Tutorial 6 & 7: Theory of Consumer Behaviour

Theory of Consumer Behaviour: Comprehensive Notes

I. Core Concepts of Consumer Behaviour

• Utility: This measures the satisfaction a consumer receives from consuming a bundle of goods.
  • Economists frequently use utility to describe consumer preferences.
• Total Utility (TU): The overall satisfaction derived from consuming a certain amount of a good.
• Marginal Utility (MU): The additional satisfaction gained from consuming one more unit of a good.
  • Relationship between TU and MU:
    • Total utility increases when marginal utility is positive (MU > 0).
    • Total utility starts decreasing when marginal utility becomes negative (MU < 0).
    • Total utility is maximized when marginal utility is zero ($MU = 0$).
• Law of Diminishing Marginal Utility: As a person consumes more and more of a given good, the marginal utility derived from each additional unit will decline.
  • Example: The $4^{th}$ glass of milk generates less satisfaction than the $3^{rd}$ glass.
  • If the marginal utility from consuming the $4^{th}$ avocado is $-2$, it implies that total utility must be decreasing at that point.

II. Budget Constraints

• Definition: A budget line shows the consumption bundles that a consumer can afford given their income and the prices of goods.
  • Budget constraints exist because consumers have to pay for goods, and they have limited incomes.
• Mathematical Representation: For two goods, X and Y, with prices $P<em>X$ and $P</em>Y$ and income $M$, the budget constraint is given by: $P<em>X X + P</em>Y Y \le M$
• Affordability: A bundle $(X, Y)$ is affordable if its total cost does not exceed the consumer's income.
  • Example: If the price of X is RM5 and the price of Y is RM4, and income is RM25:
    • Bundle (0, 7)
      ightarrow 5(0) + 4(7) = RM28 (Not affordable)
    • Bundle (3, 3)
      ightarrow 5(3) + 4(3) = RM27 (Not affordable)
    • Bundle (3, 2)
      ightarrow 5(3) + 4(2) = RM23 (Affordable)
    • Bundle (2, 4)
      ightarrow 5(2) + 4(4) = RM26 (Not affordable)
• Points on the Budget Constraint: A consumer spending all of their income would be at a point on the budget constraint.
• Points Inside the Budget Constraint: A consumer not spending all of their income would be at a point inside their budget constraint.
• Interpreting Budget Line Intercepts:
  • The intercept on an axis (e.g., the Y-axis) represents the maximum quantity of that good (e.g., Good Y) that can be purchased if all income is spent on it. This is calculated as $Income / P_Y$.
  • Example: If income is $120 and the maximum quantity of good Y one can buy is 30, then the price of good Y is 120 / 30 = $4.
  • Example: With $200 income, CD price $10, DVD price $20, max CDs is $200 / 10 = 20$.
• Shifts in the Budget Constraint:
  • Change in Income: An increase in income causes the budget constraint to shift outward, parallel to its initial position. A decrease in income causes an inward parallel shift.
  • Change in Price of One Good: A change in the price of only one good causes the budget constraint to rotate around the intercept of the other good.
    • A decrease in the price of Good X rotates the budget line outward along the X-axis.
    • An increase in the price of Good Y rotates the budget line inward along the Y-axis.
  • Proportional Change in All Prices and Income: If the prices of all goods increase by the same proportion as income, the real purchasing power of the consumer remains the same, and thus the budget constraint (and likely the quantity demanded for normal goods) will remain unchanged.

