Consumer Behaviour

[Qurratulain]

Theory of consumer choice


Utility

Economists use the term utility to describe the satisfaction or enjoyment derived from the consumption of a good or service. If we assume that consumers act rationally, this means they will choose between different goods and services so as to maximize total satisfaction or total utility.
Consumers will take into consideration

• How much satisfaction they get from buying and then consuming an extra unit of a good or service

• The price that they have to pay to make this purchase

• The satisfaction derived from consuming alternative products

• The prices of alternatives goods and services


Marginal utility

Marginal Utility is the change in total utility or satisfaction resulting from the consumption of one more unit of a good.
The hypothesis of diminishing marginal utility states that as the quantity of a good consumed increases, the marginal utility derived from that good decreases.

Example - A consumer enjoys successive pints of his favourite beer. The total and marginal utility gained from each extra pint in shown in the table below. Total utility is maximised when marginal utility = zero. Consuming the seventh pint would create dis-utility as total utility falls (marginal utility becomes negative)

[Qurratulain]

Graphical Representation

[Qurratulain]

Law of equi marginal returns


A rational consumer will spend his/her income in a way that maximises the total utility derived from all goods and services consumed.
Consider an example where a consumer has a choice between two goods A and B which have prices Pa and Pb respectively.
Total Utility will be maximised when the utility derived from the last pound's worth of A is equal to the utility derived from the last pound's worth of B.

[Qurratulain]

Graphical Representation (Equi marginal Utility)

[Qurratulain]

DERIVING THE DEMAND CURVE


Consider what happens to the law of equi-marginal returns when the price of good A falls. The equality now becomes an inequality, since the consumer now receives greater utility per pound's worth of A than from good B. In order to restore the equality and to increase total utility a rational individual will consume more of good A.

As consumption increases the marginal utility derived from good A will diminish until the above equi-marginal condition has been restored and total utility is maximised. A fall in the price of good A has resulted in an increase in quantity demanded


CRITICISMS OF UTILITY THEORY


Some economists claim that utility cannot be measured objectively. There are also doubts about the assumption of rational behaviour among consumers - particularly in a world where consumers cannot expect to have all the information available on the products available in a market.


The importance of consumer feedback

In standard price theory, the preferences of consumers are taken as fixed - yet we observe that consumer's behaviour in a market is often influenced by their interaction with other consumers and this then affects demand.
A good example of this is the behaviour of consumers who attend showings of a new film at a cinema. Their reaction to a film will often determine how many other people choose to pay to watch the same film. Consumer feedback may be more significant than any amount of hype and advertising before a film is released.

Another good example is the feedback of consumers who visit a local restaurant or feedback from people who have stayed at a particular holiday resort. Their experiences may exert a significant influence on the preferences and choices of other consumers. It is little wonder that many successful firms trace some of their success at their willingness and ability to respond pro-actively to consumer feedback.

[Qurratulain]

Building Demand with Indifference Curve Analysis


Formal construction of an demand curve requires combining the preference representation (Indifference Curves) with the affordable set of points. This affordable set is discovered by constructing the budget constraint. Suppose the consumer has income of $Y and can choose between buying Cokes (C) or Snickers (S). If PC represents the price of Cokes and PS represents the price of Snickers, then the budgetary problem says that the consumer must live under the constraint:


(1) Y = PS S + PC C

Actually, the consumer could spend less than Y so that the right hand side of equation (1) could be less than the left hand side. But, as we shall see, utility maximization will always find the consumer on the boundary of the affordable set. Thus, we keep the strict equality sign in equation (1).
To graph this line on the axes system at the right, we solve for the good on the vertical axis, C, and find that the line is C = (Y/PC) - (PS/PC) S. That is, the form of the budget constraint is linear with the vertical intercept of (Y/PC) and a slope of - (PS/PC). Of course, this simply confirms our intuition. If the consumer spends all of her income on Snickers, she can buy just Y/PS snickers if all she wanted to purchase was Snickers. Of course, most folks do not find themselves at such polar extremes; they end up purchasing some amount of both commodities. The Budget Constraint is the formal representation of the line that represents the boundary of the full set of affordable points.

We can rewrite equation (1) as:

(2) C = (Y/PC) - (PS/PC) S

Graphically, this produces a downward sloping line with vertical intercept of (Y/PC) and slope of -(PS/PC). Figure 1 depicts this graph. All points on the Budget Constraint, the blue line in Figure 1, are affordable to this consumer. Obviously, all points interior to this line are also affordable.

[Qurratulain]

****Figure 1****

[Qurratulain]

Changes in Income: What happens when income (Y) changes? First, note that the only thing we have changed is income. There has been no change in either PC or PS. Suppose that Y increases by 10% to a new level denoted by Y' Look at the vertical intercept. This point measures the maximum amount the consumer could buy if all she wanted to purchase was the good on the vertical axis. If income increases by 10% with price fixed, she could buy 10% more of the product. Likewise, if all she wanted to buy was the product on the horizontal axis, then she could buy 10% more of that good. Thus, since both intercepts increase by 10%, the new budget constraint is shifted out in a parallel fashion. Of course, from equation (2) above, you see this since the income changes have no impact on the slope coefficient, the term - (PS/PC).

You should be able to see that an income decrease, holding all prices fixed would simply shift the budget constraint in toward the origin, with no change in the slope of the line.

[Qurratulain]

****Figure 2****

[Qurratulain]

Changes in Price: Suppose that the price of one of the commodities changes. Just as above, we only change one parameter at a time. Thus, to investigate the effects of a change in the price of Snickers, the easiest way is to hold the price of Coke as well as Income fixed. Of course, we could allow more than one parameter to change, but that would make the analysis more complicated than needed.
Suppose the price of Snickers, the good on the horizontal axis, decreased by 10%. What happens to the budget constraint? With no change in the price of Snickers and no change in income, the vertical intecept remains unchanged. However, the horizontal intercept expands by 10% reflecting the fact that the 10% decrease in the price of Snickers has increased the maximum Snickers affordable. Thus, the budget constraint has rotated out; the vertical intercept is unchanged, but the slope is flatter representing the new, lower rate of tradeoff for each purchase of the now less expensive Snickers. You can verify this by looking at equation (2) above. The slope term, -(PS/PC) now has a smaller number in the numerator, meaning the curve is flatter.