JMJ Marist Brothers

COLLEGE OF BUSINESS ADMINISTRATION

Notre Dame of Marbel University
City of Koronadal

A MODULE IN BAC 101 (BASIC MICROECONOMICS)

MODULE 3, WEEK 3
THEORY OF CONSUMPTION

LEARNING OUTCOMES
At the end of the module, students will be able to:

1. Define the theory of consumption.

2. Determine the factors affecting consumer behavior.
3. Explain the importance of consumer buying behavior.
4. Relate the concept of utility analysis to consumer buying behavior.

INTRODUCTION
Microeconomics seeks to understand the behavior of individual economic agents, such as
individuals and businesses. Economists believe that individuals’ decisions, such as which goods and
services to buy, can be analyzed as choices made within certain budget constraints. Generally, consumers
are trying to get the most for their limited budget. In economic terms, they are trying to maximize total
utility, or satisfaction, given their budget constraint. Everyone has their own personal tastes and preferences.
The French say: à chacun son goût, or “Each to his own taste.” An old Latin saying goes, De gustibus non
est disputandum or “There’s no disputing about taste.” If people’s decisions are based on their own tastes
and personal preferences, however, then how can economists hope to analyze the choices consumers make?
An economic explanation for why people make different choices begins with accepting the proverbial
wisdom that tastes are a matter of personal preference. But economists also believe that the choices people
make are influenced by their incomes, by the prices of goods and services they consume, and by factors
like where they live. This chapter introduces the economic theory of how consumers make choices about
what to buy.

ACTIVITY

Share your current purchases or add to cart for the 1 st week of the month. (It can be personal or family
purchases). State the reason why you add them into cart or purchase them.

ACQUISITION OF NEW KNOWLEDGE (Live Lecture-Discussion via Schoology)

Contents:

 Consumer Behavior: Factors Affecting Consumer Behavior: Psychological, Social, Cultural,

Personal, Economic
 Utility Analysis: Utility, Total Utility, Utility Measurement: Cardinal Utility, Ordinal Utility,
Marginal Utility, Law of Diminishing Marginal Utility, Utility Maximization: Equimarginal Principle
Consumer Equilibrium, Indifference Curve, Budget Constraint/Line and Marginal Rate of
Substitution

APPLICATION (Written task).

Janice spends her entire weekly food allowance of P42 on hamburgers and soft drinks. The price of a
hamburger is P20, and the price of a soft drink is P10. Janice purchases 12 hamburgers and 18 soft drinks,
and her marginal rate of substitution between hamburgers and soft drinks is 1. Is Janice in equilibrium?
Explain. (July 7, 2021)

ASSESSMENT

Discussion. For ten (10) points each, answer the following questions briefly.

1. What is the importance of consumer buying behavior? (July 12,2021)

2. Describe the purpose, use, and shape of indifference curves. The indifference curve between a
good and garbage is positively sloped. True or false? Explain.
3. Explain how one indifference curve differs from another. Explain how to find the consumer
equilibrium using indifference curves and a budget constraint. (July 12,2021 – 10:30 AM Class)
4. The utility approach to consumer demand theory is based on the assumption of cardinal utility,
while the indifference curve approach is based on ordinal utility. Which approach is better? Why?
(July 12, 2021-2:30 PM Class)
5. What is the relationship between two goods if the MRS between them is zero or infinite? Explain.
What is the marginal rate of substitution between two complementary goods? (July 12, 2021 –
4:00 PM Class)

ASSIGNMENT (July 12, 2021)

o Problem Solving. For 10 points, solve the following problems by showing all possible solutions.
(Draw a graph in a paper and send it in jpeg format rotated)

Problem 1. Given: Budget: Php5,000

Price of Corn: Php10/kilo
Price of Rice: Php20/kilo
Satisfy: MU of Corn/Price of Corn = MU of Rice/Price of Rice using the following table.

QD of Corn TU of Corn QD of Rice TU of Rice

1 300 1 100
2 350 2 200
3 390 3 290
4 420 4 370
5 430 5 430

REFERENCE
Principles of economics (n.d.). Retreived January 14, 2021 from
https://opentextbc.ca/principlesofeconomics
CONSUMER BEHAVIOR
“Consumer behavior is the actions and the decision processes of people who purchase goods and
services for personal consumption” – Engel, Blackwell, and Mansard,
Consumer buying behavior refers to the study of customers and how they behave while deciding to buy
a product that satisfies their needs. It is a study of the actions of the consumers that drive them to buy and
use certain products. The study of consumer buying behavior is most important for marketers as they can
understand the expectation of the consumers. It helps to understand what makes a consumer to buy a
product. It is important to assess the kind of products liked by consumers so that they can release it to the
market. Marketers can understand the likes and dislikes of consumers and design their marketing efforts
based on the findings.

Consumer buying behavior studies about the various situations such as what do consumers buy, why do
they buy, when do they buy, how often do consumers buy, for what reason do they buy, and much more.
For example, consumer buying behavior is studied by consumer researchers and their aim is to know why
women buy moisturizers (to reduce skin problems), the most preferred brand (Olay, L’Oréal), how often
do they apply it (twice a day, thrice a day), where do the women prefer to buy it (supermarkets, online)
and how many times do they buy it (weekly, monthly).

Importance of Consumer Behavior. Understanding consumer behavior is essential for a company to

find success for its current products as well as new product launches. Every consumer has a different
thought process and attitude towards buying a particular product. If a company fails to understand the
reaction of a consumer towards a product, there are high chances of product failure. Due to the
changing fashion, technology, trends, living style, disposable income, and similar other factors, consumer
behavior also changes. A marketer has to understand the changing factors so that the marketing efforts
can be aligned accordingly.

Consumer Differentiation. Consumer differentiation is a way to distinguish a consumer from

several other consumers. This helps to make a target group of consumers with the same or similar
behavior. Though you have a targeted customer demographic in your business, you can still have
variations between individual customers. Each group of consumers are different and their needs and
wants differ from other groups. When a marketer is knowledgeable about differentiation of each group of
consumers, he can design separate marketing programs.

Consumer differentiation will help to tailor strategies to the needs of varying customer groups. When
consumer differentiation is done, the width and breadth of services can be expanded. Thus, a wider
group of people can be served.

Retention of Consumers. “Consumer behavior is of most importance to marketers in business studies as

the main aim is to create and retain customers” says Theodore Levitt. It is not just important to attract new
customers but it is very important to retain existing customers as well. When a customer is happy
about a particular product, he/she will repeat the purchase. Therefore, marketing the product should be
done in such a way that it will convince customers to buy the product again and again. Thus, it is very
evident that creating customer and retaining them is very important. This can be done only by
understanding and paying attention towards the consumer’s buying behavior.

