THE THEORY OF INDIVIDUAL BEHAVIOUR

Unit Objectives
By the end of this unit, you should be able to:

1. Know the meaning of consumer behaviour

 Understand the standard economic model
 Understand the concept of total and marginal utility
 Know what consumer preferences are
 Define the concept of indifference curve
2. Understand the constraints of consumer behaviour
 Budget constraint
 Changes in income
 Changes in prices
 Consumer equilibrium

Introduction
This chapter develops tools that can help a manager to understand the behaviour of
individuals, such as consumers and workers, and the impact of alternative incentives on their
decisions. The human brain is capable of processing vast amounts of information and making
complex decisions. The brain can perform tasks that even supercomputers and advanced
‘artificial intelligence’ are unable to do.

Despite the complexities of human thought processes, managers need a model to

explain how people behave in the market and workplace. Understanding individual behavior
is a valuable skill for managers to succeed in the business world. While our model of
behaviour is an abstraction of how individuals make decisions in reality, it can still provide a
useful tool for managers to predict behaviour.

Consumer behaviour
Consumers are individuals who purchase goods and services from firms for personal
use. Behaviour refers to the way a person or organism responds or reacts to a normal or
specific situation. Consumer behaviour is concerned with how consumers react to various
choices and alternatives. Managers must focus not only on the consumer but the purchaser of
the product as well. For example, a baby food manufacturer should understand the parents'
behavior, not the baby's.
 Understanding consumer behaviour is the first step in making profitable pricing,
advertising, product design, and production decisions. Firms spend a great deal of time and
money trying to estimate and forecast the demand for their products. Obtaining accurate
estimates of demand requires more than a superficial understanding of the underpinnings of
demand functions. A manager’s need for practical analysis of demand, both estimation of
demand and demand forecasting, requires an economic model of consumer behaviour to
guide the analysis.

In characterizing consumer behavior, there are two important but distinct factors to
consider: consumer opportunities and consumer preferences. Consumer opportunities
represent the possible goods and services consumers can afford to consume. Consumer
preferences determine which of these goods will be consumed. The distinction is very
important: While I can afford (and thus have the opportunity to consume) one pound of beef
liver each week, my preferences are such that I would be unlikely to choose to consume beef
liver at all. Keeping this distinction in mind, let us begin by modeling consumer preferences.

Standard economic model

There are some key assumptions of the standard economic model which is important to keep
in mind. These assumptions are

1. Buyers or economic agents are rational:

2. More is preferred to less: We are going to assume that consumers always prefer to
have more of a good rather than less of the good. For instance, if bundle A has at least
as much of every good as bundle B and more of some good, bundle A is preferred to
bundle B.
3. Buyers seek to maximize their utility: As a basic premise for analyzing consumer
behavior, we will assume that all individuals make consumption decisions with the
goal of maximizing their total satisfaction from consuming various goods and
services, subject to the constraint that their spending on goods exactly equals their
incomes. buyers are assumed to know the full range of products and services
available, as well as the capacity of each product to provide utility. We also assume
they know the price of each good and their incomes during the time period in
question.
Properties of consumer preference
Consumer theory requires that consumers be able to rank (or to order) various
combinations of goods and services according to the level of satisfaction associated with each
combination. Such combinations of goods or services are called consumption bundles. The
figure below shows a number of typical consumption bundles for two goods, X and Y. Bundle
A consists of 10 units of good X and 60 units of good Y, bundle B consists of 20X and 40Y,
bundle C consists of 40X and 20Y, and so on. Two important assumptions must be made
about how people rank bundles of goods: consumer preferences must be complete and
transitive

Complete Preference Ordering: For any given pair of consumption bundles, consumers
must be able to rank the bundles according to the level of satisfaction they would enjoy from
consuming the bundles. A consumption bundle would be ranked higher (i.e., preferred) than
another bundle if the preferred bundle yields more satisfaction than the other, less-preferred
bundle. Or, if the two bundles yield exactly the same level of satisfaction, the consumer
would be indifferent between the two bundles and would give the two bundles the same
ranking. When a consumer can rank all conceivable bundles of commodities, the consumer’s
preferences are said to be complete.

Transitive preference ordering: Consumer preferences are transitive when they are
consistent in the following way. If bundle A is preferred to bundle B, and bundle B is
preferred to bundle C, then bundle A must be preferred to bundle C. Using the symbols
presented above: If A s B, and B s C, then it follows that A s C. Consumer preferences must
be transitive, otherwise inconsistent preferences would undermine the ability of consumer
theory to explain or predict the bundles consumers will choose

The concept of utility

Utility refers to the benefits consumers obtain from the goods and services they consume.

Total and marginal utility

Given the assumption that consumers prefer more to less, intuition might tell us that
total utility increases as consumption increases. However, this may be true up to a point. For
instance: You have walked for 15 hours. You are hot, sweaty, and very thirsty. After a few
minutes, you came across ‘an ice water seller’ and decided to buy some. If you were asked to
rate the satisfaction derived from consuming the 1st sachet out of 10 (utils) at that time you
might rate it at 10. You order a 2nd sachet as you are still thirsty; the 2nd sachet still brings
some satisfaction, but if asked to rate it you might give it 8, Total utility now is 18 utils – the
second sachet has increased total utility – However, you did not rate the 2nd sachet quite as
high as the 1st because some of your thirst has been quenched. Marginal utility measures the
addition to total utility due to the consumption of an extra unit. The marginal utility of the 1st
sachet was 10 but for the 2nd sachet, marginal utility was 8.

