Chapter 4 - Theory Of Consumer Behaviour 4g4m24

Principles of Economics second edition © Oxford Fajar Sdn. Bhd. (008974-T) 2010

All Rights Reserved Ch. 4: 1

CHAPTER

4

CONSUMER BEHAVIOUR



DEFINITION OF CONSUMER BEHAVIOUR

Consumer behaviour refers to the study of consumer while engaged in the process of consumption.



UTILITY APPROACH Definition  ‘Utility’ means the satisfaction obtained from consuming

a commodity.

Two Types of Approach 1. Cardinal Approach  The cardinal utility theory says that utility is measurable and by placing a

number of alternatives so that the utility can be added.  The index used to measure utility is called utils.

2. Ordinal Approach  The ordinal utility theory says that utility is not measurable but it can be

compared.  Ordinal approach uses the ranking of alternatives as first, second, third and so on. Principles of Economics second edition © Oxford Fajar Sdn. Bhd. (008974-T) 2010


TOTAL UTILITY AND MARGINAL UTILITY TOTAL UTILITY (TU) The total satisfaction that a person gets from the consumption of goods and service.

MARGINAL UTILITY (MU) The additional to total utility as a result of consuming one more units of the same good or services. Marginal Utility (MU)

=

Change in Total Utility Change in Total Quantity

MU =  TU/  Q



LAW OF DIMINISHING MARGINAL UTILITY  Definition The additional benefit which a person derives from a given increase of a stock of a thing diminishes, other things being equal, with every increase in the stock that he already has. OR Law of Diminishing Marginal Utility states that as consumption increases more and more, marginal utility will be less and less.



LAW OF DIMINISHING MARGINAL UTILITY (cont.) TU increases from consumption of 1st unit of apple until the 5th unit of apples. After the 5th unit of apples, TU will decrease.

Units of Apples

Total Utility

Marginal Utility

1 2 3 4 5 6 7 8

20 35 45 50 50 45 35 20

20 15 10 5 0 -5 -10 -15


MU will decrease and become zero at the 5th unit of apples and further consumption of apples will not satisfy the consumer as the MU shows negative signs.


LAW OF DIMINISHING MARGINAL UTILITY (cont.) When TU is increasing, MU will be positive. When TU is at its maximum, MU will be zero. When TU is decreasing, MU will be negative.



LAW OF EQUI-MARGINAL UTILITY (EMU)  Definition The Law of Equi-Marginal Utility (EMU) states that other things being equal, a consumer gets maximum satisfaction when he allocates his limited income to the purchase of different goods, where the marginal utility derived from the last unit of money spent on each item of expenditure tends to be equal.  This is also known as conditions for maximum utility

or satisfaction.



LAW OF EQUI-MARGINAL UTILITY (EMU) (cont.) Conditions for Equilibrium For consumer equilibrium, this condition must be fulfilled. Condition 1: Every ringgit spent on every commodity must yield the same marginal utility. Marginal Utility of X Price of X

=

Marginal Utility of Y Price of Y

MUx = MUy =… = MUn Px Py Pn

Condition 2: Total expenditure of all goods must be equal to the total budget allocated to maximize utility. P1Q1 + P2Q2 + … + PnQn = Total budget



LAW OF EQUI-MARGINAL UTILITY (EMU) (cont.) EXAMPLE: Arwin has an income of RM37 and the prices of goods P, Q and R are RM5, RM1 and RM4 respectively. Fulfilling condition 1, two combination of goods are obtained: Combination 1 : 2P, 4Q and 1R Combination 2 : 4P, 5Q and 3R

Condition 1 : Every ringgit spent on every commodity must yield the same marginal utility.

Quantity

1 2 3 4 5 6 7

Product P Total MUP/PP Utility 21 41 59 74 85 91 91

Condition 2 : Total expenditure of all goods must be equal to the total budget allocated to maximize utility.


4.2 4 3.6 3 2.2 1.2 0

Product Q Total MUQ/PQ Utility 7 13 18 22 25 27 28

7 6 5 4 3 2 1

Product R Total Utility MUR/PR 16 30 42 50 55 58 60

4 3.5 3 2 1.25 0.75 0.5

Combination 1 : 2P, 4Q and 1R 2(5) + 4(1) + 1(4) = 18 Combination 2 : 4P, 5Q and 3R 4(5) + 5(1) + 3(4) = 37 So, 4 units of Product P, 5 units of Product Q and 3 units of Product R will be purchased by Arwin. All Rights Reserved Ch. 4: 11

INDIFFERENCE CURVE Definition  An indifference curve represents all the possible combinations

of two goods which will give the same level of satisfaction.

