Consumer Behavior

The Theory of Consumer Behavior

Choice & utility 

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Consumers play an important role in determining the demand for a firm’s products. They are quality conscious and price sensitive. The success of a product is dependent on the consumers’ acceptance of the product. Price sensitive customers like to buy products in small quantities at affordable prices. For example, Motorola had initially launched seven models of cellular phones at high prices but none of them were successful. On the other hand, Nokia launched a simple cellphone at an affordable price, which captured the market. Therefore, firms must try to offer products that are of high quality, at affordable prices. Consumer behavior is an important determinant of the type of product a firm should produce. Before launching a product a firm has to take into consideration its target customers tastes and preferences. For example, when Dabur Foods launched Real orange juice, consumers rejected it because it tasted bitter. Research revealed that Indian consumers wanted juices to be sweeter. Dabur then modified Real’s taste by sweetening the orange juice. Consumer behavior assumes that every individual tries to maximize his satisfaction by consuming products and service with the limited income available to him at a particular time. This limited income can also be referred to as the budget constraint.

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consumer behavior theory explains the relationship between changes in price and consumer demand. Variations in price determine whether a particular product is in demand or not. If the demand for a product is low in spite of the price being less, it can be said that consumers are not accepting that product. On the other hand, if the demand for a particular product is high, then the price of the product would increase. Hence, the manufacturer can determine and fix prices of their products according to the consumer demand. Thus, consumer behavior plays an important role for manufacturers decision making.

CHOICE AND UTILITY THEORY 

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It is important to understand the difference between preference and choice. The consumers may have preference when they have a range of products to choose from. Preferences depend upon the consumers’ likes and dislikes but the final decision is dependent on budget constraints. In order to maximize satisfaction, consumers have to choose the alternatives for which the net benefit is more. Net benefit is calculated as the difference between benefits and cost. Here, we assume that the consumers have unlimited wants or preferences and numerous choices to satisfy them. But the resources with the consumers to satisfy all these wants are limited. This resource limitation is the income constraint or budget constraint referred earlier. Thus, the income constraint limits the consumer from satisfying all his preferences and forces him to make choices.

CHOICE AND UTILITY THEORY 

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Utility in economics means the extent of satisfaction obtained from the consumption of products and services by consumers. The concept of utility was developed by economists to explain the basic principles of consumer choice and behavior. Given the available resources, the level of income and market prices of various products, it is assumed that the rational consumer allocates his spending in such a way that the preferred combination gives him the highest utility. The concept of utility is purely subjective i.e. there is no way of measuring the amount of utility that a consumer might be able to derive by consuming a particular product. In other words, utility is the psychological satisfaction that a customer derives by using a particular product. Hence, utility is not measurable but can be compared. It helps to understand how consumers make better choices. 

Measurement of Utility 

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Utility can be measured using the cardinal approach and ordinal approaches. The cardinal approach is based on the Marshallian school of thought, while the ordinal approach was proposed by the economists J.R. Hicks and P.G.D Allen. Cardinal utility approach According to Marshall, utility can be measured and quantified. This approach is based upon certain assumptions like: Utility can be measured: This approach assumes that utility can be measured in terms of units called as ‘utils,’ which are measurable and quantifiable. It reveals how much money a consumer is willing to pay for a given unit of product. In ‘util’ terms, the consumer can compare the utility of two products say mineral water and soft drinks. Thus by comparing, one can say that one bottle of mineral water provides him utility equal to 5 utils, and one bottle of soft drink gives him utility equal to 3 utils. 

Ordinal utility approach 

The proponents of the ordinal approach opine that utility cannot be measured, but can only be ranked in order of preferences. In other words, instead of measuring the utility obtained from products, they rank them in the order of preferences to match consumers’ choice. Thus, it explains that the customer is able to compare different levels of satisfaction. Hence, if a customer prefers commodity x to commodity y, he will not be in a position to compare the ‘quantitative difference’ between the twosatisfaction levels, but he can do qualitative comparisons. This approach can be explained with the help of indifference curve

Total Utility 

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In a given period of time, the amount of utility a person derives from the consumption of a particular product is called total utility. In the initial stages of consumption, the total utility increases. After consuming certain number of units the total utility becomes constant and beyond that it starts reducing.  This means that the consumption of a particular product gives satisfaction to a person initially but after some time, utility starts diminishing.

