Module 4 - Reading: Theory of Consumer Behavior PDF

## MODULE 4 - READING ### CHAPTER IV ### THEORY OF CONSUMER BEHAVIOR #### Learning Objectives - Explain the concept of utility and the basic assumptions underlying consumer preferences. - Explain the equilibrium condition for an individual consumer to be maximizing utility subject to a budget con...

## MODULE 4 - READING ### CHAPTER IV ### THEORY OF CONSUMER BEHAVIOR #### Learning Objectives - Explain the concept of utility and the basic assumptions underlying consumer preferences. - Explain the equilibrium condition for an individual consumer to be maximizing utility subject to a budget constraint. - Use indifference curves to derive a demand curve for an individual consumer. - Identify the substitution, income, and total effects of a change in the price of a good. - Explain why demand curves are downward sloping. "Choices lies on what do we want and what can we afford..." In day to day living, we always make choice especially when we consume product. The goods and services that we consume is basically the one that can satisfy us. Satisfaction is much subjected concept and no one can say that the satisfaction that I gain is the same as yours. Basically, demand first comes up with satisfaction. Satisfaction before has no measurement but in order to study the level of satisfaction, economist coined a measurement on this, it is called utility. #### Utility as Satisfaction Level of satisfaction is measured as utility and the unit of satisfaction is called utils. Remember that the higher the utils, the higher the level of satisfaction. Utility can be measured in two methods, the ordinal and cardinal method. Ordinal method is done when an individual ranks the utility for commodity. For example, Andrew ranks apple, orange and mango according to level of satisfaction he derive in consuming 1 unit of fruit. Then using ordinal method Andrew will answer in this way. I prefer apple than orange but I prefer orange than mango. From this, Andrew ranks the fruit as apples ranks 1, orange ranks 2 and mango as rank 3. Cardinal method is the process in which individual give the intensity of utils he derive in 1 unit of goods. In above example, Andrew may rate apple as 7 utils while orange 4 utils and mango has 1 util. Most of the time, the individual use ordinal method but for the purpose of studying consumer behaviour, economist often ask the cardinal value of utility of individual. For example, you ask the level of satisfaction in consuming water since water is free. Considering that you just finish jogging for 3 hours. Table 4.1 shows the total utility and marginal utility for every glass of water you drink. | Glass of H20 | Total Utility (TU) | Marginal Utility (MU) | | - | - | - | | 0 | 0 | - | | 1 | 5 | 5 | | 2 | 9 | 4 | | 3 | 12 | 3 | | 4 | 14 | 2 | | 5 | 14 | 0 | | 6 | 13 | -1 | | 7 | 10 | -3 | **Table 4.1** **Total Utility Marginal Utility for Glass of Water** As you can noticed, total utility for glass of water increases. When you drink 1 glass of water, your level of satisfaction is 5, but when you drink additional glass, your satisfaction increases to 9 and so on. However, if we're going to look for the value of marginal utility, it declines as you consume additional glass of water. Marginal utility is additional or extra utils the individual gains when he or she consumes additional 1 unit of commodity. From Table 4.1, when you drink 1 glass of water marginal utility is 5, when you drink another glass of water, the marginal utility is 4. But when you drink the 5th glass of water, your marginal utility is equal to 0 and when you drink the 6th glass, MU is equal to -1. When you graph your TU and MU: **Figure 4.1** **Total Utility and Marginal Utility in Consuming Glass of Water** From Figure 4.1, we can gleaned that when TU curve is on its peak, MU intersects the X-axis which means MU is equal to zero. The graph of MU is downward sloping. At 5th glass of water, you already get the saturation point. Saturation point is the point where your total utility curve is on its peak and the marginal utility is equal to 0. In this instance, we can observe the law of diminishing marginal utility. Law of Diminishing Marginal Utility states that as we consume more and more units of goods, the marginal utility decreases. #### INDIFFERENCE CURVE Indifference curve is a tool which shows the different combination of goods and services that an individual consumes that yields the same level of satisfaction or utility. Indifference curve has four assumptions: - There are only two goods available in the market. - Indifference curve bows against (Convex) the origin. - Any point along