Design Relevant Marketing Program. Understanding consumer behavior allows to create effective
marketing campaigns. Each campaign can speak specifically to the separate group of consumers based
on their behavior. For example, while targeting kids market, look out for venues such as TV ads, school
programs and blogs targeting young mothers. Take different messaging approaches for different
consumer groups. A study of consumer behavior enables the marketers to understand what motives
consumers to make purchases. Furthermore, the same motive can be utilized in advertising media to
stir the desire to make a purchase. Moreover, marketers should take decisions regarding the brand
logo, coupons, packing and gifts on the basis of consumer behavior.

Predicting Market Trend. Consumer behavior analysis will be the first to indicate a shift in market
trend. For example, the recent trend of consumers is towards environment friendliness
and healthy food. This changing market trend was observed by many brands By conducting consumer
behavior study, a company saves a lot of resources that might otherwise be allocated to produce a product
that will not be sold in the market. For example, in summer a brand will not waste its resources for
producing a product that will not sell in summer. Based on consumer behavior the company decides on
production strategy which will save on warehouse costs and marketing costs.

Competition. One of the most important reasons to study consumer behavior is to find out answers to
some of the questions: Is the customer buying from your competitor?; Why is a consumer buying
from your competitor?; What features attracts a consumer to your competitor products?; and
What gaps are your consumers identifying in your products when compared to your
competitors? Studying consumer behavior facilitates in understanding and facing competition.

Innovate New Products. We all know some of the big names such as New Coke, Crystal Pepsi, Colgate
Kitchen Entrées, Earring Magic Ken Doll, and Wheaties Dunk-a-Balls Cereal. Can you see the
similarities in these products? Yes, they all failed! The sad truth is that most new products and new ideas
end up in failure. An estimate of new product failures ranges from 33% to 90% based on the kind of
industry. Companies consistently strive hard to improve the success rate of their new products or
new ideas. One of the most important ways is to conduct sound and thoughtful consumer behavior study.

With the help of consumer behavior analysis, Nike realized that most of its target audience is not
professional athletes but many of them were striving to be more like them. So at the 2012 Olympics in
London, Nike introduced a campaign to encourage athletics called Find Your Greatness. It aimed to
promote the aspirations of being an athlete, not just with high-performing athletes but wanted to include
all people regardless of their physical capability. The campaign was well-planned and was data-driven
and carefully analyzed before taking any action. This message inspired many consumers and had
enormous appeal for target consumers.

Stay Relevant in the Market. When the world is changing as rapidly as it is happening today, the
biggest challenge we all face is staying relevant to our target market. And do you know what is the main
reason behind the rapid changes? It is the ever-changing behavior of our customers. Today’s consumers
have greater choices and opportunities which means they can easily switch to a company that offers better
products and services. “The pre-eminent skill required to shift ahead in the twenty-first century is the
ability to see and seize.” – Adamson and Steckel. Losing relevance will only cost the company its market
share. Have not we seen Sony Walkman failing to stay relevant in the digital music era, and the taxi
industry doom with no preparedness to battle the UBER uprise?

Improve Customer Service. Consumers require different levels of customer service, and understanding
the differences within the customer base will help provide the most appropriate service for individual
needs. For example, if you own an electronics store, high school or college students who buy a new
laptop are more likely to understand the features they are looking for than a person buying his first
computer. With the first demographic, the service goal will be to provide information about the latest
trends in technology while with the second demographic, there is a need to spend more time educating the
customer, finding out what his specific needs are, and even teaching him how to use the features of his
new electronic device.

Leading companies such as The Coca-Cola Company and Barclays have constantly improved its existing
products and focused on developing new products. The Coca-Cola Company aligns its corporate strategy
of ‘refreshing everyone who is touched by our business’, by conducting market research to identify
consumer behavior. Similarly, Barclays conducted consumer behavior study to better understand the
needs of this target market. Consumer behavior analysis has emerged as an important tool to understand
your customers. By looking into consumer psychology and the forces behind customer buying behavior,
companies can craft new products, marketing campaigns and increase profitability. Companies should
talk to consumers, watch out for frustrations, and most importantly, identify their needs and expectations.

Major Factors Influencing Consumer Behavior. Consumer behavior is influenced by many different
factors. A marketer should try to understand the factors that influence consumer behavior. Here are five
major factors that influence consumer behavior:

1. Psychological Factors. Human psychology is a major determinant of consumer behavior. These

factors are difficult to measure but are powerful enough to influence a buying decision. Some of the
important psychological factors are:

Motivation. When a person is motivated enough, it influences the buying behavior of the person. A
person has many needs: social needs, basic needs, security needs, esteem needs and self-actualization
needs. Out of all these needs, the basic needs and security needs take a position above all other needs.
Hence basic and security needs have the power to motivate a consumer to buy products and services.

Perception. Customer perception is a process where a customer collects information about a product and
interprets the information to make a meaningful image about a particular product. When a customer sees
advertisements, promotions, customer reviews, social media feedback, etc relating to a product, they
develop an impression about the product.

Learning. When a person buys a product, he/she gets to learn something more about the product.
Learning comes over a period of time through experience. A consumer’s learning depends on skills and
knowledge. While a skill can be gained through practice, knowledge can be acquired only through
experience. Learning can be either conditional or cognitive. In conditional learning the consumer is
exposed to a situation repeatedly, thereby making a consumer to develop a response towards it.
Whereas in cognitive learning, the consumer will apply his knowledge and skills to find satisfaction and
a solution from the product that he buys.

Attitudes and Beliefs. Consumers have certain attitude and beliefs which influence the buying decisions
of a consumer. Based on this attitude, the consumer behaves in a particular way towards a product. This
attitude plays a significant role in defining the brand image of a product. Hence, the marketers try hard to
understand the attitude of a consumer to design their marketing campaigns.
2. Social Factors. Humans are social beings and they live around many people who influence their
buying behavior. Human try to imitate other humans and also wish to be socially accepted in the
society. Hence their buying behavior is influenced by other people around them.

Family. Family plays a significant role in shaping the buying behavior of a person. A person develops
preferences from his childhood by watching family buy products and continues to buy the same products
even when they grow up.

Reference Groups. Reference group is a group of people with whom a person associates himself.
Generally, all the people in the reference group have common buying behavior and influence each other.

