Chapter 3
Chapter 3
Chapter 3
Consumer behavior
The study of individuals, groups, or organizations and all the
activities associated with the purchase, use and disposal of goods
and services to satisfy their needs and wants.
The process whereby individuals decide whether, what, when,
where, how, and from whom to purchase goods and services.
The study of the buying units and the exchange processes
involved in acquiring, consuming, and disposing of goods,
services, experiences, and ideas.
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THEORY OF UTILITY AND PREFERENCES
Theory of utility: is the amount of satisfaction that you will get from
the consumption of a product or service
Consumer preferences: is an individual / house holds who uses/
consumes final goods and service with a primary objective of
maximizing utility.
The consumer preferences are divided into:
Strict preference
Weak preference
Indifference preference
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Cont.……
i. Strict preference
Given any two consumption bundles X and Y, if X > Y or if he
chooses X when Y is available the consumer, definitely prefers the X-
bundle than Y.
ii. Weak preference
Weak preference means either strict preference or indifference.
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Cont.……
iii. More is better than less
Consumers always prefer more of any good to less and they are never
satisfied.
However, bad goods are not desirable and consumers will always
prefer less of them.
In defining strict preference, the consumer preferred bundle X to
bundle Y if and only if the utility X is larger than the utility of Y.
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Approaches to measure Utility
Two approaches:
a) Cardinal and
b) ordinal approaches.
The Cardinal Utility theory
Utility can be quantitatively measured like weight,
height, & temperature with a unit of measurement of
satisfaction called utils.
A util is a cardinal number like 1,2,3 etc simply attached to
utility.
It is a hypothetical satisfaction unit measuring .
Assumptions of Cardinal Utility theory
A. Rationality of consumers
It means that the consumers consume first a commodity which yields the
the consumer.
A given unit of money deserves the same value at any time or place it is to
be spent. 6
Cont.….
D. Limited Money Income
The consumer has limited money income to spend on the goods
and services, he/she chooses to consume.
E. Diminishing Marginal Utility (DMU)
The marginal utility of a commodity diminishes as the
consumer consumes more quantities of the commodity.
Units of
Quantity
(x)
consumed 0 1st 2nd 3rd 4th 5th 6th
Unit Unit unit unit unit Unit Unit
MUX 0 10 6 4 2 0 -2
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Graphically, MU is the slope of total utility.
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As the consumer consumes more of a goods;
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Limitation of the Cardinalist approach
changes.
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2. The Ordinal Utility Theory
The ordinalist school postulates that utility cannot be
measured absolutely but different consumption
bundles are ranked according to preferences.
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Assumptions of Ordinal Utility theory
1. The Consumers are rational
2. Utility is ordinal i.e. utility is not absolutely (cardinally)
measurable.
Consumers are required only to order or rank their
preference
3. Diminishing Marginal Rate of Substitution (MRS):
It is the rate at which a consumer is willing to substitute one commodity
(x) for another commodity (y) so that his total satisfaction remains the
same.
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Assumptions of Ordinal Utility theory----------
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Indifference Set, Curve and Map
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Table2.4 Indifference Schedule
Bundle A B C D
(Combination)
Orange(X) 1 2 4 7
Banana (Y) 10 6 3 1
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Indifference Curves:
Is the locus of points shows the various
combinations of two goods that provide the
consumer the same level of satisfaction;
so that the consumer is indifferent as to the
particular combination he/she consumes.
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By transforming the above indifference schedule
into graphical representation, we get an indifference
curve.
10 A
Banana Good B
(Y) Indifference
B
Curve (IC)
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C
2 IC3
D IC2
1
IC1
1 2 4 7 Good A
OrangeX)) (X)
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Properties of ICs
a) Are negatively sloped
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C) A higher IC is always preferred to a lower
one.
The further away from the origin an IC lies,
the higher the level of utility it satisfies:
D) Are convex to the origin
E) The slope of an indifference curve
decreases as we move along the curve from the
left downwards to the right.
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Positively sloped and intersected ICs
Banana B
Banana
E
D IC2
C
A
IC1
Orange Orange X
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Marginal rate of substitution (MRS)
Marginal rate of substitution is a rate at which
consumers are willing to substitute one
commodity for another in such a way that the
consumer remains on the same indifference
curve.
It shows a consumer‘s willingness to substitute
one good for another while he/she is indifferent
between the bundles.
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MRS Cont.….
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The Budget Line
Is a graph indicating d/t combinations of two goods that
a consumer can buy with a given income at a given
prices.
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Budget Line Equation
We can express the budget constraint as:
M PX X PY Y
Where, PX = price of good X
PY = price of good Y
X = quantity of good X
Y= quantity of good Y
M= consumer’s money income
This means that consumer’s money income is the amount
of money spent on X plus the amount spent on Y.
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Example:
Suppose a household with 30 Birr per day to
spend on banana(X) at 5 Birr each and Orange(Y)
at 2 Birr each.
5X + 2Y = 30
From this equation we can have d/t alternative
purchase possibilities of the two goods
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5X + 2Y = 30
Consumption
A B C D E F
Alternatives
Kgs of banana (X) 0 1 2 3 4 6
Total Expenditure 30 30 30 30 30 30
M/PY
B
A
M/PX
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Factors Affecting the Budget Line
1. Changes in consumer income
If the income of the consumer changes (keeping the
prices of the commodities unchanged), the budget line
shifts (changes).
upward shift of the budget line if increase in
income;
downward shift of the budget line if decrease in
income; that leads the consumer to buy less quantity
of the two goods.
but the slope of the budget line does not changes
when income changes.
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Fig.2.8 Effects of change in income
M/Py
B B2
M1/Py
B1
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2. Changes in Price of the commodities
Y Y
B1 B1
B
B
X X
Fig.a Fig.b
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Changes in the prices of X and Y ;
shifts the budget line
changes the intercept of budget
line
changes slope of the budget
line
( PX / PY ). =
MRS XY
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Figure2.14 Consumer equilibrium
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END!!
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