the curve utilizes the same level of satisfaction. - Indifference curve never intersects. **Figure 4.2 is an example of indifference curve** **Description:** Graphically, the indifference curve is drawn as a downward sloping convex to the origin. The graph shows a combination of two goods that the consumer consumes. The above diagram shows the U indifference curve showing bundles of goods A and B. To the consumer, bundle A and B are the same as both of them give him the equal satisfaction. In other words, point A gives as much utility as point B to the individual. The consumer will be satisfied at any point along the curve assuming that other things are constant. **Figure 4.2 (b)** #### INDIFFERENCE MAP Indifference Map is a set or collection of indifference curves which represents various levels of satisfaction or utility. Indifference curve lies above and to the right of another indicates a higher level of satisfaction. If indifference curves IC1 and IC2 intersects, one of the assumption (i.e. No.4) of consumer theory is violated. Based to this diagram, the consumer should be indifferent among combination of goods A, B and C. Yet B should be preferred to A because B has more of both goods. #### BUDGET CONSTRAINTS Budget Constraints refers to the constraints that consumer face as a result of limited incomes. Budget Line refers to all combinations of goods for which the total amount of money spent is equal to income. As we all know, there is no free in this world. All commodities have its price. Therefore an individual cannot easily choose among the combination of goods that lies along the indifference curve. Therefore, we may say that we are constraints with our budget. In order to determine the combination of goods that will satisfy our utility and budget, economist use the budget line. Budget line is the line that represents combination of goods that can be purchased by your income. Figure 4.3 shows the budget line of an individual. If individual has Php1,000 therefore, at point A, individual can buy 10 units of food and 4 units of clothes. On the other hand, using Php1,000 as well, individual can purchase at point B where he can buy 4 units of food and 12 units of clothes. **COMBINATION OF GOODS X AND Y AND THE BUDGET LINE** | FOOD (X) | CLOTHING (Y) | TOTAL | | - | - | - | | 0 | 50 | Php1,000 | | 20 | 40 | Php1,000 | | 40 | 30 | Php1,000 | | 60 | 20 | Php1,000 | | 80 | 10 | Php1,000 | | 100 | 0 | Php1,000 | **Table 4.1** **Figure 4.3** **Budget Line** Figure 4.3 shows the budget line associated with the combination of the good X and Y given in the table 4.1. As you can see, giving up of a unit clothing saves Php20 and buying two units of costs Php10, the amount of clothing given up for food along the budget line must be the same everywhere, Therefore, the budget line is a straight line from point A to point F, in his scenario, the budget line is given by the equation F+20(c) = Php100. #### CONSUMER EQUILIBRIUM Consumer equilibrium is the point where budget line tangent to the indifference curve. In real sense, it is a combination of goods in which the individual optimize his utility and budget. **Figure 4.4** **Consumer Equilibrium** Referring to table 3.2, the consumer equilibrium can be found at point C. Therefore, individual can consume 2 units of food and 6 units of clothes which also satisfy his income. Mathematically, consumer equilibrium can be expressed in terms of: Where MUx is the marginal utility for first commodity, MUy is the marginal utility for second commodity, Px is price of first commodity and Py is the price of second commodity. Let us say that Cynthia wants to buy Pizza and render Video Rentals. Suppose that she has a monthly budget for two commodities of Php3.00, each pizza cost Php6.00 and video rentals of Php36.00. **Availing the Video Rentals** | Q | TU | MU | MU/P | | - | - | - | - | | 0 | 0 | - | - | | 1 | 200 | 200 | 33.33 | | 2 | 290 | 90 | 15 | | 3 | 370 | 80 | 13.33 | | 4 | 440 | 70 | 11.67 | | 5 | 500 | 60 | 10 | | 6 | 590 | 50 | 8.33 | | 7 | 900 | 40 | 6.67 | **Consumption of Pizza** | Q | TU | MU | MU/P | | - | - | - | - | | 0 | 0 | - | - | | 1 | 250 | 250 | 83.33 | | 2 | 295 | 45 | 15 | | 3 | 335 | 40 | 13.33 | | 4 | 370 | 35 | 11.67 | | 5 | 400 | 30 | 10 | | 6 | 425 | 25 | 8.33 | | 7 | 445 | 20 | 6.67 | In this case, quantity 2-6 for both commodities satisfy the condition of consume equilibrium. But to determine which combination she can afford, then you need to multiply the combination of goods to its price. In this case the point where Cynthia will consume 4 units of pizza and 4 movies theatre, In computation: 1 = PxX + PyY 36 = (Php6 x 4) + (Php3X) Php36.00 = Php36.00