Roles and status. A person is influenced by the role that he holds in the society. If a person is in a high
position, his buying behavior will be influenced largely by his status. A person who is a Chief Executive
Officer in a company will buy according to his status while a staff or an employee of the same company
will have different buying pattern.

3. Cultural factors. A group of people are associated with a set of values and ideologies that belong to
a particular community. When a person comes from a particular community, his/her behavior is
highly influenced by the culture relating to that particular community.

Culture. Cultural factors have strong influence on consumer buyer behavior. They include the basic
values, needs, wants, preferences, perceptions, and behaviors that are observed and learned by a consumer
from their family members and important people around them.
Subculture. Within a cultural group, there exists many subcultures. These subcultural groups share the
same set of beliefs and values. Subcultures can consist of people from different religion, caste,
geographies and nationalities. These subcultures by itself form a customer segment.

Social Class. Each and every society across the globe has form of social class. The social class is not just
determined by the income but also other factors such as the occupation, family background, education and
residence location. Social class is important to predict the consumer behavior.

4. Personal Factors. Factors that are personal to the consumers influence their buying behavior. These
personal factors differ from person to person, thereby producing different perceptions and consumer
behavior.

Age. Age is a major factor that influences buying behavior. The buying choices of youth differ from that
of middle-aged people. Elderly people have a totally different buying behavior. Teenagers will be more
interested in buying colorful clothes and beauty products. Middle-aged are focused on house, property
and vehicle for the family.

Income. Income has the ability to influence the buying behavior of a person. Higher income gives higher
purchasing power to consumers. When a consumer has higher disposable income, it gives more
opportunity for the consumer to spend on luxurious products. Whereas low-income or middle-income
group consumers spend most of their income on basic needs.

Occupation. Occupation of a consumer influences the buying behavior. A person tends to buy things that
are appropriate to this/her profession. For example, a doctor would buy clothes according to this
profession while a professor will have different buying pattern.
Lifestyle. Lifestyle is an attitude and a way in which an individual stay in the society. The buying
behavior is highly influenced by the lifestyle of a consumer. For example when a consumer leads a
healthy lifestyle, then the products he buys will relate to healthy alternatives than junk food.

5. Economic Factors. The consumer buying habits and decisions greatly depend on the economic
situation of a country or a market. When a nation is prosperous, the economy is strong, which leads to
the greater money supply in the market and higher purchasing power for consumers. When consumers
experience a positive economic environment, they are more confident to spend on buying products.
Whereas, a weak economy reflects a struggling market that is impacted by unemployment and lower
purchasing power. Economic factors bear a significant influence on the buying decision of a
consumer.

Personal Income. When a person has a higher disposable income, his purchasing power increases
simultaneously. Disposable income refers to the money that is left after paying for the tax and saving.
When there is an increase in disposable income, it leads to higher expenditure on various items. But when
the disposable income reduces, spending on multiple items also reduced.

Family Income. Family income is the total income from all the members of a family. When more people
are earning in the family, there is more income available for basic needs and luxuries. Higher family
income influences the people in the family to buy more. When there is a surplus income available for the
family, the tendency is to buy more luxuries which otherwise a person might not have been able to buy.

Consumer Credit. When a consumer is offered easy credit to purchase goods, it promotes higher
spending. Sellers are making it easy for the consumers to avail credit in the form of credit cards, easy
installments, bank loans, hire purchase, and many such other credit options. When there is higher credit
available to consumers, the purchase of comfort and luxury items increases.

Liquid Assets. Consumers who have liquid assets tend to spend more on comfort and luxuries. Liquid
assets are those assets which can be converted into cash very easily. Cash in hand, bank savings and
securities are some examples of liquid assets. When a consumer has higher liquid assets, it gives him
more confidence to buy luxury goods.

Savings. A consumer is highly influenced by the amount of savings he/she wishes to set aside from his
income. If a consumer decided to save more, then his expenditure on buying reduces but if a consumer is
interested in saving more, then most of his income will go towards buying products.

UTILITY ANALYSIS

A subset of consumer demand theory that analysis consumer behavior and market demand using total
utility and marginal utility. The key principle of utility analysis is the law of diminishing marginal utility
which offers an explanation for the law of demand and the negative slope of the demand curve. Utility
analysis, a subset of consumer demand theory, provides insight into an understanding of market
demand and forms a cornerstone of modern microeconomics. This investigates consumer behavior like
market purchases based on the satisfaction of wants and needs (utility) from the consumption of a good.

Utility is the satisfaction of wants and needs obtained from the use or consumption of goods and services.
It refers to the degree of pleasure or satisfaction that an individual receives from an economic act. The
terms utility and satisfaction are used interchangeably in economics. Utility is integral to utility analysis,
consumer demand theory, and the microeconomic analysis of consumer behavior and market demand.
Utility is another term for the satisfaction of wants and needs obtained from the consumption of goods.
Two other economic terms that are also frequently used to capture this notion are welfare and well-being.
Whichever term is used, the underlying concept is the same: Utility is the extent to which unlimited wants
and needs are fulfilled using the goods and services produced from society's limited resources. The utility
concept is an integral part of consumer demand theory and the in-depth study of market demand, the
demand curve, and the law of demand. Most economists would agree that human beings are, by nature,
utility-maximizing agents; human beings choose between one act or another based on each act's expected
utility. The controversial part comes in the application and measurement of utility.

The official, technical economic use of the term "utility" is NOT interchangeable with the common,
everyday synonym "useful." When used in the analysis of consumer behavior, utility assumes a very
precise meaning. For example, a common "utility" knife is one with many uses, something that is handy
to have around. In baseball, a "utility" player can perform quite well at several different positions and is
thus useful to have on the team. Moreover, a public "utility" is a company that supplies a useful product,
such as electricity, natural gas, or trash collection. In contrast, the specific economic use of the term
utility in the study of consumer behavior means the satisfaction of wants and needs obtained from the
consumption of a commodity. The good consumed need not be "useful" in the everyday sense of the term.
It only needs to provide satisfaction. In other words, a frivolous good that has little or no practical use can
provide as much utility as a more useful good.
Not Quantifiable. When analyzing consumer demand, economists are prone to use phrases like "level of
utility." However, in spite what this phrase implies, utility is NOT quantifiable like many other human
characteristics. Utility is NOT a quantifiable, measurable, comparable characteristic. It falls into the same
unmeasurable category as happiness, beauty, and love. There are no benchmark measures for these
notions. Much like “beauty is in the eye of the beholder,” so too is utility. Even though economists make
extensive use of the utility measurement unit termed "util," any such utility unit is purely hypothetical and
only designed to make the presentation of assorted utility-related concepts easier.
The Origin of Utility. The development of utility theory begins with a logical deduction. Voluntary
transactions only occur because the trading parties anticipate a benefit; the transaction would not happen
otherwise. In economics, "benefit" means receiving more utility. Economists also say that human beings
rank their activities based on utility. A consumer who chooses to eat an apple rather than an orange must
value the apple more highly, and thus anticipates more utility from it.

