Lecture Note 02 Consumer Behavior (Student Copy) PDF

Inteke 41/SS/Micro 1 1 Layout of the Lecture……… 2.1 Introduction 2.2 Theory of Consumer Demand: Cardinal Utility Approach 2.2.1 Total Utility & Marginal Utility 2.2.2 The Law of Diminishing Marginal Utility 2.2.3 Consumer Equilibrium 2.2.4 Limitation of...

Inteke 41/SS/Micro 1 1 Layout of the Lecture……… 2.1 Introduction 2.2 Theory of Consumer Demand: Cardinal Utility Approach 2.2.1 Total Utility & Marginal Utility 2.2.2 The Law of Diminishing Marginal Utility 2.2.3 Consumer Equilibrium 2.2.4 Limitation of Cardinal Utility Approach 2.3. Theory of Consumer Demand: Ordinal Utility Approach 2.3.1 Ordinal Utility Concept & Its Assumptions 2.3.2 Indifference Curve: Introduction 2.3.3 The Concept of Marginal Rate of Substitution (MRS) 2.3.4 Properties of Indifference Curves 2.3.5 Budgetary Constraint & the Budget Line 2.3.6 Consumer Equilibrium: The Ordinal Utility Approach 2.3.7 Change in Income & Consumer Behavior 2.3.8 Change in Price & Consumer Bahavior 2.3.9 Income & Substitution Effect 2.4 Comparison of Cardinal & Ordinal Utility Approaches 2 Inteke 41/SS/Micro 2  2.1 Introduction Ø The basic objective of consumer’s behavior is utility maximization. What is Utility? Ø In economic sense, utility is a psychological phenomenon: it is a feeling of satisfaction, pleasure, happiness or well being which a consumer derives from the consumption of a commodity. How do we measure utility? Ø The classical and neoclassical economists assume that “ utility is measurable cardinally” (measurable in terms of cardinal numbers 1,2 ,3…..). – Cardinal Utility Approach Ø The modern economists believe that “ utility is not measurable cardinally, it is measurable by ordinally” (in terms of prefer ability of one good over another). – Ordinal Utility Approach Inteke 41/SS/Micro 3 3 2.2 Theory of Consumer Demand: Cardinal Utility Approach Inteke 41/SS/Micro 4 4 Introduction Ø Cardinal utility approach is based on the assumption that “utility is measurable cardinally”. Ø A neoclassical economist, Walras introduced a term “Util” to measure the utility of a commodity. Ø Later, it was agreed to use money as the measure of utility with following assumptions. 1. Utility of a commodity equals the money a consumer is willing to pay. 2. Utility of money remains constant. 3. Utility of one unity of money = one util (Sri Lankan 1 rupee = I util). Ø Going by this method of measuring utility, the utility of a commodity for a consumer equals the money (the price) which he or she is willing to pay for the commodity. ü For ex… if a thirsty person is willing to pay Rs. 50 for a bottle of Pepsi, his utility of one bottle of pepsi is 50 utils. Inteke 41/SS/Micro 5 5  2.2.1 Total Utility (TU) & Marginal Utility (MU) Total utility [TU] is defined as the amount of utility an individual derives from consuming a given quantity of a good during a specific period of time. Inteke 41/SS/Micro 6 6  Nature of Total Utility § When more and more units of a good are consumed in a specific time period, the utility derived tends to increase at a decreasing rate (until Q=6) § Total Utility (TU) is maximum at the point where Q=6. § After that an additional units cause total utility to diminish. (TU begins to decline) Inteke 41/SS/Micro 7 7 2.2.3 Marginal Utility (MU) Marginal Utility [MU] is the change in total utility [DTU] caused by a one unit change in quantity [DQ] ; Inteke 41/SS/Micro 8 8  Nature of Marginal Utility § Marginal Utility (MU) is the change in total utility associated with a 1 unit change in consumption. § As total utility increases at a decreasing rate, MU declines. § As total utility declines, MU is negative. § When TU is a maximum, MU is 0. Inteke 41/SS/Micro 9 9 2.2.3 The Law of Diminishing Marginal Utility § The Cardinal Utility Analysis of the consumer behavior is based on the law of diminishing MU. § This law states that when the quantity consumed of a commodity increases per unit of time, the utility derived by the consumer from the successive units goes on decreasing (while the consumption of all other goods remains constant). § For ex…., suppose you are very hungry and you are offered sandwiches to eat. ü the utility that you derive from the 1st piece of sandwich would give you the highest MU. ü when you eat the 2nd piece, you get a lower MU than the 1st one. ü As you go on eating more sandwiches, your MU goes on decreasing. Inteke 41/SS/Micro 10 10 The Law of Diminishing Marginal Utility (Assumptions) 1. The unit of the consumer goods must be standard, e.g. a cup of tea, a bottle of cool drink and so on. If the units are small or large, the law may not apply. 