III. Indifference Curves (ICs)

• Definition: Indifference curves graphically represent an individual's preferences by showing various combinations of two goods that yield the same level of satisfaction (utility) for the consumer.
• Properties of Indifference Curves:
  1. Downward Sloping: To maintain a constant level of satisfaction, if the consumption of one good increases, the consumption of the other must decrease.
  2. Higher Indifference Curves Reflect Higher Utility: Consumers always prefer more of a good to less, so bundles on higher indifference curves are preferred to those on lower ones.
  3. Do Not Cross: Indifference curves cannot intersect. If they did, it would imply that a single consumption bundle provides two different levels of utility, which is a contradiction.
  4. Bowed Inward (Convex to the Origin): This shape reflects the Law of Diminishing Marginal Rate of Substitution (MRS).
     • It signifies that a consumer's willingness to trade away a good they have in abundance diminishes as they consume more of it and less of the other.
     • Put differently, as you move down an indifference curve, giving up units of the good on the vertical axis (Y) to get more of the good on the horizontal axis (X), the amount of Y you are willing to give up for an additional unit of X decreases.
• Slope of an Indifference Curve: The slope of an indifference curve at any point is called the Marginal Rate of Substitution (MRS).
  • The MRS is the rate at which a consumer is willing to exchange one good for another while maintaining a constant level of satisfaction.

IV. Consumer Choice and Utility Maximization

• Purpose of Consumer Choice Theory: It provides the foundation for understanding product demand and examines the tradeoffs inherent in decisions made by consumers. Its goal is to explain how consumers maximize their utility given their budget constraints.
• Rational Consumer: A rational consumer is likely to have maximized his/her utility.
• Optimal Consumption Bundle: This is the bundle of goods that provides the highest possible utility to the consumer, given their budget constraint.
  • Graphically, this occurs where the highest attainable indifference curve is tangent to the budget line. At this point, the slope of the indifference curve (MRS) equals the slope of the budget line (price ratio).
  • Mathematically, for two goods X and Y, the utility-maximizing condition is: $\frac{MU<em>X}{P</em>X} = \frac{MU<em>Y}{P</em>Y}$ This means the marginal utility per dollar spent on each good is equal.
• Example of Utility Maximization (with discrete units):
  • Given income and prices, consumers will purchase goods by allocating their spending to units that provide the highest marginal utility per dollar, continuing until the budget is exhausted or $MUX/PX = MUY/PY for the last dollar spent on each good.
  • Case 1: Income RM10, Salad P=RM3, Sausage Roll P=RM2
    • Thomas's optimal consumption bundle is 2 Salads and 2 Sausage Rolls ($3 \times 2 + 2 \times 2 = RM10$).
    • At this bundle, the total utility from Salads is from the $1^{st}$ (15) and $2^{nd}$ (10) units, so $TU<em>S = 15+10 = 25$. The total utility from Sausage Rolls is from the $1^{st}$ (20) and $2^{nd}$ (10) units, so $TU</em>{SR} = 20+10 = 30$. Total utility $25+30=55$.
  • Case 2: Income RM18, Salad P=RM3, Sausage Roll P=RM2
    • Thomas's optimal consumption bundle is 4 Salads and 3 Sausage Rolls ($3 \times 4 + 2 \times 3 = RM18$).
    • Total utility $TU<em>S(4) = 40$. $TU</em>{SR}(3) = 36$. Total utility $40+36=76$.

V. Effects of Price and Income Changes

• Two Effects of a Price Change:
  1. Substitution Effect: The change in consumption that results from a change in the relative attractiveness of goods due to a price change, holding utility constant.
     • This effect moves the consumer along the same indifference curve to a point with a new marginal rate of substitution.
  2. Income Effect: The change in consumption that results from the change in the consumer's real purchasing power due to a price change.
• Normal vs. Inferior Goods (Example):
  • Assume Coffee is an inferior good and Snickers is a normal good. If the price of Snickers increases:
    • Substitution Effect: Snickers becomes relatively more expensive, so consumption of Snickers decreases.
    • Income Effect: Real income decreases. Since Snickers is a normal good, its consumption decreases. Since Coffee is an inferior good, its consumption increases.
    • Overall Result: A decrease in Snickers consumption and an increase in Coffee consumption (assuming the income effect for coffee outweighs any substitution effect pushing for less coffee).

VI. Approaches to Utility

• Cardinal Approach:
  • Assumes utility is measurable and quantifiable, assignable with numerical values (e.g.,