The Usefulness of Utility. Utility theory has been quite useful in understanding the economic action of
individuals, households, and firms but only in broad strokes. In reality, people may eat a third hamburger
for reasons that elude the rational actor assumption of standard economic models. For instance, a leftover
hamburger may be considered wasted food and in order to prevent waste, it is eaten. This more ethical or
qualitative evaluation of "utility" is difficult to capture in mathematical models. Behavioral
economics has also revealed time and again how economic actors deviate from rational expectations in
everyday life and fail to maximize utility. Moreover, empirical work shows that people have inconsistent
preferences. While somebody may prefer apples to oranges this week, next week oranges may be what is
craved. As a result of these and other factors, some have questioned the usefulness of utility in practice.
Even though no economist truly believes that utility can be measured this way, some still consider utility
a useful tool in microeconomics. Cardinal utility places individuals on utility curves and can track
declines in marginal utility across time. Microeconomics also performs interpersonal comparisons with
cardinal utility. Other economists argue that no meaningful analysis can come out of imaginary numbers
and that cardinal utility and utils are logically incoherent.

Total Utility. Utility analysis begins with the total utility derived from the consumption of different
quantities of a good. Total utility is simply a measure of the total satisfaction of wants and needs obtained
from the consumption or use of a good or service. It is often convenient to present total utility for a range
of quantities in a table such as the one displayed to the right.
Utility analysis is based on the presumption that the amount of utility generated from the consumption of
a good can be explicitly measured. The standard hypothetical measurement unit is "utils." Suppose, for
example, that Edgar spends a day riding the Monster Loop Death Plunge roller coaster at the Shady
Valley Amusement Park, then records the amount of total utility achieved at the end of each ride.

 Before his first ride, Edgar receives no utility. No activity, no utility.

 Edgar's first ride generates 11 utils of utility.
 The total utility generated if Edgar takes 8 rides is 32 utils.
 Edgar's utility increases for the first 6 rides, reaching a high of 36 utils before declining back to 32
utils for the 8th ride.
 Presumably Edgar's utility continues to decline after the 8th ride.
 Edgar obtains the highest total utility from 6 rides on the roller coaster.

The motivation that guides Edgar's roller coaster riding is to maximize utility, to consume the quantity of
the good that generates the highest level of utility. In this example, utility is maximized at 6 rides.

In many situations, however, the consumption of a good faces constraints. Edgar, for example, might face
a time constraint because he plans to attend a live concert of the rock-and-roll group that prevents him
from riding more than 4 times. Or he might face an income constraint because the amusement park
charges $1 per ride and he has only $5 in his pocket. In these situations Edgar and others, might pursue
constrained utility maximization. This means achieving the highest possible utility, given restrictions that
prevent the highest overall level of utility from being achieved.
Utility Measurement. A quantification of the satisfaction of wants and needs achieved through the
consumption of goods and services. In principle, utility measurement can take one of two forms: (1)
cardinal and (2) ordinal.

Cardinal and Ordinal Utility. The ranking of utility is known as an ordinal utility. It is not a controversial
topic; however, most microeconomic models also use cardinal utility which refers to measurable, directly
comparable levels of utility. Cardinal utility is measured in units called "utils" to transform the logical to
the empirical. The ordinal utility might say that, the consumer prefers the apple to the orange. Cardinal
utility might say that the apple provides 80 utils while the orange only provides 40 utils. Economists
sometimes employ what is known as an indifference curve to elucidate the cardinal utility of two or more
goods in graphical form.

Cardinal Utility. Cardinal utility is the measurement of satisfaction using numerical values (1, 2, 3, etc.)
that are comparable and based on a benchmark or scale. Height and weight are common cardinal
measures.
 Suppose Winston is 72 inches tall and weighs 180 pounds. In contrast, Pollyanna Pumpernickel is 64
inches tall and weighs 100 pounds. Anyone can easily conclude that Winston is taller and heavier
than Paula. However, these cardinal measures also make it possible to compare how much taller and
heavier Winston is than Paula. In fact, Winston is 12.5 percent taller and 80 percent heavier than
Paula.
 Now consider the height and weight of Barton, a hulking professional athlete, who is 81 3/4 inches
tall and weighs 324 pounds. These cardinal measures indicate that Barton is 12.5 percent taller and 80
percent heavier than Winston. The proportional difference between Barton and Winston is exactly the
same as that between Winston and Paula.

Herein lies the benefit of cardinal utility. It is (or would be) based on a fixed scale that allows for
comparisons among consumers. Unfortunately such cardinal measurement does not presently exist for
utility. The theoretical prospects of generating such a measurement are also slight. Although early
economists worked from the presumption that utility could be quantified with a cardinal measure similar
that used for height and weight, the subjective nature of utility makes cardinal measurement unlikely.

Utility is inherently subjective. The satisfaction Pollyanna Pumpernickel obtains from eating a hot fudge
sundae is based on her own personal wants and needs, her likes and dislikes. There is no way to compare
her satisfaction with that received from an identical hot fudge sundae consumed by Winston Smythe
Kennsington III or Barton Broadway. There is no way to measure how much more or less satisfaction
each person receives. Does Barton receive 12.5 percent more utility than Winston? Does Winston receive
12.5 percent more than Paula? Who can say? Moreover, there also is no way to compare the satisfaction
Paula receives from a hot fudge sundae versus watching Barton Broadway participate in his professional
sporting pursuit. Does Paula receive 80 percent more utility from a hot fudge sundae than from watching
Barton? Who can say?
Ordinal Utility. Ordinal utility is the ranking of preferences (first, second, third, etc.) that are only
comparable on a relative basis. Sporting events are commonly subject to ordinal measures. Suppose,
Pollyanna, Winston, and Barton engage in a friendly footrace. Being a highly trained, well-conditioned
athlete, Barton finishes first. The petite but tenacious, Paula comes in second. Winston, hobbled by an old
knee injury comes in third. The ranking achieved by these three runners depends only on the order of their
finish. It matters not how swiftly each one covers the distance.