2. consumers’ taste and preference remains unchanged during the period of consumption. 3. There must be continuity in consumption and where break in continuity is necessary, it must be appropriately short. 4. The mental condition of the consumer remains normal during the period of consumption. Inteke 41/SS/Micro 11 11  2.2.4 Consumer Equilibrium: Cardinal Utility Approach § If there were no costs associated with choices, the individual will consume a good until MU = 0 (this maximizes TU) § Typically, individuals are constrained by a budget [or income] and the prices they pay for the goods they consume. § Therefore, it is important to explain how a consumer allocate his money income to the various goods and services to arrive at his equilibrium. Inteke 41/SS/Micro Cont… 12 12  Conti… Assumptions 1. Rationality: It is assumed that the consumer is rational. It means that he buys first a commodity which gives the highest utility and he buys last a commodity which gives the least utility. 2. Limited Money Income: The consumer has a limited money income to spend on goods and services. 3. Maximization of Satisfaction: Every rational consumer tries to maximize his satisfaction from his given money income. 4. Utility is cardinally measurable. 5. Diminishing MU 6. Constant Utility of Money: The MU of money remains constant whatever the level of consumer’s income and each unit of money has utility equal to 1. 7. Utility is Additive: U=f(x1, x2, x3, ……… xn ) Inteke 41/SS/Micro Cont… 13 13 Consumer Equilibrium: Cardinal Utility Approach A Single Commodity Case Ø Suppose that a consumer with certain money income consumes only one commodity, X. Ø Since both his money income and commodity X have utility for him, he can either spend his money income on commodity X or retain it with himself. Ø If MUx > MUm : TU can be increased by exchanging money for the commodity. Therefore a utility maximizing consumer exchange his money income for the commodity X. Ø the utility maximization consumer reaches his equilibrium at the level of consumption at which MUx = MUm. Inteke 41/SS/Micro Cont… 14 14 Conti…. Ø In reality the price of most goods is more than Rs. 1. In that case, the consumer's equilibrium can be expressed as; MUx = Px(MUm) : (where MUm=1) Ø the utility maximization consumer reaches his equilibrium at the level of consumption at which MUx = Px. Inteke 41/SS/Micro Cont… 15 15  Consumer Equilibrium: Cardinal Utility Approach A Single Commodity Case (Graphical Presentation) Inteke 41/SS/Micro 16 16 Consumer Equilibrium: Cardinal Utility Approach The Multiple Commodity Case Ø In reality, a consumer consumes a large number of goods. Let’s see how a consumer consuming a large number of goods and services reaches his equilibrium. Ø Let’s suppose that a consumer consumes only two commodities, X and Y. Their prices given as Px and Py. Ø Following the rule of single commodity case, the consumer distributes his income between commodities X and Y where, MUx = Px MUy = Py Inteke 41/SS/Micro Cont… 17 17 Inteke 41/SS/Micro 18 18 Inteke 41/SS/Micro 19 19 Consumer Equilibrium: Cardinal Utility Approach Derivation of Demand Curve Ø For the derivation of demand curve, we consider a single commodity (X) case. Ø According to cardinal utility approach, a consumer reaches his equilibrium where MUx = Px. Ø This equilibrium condition is used to derive consumer's demand curve for commodity X as shown in the following figure. Inteke 41/SS/Micro Cont… 20 20  Consumer Equilibrium: Cardinal Utility Approach A Single Commodity Case (Graphical