In a move from point d to point e, the consumer is willing to give up only 2 units of A to get 2 more units of B, so the MRS is only 2/2, or 1. Having still less of A and more of B at point e, the consumer is willing to give up only 1 unit of A in return for 2 more units of B and the MRS falls to ½. In general, as the amount of B increases, the marginal utility (MU) of additional units of B decreases. Similarly, as the quantity of A decreases, its MU increases. In Figure 2.4 we see that in moving down the curve, the consumer will be willing to give up smaller and smaller amounts of A to offset acquiring each additional unit of B. – The result is a curve with a diminishing slope, that is convex to the origin. The MRS declines as one moves southeast along the indifference35 curve.  The Indifference Map The single indifference curve of Figure 2.4 reflects some constant (but unspecified) level of total utility (TU) or satisfaction. It is possible to sketch a whole series of indifference curves or an indifference map, as shown in Figure 2.5. Each curve reflects a different level of TU. Specifically, each curve to the right of our original curve (labeled I3 in Figure 2.5) reflects combinations of A and B that yield more utility than I3. q I4 I3 I2 I1 0 36 Figure 2.5: An Indifference map  Equilibrium at Tangency A budget line can be superimposed on the consumer’s indifference map, as shown in Figure 2.6. Of the attainable combinations of A and B, the consumer will prefer the combination that yields the greatest satisfaction or utility. Specifically, the utility maximizing combination will be the one lying on the highest attainable indifference curve. It is called the consumer’s equilibrium position. QA 8 W Y X 4 I3 Z 0 2 4 6 8… 12 QB 37 Figure 2.6: The consumer’s equilibrium position  Equilibrium at Tangent In Figure 2.6, the consumer’s equilibrium position is represented by point X, where the budget line is tangent to indifference curve I3. – At point X the consumer buys 4 units of A at $1.50 per unit and 6 units of B at $1 per unit with a $12 money income. – Points Z and Y represent attainable combinations of A and B but yield less total utility (TU) as evidenced by the fact that they are on lower indifference curves. – Point W would entail more utility than X, but it requires a greater income than $12 represented by the budget line. Therefore, point W is unattainable with the budget of $12. Note that, according to the definition of tangency, the slope of the highest attainable indifference curve equals the slope of the budget line. – Because the slope of the indifference curve reflects the MRS and the slope of the budget line is PB/PA, the consumer’s optimal or equilibrium position is the point where MRS = PB/PA 38 [(MRS = 4/6 = 2/3); (PB/PA = $1.0/$1.50 = 2/3)]  The Measurement of Utility Marginal utility theory of demand differs from the indifference curve theory in that the marginal utility theory assumes that utility is numerically measurable. – That is, the consumer can say how much extra utility he/she derives from each extra unit of A or B. – The consumer needs that information to realize the utility maximizing (equilibrium) position, as indicated by (MUA/PA) = (MUB/PB) The indifference curve approach imposes a less stringent requirement on the consumer. – The consumer need only to specify whether a particular combination of A and B will yield more than, or less than, or the same amount of utility as some other combination of A and B. For example, the consumer need only say that 6 units of A and 7 units of B will yield more (or less) satisfaction than will 4 units of A and 9 units of B. Indifference curve theory does not require that the consumer specify how much more (or less) satisfaction will be realized. 39  Equilibrium in MU and Indifference curve theories When we compare the equilibrium situations in the two theories, we find that in the indifference curve analysis the MRS = PB/PA at equilibrium; However, in the marginal utility approach the ratio of marginal utilities equals PB/PA. – Thus, if we begin with the utility maximizing rule, MUA/PA = MUB/PB, – and then multiply through by PB and divide through by MUA, we obtain PB/PA = MUB/MUA. – In the indifference curve analysis we know that at equilibrium position MRS = PB/PA. – Hence, at equilibrium, MRS also equals MUB/MUA It is therefore, deduced that at equilibrium, the MRS is equivalent in the marginal utility approach to the ratio of the marginal utilities of the last purchased units of the two products. 40 The Derivation of the Demand Curve (2) Exercise – We noted earlier that with a fixed price for A, an increase in the price of B will cause the bottom of the budget line to fan inward to the left. – Use that fact to derive a demand curve for product B with the following data. Assume that the money income is $12 and that prices of commodities A and B are PA = $1.50 and PB = $1, respectively. Now assume that PB increases to $1.50 while money income and PA remain constant (at $12 and $1.50, respectively). Label your budget lines, indifference curves and the 41 demand curve clearly.  References McConnell, R.C. and Stanley L. Brue (2002). Economics: principles, problems and policies, 15th ed., New York, USA, McGraw-Hill Companies Inc. pp394 - 414 42