The utility function

Consumer preferences can be represented as a utility function. A utility function shows an
individual’s perception of the level of utility that would be attained from consuming each
conceivable bundle or combination of goods and services. A simple form of a utility function
for a person who consumes only two goods, X and Y, might be

U= f (X, Y)

where X and Y are, respectively, the amounts of goods X and Y consumed, f means “a
function of” or “depends on,” and U is the amount of utility the person receives from each
combination of X and Y. Thus, utility depends on the quantities consumed of X and Y. The
actual numbers assigned to the levels of utility are arbitrary. We need only say that if a
consumer prefers one combination of goods, say, 25X and 35Y, to some other combination,
say, 10X and 25Y, the amount of utility derived from the first bundle is greater than the
amount from the second

U= f(25,35) ˃ U f (10,25 )

Indifference curve
Limitations
In making decisions, individuals face constraints. There are legal constraints, time
constraints, physical constraints, and, of course, budget constraints. To maintain our focus on
the essentials of managerial economics without delving into issues beyond the scope of this
course, we will examine the role prices and income play in constraining consumer behavior.
Budget constraint
Simply stated, the budget constraint restricts consumer behavior by forcing the consumer to
select a bundle of goods that is affordable. If a consumer has only $30 in his or her pocket
when reaching the checkout line in the supermarket, the total value of the goods the consumer
presents to the cashier cannot exceed $30. To demonstrate how the presence of a budget
constraint restricts the consumer’s choice, we need some additional shorthand notation. Let
M represent the consumer’s income, which can be any amount. By using M instead of a
particular value of income, we gain generality in that the theory is valid for a consumer with
any income level. We will let Px and Py represent the prices of goods X and Y, respectively.
Given this notation, the opportunity set
also called the budget set(The bundles of goods a consumer can afford) may be expressed
mathematically as

PxX + PyY ≤ M
In words, the budget set defines the combinations of goods X and Y that are affordable for the
consumer: The consumer’s expenditures on good X, plus her or his expenditures on good Y,
do not exceed the consumer’s income. Note that if the consumer spends his or her entire
income on the two goods, this equation holds with equality. This relation is called the budget
line (The bundles of goods that exhaust a consumer’s income)

PxX + PyY = M
In other words, the budget line defines all the combinations of goods X and Y that exactly
exhaust the consumer’s income.
It is useful to manipulate the equation for the budget line to obtain an alternative expression
for the budget constraint in slope-intercept form. If we multiply both sides of the budget line
by 1/Py, we get
Px M
X +Y=
Py Py
Solving for Y yields
 M Px
Y= − X
Py Py
M Px
Note that Y is a linear function of X with a vertical intercept of and a slope of – . The
Py Py
upper boundary of the budget set in the Figure below is the budget line.
Opportunity set

Budget Line
M Px
Y= − X
Py Py
n

M
Py
Unaffordable

 H
PPPP

M
0
Px
Affordable

Similarly, if the consumer spent his or her entire income on good Y, expenditures on Y would
exactly equal income:
Py Y = M
Consequently, the maximum quantity of good Y that is affordable is
M
Y=
Py
Px
The slope of the budget line is given by – and represents the market rate of substitution
Py
between goods X and Y.
Market rate of substitution
To obtain a better understanding of the market rate of substitution between goods X and Y,
consider in the Figure below, which presents a budget line for a consumer who has $10 in
income and faces a price of $1 for good X and a price of $2 for good Y. If we substitute these
values of Px, Py, and M into the formula for the budget line, we observe that the vertical
M 10
intercept of the budget line (the maximum amount of good Y that is affordable) is = =¿
Py 2
 M 10
5. The horizontal intercept is = =10and represents the maximum amount of good X
Px 1
that can be purchased. The slope of the budget line is –
Px
Py
=−
1
2
. ()
The reason the slope of the budget line represents the market rate of substitution between the
two goods is as follows: Suppose a consumer purchased bundle A in the Figure below, which
represents the situation where the consumer purchases 3 units of good Y and 4 units of good
X. If the consumer purchased bundle B instead of bundle A, she would gain one additional
unit of good Y. But to afford this, she must give up 2 units (4 − 2 = 2) of good X. For every
unit of good Y the consumer purchases, she must give up 2 units of good X in order to be able
to afford the additional unit of good Y. Thus the market rate of substitution is
Δ Y 4 – 3 −1
= = ,which the slope of the budget line is.
ΔX 2–4 2
Y

5
4

X
2 4 10

Changes in income
The consumer’s opportunity set depends on market prices and the consumer’s income. As these parameters
change, so will the consumer’s opportunities. Let us now examine the effects on the opportunity set of changes
in income by assuming prices remain constant.

If a consumer spent the entire income on good X, the expenditures on good X would exactly equal the
consumer’s budget constraint is graphed in Figure 4–3. The shaded area represents the consumer’s budget set, or
opportunity set. In particular, any combination of goods X and Y within the shaded area, such as point G,
represents an affordable combination of X and Y. Any point above the shaded area, such as point H, represents a
bundle of goods that is unaffordable. consumer’s income:
Px X = M