Presentation) Inteke 41/SS/Micro 21 21 Conti….. Ø Suppose that the consumer is in equilibrium at point E1. At this point, price = P3 and quantity is OQ1 Ø If the price of X falls to P2, he buys and consumes more (OQ2) to maximize his satisfaction and the new equilibrium condition would be MUx = P2. Ø Similarly, if the price of X falls further, he buys and consumes more to maximize his satisfaction. Ø Figure (b) shows that when the price is P3 the equilibrium quantity is OQ1. When the price decreases to P2, the equilibrium point shifts downwards to point E2 where equilibrium quantity is OQ2. Ø Similarly, when the price decreases to P1, the equilibrium point shifts downwards to point E1 where equilibrium quantity is OQ3. Ø By connecting J, K & L points, we can get the demand curve for commodity X. Inteke 41/SS/Micro Cont… 22 22  Limitations of Cardinal Utility Approach Ø the assumption that utility is cardinally measurable is not sustainable. Utility is a subjective concept which can’t be measured objectively or quantifiably. Ø the assumption that MU of money remains constant is unrealistic. MU of money like other goods subjective to change. Ø this approach ignores the substitution and income effects which might operate simultaneously. Inteke 41/SS/Micro Cont… 23 23 2.3 Theory of Consumer Demand: Ordinal Utility Approach Inteke 41/SS/Micro 24 24 2.3.1 Ordinal Utility Concept & Its Assumptions Ordinal Utility Concept Ø The term ordinal utility indicates the consumer’s preference (choice) for one commodity over another. § For ex, an individual may not be able to specify how much utility derive by eating a chocolate. However, they can always tell what they prefer given a choice between chocolate and ice cream Ø Consumers can list all the commodities they consume in the order of their preference for the goods. This gives the essence of ordinal utility. Inteke 41/SS/Micro 25 25  Cont….. Assumptions of the Ordinal Utility Theory 1. Rationality. § A consumer is assumed a rational being and he aims at maximizing his total satisfaction. 2. Ordinal Utility. § Utility is only ordinally measurable and consumers are able to express only the order of their preferences. 3. Transitivity & Consistency of Choice. § Transitivity of choice means that if a consumer prefers A to B and B to C, they must prefer A to C. Or if they treat A=B and B=C, they must treat A=C. § Consistency of choice means that if a consumer prefer A to B during one period, they must not prefer B to A in another period or must not treat them as equal, every other factors remaining the same.. 4. Diminishing MarginalInteke Rate of Substitution. 41/SS/Micro 26 26  2.3.2 Indifference Curve: Introduction Ø For ex, let’s suppose that a consumer forms five combinations a, b, c, d, and e of two commodities, X and Y as presented in the following table. Combination Commodity X Commodity Y Utility a 25 5 U b 15 7 U c 10 12 U d 6 20 U e 4 30 U § All the above combinations give the consumer the same level of satisfaction (U). Therefore, the consumer is indifferent to the choice between them. § Those combinations can be plotted graphically, and it results in a curve. Inteke 41/SS/Micro 27 27  Conti….. § On this curve, one can locate many other points showing many other combinations of X and Y, which give the same level of satisfaction. Therefore, the consumer is indifferent to the choice between the points on the curve. Therefore, the curve is called the “Indifference Curve” An Indifference Curve (IC) is defined as the locus of points each representing a different combination of two goods giving the same utility (satisfaction). Inteke 41/SS/Micro 28 28  2.3.3 The Concept of Marginal Rate of Substitution (MRS) Ø To explain the concept of MRS, let’s suppose that a consumer consumes only two goods, X and Y and the utility function is given as follows. U= 𝒇(𝑿, 𝒀) § Let’s now suppose that the consumer substitute X for Y such that the total utility remains the same. § When the consumer sacrifices some units of Y, the stock of Y decreases by ∆Y and the consumer loses a part of the total utility of the goods. This loss of utility may be express as follows. -∆Y. 