consumers behavior theory

Managerial Economics

Consumer’s

BehaviorBy: Christine M. Perez

Learning Outcome

To develop competence through Knowledge, Sensitivity, Skills and Values in Managerial Economics through Consumer’s Behavior Theory

Topic Outline:• Definition of Consumer Behavior Theory• Two Utility Approaches used in Consumer

Behavior Theory• Definition of Utility• Basic Assumption• The Utility Function• LAW OF Diminishing MARGINAL UTILITY• Budget Line and Indifference Curve Analysis• Utility Maximization• Marginal rate of substitution• Optimum Combination and the Marginal Rate of

Substitution• An Individual Consumer’s Demand Curve• Substitution and Income Effects• Why demand slopes downward• Market Demand Curves• Paradox of value/ Water-Diamond Theory

References• Carlos Manapat and Fernando Pedrosa. Economics, Taxation and Agrian

Reform (Revised Edition). C & E Publishing, Inc Quezon City Philippines.

• Dominick Salvatore PhD. Microeconomics: Theory and Applications 4th edition McGraw-Hill Companies, Inc. (2003), NY USA.

• Evan J. Douglas. Managerial Economics and strategy 4th edition. A. Simon

and Schuster Company, Prentice Hall Inc(1993). NJ USA • James McGuigan, R. Charles Mayer, Frederick deB Harris. Managerial

Economics: Applications, Strategy and tactics 9th edition, South-Western Thomson (2006), OH USA.

• Keeney, R.L. and H. Raiffa. Decisions with Multiple Objectives: Preference and Value Tradeoffs. Cambridge University Press (1993), Cambridge.

• • Mark Hirschey. Fundamentals of Managerial Economics 9th edition,

South-Western Cengage Learning (2013), OH, USA.

References• Michael R. Baye, Managerial Economics and Business Strategy, 3rd

edition. The McGraw-Hill Companies, Inc.(1999), NY USA.

• R. H. Frank, Microeconomics and Behaviour, 9th edition, McGraw-Hill Companiess, Inc. (2014), NY USA.

• S. Charles Maurice and Christopher R Thomas. Managerial Economics

9th edition McGraw-Hill (2008), NY USA. • Wayne D. Hoyer; Rik Pieters; Deborah J MacInnis Mason. Managerial

Economics 6th edition. South-Western Cengage Learning (2003). OH USA.

• http://www.referenceforbusiness.com/management/ Utility-Theory.html • http://www.mymba.com/management/ economics-definition.html

http://www.referenceforbusiness.com/management/%20Utility-Theory.html

http://www.mymba.com/management/%20economics-definition.html

Managerial Economics• provides a useful framework for understanding how consumers make trade-off. Every consumer decision involves trade-offs between price, quantity, timeliness and host of related factors. The consideration of such trade-offs and the methods used by the consumers to make consumption decisions are called the study of consumer behavior (Hirschey).

Consumer Behavior Theory

Consumer Behavior

economics

marketing

social anthropology

sociology

psychology

Consumer Behavior Theory• The study of individuals, groups, or organizations and the processes they use to select, secure, use, and dispose of products, services, experiences, or ideas to satisfy needs and the impacts that these processes have on the consumer and society.

• The theory of consumer behavior provides the foundation for the study of consumer demand

• Follows directly from the theory of maximization


principles to describe consumer behavior

Incentives

Marginal Changes

Opportunity Cost

Trade-off

Consumer Behavior Theory• Utility – the satisfaction of individual receives from goods or combination of goods.

• Utility approach provides a methodological framework for the evaluation of alternative choices made by individuals, firms and organizations

Consumer Behavior Theory - Utility Approach

Basic Assumption

Consumers are rational

Preferences are transitive

Preferences are complete

Nonsatiation Principle

Consumer Behavior Theory - Utility Function

• utility function is an equation that shows an individual’s perception of the level of utility that would be attained from consuming each conceivable bundle (or combination) of goods.

U = index of utility depending on the

quantities consumed of goods or servicesX, Y = amount goods or services consumedf = function of


Two Utility Approaches

Budget Line and Indifference Curve Analysis

LAW OF Diminishing MARGINAL UTILITY

LAW OF Diminishing MARGINAL UTILITY is the law of economics stating that as a person increases consumption of a product - while keeping consumption of other products constant - there is a decline in the marginal utility that person derives from consuming each additional unit of that product.

budget line is the locus of all combinations or bundles of goods that can be purchased at given prices if the entire money income is spent.

indifference curve is a graph showing combination of two goods that give the consumer equal satisfaction and utility



Marginal utility

Total utility

1. The number of units of utility that a consumer gains from consuming a given quantity of a good, service, or activity during a particular time period.

