Theory of Consumer Behaviour
1. Introduction to Consumer Behaviour
The theory of consumer behaviour is a fundamental concept in microeconomics that seeks to explain how individuals make purchasing decisions. It focuses on how consumers allocate their limited income among various goods and services to maximize their satisfaction or utility. This theory is built upon a set of assumptions about consumer preferences and the nature of goods.
2. Utility Theory
Utility refers to the satisfaction or benefit a consumer derives from consuming a good or service. There are two main approaches to utility theory: the cardinal approach and the ordinal approach.
2.1 Cardinal Approach to Utility
The cardinal approach, associated with economists like Jeremy Bentham and William Stanley Jevons, assumes that utility is measurable and quantifiable. It states that utility can be expressed in specific units, often referred to as "utils." This approach introduces the concepts of total utility and marginal utility.
2.1.1 Total Utility (TU)
Total utility is the aggregate satisfaction a consumer gets from consuming a certain quantity of a good. As a consumer consumes more units of a good, total utility generally increases, but at a diminishing rate.
2.1.2 Marginal Utility (MU)
Marginal utility is the additional satisfaction gained from consuming one more unit of a good. The law of diminishing marginal utility states that as a consumer consumes successive units of a good, the marginal utility derived from each additional unit tends to decrease, assuming other factors remain constant.
Example: Imagine eating slices of pizza. The first slice might give you immense satisfaction (high MU). The second slice will likely still be satisfying, but less so than the first (lower MU). By the fifth or sixth slice, you might feel full, and the additional satisfaction (MU) from another slice could be zero or even negative.
2.1.3 Law of Diminishing Marginal Utility
This law is a cornerstone of the cardinal approach. It is crucial for understanding demand. As consumption of a good increases, the extra satisfaction from each additional unit declines. This explains why consumers are willing to buy more of a good only if its price falls.
2.1.4 Law of Equi-Marginal Utility
This law, also known as the law of maximum satisfaction, explains how a consumer allocates their limited income to maximize total utility. It states that a consumer will achieve maximum satisfaction when the marginal utility per unit of currency spent on each good is equal. Mathematically:
MUx / Px = MUy / Py = ... = MUn / Pn
Where MUx is the marginal utility of good X, Px is the price of good X, and so on for other goods.
If the ratio is not equal, the consumer can increase their total utility by shifting spending from a good with a lower ratio to one with a higher ratio.
2.2 Ordinal Approach to Utility
The ordinal approach, developed by economists like J.R. Hicks and R.G.D. Allen, argues that utility is not measurable in cardinal terms but can be ranked or ordered. Consumers can express preferences for bundles of goods (e.g., "I prefer bundle A to bundle B," or "I am indifferent between bundle A and bundle B"). This approach uses indifference curves and budget lines.
2.2.1 Indifference Curves
An indifference curve represents all combinations of two goods that provide a consumer with the same level of satisfaction. Key properties of indifference curves include:
- They are downward sloping.
- They are convex to the origin.
- They do not intersect each other.
- Higher indifference curves represent higher levels of utility.
2.2.2 Marginal Rate of Substitution (MRS)
The MRS is the rate at which a consumer is willing to give up one good to obtain one more unit of another good, while remaining at the same level of satisfaction. It is represented by the slope of the indifference curve. As a consumer moves down an indifference curve (consuming more of one good and less of another), the MRS typically diminishes, reflecting the law of diminishing marginal utility.
MRSxy = - ΔY / ΔX
The diminishing MRS is the reason for the convex shape of the indifference curve.
2.2.3 Budget Line
A budget line (or budget constraint) shows all possible combinations of two goods that a consumer can afford given their income and the prices of the goods. The budget line is downward sloping, indicating that to buy more of one good, the consumer must buy less of the other.
The equation for a budget line is: PxX + PyY = M, where Px and Py are the prices of goods X and Y, X and Y are the quantities, and M is the consumer's income.
2.2.4 Consumer Equilibrium
Under the ordinal approach, consumer equilibrium is achieved at the point where the budget line is tangent to the highest possible indifference curve. At this point, the slope of the indifference curve (MRSxy) is equal to the slope of the budget line (the ratio of prices, Px / Py).
MRSxy = Px / Py
This condition signifies that the rate at which the consumer is willing to substitute goods is equal to the rate at which the market allows them to substitute goods through their prices.
3. Derivation of the Demand Curve
The theory of consumer behaviour helps derive the individual consumer's demand curve. This is typically done by examining how consumer equilibrium changes in response to changes in the price of a good, while income and the price of the other good remain constant.