𝑴𝑼𝒙 § On the other hand, as a result of substitution, the stock of X increases by ∆X. This gain of utility from ∆X can be expressed as follows. +∆X. 𝑴𝑼𝒙 Inteke 41/SS/Micro 29 29  Cont….. § The total utility remains the same only when, -∆Y. 𝑴𝑼𝒙 = +∆𝑿. 𝑴𝑼𝒙 § Rearranging the above equation, we can get, !∆𝒀 𝑴𝑼𝒙 = 𝑴𝑼𝒚 ∆𝑿 § Here, ∆Y/ ∆X or MRSyx (when X is substituted for Y) shows the slope of the indifference curve. § Similarly, ∆X/ ∆Y gives MRSxy, when Y is substituted for X. !∆𝑿 𝑴𝑼𝒚 MRSx,y = = 𝑴𝑼𝒙 ∆𝒀 !∆𝒀 𝑴𝑼𝒙 MRSy,x = = ∆𝑿 𝑴𝑼𝒚 Inteke 41/SS/Micro 30 30  Cont….. Diminishing Marginal Rate of Substitution ü The assumption of diminishing MRS states that when a consumer substitute one commodity (say Y) for another (say X), the MRS decreases as the stock of Y increases and that of X decreases. ü When the consumer move from point a to point b on the indifferent curve (fig.2.1), he gives up 10 units of the commodity X and take 2 units of commodity Y. It gives the following expression: MRSx,y = !∆𝑿 = !𝟏𝟎 =5 ∆𝒀 𝟐 ü As the consumers move down from point b to point c, they loss 5 units of X and gain 5 units of Y, giving the equation: MRSx,y = !∆𝑿 = !𝟓 =1 Inteke∆𝑿 41/YS/Micro 𝟓 31 31  Cont….. ü Complete the following table. Movement on IC Change in X (-∆X) Change in Y (∆Y) MRSx,y = ∆X/∆Y From point a to point b From point b to point c From point c to point d From point d to point e ü According to the values of MRSxy, when the consumer moves down along the indifference curve from a to e, MRS is diminishing. ü The diminishing MRS causes the indifference curves to be convex to the origin. Inteke 41/SS/Micro 32 32  2.3.4 Properties of Indifference Curves Ø Indifference curve has following 4 basic properties. 1. Indifference curves have a negative slope. 2. Indifference curves are convex to the origin. 3. Indifference curves do not intersect. 4. An upper IC implies a higher level of satisfaction than the lower ones. Inteke 41/SS/Micro 33 33  Cont….. 1. Indifference curves have a negative slope. Ø The negative slope of IC implies that a basket of two substitute goods, if the quantity of one commodity decreases, the quantity of the other commodity must increase in order to maintain the same level of satisfaction. 2. Indifference curves are convex to the origin. Ø The convexity of the ICs implies that; § the two goods are imperfect substitution for one another. § Convexity in the IC is caused by the diminishing MRS Inteke 41/SS/Micro 34 34  Cont….. 3. Indifference curves do not intersect. Ø If two ICs intersect, it would mean a violation of the consistency or transitivity assumption for consumer’s preferences. Let’s now prove it graphically. Inteke 41/SS/Micro 35 35  Cont….. Ø Suppose two indifference curves, IC1 and IC2, intersect at point A. And consider two other points, point B on the IC1 and point C on the IC2. Ø Point A, B and C represent three different combinations of X and Y. Points A and B fall on the same IC1 and therefore, in terms of utility, the combination of goods X and Y at these points give the same utility (A=B). Ø Similarly, point A and C fall on the IC2. It means that in terms of utility, A=C. Ø Since, A=B and A=C, it means that: B=C. Ø However, combinations B and C cannot be equal in terms of utility. Therefore, the intersection violate the transitivity rule which is a logical necessity in indifference curve analysis. Inteke 41/SS/Micro 36 36  Cont….. 4. An upper IC implies a higher level of satisfaction than the lower ones. Ø An IC placed above and to the right of another IC represents a higher level of satisfaction than the lower one. The reason is that an upper IC contains a larger quantity of one or both the goods than the lower one. Ø According to the above graph, movement from point a to point b shows the increase of Y (the quantity X remains the same). Ø The movement from point a to point d shows the increase of X (the quantity Y remains the same). Ø The movement from point a to point c shows the increase of both X and Y). Ø Therefore, the level of satisfaction indicated by the upper indifference curve Inteke 41/SS/Micro would always be greater than that indicated by the lower indifference curve. 