Assumptions 1. Scale of preferences 2. Consumers’ preferences are transitivity 3. Rationality 4. Diminishing marginal rate of substitution 5. Concept of ordinal utility



INDIFFERENCE CURVE (cont.) An indifference schedule is a list of combination of two goods that give equal satisfaction to the consumer.

Combinations

Good Y

Good X

A

12

2

B

6

4

C

4

6

D

3

8

E

2

12

The table above shows all the five combinations, which will give the equal level of satisfaction. Principles of Economics second edition © Oxford Fajar Sdn. Bhd. (008974-T) 2010


INDIFFERENCE CURVE (cont.) An indifference curve represents all those combinations of two goods; X and Y which yield the same level of satisfaction to a consumer.



INDIFFERENCE MAP An indifference map shows a set of indifference curve.

The higher the indifference curve from the origin, higher will be the utility. IC3 has the higher satisfaction. Principles of Economics second edition © Oxford Fajar Sdn. Bhd. (008974-T) 2010


INDIFFERENCE CURVE  Marginal Rate of Technical Substitution

- Refers to the rate at which one good is substituted for another good. Combinations

Good Y

Good X

A B

12 8

1 2

Marginal Rate of Substitution 4Y : 1X

C D

5 3

3 4

3Y : IX 2Y : 1X

E

1

5

1Y : 1X

 Characteristics of Indifference Curve 1. Indifference curve slopes downward from left to right. 2. Indifference curve are convex to the origin. 3. Higher indifference curves represent higher level of satisfaction. 4. Indifference curve never intersect each other. 5. Indifference curve does not touch the Y axis or X axis. Principles of Economics second edition © Oxford Fajar Sdn. Bhd. (008974-T) 2010


BUDGET LINE A budget line represents various combinations of two goods, which can be purchased with a given amount of money at the given price of each unit.



CHANGES IN BUDGET LINE 1. Change in Consumer’s Income

An increase in consumer’s income will lead to a shift of the budget line to the right, A1B1 A decrease in consumer’s income will shift the budget line to the left as represented by A2B2 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. (008974-T) 2010


CHANGES IN BUDGET LINE 2. Change in Price of Good X Budget Line

Budget Line 30

30

25 20

AB

15

A1B1

Good Y 10

Good Y

Good Y

20

AB

10

5

A1B1 0

0 2

4

6

8

10

12

14

Good X

Price of good X increase from RM1 to RM2 and price of good Y constant


2

4

6

8

10 12 14 16 18 20 22 24

Good X Good X

Price of good X decrease from RM1 to RM0.50 and price of good Y constant


CHANGES IN BUDGET LINE 3. Change in Price of Good Y Budget Line

30

30

25

25

20

20

AB

15

AB1

Good Y 10 5

Good Y

Good Y

Budget Line

AB

15

AB1

Good Y 10 5

0

0 2

4

6

8

10

12

14

Good X

Price of good Y increase from RM0.50 to RM1 and price of good X constant


2

4

6

8

10

12

14

Good X

Price of good Y decrease from RM0.50 to RM0.40 and price of good X constant


CONSUMER EQUILIBRIUM A consumer is in equilibrium when he or she is consuming the best possible combination of two goods with the given amount of income.

At point b, and e, the consumer will have a lesser satisfaction at IC3 with the same amount of income

Consumer equilibrium is reached when indifference curve tangent with budget Line which represents best combination of two goods with limited income as point C.



INCOME, PRICE AND SUBSTITUTION EFFECT  INCOME EFFECT The income effect is defined as the effect on the purchases of the consumer caused by changes in income with prices of goods remaining constant.

 PRICE EFFECT Price effect explains what happens to the consumers’ equilibrium position when the price of one good changes while the price of another good and other factors remains constant.

 SUBSTITUTION EFFECT Substitution effect explains what happens to the consumers’ equilibrium position when the price of both good changes – price of one rises and price of another falls while other factors remains constant. Principles of Economics second edition © Oxford Fajar Sdn. Bhd. (008974-T) 2010


CONSUMER SURPLUS Consumer surplus is defined as the excess of what a consumer is willing to pay and what he/she actually pays. Example : Suppose Sally who is fond of chocolates is ready to pay for each successive bar of chocolate as shown in table below. Assume that Sally is willing to pay lower price for the successive bar of chocolates. Assume the market price of one bar of chocolate is RM1.00.

Bars of chocolate

1

2

3

4

5

Price (RM)

2.50

2.00

1.50

1.00

0.80

CONSUMER SURPLUS = TOTAL VALUE – (MARKET PRICE x NUMBER OF UNITS CONSUMED) Price (RM)

2.50

CONSUMER SURPLUS

1.00 DD

0

Consumer surplus = (2.50 + 2 + 1.50 + 1) – (1 x 4) = RM3.00 Quantity

4



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