2. The higher a consumer’s total utility, the greater that consumer’s level of satisfaction.

The amount by which total utility rises with consumption of an additional unit of a good, service, or activity, all other things unchanged

MU U X

As a consumer has more of a ‘good’, the extra (marginal) utility they enjoy from each successive extra unit of the good declines

LAW OF Diminishing MARGINAL UTILITY:

illustration

The Budget Line• Opportunity Set

The set of consumption bundles that are affordable.

•PxX + PyY M.• Budget Line

Shows all possible commodity bundles that can be purchased at given prices with a fixed money income

•PxX + PyY = M• Market Rate of Substitution– The slope of the budget line•-Px / Py

Y

X

The Opportunity Set

Px

Py

Budget Line

X YM P X P Y

X

Y Y

PMY XP P

o rX YM P X P Y

X

Y Y

PMY XP P

o r

The Budget Line: illustrationGiven:Px = P 5.00Py = P 10.00M = P1,000.00

PxX + PyY = M

Consumer’s Budget Constraint

Changes in the Budget Line

• Changes in Income– Increases lead to a parallel, outward shift in the budget line.

– Decreases lead to a parallel, downward shift.

• Changes in Price– A decreases in the price of good X rotates the budget line counter-clockwise.

– An increases rotates the budget line clockwise.

X

Y

X

YNew Budget Line for a price decrease.

Shifting Budget Lines: Change in Money

(increase)Original Given Budget line ABPx = P 5.00Py = P 10.00M = P1,000.00

Formula:PxX + PyY = M

New Given:M = P2,000.00Slope of the line = 1/2

Formula: M / PxX M /

PyY

Budget line RN

Shifting Budget Lines: Change in Money

(decrease)Original Given Budget line ABPx = P 5.00Py = P 10.00M = P1,000.00


New Given:M = P 800.00Slope of the line = 1/2

Formula: M / PxX M /

PyY

Budget line FZ

Panel B – Changes in price of X

200

100A

B250

D

R

N

120

240

Shifting Budget Lines : Graph

Quan

tity o

f Y

Quantity of X

Panel A – Changes in money income

Quan

tity

of Y

Quantity of X

A

B

100F

Z

80

160 200 125C

Shifting Budget Lines: Change in Price

(decrease)Original Given Budget line ABPx = P 5.00Py = P 10.00M = P1,000.00


New Given:

Px = P 4.00Vertical intercept = same (M / PyY = 100 units)

Budget line ADM / PXX= 250 units

Shifting Budget Lines: Change in Price

(increase)Original Given Budget line ABPx = P 5.00Py = P 10.00M = P1,000.00


New Given:

Px = P 8.00Vertical intercept = same (M / PyY = 100 units)

Budget line ACM / PXX= 125 units

Panel B – Changes in price of X

200

100A

B250

D

R

N

120

240

Shifting Budget Lines Graph

Quan

tity o

f Y

Quantity of X

Panel A – Changes in money income

Quan

tity

of Y

Quantity of X

A

B

100F

Z

80

160 200 125C

Indifference Curve Analysis

Indifference Curve– A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction.

Marginal Rate of Substitution– The rate at which a consumer is willing to substitute one good for another and stay at the same satisfaction level.

I.

II.

III.

Good Y

Good X

Indifference curve

The properties of

indifference curve

cannot intersect

downward-sloping / negatively sloped

convex

Locus of points representing different bundles of goods, each of which yields the same level of total utility

Indifference Curve All combination in the indifference curve yield the consumer the same level of utility

Indifference Curve Indifference Curve I Indifference Curve II

Product X Product Y Product X Product Y 1 12 2 122 10 3 83 8 4 44 7 5 25 66 5

Indifference curve : illustration Indifference Curve I

Indifference Curve II

Indifference Curve III

Qx1 Qy1 Qx2 Qy2 Qx3 Qy31 10 3 10 5 122 5 4 7 6 93 3 5 5 7 74 2.3 6 4.2 8 6.25 1.7 7 3.5 9 5.56 1.2 8 3.2 10 5.27 0.8 9 3 11 58 0.5 10 2.9 12 4.99 0.3 10 0.2

Utility maximization

Utility maximization (constraint/

tools to analyze)

Marginal rate of substitution

expanded maximization principle

Marginal utility interpretation of

equilibrium

Maximizing utility subject to a limited money income

Maximizing utility subject to a limited money incomeUtility maximization subject to a limited money income occurs at the combination of goods for which the indifference curve is just tangent to the budget line

X X

Y Y

MU PYMRSX MU P

Consumer allocates income so that the marginal utility per dollar spent on each good is the same for all commodities purchased

X Y

X Y

MU MUP P

A•

I

C•

•B

II

R

T

Utility Maximization:

Quantity of burgers

Quanti

ty of

pizzas

0 8020 10040 60

10

20

30

40

50

7010 9030 50

•EIII

•D

IV

45

15

Given :

Budget = P 400.00

Ppizza = P 8.00Pburger = P 4.00

Marginal utility interpretation of

equilibrium• The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction.

