Consumer behavior

Theory of Consumer Behavior

Introduction

• In daily life, people buy goods and services for consumption to derive satisfaction.

• Consumer theory explores how individuals decide which goods and services to purchase.

Consumer Choice

• Consumer theory suggests that we can understand consumer preferences from their choices.

• Consumers compare different bundles of goods to make choices.

• When comparing two consumption bundles, a consumer will either prefer one bundle over the other or be indifferent between them.

Preferences

• To determine preference, observe consumer behavior in choice situations.

• If a consumer consistently chooses bundle X over bundle Y when both are available, it suggests a preference for X.

• $X \succ Y$ indicates that the consumer strictly prefers X to Y.

Indifference

• If a consumer is indifferent between two bundles, it's denoted as $X \sim Y$.

• Indifference means the consumer derives equal satisfaction from consuming either bundle X or bundle Y.

• Weak preference, denoted $X \succeq Y$, means the consumer either prefers X or is indifferent between X and Y.

The Concept of Utility

• Utility is the satisfaction or pleasure from consuming a good or service.

• It represents the power of a product to satisfy human wants.

• A consumer prefers bundle X over bundle Y if and only if the utility of X is greater than the utility of Y.

Utility vs. Usefulness

• Utility and usefulness are not the same.

• Usefulness is product-centric (based on the function of the product), while utility is consumer-centric (based on the satisfaction derived by the consumer).

• For example, a painting may be functionally useless but provide great utility to art lovers.

Subjectivity of Utility

• Utility is subjective and varies from person to person.

• The utility derived from a product may not be the same for two different individuals.

• For example, non-smokers may not derive any utility from cigarettes.

Utility Variation

• Utility can vary based on place and time.

• The utility derived from drinking coffee in the morning may differ from the utility derived during lunch time.

Approaches to Measuring Utility

• There are two main approaches to measuring or comparing consumer utility: cardinal and ordinal approaches.

• The cardinalist school believes utility can be measured objectively.

• The ordinalist school believes utility cannot be measured in cardinal numbers but can be ranked or ordered.

Cardinal Utility Theory

• Cardinal utility theory states that utility is measurable in arbitrary units called utils (e.g., 1, 2, 3).

• For example, consuming an orange gives Bilen 10 utils, and a banana gives her 8 utils. This indicates Bilen gets more satisfaction from the orange than the banana.

Assumptions of Cardinal Utility Theory

• Rationality: Consumers aim to maximize satisfaction given budget constraints.

• Measurable Utility: Utility is cardinally measurable in utils.

• Constant Marginal Utility of Money: The value of a unit of money is constant regardless of when or where it's spent.

• Diminishing Marginal Utility (DMU): The utility derived from each additional unit of a commodity decreases as consumption increases.

Total and Marginal Utility

• Total Utility (TU): The total satisfaction from consuming a specific quantity of a commodity at a particular time.

• Total utility increases as more of a good is consumed, up to a saturation point.

• Marginal Utility (MU): The additional satisfaction from consuming one more unit of a product.

• Marginal utility is the change in total utility resulting from the consumption of one more unit of a product.

• Graphically, it's the slope of the total utility curve.

• Mathematically, marginal utility is: $MU = \frac{\Delta TU}{\Delta Q}$

Relationship between TU and MU

• When TU is increasing, MU is positive.

• When TU is maximized, MU is zero.

• When TU is decreasing, MU is negative.

Law of Diminishing Marginal Utility

• The law states that as the quantity consumed of a commodity increases per unit of time, the utility derived from each successive unit decreases, assuming consumption of all other commodities remains constant.

• The extra satisfaction declines as more of the product is consumed in a given period.

Assumptions of the Law of Diminishing Marginal Utility

• The consumer is rational.

• The consumer consumes identical/homogenous products.

• The commodity has similar quality, color, design, etc.

• There is no time gap in consumption.

• Consumer tastes/preferences remain unchanged.

Limitations of Cardinal Approach

• The assumption of cardinal utility is doubtful since utility may not be quantified objectively.

• The assumption of constant MU of money is unrealistic because as income increases, the marginal utility of money changes.

Ordinal Utility Theory

• Ordinal utility approach suggests consumers cannot express utility in absolute terms but can rank commodities in order of preference.

• Consumers rank commodities as 1st, 2nd, 3rd, etc.

• Consumers need not know the specific utility of various commodities to make a choice, but they need to rank the baskets of goods according to the satisfaction each bundle provides.

Assumptions of Ordinal Utility Theory

• Rationality: Consumers maximize satisfaction given income and market prices.

• Ordinal Utility: Utility is not cardinally measurable; consumers only need to rank preferences.

• Diminishing Marginal Rate of Substitution: The rate at which a consumer is willing to substitute one commodity for another while maintaining total satisfaction.

• The rate diminishes as the consumer consumes more of the good.

• Total utility is measured by the quantities of all items consumed.

• Consistent Preferences: Consumer preferences are consistent. If a consumer prefers X to Y and Y to Z, then they should prefer X to Z (Axiom of Transitivity).

Indifference Curves

• Indifference curves represent combinations of two goods that give a consumer the same level of satisfaction or utility.

• Utility remains constant across all points on the curve.

• They illustrate consumer preferences and choices.

• It's a graph showing different combinations of two goods with which a consumer is equally satisfied.

Properties of Indifference Curves

• Downward Sloping: Reflecting the tradeoff between the two goods; to maintain the same level of utility, increasing one good requires decreasing the other.

• Convex to the Origin: Reflecting the diminishing marginal rate of substitution (MRS).

• Non-intersecting: Intersecting curves would imply a consumer derives the same utility from different combinations, which contradicts the principle of distinct satisfaction levels.

• Higher Curves Represent Higher Utility: Curves farther from the origin are preferred.

• Do Not Touch Axes: Implying the consumer derives utility from both goods.

Marginal Rate of Substitution

• Marginal Rate of Substitution (MRS) is the slope of an indifference curve, indicating how much of one good a consumer is willing to give up for one more unit of the other while keeping utility constant.

• The MRS typically diminishes as the consumer moves along the curve, making the curve convex.

Budget Line

• A budget line (or budget constraint) represents the combinations of two goods or services a consumer can afford, given income and prices.

• It's a graphical representation of spending limits.

Consumer Equilibrium

• Consumer equilibrium is when a consumer maximizes utility subject to their budget constraint.

• It's achieved when income is allocated so that satisfaction cannot be improved by spending differently.

Consumer Surplus

• Consumer surplus is the difference between what a consumer is willing to pay for a good and what they actually pay.

• It represents the extra satisfaction consumers receive when they pay less than their willingness to pay. Also perceived value derives utility.