consumer behaviour

what is utility

the subjective satisfaction or pleasure a consumer derives from consuming a good

usefulness

objective, functional and practical

utility

subjective, psychological and preference-based

types of utility

cardinal utility and ordinal utility

cardinal utility

satisfaction derived through quantifying and measurements (utils)

ordinal utility

satisfaction derived through ranking consumer’s preferences

between cardinal utility and ordinal utility, which one is more realistic

ordinal utility

total utility

the aggregate amount of satisfaction derived from consuming a specific quantity of a good over a given period

marginal utility

the additional or extra satisfaction gained from consuming exactly one more unit of a good

MU =

change in TU/change in Q

law of diminishing marginal utility

as a consumer consumes successive units of a specific good, the marginal utility derived from each additional unit will eventually decline

what are the core assumptions of consumer choice

1. rational behaviour

2. defined preferences

3. budget constraint

4. prices

further explain the law of diminishing marginal utility

• first unit gives the consumer the most satisfaction

• subsequent units provide progressively less satisfaction as the consumer approaches saturation

• a rational consumer will only purchase additional units of a good if the price decreases

what is a budget constraint

looks at how a consumer’s income (M) dictates he/she purchasing power

what is the formula for the budget constraint

M = Px.X + Py.Y

how consumer’s maximise utility

they allocate their budget such that the last R spent on each product yields the exact same amount of extra satisfaction

utility-maximising condition

MUx/Px = MUy/Py

how can you analyse ordinal utility

indifference curve

indifference curve

shows all possible combinations of two products between which the consumer is indifferent about

why is it better to have more of something than less of something

it increases your total utility

family of indifference curves

each indifference curve that are related by the same two goods, but each represent a unique level of utility

what are the properties of indifference curves

• downward sloping

• convex with respect to the origin

• do not cross each other

what is the slope of the indifference curve called

marginal rate of substitution (MRS)

marginal rate of substitution (MRS)

the rate at which the consumer is willing to substitute between two goods

what is the assumption about preferences

preferences are:

• complete transitive

• non-satiety exhibited by consumers

MRS =

MUX/MUY

what is the budget line/constraint used for

to understand which bundle of goods the consumer can actually afford

what do you need to construct a budget line

• consumer’s total income (M)

• price of good X

• price of good Y

Px.X

the total amount of money spent on good X

Py.Y

the total amount of money spent on good Y

M

to completely use up my budget, total spending on good X and Y must equal total income

-Px/Py

slope of budget line

M/Py or Px

intercept of good Y or good X

Y =

-Px/Py + M/Py

what can the slope of the budget line be interpreted as

marginal rate of transformation (MRT)

what happens when there is a change in consumer’s income (M)

the budget line shifts left (decrease) or right (increase)

what happens when there is a change in price of good X or Y

it causes the BL to pivot inward or outward

what happens when the budget line pivots inward

increase in price of good X or good Y

what happens when the budget line pivots outward

decrease in price of good X or good Y

when will BL and IC be in equilibrium

when MRT = MRS

when does equilibrium occur

when the consumer is willing to trade at the rate of the opportunity cost

income effect

changes to consumers’ real income levels can affect their purchasing patterns

substitution effect

consumers switching to cheaper products as prices increase/decrease

substitution effect will cause…

a movement along the indifference curve

income effect will cause a…

parallel shift of my budget line

how do you explain the income and substitution effect on the graph

construct a hypothetical budget line (tangent to original BL)

what happens when price increases for income effect

it decreases the purchasing power or real income

what happens when price decreases for income effect

it increases the purchasing power or real income

what happens when the price of good A decreases (substitution effect)

you will buy more of good A and less of good B because good B has relatively become more expensive than A

total effect

the total change in consumption when price changed

normal goods for when you have a price change

• the SE on the good will always go in the opposite direction to the price change

• the IE will work in the same direction as the substitution for the good

inferior good for when you have a price change

• the SE on the good will always go in the opposite direct to the price change

• the IE will work in the same direction as the SE for the good

explain the diamond and water paradox (water)

• it is low in price but high in value 

• high TU but low MU 

• water is valuable (has a large CS) but it s cheap 

explain the diamond and water paradox (diamond)

• it is high in price but low in value

• low TU but high MU

• diamonds are less valuable than water

• have a smaller CS but expensive