Suppose that Barton edges out Paula by the slimmest of margins for first place while Winston finishes
well behind. Or alternatively, suppose that Barton finishes well in front while Paula edges Winston by the
slimmest of margins for second place. Or lastly, suppose that each finishes the race at almost the same
time with Barton coming in just ahead of Paula, who is slightly in front of Winston.

The absolute difference between each runner is irrelevant to the order of finish. Barton is awarded the
gold medal for first. Paula receives the silver medal for second. And Winston has the bronze medal for
third. Ordinal utility applies this ranking to preferences. In the modern analysis of consumer demand, the
actual level of utility generated from the consumption of a good is irrelevant. Only the ranking of
preferences is important. Does Paula like hot fudge sundaes 80 percent more than watching Barton
perform athletic activities? It matters not. It only matters that she likes hot fudge sundaes more than
Barton's endeavors.

Utility measurement provides a basis for discussing the satisfaction of wants and needs derived from
consumption, which then enables an understanding of the role utility plays in market demand. When
economists began looking into the influence utility has on price in the 1800s, they presumed that utility
was a characteristic (like height and weight) that could be measured in a cardinal manner.

However, as the study of consumer demand theory progressed, economists realized that cardinal
utility was both unlikely and unneeded. Ordinal utility was not only more realistic, it also provided a
sufficient theoretical basis for analyzing the connection between utility and market demand.
Marginal Utility. Marginal utility looks at the added satisfaction that somebody gains (or loses) from
consuming one additional unit of a good or service. Eating a hamburger when hungry provides a lot of
utility; a second hamburger is perhaps with less; and a third may even with lower utility since you are
already quite full. The law of diminishing marginal utility describes this effect where adding one more
unit of something results in fewer and fewer gains in utility for the consumer.

Total utility is used as a starting point for utility analysis. However, a great deal of additional insight is
gained from marginal utility. Marginal utility is the additional utility or extra satisfaction of wants and
needs obtained from the consumption or use of an additional unit of a good or service or the extra
satisfaction gained from an extra unit of a good.
change in total utility (∆TU)
Marginal utility is specified as: marginal utility =
change in quantity (∆Q)
If total utility increases from 20 to 27 utils, marginal utility is 7 utils.
The far right column of the table (Roller Coaster Utility) presents marginal utility values derived from
each ride Edgar undertakes. Marginal utility from the first ride is 11 utils. The extra utility generated by
the second ride is 9 utils. The third ride provides another 7 utils.

Marginal utility provides a direct link between utility analysis and demand. The demand price a buyer is
willing to pay for a given good is based on the marginal utility derived from consuming the good. Edgar
is most likely willing is to pay more for the first ride than the fifth ride, in that the first ride generates 11
utils of satisfaction but the fifth ride generates only 3 utils.
The Law of Diminishing Marginal Utility. Marginal utility decreases as Edgar takes more rides. This
decreasing marginal utility reflects the law of diminishing utility stating that the marginal utility or the
extra utility obtained from consuming a good, decreases as the quantity consumed increases. In essence,
each additional good consumed is less satisfying than the previous one. This law is particularly important
for insight into market demand and the law of demand.
If each additional unit of a good is less satisfying, then a buyer is willing to pay less. As such, the demand
price declines. This inverse law of demand relation between demand price and quantity demanded is a
direct implication of the law of diminishing marginal utility.

Utility Maximization. Utility maximization is the process or goal of obtaining the highest level of utility
from the consumption of goods or services. The goal of maximizing utility is a key assumption
underlying consumer behavior studied in consumer demand theory. Consumers are assumed to make
choices, especially concerning the purchase of goods, such that they obtain the highest possible level of
satisfaction. Utility maximization can be achieved at the peak of the total utility curve.

Utility maximization is the guiding notion underlying consumer choices analyzed with consumer demand
theory and utility analysis. It makes sense to think that people are generally motivated to do what is best
for them, to purchase the most satisfying goods, to make the decisions that do more good than harm, to
improve their overall living standards and well-being, that is, to maximize their utility. Working through
the logical consequences of this assumption, when combined with other principles of consumer behavior
especially the law of diminishing marginal utility, makes it possible to gain insight into market
demand and the law of demand.

The accompanying table can be used to illustrate utility maximization. The numbers indicate the total
utility obtained by Edgar while riding the Monster Loop Death Plunge roller coaster at the Shady Valley
Amusement Park. The right-hand column is the accumulated satisfaction Edgar receives from riding the
Monster Loop Death Plunge roller coaster 8 times during his day at the amusement park.

The numbers indicate that Edgar receives the greatest total utility of 36 utils by Roller Coaster Utility
riding the Monster Loop Death Plunge roller coaster 6 times. Taking 5 trips
around the Monster Loop Death Plunge roller coaster track generates only 35
utils. Likewise, 7 rides generate only 35 utils. Maximum utility comes from 6
rides and only 6 rides. Anything else comes in less.

The Peak of the Curve. Utility maximization can be identified with Total Utility Curve
a TU curve. The maximum level of utility obtained by Edgar riding
the roller coaster is relatively obvious. The total utility curve reaches
its highest point for 6 roller coaster rides. The curve increases up to
the sixth ride, then declines for subsequent rides.
Real World Constraints. In the real world, the goal of utility maximization often encounters obstacles
that prevent obtaining the highest overall level of utility. In many circumstances, consumers are unable to
reach the peak of the total utility curve (constrained utility maximization). The constraints could be
physical or legal. Edgar might not be able to ride the Monster Loop Death Plunge roller coaster 6 times
because a bolt of lightning struck the track destroying a large section or perhaps the Park obtained a court
order preventing Edgar in entering the park. But, the constraints facing most consumers most of the time
are economic as they have limited income and cannot afford to buy as much good as they want. If Edgar
is charged $1 per ride and has only $5, then he is not able to achieve the utility maximizing 6 rides.

The Essence of Life. While everyday, noneconomist folks seldom use the term utility maximization, it is
a powerful motivation force underlying a great deal of the decisions people make and the actions they
take. There is close connection between utility maximization, unlimited wants and needs, and the
pervasive problem of scarcity.

While Duncan might buy a freshly prepared Hot Momma Fudge Bananarama Ice Cream Sundae because
it just "sounds tasty," what he is really trying to do is to raise his utility level to its maximum. He is
motivated to eat the hot fudge sundae because it adds more to his utility total. And if he can add to his
utility total, then he is not AT the maximum.