Marginal Utility 

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According to Prof. Boulding, “The marginal utility of any quantity of a commodity is the increase in total utility which results from a unit increase in consumption.” In other words, marginal utility of a commodity is the additional utility derived by a consumer, by consuming one more unit of that commodity. From the below table, it is clear that every increase in the consumption of a product reduces its marginal utility. Let us analyze the relationship between total utility and marginal utility. Marginal utility starts diminishing as the consumer starts consuming more units of a product. When marginal utility reaches zero, total utility reaches its maximum and remains constant. When marginal utility becomes negative it implies that the total utility has started diminishing. 

Total utility & marginal utility

LAW OF DIMINISHING MARGINAL UTILITY 

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The law of diminishing marginal utility states that if a consumer goes on consuming more units of a particular product at a given point of time, his total utility increases but only at a diminishing rate. The law says that more a consumer consumes a product, the less is the utility he derives from the consumption of the same product. In other words, the desire of that product goes on decreasing as he consumes more and more units of that product. According to Alfred Marshall, the law of diminishing marginal utility is, “The additional benefit which a person derives from a given increase of his stock diminishes with every increase in the stock that he already has.” Marginal utility reveals how much a consumer is ready to sacrifice for a particular product. Usually, the consumer pays high price for the first unit of a product, since his desire to get that product is very high. As he goes on consuming more units of the same product, his utility level goes down and he pays less for the same commodity.

Application and Uses of Diminishing Marginal Utility  

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Explains value paradox The law of diminishing marginal utility explains the factors that determine the value of a product. Adam Smith in his book “The Wealth of Nations” (1776) formulated a theory to explain why different products have different market values. In an attempt to explain this theory, he introduced the ‘diamond-water’ paradox. He said that an essential commodity like water is priced lower, when compared to a less essential product like diamond. He explained this through two concepts: value in use and value paradox. Though diamond has a low value in use but a high value in exchange while water has high value in use but low value in exchange. Hence, ‘diamond-water’ paradox explains that the more quantity of a product we have, the marginal utility starts diminishing. If the availability of a product is less, marginal utility would be high. 

Explains the derivation of Law of demand  Diminishing marginal utility helps to derive the law of demand and explain the downward sloping of the demand curve. It also helps to analyze why prices fall. It also explains consumer surplus, and how it is derived.  

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LEMU 

According to Marshall, the law of equi marginal utility says: “If a person has a product which can be put to several uses, he will distribute it among these uses in such a way that it has the same marginal utility. If the product has a greater marginal utility in one use than in another, the person would gain by taking away some of the product from the second use and applying it to the first.”  In other words, the law states that the consumer will spend his money income on different products in such a way that the marginal utility of each product is proportional to its price. Hence, the consumer will have the same level of satisfaction while consuming the two products. 

Demand 

By continuing to change the price of good X [and holding all other variables, PY , budget or income and preferences

constant,] the rest of the demand for

good X can be mapped.  All price and quantity combinations on the demand for X are equilibrium points for the consumer [They are maximizing utility; holding all other variables, PY , budget or income and preferences constant]

By changing the price of the good [in this case, good X] and holding all other variables [PY , budget or income and

preferences] constant, the demand for the good can be The demand function mapped. is a schedule of the quantities that individuals are willing and able to buy at a schedule of prices during a specific period of time, ceteris paribus.

P X5 4

De m an d

3 2 1 1

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3

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5

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7 QX/ut

The demand function has a negative slope because of the income and As substitution Income effect: the price effects. of a good that you buy increases and money incomeis held constant, your real income decreases and you can not afford to buy as much as you P could before. Substitution effect: As X5 the price of one good rises 4 relative to the prices of De 3 other goods, you will tend m a nd to substitute the good 2 that is relatively cheaper 1 for the good that is relatively more expensive. 1 2 3 4 5 6 7 QX/ut

Income effects As the price of a good that you buy increases, you will have less real income.  This is the basis of price indices that measure changes in real income as prices rise or fall.  The consumer price index is one of the indices that is used [currently there is a debate about how it is calculated]. 

Substitution Effects As the price of a good increases [decreases] while the prices of other goods is constant, it becomes relatively more [less] expensive.  Individuals would substitute relatively less expensive goods for relatively more expensive ones even if their real income were constant. 

CONSUMER SURPLUS Notice that someone is willing and able to pay $6.80 for the

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Sup pl

If the market price [established by S and D] were first $3, unit.the buyer would purchase at $3 even though they PX were willing to pay $6.80 for the first unit. 7 They receive utility 6.8 that they did not have 0 6 to pay for [6.80-3.00]. 5 consume This is called consumer 4 r surplus. De surplus 3 m At market a nd 2 Consumer surplus will be equilibrium, the area above the market 1 price and below the 1 2 3 4 5 6 7 QX/ut demand function.

