2. THE CONSUMER IS OF FUNDAMENTAL INTEREST TO THE ECONOMIST
BECAUSE IT IS TO SATISFY THE DEMANDS OF CONSUMERS THAT
PRODUCTION TAKES PLACE.^
THEORY OF CONSUMER BEHAVIOUR
3. BRAINSTORMING QUESTIONS
The analysis of a number of important policy questions requires an understanding of
consumer demand as expressed in the market place. For example, the policy analyst might
require information on the following:
In the course of economic development with average incomes rising, which sectors in the
economy will prosper and which will decline in importance? Within the agricultural
sector, which producers will enjoy an increasing demand for their products and which
producers will face a stagnant or declining market?
How would the pattern of consumption change, if the distribution of income were to
change? Will an increased rate of urbanisation have any effect on consumption?
If the price of a particular food product is changed, say by imposing a sales tax or a
subsidy, how will consumers respond? What will be the effect on consumption of that
product, the consumption of other foods, the government exchequer etc. ?
4. A basis for theoretical and empirical work on these types of questions is
provided by the neoclassical model of consumer behaviour and it is with this
approach that this presentation is concerned.
In this model, it is hypothesised that the consumer has some sense of
preference among different products and he or she will attempt to get the
most satisfaction out of consumption allowed by a limited budget- maximum
utility. (UTILITY?????)-
To present this model, extensive use is made on indifference curves. They are
are adopted here for two reasons i.e.:
a. they are extremely useful analytical devices in a number of settings and,
b. the neoclassical demand model specified in this theory is completely
symmetric with the production model (factor-factor relationship) where
isoquants in production take the place of indifference curves in
consumption.
5. THE BASIC RELATIONSHIPS-CONSUMER DEMAND
A consumer's demand for a commodity is the amount of it which the
consumer is willing and able to buy, under given conditions, per unit of
time, in a specified market, and at specified prices.
NB** Demand is not the same as desire or need. The economic analysis of
demand is concerned with actual market behaviour. (Demand-
willingness to purchase a commodity.)
Traditional economic theory suggests that, given the consumer's tastes
and preferences, the demand for a commodity will be determined by:
a. the price of the product;
b. the prices of other products;
c. the consumer's income *
6. The consumer always aims at gaining the greatest possible satisfaction,
welfare and utility from the consumption of goods.
The choice, however, is constrained by the consumer's purchasing power or
income, and will be influenced by the prices of the goods available.
The theory recognises that consumer behaviour will depend to some degree
on individual preferences, which may be linked to the age, sex, education,
religion, social class, location or other characteristics of the consumer.
Therefore, based on these assumptions about the consumer, the consumer
demand theory will be used to derive the following three basic relationships:
1. the demand function
2. the demand curve
3. the Engel curve
7. 1. THE DEMAND FUNCTION
It is used to summarise the relationship between the quantities of a
good (say Q ₁) and the economic factors which influence the
consumer's choice, and is denoted as shown below:
𝑸₁ = 𝒇(𝑷₁, 𝑷₂, … 𝑷ₓ, 𝑴)
where Q ₁ is the quantity of the good purchased in a given time period,
P ₁,...,P ₓ are the prices (𝒙) of the consumer goods in the market and M
denotes the consumer's income.
This relationship is specified given the consumer's tastes.
8. 2. THE DEMAND CURVE
The demand curve, or demand schedule, is the representation of the
quantities of the commodity which the consumer is willing and able to
purchase at every possible price over the relevant range, with all other
factors being held constant.
9. As shown above, the demand curve is downward sloping indicating an
inverse relationship between price and quantity, i.e. the lower the price, the
more Q₁ the consumer will buy.
A change in (own) price would induce a movement along the demand curve.
As all other factors are held constant, the demand curve can be represented
mathematically as:
𝑸₁ = 𝒇(𝑷₁|𝑷₂, … 𝑷ₓ, 𝑴)
NB**** If there is a change in income or in a price other than P₁ the whole
demand curve will shift.
10. 3. THE ENGEL CURVE
The Engel curve depicts the relationship between the quantity of a good purchased and consumer income, all other
factors held constant.
The Engel curve is the graphical representation of the following form of the demand function:
𝑸₁ = 𝒇(𝑴|𝑷₁, 𝑷₂, … 𝑷ₓ, )
If, as income rises, the consumer chooses to buy more of a particular commodity, the commodity is termed a normal
good (Fig. 5.2(a)). On the other hand, if less of a good is purchased as income rises, the commodity is termed an
inferior good (Fig. 5.2(b)) (next slide).
12. THE ANALYSIS OF CONSUMER CHOICE
In general, it has been noted that consumers seek to maximize the satisfaction derived from the consumption of goods and
services.
Consumer theory only requires that a number of general propositions about the nature of consumer preferences should
hold. These are:
1. The consumer can compare any two combinations (or bundles) of goods and decide whether one bundle is preferred
to the other or that he or she is indifferent between them, i.e. the consumer can rank combinations of goods in order
of preference.
2. The consumer is consistent in his or her choices. For example, if bundle A is preferred to bundle B and bundle B is
preferred to a third bundle, C, then the consumer will prefer bundle A to bundle C. This is known as the transitivity
assumption.