Equimarginal principle. The equimarginal principle states that consumers will choose a combination of
goods to maximise their total utility. This will occur where

The consumer will consider both the marginal utility MU of goods and the price. In effect, the consumer
is evaluating the Marginal Utility/Price known as the marginal utility of expenditure on each item.

Example of marginal utility for Goods A and B

Units MU good A MU Good B

1 40 22

2 32 20

3 24 18

4 16 16

5 8 14

6 0 12

Suppose the price of good A and good B was £1. Then the optimum combination of goods would be
quantity of 4. Because at quantity of 4 – 16/£1 = 16/£1

Law of Equimarginal Utility. In the real world, a consumer may purchase more then one commodity.
Let us assume that a consumer purchases two goods X and Y. How does a consumer spend his fixed
money income in purchasing two goods to maximize total utility? The law of equi-marginal utility tells
us the way how a consumer maximizes his total utility. Before elaborating this law, let us assume: a)
consumers act rationally b) tastes and preferences, income, prices, etc, remain constant.
The equi-marginal principle is based on the law of diminishing marginal utility. The equi-marginal
principle states that a consumer will be maximizing his total utility when he allocates his fixed
money income in such a way that the utility derived from the last unit of money spent on each good
is equal.

Suppose a man purchases two goods X and Y whose prices are P X and PY, respectively. As he purchases
more of X, his MUX declines while MUY rises. Only at the margin the last unit of money spent on X has
the same utility as the last unit of money spent on Y and the person thereby maximizes his satisfaction.
Only when this is true, the consumer will not be distributing his money in buying good X and Y, since by
reallocating his expenditure he cannot increase his total utility.

This condition for a consumer to maximize utility is usually written in the following form: MUX/PX =
MUY/PY. So long as MUY/PY is higher than MUX/PX, the consumer will go on substituting Y for X until
the marginal utilities of both X and Y are equalized. The marginal utility per rupee spent is the marginal
utility obtained from the last unit of good consumed divided by the price of good (i.e., MU X/PX or
MUY/PY). A consumer thus gets maximum utility from his limited income when the marginal utility per
rupee spent is equal for all goods.

Example. This equi-marginal principle or the law of substitution can be explained in terms of an
arithmetical example. We have shown marginal utility schedule of X and Y from the different units
consumed. Let us also assume that prices of X and Y are Php4 and Php5, respectively.

MUX and MUY schedules show diminishing marginal utilities for both goods X and Y from the different
units consumed. Dividing MUX and MUY by their respective prices we obtain weighted marginal utility or
marginal utility of money expenditure.

MUX/PX and MUY/PY are equal to 6 when 5 units of X and 3 units of Y are purchased. By purchasing
these combinations of X and Y, the consumer spends his entire money income of Php35 (= Php4 x 5 +
Php5 x 3) and, thus, gets maximum satisfaction [10 + 9 + 8 + 7 + 6] + [11 + 10 + 6] = 67 utils. Purchase
of any other combination other than this involves lower volume of satisfaction.

Graphical Representation. The above principle can also be illustrated in terms of a figure. We have
drawn marginal utility curves for goods X and Y. Here we use marginal utility and price. Marginal utility
per peso spent on good X = MUX/PX, and that of Y = MUY/PY. The MUX/PX curve has been shown in Fig.
2.12(a) while the MUY/PY curve has been shown in Fig. 2.12(b). We have not drawn negative portion of
the marginal utility curves.
Now, by superimposing Fig. 2.12(b) on Fig. 2.12(a), we get Fig. 2.13 in which we measure available
income—00’—of the consumer on the horizontal axis.

As we move rightwards from ‘O’, amount spent on X increases and, as we move leftwards from ‘O’,
amount spent on Y increases. How does our consumer allocate his total income in buying both goods X
and Y is described by equalizing per peso spent on both?

Our consumer maximizes his total utility by spending OD amount on good X and O’D amount on good
Y. By purchasing this combination, the consumer equalizes marginal utilities per peso spent on X and Y
at point E (MUX/PX = MUY/PY = ED). No other combination will give greater satisfaction.

If our consumer spends OC on good X and O’C on good Y then MU X/PX will exceed MUY/ PY by the
distance AB. This will induce the consumer to buy more of X and less of Y. As a result, MUX/PX will fall,
while MUY/PY will rise until equality is restored at point E. Similarly, if the consumer spends OH on X
and O’H on Y then MUX/PX< MUY/PY. Now, the consumer will buy more of Y and less of X. This
substitution between X and Y will continue until MU X/PX= MUY/PY. Therefore, the consumer can derive
maximum satisfaction only when marginal utility per peso spent on good X is the same as the marginal
utility per peso spent on another good Y. When this condition is met, the consumer does not find any
interest in changing his expenditure pattern.

The equilibrium condition can now be rewritten as: MUX/PX= MUY/PY. This equation can, however, be
rearranged in the following form: MUX/MUY = PX/PY. This equation states that a consumer reaches
equilibrium when he equalizes the ratio of marginal utilities of both goods with the price ratio. However,
this equilibrium condition can be extended to ‘n’ number of commodities. For ‘n’ number of
commodities, the equilibrium condition is: MUA/PA= MUB/PB= MUC/PC = ……… = MUn/Pn.

The Paradox of Value. We know that a consumer reaches equilibrium when marginal utility for a
commodity is equal to its price (MUX = PX). Thus, there is a link between price and MU rather than price
and TU. Price of a commodity is determined in accordance with its MU instead of TU. Earlier economists
could not explain why the price of water is so less though its total utility is great and why the price of
diamond is so high though it has virtually no utility. This problem came to be known as the paradox of
value. It was Marshall who resolved this paradox using MU. Water is available almost in plentiful
amount. Its MU is thus low because of its abundance. As its MU is low, the price of water is low. On the
other hand, the supply of diamond is scarce in relation to demand. Though its total utility is comparatively
less, its MU is too high because of scarcity. So its price is high. Thus, the value or price of a commodity
depends not on its total utility but on marginal utility and availability of commodity.