Demand 

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Demand functions can be derived from utility [cardinal measures] or indifference functions [ordinal measures] Normally, demand functions show and inverse relationship between price and quantity a change in price “causes” a change in “quantity demanded” a change in any other variable [income, prices of related goods, population, preferences, . . .] will “cause a change in demand” or shift of demand

The Indifference Curve Indifference Curve: A curve connecting the set of bundles that are equally preferred to one another. Here, the consumer would be indifferent if offered a choice between any of pair of bundles on the same indifference curve.

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Why it is downward sloping? Because of the law of opportunity cost.

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All bundles among which a consumer is indifferent

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◦ “Indifference map” is all of a consumer’s indifference curves ◦ All bundles (Xa, Ya) such that: (Xa, Ya) ~ (X0, Y0)

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Properties of Indifference Curves

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1. Every bundle is on some indifference curve 2. Two indifference curves never cross 3. An indifference curve is not “thick” 4. Indifference curve slopes downward, Diminishing MRS 5. A bundle that has more of all goods is on a higher indifference curve (“no satiation”) 6. Rationality 7. Monotonicity – more of a good is preferred to less 

Indifference Curves Rational--behave consistently

Good Y

5 Indifference Curve

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Good X

Good Y

5

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I Indifference Map 3 I 2

I 1

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Good X

Indifference Curve: All Bundles among which a consumer is indifferent A graph of all the indifference curves is called an indifference map There are infinitely many curves.

Marginal Rate of Substitution (MRS): Slope of the Indifference Curve

Marginal Rate of Substitution Slope of Indifference Curve: shows Marginal Rate of Substitution (MRS). The rate at which one good can be traded off for another while leaving the consumer equallyoff.  MRS: At any point of IC, the rate at which one good can be exchanged for another, holding consumer satisfaction constant. Slope = dY/dX  Question 

◦ How much more of a good (e.g., Y) would a consumer require to compensate them for loss of a unit of another good (e.g., X)

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Measurement

◦ MRS measures willingness to make this substitution:

Figure 21-2. The Consumer’s Preferences Quantit yof Pepsi

C

B

D I 2

A 0

Indifference curve, I 1

Quantit yof Pizza

Representing Preferences with Indifference Curves 

An indifference curve is a curve that shows consumption bundles that give the consumer the same level of satisfaction.

Representing Preferences with Indifference Curves 

The Consumer’s Preferences ◦ The consumer is indifferent, or equally happy, with the combinations shown at points A, B, and C because they are all on the same curve.

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The Marginal Rate of Substitution ◦ The slope at any point on an indifference curve is the marginal rate of substitution.  It is the rate at which a consumer is willing to trade one good for another. It is the amount of one good that a consumer requires as compensation to give up one unit of the other good.

Figure 21-2. The Consumer’s Preferences Quantit yof Pepsi

C

B MR S

D I

1

2

A 0

Indifference curve, I 1

Quantit yof Pizza

Four Properties of Indifference Curves Higher indifference lower ones.  Indifference curves  Indifference curves  Indifference curves 

curves are preferred to are downward sloping. do not cross. are bowed inward.

Figure 21-2. The Consumer’s Preferences Quantit yof Pepsi

C

B

D I 2

A 0

Indifference curve, I 1

Quantit yof Pizza

Four Properties of Indifference Curves 

Property 2: Indifference curves are downward sloping.

◦ A consumer is willing to give up one good only if he or she gets more of the other good in order to remain equally happy. ◦ If the quantity of one good is reduced, the quantity of the other good must increase. ◦ For this reason, most indifference curves slope downward.

Figure 21-2. The Consumer’s Preferences Quantit yof Pepsi

Indifference curve, I 0

1

Quantit yof Pizza

Figure 21-3. The Impossibility of Intersecting Indifference Curves Quantit yof Pepsi C A

B

0

Quantit yof Pizza

Four Properties of Indifference Curves 

Property 4: Indifference curves are bowed inward. ◦ People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little. ◦ These differences in a consumer’s marginal substitution rates cause his or her indifference curve to bow inward.

OPTIMIZATION: WHAT THE CONSUMER CHOOSES Consumers want to get the combination of goods on the highest possible indifference curve.  However, the consumer must also end up on or below his budget constraint. 

The Consumer’s Optimal Choices Combining the indifference curve and the budget constraint determines the consumer’s optimal choice.  Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent. 

The Consumer’s Optimal Choice The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.  At the consumer’s optimum, the consumer’s valuation of the two goods equals the market’s valuation. 

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Figure 21-6. The Consumer’s Optimum Quantit yof Pepsi Optimu m B

A I I

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Budget constraint

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3

2

1

Quantit yof Pizza