3. The consumer prefers more of a good to less of it. If bundle A contains more of one good and no less of the other
goods than bundle B, then A will always be preferred to B. This is the non-satiation assumption.
13. Consumer preferences can be illustrated graphically using an indifference map.
THE INDIFFERENCE MAP
14. Here we assume that there are only two goods, Q1 (e.g. food) and Q2 (e.g.
aggregate quantity of all other goods).
Each indifference curve identifies the various combinations of Q1 and Q2 which
yield the same level of satisfaction. Hence five units of Q2 with 20 units of Q1 is
as satisfactory to the consumer as 10 units of Q2 and 7 units of Q1 (both points
lie on the same curve Iо).
The most preferred combination is of 12 units of Q2 and 15 units of Q1 and hence
is associated with a higher indifference curve (I₁).
15. CHARACTERISTICS OF AN INDIFFERENCE CURVE
o The assumptions of non-satiation and transitivity imply that no two indifference
curves can intersect.
o The indifference curve is assumed to be smooth, downward sloping and convex to the
origin.
o Its particular shape reflects a diminishing marginal rate of substitution between the
two goods. If the quantity of Q2 is successively reduced by equal amounts, increasing
quantities of Q1 are required to leave the consumer indifferent to the change.
The marginal rate of substitution (MRS) is the term given to the slope of the
indifference curve: the slope becomes less steep as the quantity of the commodity
measured on the horizontal axis (Q1) increases. Denoted as:
𝑺𝒍𝒐𝒑𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒊𝒏𝒅𝒊𝒇𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒄𝒖𝒓𝒗𝒆 =
△ 𝑸₂
△ 𝑸₁
= 𝑴𝑹𝑺 𝒐𝒇 𝑸𝟏 𝒇𝒐𝒓 𝑸𝟐
17. THE BUDGET LINE
The budget line depicts the budget constraint or the set of maximum feasible
consumption choices, given the levels of income and prices.
Its slope is given as the ratio of the two product prices, P1/P2.
If the consumer spends all available income on Q1, then at most Mo/P1 units of Q1
could be obtained. On the other hand, if all income is spent on Q2, M0/P2 units of
that good could be purchased and hence some combination of the two goods could be
chosen.
However, consumers will wish to select the consumption pattern out of all those
available which will yield the highest possible level of satisfaction. In terms of Fig.
5.5 (below), this will be the combination of Q1 and Q2 associated with the highest
attainable indifference curve.
18. **The point of tangency between this highest attainable indifference curve and the
budget line defines the optimal consumption pattern, Q*₁ and Q*₂, which is termed
CONSUMER EQUILIBRIUM.
THE CONSUMER EQUILIBRIUM
19. CONSUMER EQUILIBRIUM
The consumer equilibrium is found at the point where the slope of the indifference curve is
the same as that of the budget line i.e.
𝑴𝑹𝑺 𝒐𝒇 𝑸𝟏 𝒇𝒐𝒓 𝑸𝟐 = (−)
𝑷𝟏
𝑷𝟐
This equilibrium condition applies to all consumers, irrespective of the position of their
indifference curves.
Each consumer, in seeking maximum satisfaction from consumption will equate his/her
marginal rate of substitution with the ratio of commodity prices. But all consumers in a
given market face the same relative prices and so, at equilibrium, all consumers have the
same rate of commodity substitution.
Relative prices therefore provide a direct measure of the rate at which consumers substitute
one good for another.
20. VARIATIONS IN THE CONSUMER’S EQUILIBRIUM
♣ Now let’s look at the effects of price and income changes by
examining how they change equilibrium consumption via different
types of shift in the budget constraint.
♣ If consumer income increases, with product prices remaining the
same, there will be a parallel shift in the budget line to the right. The
increased purchasing power permits more of both goods to be
purchased. A new equilibrium will be found at the point of tangency
between the budget line and a (higher) indifference curve.
♣ The locus of such equilibria as income changes is termed the
income-consumption line (ICL).
♣ The response to the income change will depend on whether the
good in question is a normal or an inferior one.
23. If the price of a commodity (say Q1 falls), ceteris paribus the budget line swivels in the manner
shown in Fig. 5.9(a). The maximum amount of Q2 which can be bought has not changed but
the budget constraint now cuts the Q1 axis at a higher level, since, with the same income, more
of this good can now be obtained. For each price of Q1 there is a preferred consumer
equilibrium and the locus of these points generates the price-consumption line (PCL) in Fig.
5.9(b).
In this figure, as the price of Q1 falls, the consumption of both goods increases i.e. the goods
are complements. This type of price-consumption line can be obtained if, for example, Q1 and
Q2 were coffee and sugar respectively. Hence as the price of coffee falls, the demand for coffee
increases and this in turn induces an increase in sugar consumption.
Alternatively, the goods being analysed might be substitutes, yielding a price consumption line
of the form in Fig. 5.9(c). In this case, as the consumption of Q1 (say, coffee) increases in
response to the fall in its price, the consumption of Q2 (say, tea) decreases. As the price (P) of
Q1 falls ceteris paribus, the associated quantities (Q) can be read off the price consumption
line. These combinations can be plotted, thus generating the demand curve for good Q1.