Assumptions of marginal utility theory

 Consumers are rational

 Utility can be described in cardinal terms (e.g. monetary units)
 Constant prices and incomes.
 Goods can be split up into small units

Limitations of marginal utility theory

 The difficulty of evaluating utility. When consumers purchase goods, they may have a rough idea of
how much utility the good will give, but often they don’t – especially for new goods. In practical
terms, consumers can’t give a cardinal (numerical) value to utility
 Consumers do not have time to work out marginal utility/price. Instead, they often purchase out
of habit or gut feeling.
 Consumers are not always rational. For example, we often see over-consumption of demerit goods
(goods which give very low marginal benefit). Or consumers may be influenced by advertising and
purchase on impulse.
 Numerous goods. In the real world, consumers have fluctuating income, and innumerable goods to
choose between. This makes even rough calculations difficult.
 Many goods are related or complementary
 Some goods are indivisible

Indifference Curve Analysis. Economists use the vocabulary of maximizing utility to describe consumer
choice. So far in the text, we have described the level of utility that a person receives in numerical terms.
This section presents an alternative approach to describing personal preferences called indifference curve
analysis which avoids the need for using numbers to measure utility. By setting aside the assumption of
putting a numerical valuation on utility, an assumption that many students and economists find
uncomfortably unrealistic, the indifference curve framework helps to clarify the logic of the model.

Indifference Curve. People cannot really put a numerical value on their level of satisfaction. However,
they can, and do, identify what choices would give them more, or less, or the same amount of satisfaction.
An indifference curve shows all combinations of goods that provide an equal level of utility or
satisfaction.

For example, Figure 1 presents three indifference curves that represent Lilly’s preferences for the
tradeoffs that she faces in her two main relaxation activities: eating doughnuts and reading paperback
books. Each indifference curve (Ul, Um, and Uh) represents one level of utility. First we will explore the
meaning of an individual indifference curve and then we will look at the relationship between
different indifference curves.

Lilly’s Indifference Curves

Lilly would receive equal utility from all combinations of books and doughnuts on a given indifference
curve. Any points on the highest indifference curve Uh, like F, provide greater utility than any points like
A, B, C, and D on the middle indifference curve Um. Similarly, any points on the middle indifference curve
Um provide greater utility than any points on the lowest indifference curve Ul. Each point on the
indifference curves represents the same level of satisfaction.

Properties of Indifference Curve

 The indifference curve has a negative slope.

 Indifferent curves do not intersect.
 They are convex from below, i.e., convex to the origin.
 An indifference curve that lies to the right of another, yields more utility.
 Indifference curves must conform to a number of properties. 1. Each point on an indifference curve
represents the same level of utility or satisfaction to a consumer. There is a different indifference curve
for each specific level of utility or satisfaction. 2. As many indifference curves as you want can be
drawn, with each indifference curve representing a different level of utility. Indifference curves are
everywhere dense. 3. Indifference curves never intersect or cross each other. In addition, if we are
going to determine how a consumer should allocate income between goods, it is important that
indifference curves have two additional properties: 1. Indifferences curves should bow inward toward
the origin of the graph. This is called convex to the origin. 2. Indifference curves should have
continuously turning tangents. They should have a very smooth inward bow with no flat spots, corners
or other places where they are not bowed inward to the origin.

Shape of an Indifference Curve. The indifference curve Um has four points labeled on it: A, B, C, and D
(in Figure 1). Since an indifference curve represents a set of choices that have the same level of utility,
Lilly must receive an equal amount of utility, judged according to her personal preferences, from two
books and 120 doughnuts (point A), from three books and 84 doughnuts (point B) from 11 books and 40
doughnuts (point C) or from 12 books and 35 doughnuts (point D). She would also receive the same
utility from any of the unlabeled intermediate points along this indifference curve.

Indifference curves have a roughly similar shape in two ways: 1) they are downward sloping from left to
right; 2) they are convex with respect to the origin. In other words, they are steeper on the left and flatter
on the right. The downward slope of the indifference curve means that Lilly must trade off less of one
good to get more of the other, while holding utility constant. For example, points A and B sit on the same
indifference curve Um, which means that they provide Lilly with the same level of utility. Thus,
the marginal utility that Lilly would gain from, say, increasing her consumption of books from two to
three must be equal to the marginal utility that she would lose if her consumption of doughnuts was cut
from 120 to 84—so that her overall utility remains unchanged between points A and B. Indeed, the slope
along an indifference curve as the marginal rate of substitution, which is the rate at which a person is
willing to trade one good for another so that utility will remain the same.

Indifference curves like Um are steeper on the left and flatter on the right. The reason behind this shape
involves diminishing marginal utility—the notion that as a person consumes more of a good, the marginal
utility from each additional unit becomes lower. Compare two different choices between points that all
provide Lilly an equal amount of utility along the indifference curve Um: the choice between A and B,
and between C and D. In both choices, Lilly consumes one more book, but between A and B her
consumption of doughnuts falls by 36 (from 120 to 84) and between C and D it falls by only five (from 40
to 35). The reason for this difference is that points A and C are different starting points, and thus have
different implications for marginal utility. At point A, Lilly has few books and many doughnuts. Thus,
her marginal utility from an extra book will be relatively high while the marginal utility of additional
doughnuts is relatively low—so on the margin, it will take a relatively large number of doughnuts to
offset the utility from the marginal book. At point C, however, Lilly has many books and few doughnuts.
From this starting point, her marginal utility gained from extra books will be relatively low, while the
marginal utility lost from additional doughnuts would be relatively high—so on the margin, it will take a
relatively smaller number of doughnuts to offset the change of one marginal book. In short, the slope of
the indifference curve changes because the marginal rate of substitution—that is, the quantity of one good
that would be traded for the other good to keep utility constant—also changes, as a result of diminishing
marginal utility of both goods.

Field of Indifference Curves. Each indifference curve represents the choices that provide a single level of
utility. Every level of utility will have its own indifference curve. Thus, Lilly’s preferences will include
an infinite number of indifference curves lying nestled together on the diagram even though only three of
the indifference curves, representing three levels of utility, appear in Figure 1. In other words, an infinite
number of indifference curves are not drawn on this diagram but you should remember that they exist.

Higher indifference curves represent a greater level of utility than lower ones. In Figure 1, indifference
curve Ul can be thought of as a “low” level of utility, while Um is a “medium” level of utility and Uh is a
“high” level of utility. All of the choices on indifference curve Uh are preferred to all of the choices on
indifference curve Um, which in turn are preferred to all of the choices on Ul.