37 37 2.3.5 Budget Line What is a budget line? Ø Budget Line (BL) is a boundary showing the largest possible combinations of goods that a consumer can buy in a market, given his money income and market prices of the goods. Inteke 41/SS/Micro 38 38 Derivation of a BL: Ø Assume that M (income) = 100, PX (price of X) = 20 & PY (price of Y) = 25. 1. What is the maximum amount of X you can buy? 2. What is the maximum amount of Y you can buy? YY 0 X Inteke 41/SS/Micro 39 39 Budget Equation. X l PX + Y l PY = M Expenditure Expenditure Money income on good X on good Y of the consumer Inteke 41/SS/Micro 40 40  Features: Point A: Expenditure ____ Income Point B: Expenditure ____ Income Point C: Expenditure ____ Income Y l l C l B A 0 X Inteke 41/SS/Micro 41 41  Cont… What Causes Shifts in the Budget Line Ø The two-factors that cause shifts in the budget line are as follows. 1. Changes in consumer’s income § If a consumer’s income increases (the prices of X and Y remaining the same) the budget line shifts upwards, remaining parallel to the original budget line. Y § If a consumer’s income decreases the budget line shifts downward, remaining parallel to the original budget line. 0 X Inteke 41/SS/Micro 42 42  Cont… 2. Changes in the prices of goods If income M remaining the same, a change in prices changes the position of the budget line. ü For ex. If M and Py remain constant and Px decreases, the budget line wil shift to the right only from the X-axis ü If M and Px remain constant and Py increases, the budget line will shift to the left only from the Y-axis Inteke 41/SS/Micro 43 43  Cont… Slope of the Budget Line Ø Understanding of the slope of the budget line is important in determining consumers’ equilibrium. Inteke 41/SS/Micro 44 44 2.3.6 Consumer Equilibrium: The Ordinal Utility Approach Ø According to the ordinal utility approach, two conditions must be satisfied for the consumer to be in equilibrium. 1. Necessary or fist-order conditions : MRS must be equal to the price ratio. MRSx,y = Px/Py 2. Supplementary or second-order conditions : the first condition must be fulfilled at the highest possible indifference curve. Inteke 41/SS/Micro 45 45  Cont… Ø For ex, consumer equilibrium can be illustrated graphically as follows. Ø The indifference curve IC1, IC2 and IC3 represent an indifference map of a consumer. Ø The budget line is given by the line AB. Ø At point E, the slopes of indifference curve IC2 and the budget line AB are equal. This fulfill our first-order condition. Ø Given the budgetary constraint, the IC2 is the highest possible indifference curve that the consumer can reach. Therefore, point E satisfy also the second-order condition. Inteke 41/SS/Micro 46 46  Cont… Ø Note that the first-condition is satisfied at point J and K also. ü However, these points J and K do not satisfy the secondary- condition because the IC1 which represent these points is not the highest possible indifference curve. (IC2 is higher than IC1 and therefore the level of satisfaction at point E is greater than that on any other point on IC1) Inteke 41/SS/Micro 47 47  2.3.7 Change in Income & Consumer Behavior Income Effects on Consumer Behavior Towards Normal Goods. Ø Normal goods are, in general, goods whose consumption increases with increase in consumer’s income. Ø When consumers’ income (M) increases (while prices remaining constant), their budget line shifts upwards remaining parallel to the original budget line. (refer the following graph) Inteke 41/SS/Micro 48 48  Cont… Ø Suppose, a consumer’s income is given by M1, his budget line is given by the line AB and the consumer is initially in equilibrium at point E1. ü When consumer’s income increases from M1 to M2, the budget line shifts from position AB to CD and the consumer reaches a new equilibrium at point E2 on IC2. ü Similarly, if the consumer’s income increases from M2 to M3, the budget line shifts from position CD to EF and the consumer reaches a new equilibrium at point E3 on IC3. ü