3.1 Price-Consumption Curve (PCC)
The PCC traces the optimal consumption bundles chosen by a consumer as the price of one good changes. As the price of good X falls (holding income and Py constant), the budget line pivots outwards. The consumer moves to successively higher indifference curves, and the tangency points form the PCC.
3.2 Individual Demand Curve
By plotting the price of good X against the quantity of X demanded at each equilibrium point identified from the PCC, we can derive the individual demand curve. This curve is generally downward sloping, reflecting the law of demand.
3.3 Income-Consumption Curve (ICC) and Engel Curve
Similarly, changes in income (holding prices constant) trace out the Income-Consumption Curve (ICC). The ICC shows how consumption of goods changes as income changes. From the ICC, we can derive the Engel Curve, which shows the relationship between income and the quantity demanded of a good.
4. Elasticity of Demand
Elasticity measures the responsiveness of the quantity demanded to a change in one of its determinants, primarily price.
4.1 Price Elasticity of Demand (PED)
PED measures how much the quantity demanded of a good responds to a change in its price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price.
PED = (% Change in Quantity Demanded) / (% Change in Price)
PED = (ΔQ/Q) / (ΔP/P)
Values can range from 0 (perfectly inelastic) to infinity (perfectly elastic). If |PED| > 1, demand is elastic; if |PED| < 1, demand is inelastic; if |PED| = 1, demand is unit elastic.
4.2 Income Elasticity of Demand (IED)
IED measures the responsiveness of quantity demanded to a change in consumer income.
IED = (% Change in Quantity Demanded) / (% Change in Income)
IED > 0 for normal goods; IED < 0 for inferior goods; IED > 1 for luxury goods.
4.3 Cross-Price Elasticity of Demand (XED)
XED measures the responsiveness of the quantity demanded of one good to a change in the price of another good.
XED = (% Change in Quantity Demanded of Good X) / (% Change in Price of Good Y)
XED > 0 for substitute goods; XED < 0 for complementary goods; XED = 0 for unrelated goods.
5. Consumer Surplus
Consumer surplus is the difference between the total amount consumers are willing to pay for a good or service and the total amount they actually pay. It represents the net benefit or gain consumers receive from purchasing a good.
Graphically, it is the area below the demand curve and above the market price, up to the quantity consumed.
6. Revealed Preference Theory
Developed by Paul Samuelson, the Revealed Preference Theory offers an alternative to utility theory, avoiding the need for cardinal or ordinal measurement of utility. It focuses on observable consumer choices.
6.1 Axioms of Revealed Preference
- Direct Revelation Axiom: If bundle A is chosen when bundle B is affordable, then A is revealed to be preferred to B.
- Consistency Axiom (Weak Axiom of Revealed Preference - WARP): If A is revealed preferred to B, then B must not be revealed preferred to A. In simpler terms, if a consumer chooses bundle A over bundle B when both are affordable, they should not choose bundle B over bundle A when both are affordable.
- Strong Axiom of Revealed Preference (SARP): If A is directly or indirectly revealed preferred to B, then B must not be revealed preferred to A. This is a more stringent condition ensuring consistency across multiple choices.
Revealed preference theory uses these axioms to derive demand curves and demonstrate properties like the downward slope of the demand curve, without relying on the concept of utility.
7. Limitations and Extensions
The classical theories of consumer behaviour often rely on strong assumptions such as perfect rationality, perfect information, and utility maximization. Behavioral economics offers insights into how real consumers deviate from these assumptions, incorporating psychological factors like:
- Bounded Rationality: Consumers may not always make perfectly rational decisions due to cognitive limitations.
- Heuristics and Biases: Consumers often use mental shortcuts (heuristics) that can lead to systematic errors (biases).
- Framing Effects: How choices are presented can influence decisions.
- Endowment Effect: People tend to value things they own more highly than things they don't.
These extensions acknowledge the complexities of human decision-making in real-world consumption patterns.
| Concept | Key Idea | Associated Concepts/Laws | Graphical Representation |
|---|---|---|---|
| Cardinal Utility | Utility is measurable (in utils) | Total Utility, Marginal Utility, Law of Diminishing MU, Law of Equi-Marginal Utility | TU & MU curves |
| Ordinal Utility | Utility is rankable (preferences) | Indifference Curves, MRS, Budget Line, Consumer Equilibrium | Indifference Map, Budget Line |
| Demand Derivation | Explains relationship between price and quantity demanded | PCC, Individual Demand Curve | PCC, Demand Curve |
| Revealed Preference | Consumer choices reveal preferences | WARP, SARP | Choice bundles |