Unit 2: Theory of Consumer Behaviour

1. Cardinal utility vs Ordinal utility

Utility is the measure of satisfaction a consumer gets from consuming a good or service. There are two main approaches to measuring it:

2. Cardinal Utility and Optimum Choice

The cardinal approach assumes you can measure satisfaction. The goal of the consumer is to maximize their total utility.

• Total Utility (TU): The total satisfaction from consuming *all* units of a good.
• Marginal Utility (MU): The *additional* satisfaction from consuming *one more* unit of a good.

  MU = (Change in TU) / (Change in Quantity)

Optimum Choice (Law of Equi-Marginal Utility):
A consumer is at their optimum (maximizing utility) when they have allocated their income so that the last dollar spent on every good gives them the same amount of marginal utility.

MU_X / P_X = MU_Y / P_Y = ... = MU_M (Marginal Utility of Money)

• MU_X / P_X is the "bang for your buck" from good X.
• If (MU_X / P_X) > (MU_Y / P_Y), you are getting more satisfaction per dollar from good X. You should buy *more* X and *less* Y.
• As you buy more X, its MU falls (see LDMU), and as you buy less Y, its MU rises. This continues until they become equal.

3. Law of Diminishing Marginal Utility (LDMU)

The Law: Ceteris paribus, as a person consumes more and more units of a good, the marginal utility (additional satisfaction) derived from each successive unit will eventually decrease.

Example: The first slice of pizza gives you 20 utils (you're starving). The second gives 15 utils. The third gives 8 utils. The eighth slice might give 0 or even negative utils (you feel sick).

This law is the reason why the demand curve slopes downwards.

4. Indifference Curve and Indifference Map

This is the main tool of the ordinal utility approach.

Indifference Curve (IC): A curve that shows all the different combinations (bundles) of two goods that give a consumer the same level of satisfaction (utility).

The consumer is "indifferent" between any two points on the same IC.

Properties of Indifference Curves:

1. They are downward sloping: To get more of Good X, you must give up some of Good Y to stay at the same satisfaction level.
2. They are convex to the origin: This reflects the Diminishing Marginal Rate of Substitution (MRS).
   • MRS: The rate at which a consumer is willing to give up Good Y to get one more unit of Good X.
   • Diminishing MRS: When you have a lot of Y and little X, you'll give up a lot of Y for one X. When you have little Y and a lot of X, you'll give up very little Y for one more X.
3. Higher ICs represent higher utility: A bundle on IC₂ is always preferred to a bundle on IC₁.
4. ICs never intersect: This would violate the assumption of rational preferences (transitivity).

An Indifference Map is a collection of many indifference curves, showing the consumer's entire preference system.

5. Budget Constraint (or Budget Line)

The budget line shows all the combinations of two goods that a consumer can purchase, given their income (M) and the prices of the goods (P_X, P_Y).

Equation of the Budget Line:
(P_X * Q_X) + (P_Y * Q_Y) = M

The slope of the budget line is -(P_X / P_Y). It represents the market rate of trade-off (opportunity cost).

6. Consumer's Optimum Choice (Ordinal Approach)

The consumer wants to reach the highest possible indifference curve while staying on or inside their budget line.

This "optimum" or "equilibrium" occurs at the point of tangency between the budget line and an indifference curve.

At the point of tangency:

Slope of IC = Slope of Budget Line
MRS = P_X / P_Y

This is the same conclusion as the cardinal approach (MU_X/MU_Y = P_X/P_Y), just derived differently.

7. Price Consumption Curve (PCC) and Income Consumption Curve (ICC)

• Income Consumption Curve (ICC): Shows how the consumer's optimal bundle changes when their income changes (holding prices constant). It is the line connecting all the tangency points as the budget line shifts outwards.
  • For normal goods, the ICC slopes upwards.
  • For an inferior good, the ICC will bend backwards.
• Price Consumption Curve (PCC): Shows how the consumer's optimal bundle changes when the price of one good changes (holding income and the other price constant). It is the line connecting all the tangency points as the budget line rotates.

8. Income and Substitution Effects (Hicks and Slutsky)

When the price of a good (e.g., Good X) falls, the consumer buys more of it. This total change in quantity (the "Price Effect") can be broken down into two parts:

1. Substitution Effect (SE):
   • What is it? The change in consumption due to the good becoming *relatively cheaper* than other goods.
   • Direction: Always positive. You *always* buy more of the good that has become cheaper.
2. Income Effect (IE):
   • What is it? The change in consumption due to the price drop *increasing your real income* (your purchasing power). You feel richer.
   • Direction:
     • Normal Good: Positive (you buy more).
     • Inferior Good: Negative (you buy less).

Price Effect = Substitution Effect + Income Effect

The Hicksian and Slutsky methods are two different ways of graphically separating these two effects.

• Hicksian Method: Uses a "compensating" budget line that is tangent to the *original* indifference curve.
• Slutsky Method: Uses a compensating budget line that passes through the *original* bundle.

9. Derivation of Demand Curves from ICs

The individual demand curve can be derived directly from the Price Consumption Curve (PCC).

How to do it:

1. Start with a consumer in equilibrium at price P₁ (e.g., 10) and quantity Q₁ (e.g., 5 units).
2. Now, let the price of the good fall to P₂ (e.g.,5). The budget line rotates outwards.
3. The consumer finds a new equilibrium on a higher IC, at quantity Q₂ (e.g., 12 units).
4. In a new graph (with Price on the Y-axis and Quantity on the X-axis), plot these two points: (P=10, Q=5) and (P=5, Q=12).
5. Connecting these points gives you the consumer's demand curve.