We can join the all equilibrium points and draw the “Income- Consumption Curve (ICC)”. ü The “Income-Consumption Curve (ICC) can be defined as the locus of points representing various combinations of two commodities purchased by the consumers at different levels of Inteke 41/SS/Micro 49 their income, all other factors remaining the same. 49 Income and Consumption: The Engle Curve Ø Engle curve shows the relationship between the income and expenditure, in terms of money, on a particular good. Engle curve is derived from ICC curve as follows. Inteke 41/SS/Micro 50 50  Cont… ü As shown in the graph, the consumption of commodity X increases from OX1 to OX2 to OX3 and then to OX4 as the income increases from M1 to M2 to M3 and then to M4. ü Simultaneously, the consumer moves from equilibrium E1 to E2 to E3 to E4. ü The relationship between income and quantity X demanded plotted in the graph shows the Engle curve. ü The shape of the Engle curve depends on the shape of the ICC curve. Inteke 41/SS/Micro 51 51  2.3.8 Changes in Prices & Consumer Behavior Ø In this section, we discuss the effects of changes in the prices of a commodity on the quantity of its consumption, all other prices and consumer’s income remaining constant. Ø The consumer’s response to the change in price depends also on whether a commodity is a normal good or an inferior good. 2.8.1 Changes in Price and Consumer Behavior: Case of Normal Goods. Ø When the price of a commodity changes (all other factors remaining constant) both the position and the slope of the budget line change. Inteke 41/SS/Micro 52 52  Cont… ü Suppose that the consumer is initially in equilibrium at point E1. Now, if the price of X decreases the consumer’s budget line shifts from its initial position LK to the position LN. ü With the increase of the consumer purchasing power, the consumer can buy more of X (or more of both goods). ü As a result, consumer reaches a higher indifference curve IC2 and finds a new equilibrium at point E2. ü According to the graph, with successive falls in the price of X, the consumer’s equilibrium shifts from E2 to E3 to E4. ü By joining the points of equilibrium E1, E2, E3, and E4, we can get a curve called “ Price-Consumption Curve” (PCC). Inteke 41/SS/Micro 53 53  Cont… v What is Price-Consumption Curve ? ü The PCC is a locus of all those points of equilibrium on the indifference curves that result from the change in the price of commodity X. It shows the changes in the consumption basket due to changes in the price of commodity X. In other words, the PCC shows the consumer’s response to changes in the price of X. Inteke 41/SS/Micro 54 54  Derivation of Consumer Demand Curve Ø Previously, we discussed the derivation of consumer demand under the cardinal utility approach using the MU curve. In this section, we show the derivation of consumer demand under the ordinal utility approach using IC technique. Ø The derivation of the demand curve for commodity X is illustrated in the following figure. Inteke 41/SS/Micro 55 55 Inteke 41/SS/Micro 56 56  Cont… ü The figure (a) shows the derivation of the PCC. As shown in the figure, the consumer is initially in equilibrium at point E1 and they consume OX1 of X. ü When the price of X decreases, the consumer moves to equilibrium point E2 and they consume OX2. When the price of X falls further, the consumer moves to equilibrium point E3 and they consume OX3. ü The demand curve can be drawn directly by plotting the data shown in figure (a). As shown in figure (b), the vertical axis measures the price of commodity X (Px3, Px2, Px1) representing the three prices we have considered in figure (a). Inteke 41/SS/Micro 57 57  Cont… ü We know that the quantity consumed at Px3 is OX1, at Px2 is OX2 and at PX1 is OX1. P values in Y axis and Q values in X axis intersect at the points E1, E2, and E3 respectively. ü By joining the points E1, E2 and E3, we get the demand curve, D, as shown in figure (b). Inteke 41/SS/Micro 58 58 2.4 Comparison of Cardinal & Ordinal Utility Approaches Inteke 41/SS/Micro 59 59 ASSIGNMENT 1 ????? Inteke 41/SS/Micro 60 60