Economics Chapter 2.2 – Theory of Consumer Behaviour

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Chapter 2.2 – Theory of Consumer Behaviour

Economics Chapter 2.2: Theory of Consumer Behaviour

This chapter delves into how individual consumers make choices to allocate their income to different goods and services to maximize satisfaction. It explores the fundamental economic issue of choice under conditions of scarcity, examining consumer preferences, budget constraints, and demand behavior.

2.1 Utility

Utility refers to the satisfaction or pleasure derived by a consumer from consuming goods or services. It is a subjective concept, varying from individual to individual, and plays a central role in consumer decision-making.

2.1.1 Cardinal Utility Analysis

Cardinal utility assumes that utility can be quantified and expressed in measurable units. It follows that consumers make decisions by maximizing total utility, which is the sum of the satisfaction derived from consuming multiple units of goods.

  • Total Utility (TU): This is the overall satisfaction a consumer gets from consuming a specific quantity of goods. TU increases with the amount consumed, though at a diminishing rate.
  • Marginal Utility (MU): Marginal utility refers to the additional satisfaction obtained from consuming one more unit of a good. It is calculated as the change in total utility from consuming an additional unit.

Law of Diminishing Marginal Utility

The Law of Diminishing Marginal Utility states that as more units of a good are consumed, the additional satisfaction (marginal utility) derived from each subsequent unit decreases. Eventually, marginal utility may even become negative, indicating dissatisfaction from consuming additional units.

  • Example: Eating one chocolate may bring great satisfaction, but as the consumer eats more, the enjoyment from each additional chocolate diminishes.

2.1.2 Ordinal Utility Analysis

Ordinal utility analysis assumes that consumers can rank their preferences without assigning numerical values to their satisfaction. This approach reflects more realistic consumer behavior as consumers typically order preferences rather than measure them.

Indifference Curves

An indifference curve shows combinations of two goods that provide the consumer with the same level of satisfaction. The consumer is indifferent between any two bundles on the same curve because they yield equal utility.

  • Marginal Rate of Substitution (MRS): MRS is the rate at which a consumer is willing to give up one good in exchange for more of another, while maintaining the same level of utility. The MRS diminishes as the consumer substitutes one good for another due to the Law of Diminishing Marginal Rate of Substitution.

Shape of Indifference Curves

  • Convex Shape: Indifference curves are convex to the origin, reflecting the diminishing MRS as more of one good is consumed.
  • Perfect Substitutes: When goods can replace each other perfectly, the indifference curve becomes a straight line.
  • Perfect Complements: When goods are always consumed together (e.g., left and right shoes), the indifference curve forms a right angle.

Indifference Map

An indifference map is a collection of indifference curves, representing different levels of utility. Higher indifference curves correspond to higher levels of satisfaction.

  • Non-Intersection: Indifference curves never intersect. If two curves were to cross, it would imply contradictory preferences, which is impossible.

2.2 The Consumer’s Budget

A consumer’s budget reflects the total income available for spending on goods and services. The combination of goods that the consumer can afford, given their income and the prices of goods, is called the budget set.

2.2.1 Budget Line

The budget line represents all possible combinations of two goods that a consumer can buy, given their income and the prices of goods.

  • Mathematical Representation: p1x1+p2x2=Mp_1x_1 + p_2x_2 = Mp1​x1​+p2​x2​=M
    • p1p_1p1​ and p2p_2p2​ are the prices of goods 1 and 2.
    • x1x_1x1​ and x2x_2x2​ are the quantities of goods 1 and 2.
    • MMM is the consumer’s income.

The budget line slopes downward because an increase in the consumption of one good requires a decrease in the consumption of the other (opportunity cost).

Shifts in the Budget Line

  • Income Change: An increase in income shifts the budget line outward (parallel shift), allowing the consumer to afford more goods. Conversely, a decrease in income shifts the budget line inward.
  • Price Change: A change in the price of a good causes the budget line to pivot. If the price of one good decreases, the consumer can afford more of it, flattening the slope of the budget line.

2.3 Optimal Choice of the Consumer

The optimal consumption bundle is the combination of goods that maximizes the consumer’s satisfaction, given their budget constraint.

  • Tangent Point: The consumer’s optimal choice is at the point where the budget line is tangent to the highest attainable indifference curve. At this point, the Marginal Rate of Substitution (MRS) between the two goods equals the ratio of their prices: MRS=p1p2MRS = \frac{p_1}{p_2}MRS=p2​p1​​
  • This point represents the maximum utility the consumer can achieve with their given budget.

2.4 Demand

Demand is the quantity of a good that a consumer is willing and able to purchase at various prices, holding other factors constant (ceteris paribus). Demand depends on:

  1. The price of the good.
  2. The prices of related goods.
  3. The consumer’s income.
  4. The consumer’s tastes and preferences.

2.4.1 Demand Curve and Law of Demand

The demand curve shows the relationship between the price of a good and the quantity demanded, all else being equal. It typically slopes downward, reflecting the Law of Demand: as the price of a good decreases, the quantity demanded increases, and vice versa.

2.4.2 Normal and Inferior Goods

The effect of a change in income on demand depends on whether the good is normal or inferior:

  • Normal Goods: Demand increases as income increases (e.g., luxury items).
  • Inferior Goods: Demand decreases as income increases (e.g., cheaper, low-quality goods).

2.4.3 Substitutes and Complements

  • Substitute Goods: Goods that can replace each other in consumption (e.g., tea and coffee). When the price of one substitute increases, the demand for the other increases.
  • Complementary Goods: Goods that are used together (e.g., cars and fuel). When the price of one complement rises, the demand for the other falls.

2.5 Market Demand

The market demand for a good is the sum of all individual consumers’ demand at each price level. It is derived by horizontally summing the individual demand curves of all consumers in the market.

2.6 Elasticity of Demand

Elasticity measures how sensitive the demand for a good is to changes in its price. The price elasticity of demand (PED) is the percentage change in the quantity demanded divided by the percentage change in price.

2.6.1 Types of Price Elasticity of Demand

  1. Elastic Demand (PED > 1): Demand is highly responsive to price changes (luxury goods).
  2. Inelastic Demand (PED < 1): Demand changes little with price changes (necessities).
  3. Unitary Elasticity (PED = 1): Percentage change in demand equals the percentage change in price.

2.6.2 Factors Determining Price Elasticity

  • Availability of Substitutes: Goods with close substitutes tend to have elastic demand.
  • Necessity vs. Luxury: Necessities tend to have inelastic demand, while luxuries have more elastic demand.
  • Time Period: Demand is more elastic over the long term because consumers can adjust their behavior.

2.6.3 Elasticity Along a Linear Demand Curve

Elasticity varies along a linear demand curve:

  • At higher prices, demand is elastic.
  • At lower prices, demand becomes inelastic.
  • At the midpoint of the demand curve, elasticity is unitary.

2.7 Consumer Expenditure and Elasticity

The impact of price changes on total consumer expenditure depends on the elasticity of demand:

  • If demand is elastic, a price decrease leads to an increase in total expenditure.
  • If demand is inelastic, a price decrease leads to a decrease in total expenditure.

2. 8 Summary of Key Concepts

  • Utility: Satisfaction derived from consumption, measured by cardinal (numerical) or ordinal (ranking) methods.
  • Indifference Curves: Graphical representation of bundles that yield the same utility.
  • Budget Line: Represents all combinations of goods a consumer can afford given their income and prices.
  • Demand: The relationship between price and the quantity of a good consumers are willing to buy.
  • Elasticity: Measures the responsiveness of demand to price changes.

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