I.

II.

III.

X

Y

Consumer Equilibrium

Marginal utility interpretation of equilibrium : illustrationGiven

Px = P 4.00Py = P 2.00Qx = 20 unitsQy = 30 units M = P 140.00

Suppose that the MU of last unit of X is 20 and the MU of Y is 16.

5<8

Expanded maximization principle

• We have assumed that the consumer purchases only two goods. The analysis is easily extended to any number of goods.


• The marginal rate of substitution (MRS) is a measure of the number of units of Y that must be given up per unit of X added so as to maintain a constant level of utility.


A = 10X & 60YB = 20X & 40YC = 40X & 20YD = 50X & 15Y

Optimum Combination

• The combination of the budget line and indifference curve as shown in the graph will shows the optimum combination or optimal combination

Budget Schedule Indifference SchedulePoint

sProduct

XProduct

YPoint

sProduct

X Product YA 8 0 J 2 8B 7 1 K 3 6C 6 2 L 4 4D 5 3 M 6 3E 4 4 N 7 2F 3 5 G 2 6 H 1 7

Optimum Combination : illustration

Using the principle of marginal rate of substitution, we can see that at point L on the indifference curve, the ratio of product Y to product X is 4:4 or 1:1.

Given:Budget = P 8.00Px = P 1.00Py = P 1.00

Individual Demand Curve

• An individual’s demand curve is derived from each new equilibrium point found on the indifference curve as the price of good X is varied.

X

Y

P

X

D

III

P0

P1

X0 X1

Deriving a Demand Curve : illustration

M = P 1,000.00PX = P 10.00 Py = P 10.00Budget line 1 = 100Y to 100XDemand schedule for product X

Price Quantity Demanded

P 10.00

50

8.00

65

5.00

90

Deriving a Demand Curve : illustration

Quanti

ty of

YPr

ice of

X

(P)

Quantity of X

Quantity of X

100

2001251000

0

Px=P10

Px=P5

Px=P8

906550

906550

5

810

Demand for X

Market Demand & Marginal Benefit

• List of prices & quantities consumers are willing & able to purchase at each price, all else constant

• Derived by horizontally summing demand curves for all individuals in market

• Because prices along market demand measure the economic value of each unit of the good, it can be interpreted as the marginal benefit curve for a good

Derivation of Market Demand

Quantity demanded

Price Consumer 1 Consumer 2 Consumer 3 Market demandP6

21

543

3

1213

5810

0

710

135

0

68

014

3

2531

61219

Derivation of Market Demand

Substitution and Income Effects

When price changes, total change in quantity demanded is composed of two parts

Income Effects

Substitution EffectsThe substitution effect is the change in the consumption of a good that would result if the consumer remained on the original indifference curve after the price of the good changes.

The income effect from a price change is the change in the consumption of a good resulting strictly from the change in purchasing power. The direction of the income effect is uncertain.

Substitution EffectsGiven:Budget line (M) = P 150.00PX = P 15.00 Py = P 7.5

Original Budget line : AB

Given new:Budget line (M) = P 150.00PX = P 6.00 Py = P 7.5

New Budget line : AD

Income & Substitution Effects: A Decrease in

PxTotal effect of price decrease

= Substitution effect

+ Income effect

9

= 5 + 4

Total effect of price decrease

= Substitution effect

+ Income effect

3

= 5 + (-2)

Substitution & Income Effects

• Consider the substitution effect alone:– Amount of good consumed must vary inversely with price

• Income effect reinforces the substitution effect for a normal good & offsets it for an inferior good

Summary of Substitution & Income Effects

Substitution Effect

Income Effect

Price of X decreases:Normal Good

Inferior GoodPrice of X increases:

Normal GoodInferior Good

X risesX rises

X rises

X rises

X falls

X fallsX falls

X falls

Paradox of value/ Water-Diamond Theory

states that a good with more value in use has less or little value in exchange and a good with more value in exchange has less or little in value in use.

Managerial Economics

Consumer’s

BehaviorBy: Christine M. Perez

consumers behavior theory

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