To understand why higher indifference curves are preferred to lower ones, compare point B on
indifference curve Um to point F on indifference curve Uh. Point F has greater consumption of both
books (five to three) and doughnuts (100 to 84), so point F is clearly preferable to point B. Given the
definition of an indifference curve—that all the points on the curve have the same level of utility—if
point F on indifference curve Uh is preferred to point B on indifference curve Um, then it must be true
that all points on indifference curve Uh have a higher level of utility than all points on Um. More
generally, for any point on a lower indifference curve, like Ul, you can identify a point on a higher
indifference curve like Um or Uh that has a higher consumption of both goods. Since one point on the
higher indifference curve is preferred to one point on the lower curve, and since all the points on a given
indifference curve have the same level of utility, it must be true that all points on higher indifference
curves have greater utility than all points on lower indifference curves.
These arguments about the shapes of indifference curves and about higher or lower levels of utility do not
require any numerical estimates of utility, either by the individual or by anyone else. They are only based
on the assumptions that when people have less of one good they need more of another good to make up
for it, if they are keeping the same level of utility, and that as people have more of a good, the marginal
utility they receive from additional units of that good will diminish. Given these gentle assumptions, a
field of indifference curves can be mapped out to describe the preferences of any individual.

Individuality of Indifference Curves. Each person determines his or her own preferences and utility.
Thus, while indifference curves have the same general shape (slope down, and the slope is steeper on the
left and flatter on the right) the specific shape of indifference curves can be different for every person.
The diagram applies only to Lilly’s preferences. Indifference curves for other people would probably
travel through different points.

People seek the highest level of utility which means that they wish to be on the highest possible
indifference curve. However, people are limited by their budget constraints which show what tradeoffs
are actually possible. The solution to this problem, the combination of goods and services that will
maximize an individual’s total utility given their budget, is called the consumer equilibrium.

Return to the situation of Lilly’s choice between paperback books and doughnuts. Say that books cost $6,
doughnuts are 50 cents each, and that Lilly has $60 to spend. Along with the budget line are shown the
three indifference curves. What is Lilly’s utility-maximizing choice? Several possibilities are identified in
the diagram.

Lilly’s Indifference Curves and a Budget Constraint

Lilly’s preferences are shown by the indifference curves. Lilly’s budget constraint, given the prices of books
and doughnuts and her income, is shown by the straight line. Lilly’s optimal choice will be point B, where
the budget line is tangent to the indifference curve Um. Lilly would have more utility at a point like F on
the higher indifference curve Uh, but the budget line does not touch the higher indifference curve Uh at any
point, so she cannot afford this choice. A choice like G is affordable to Lilly, but it lies on indifference
curve Ul and thus provides less utility than choice B, which is on indifference curve Um.

The choice of F with five books and 100 doughnuts is highly desirable, since it is on the highest
indifference curve Uh of those shown in the diagram. However, it is not affordable given Lilly’s budget
constraint. The choice of H with three books and 70 doughnuts on indifference curve Ul is a wasteful
choice, since it is inside Lilly’s budget set, and as a utility-maximizer, Lilly will always prefer a choice on
the budget constraint itself. Choices B and G are both on the opportunity set. However, choice G of six
books and 48 doughnuts is on lower indifference curve Ul than choice B of three books and 84
doughnuts, which is on the indifference curve Um. If Lilly were to start at choice G, and then thought
about whether the marginal utility she was deriving from doughnuts and books, she would decide that
some additional doughnuts and fewer books would make her happier—which would cause her to move
toward her preferred choice B. Given the combination of Lilly’s personal preferences, as identified by her
indifference curves, and Lilly’s opportunity set, which is determined by prices and income, B will be her
utility-maximizing choice.

The highest achievable indifference curve touches the budget constraint at a single point of tangency.
Since an infinite number of indifference curves exist, even if only a few of them are drawn on any given
diagram, there will always exist one indifference curve that touches the budget line at a single point of
tangency. All higher indifference curves, like Uh, will be completely above the budget line and, although
the choices on that indifference curve would provide higher utility, they are not affordable given the
budget set. All lower indifference curves, like Ul, will cross the budget line in two separate places. When
one indifference curve crosses the budget line in two places, however, there will be another, higher,
attainable indifference curve sitting above it that touches the budget line at only one point of tangency.

Budget Constraint/Line. A budget constraint occurs when a consumer is limited in consumption patterns
by a certain income. When looking at the demand schedule we often consider effective demand. Effective
demand is what people are actually able to spend given their limitations of income. Temporary budget
constraints can be overcome by borrowing, but in the long term budget constraints are determined by
income such as rent and wages.

Diagram showing a budget constraint and indifference curves

 Income = £40 Price of apples = £1 Price of bananas = £2
The budget line is B1 – this shows maximum consumption with current income. To maximize utility, the
consumer can choose on IC1, 20 apples, 10 bananas. An increase in income would shift the budget line to
the right.
Indifference curves and budget lines. An indifference curve is a line showing all the combinations of two
goods which give a consumer equal utility. In other words, the consumer would be indifferent to these
different combinations.

Table plotted as indifference curve. The indifference curve is convex because of diminishing marginal
utility. When you have a certain number of bananas (all you want to eat in a week). Extra bananas give
very little utility, so you would give up a lot of bananas to get something else.

Indifference curve map. We can also show different indifference curves. All choices on I2 give the same
utility. But, it will be a higher net utility than indifference curve I1. I4 gives the highest net utility.
Basically, I4 would require higher income than I1.
Optimal choice of goods for consumer. Given a budget line of B1, the consumer will maximize utility
where the highest indifference curve is tangent to the budget line (20 apples, 10 bananas). Given current
income, IC2 is unobtainable. IC3 is obtainable but gives less utility than the higher IC1. The optimal
choice of goods can also be shown with the equimarginal principle.

Income-consumption curve. As income rises, you can afford to consume on higher indifference curves.
This optimal choice will shift to the right. This we can plot consumption as income rises.

Impact of lower price. With a lower price of bananas (from £2 to £1.50), we can now afford more
bananas with the same income. The budget line shifts to the right. With lower prices, we can now
consume at a higher indifference curve of IC2, enabling more bananas and apples.

Income and substitution effect of a rise in price. When the price of a good rises, people buy less for two
reasons: Income effect that looks at the effect of a price increase on disposable income. If the price of a
good increases, then consumers will have relatively lower disposable incomes; and Substitution effect
that looks at the effect of a price increase compared to alternatives.

Income and substitution for normal good. A rise in price changes the budget line - buy less of Bananas -
budget curve shifts to B2. Consumption falls from point A to point C (fall in Q of bananas from Q3 to Q1.
To find different substitution and income effects. We draw a new budget line parallel to B2 but tangent
to the first indifference curve which enables the consumer to obtain the same utility. By focusing on B-3,
we are examining the effect of price change – ignoring any income effect. The change from A to B (Q3 to
Q2) is purely due to the substitution effect and relative price change.

Income effect. However, income has fallen causing the consumer to choose from a lower indifference
curve I2. The change due to income is b to c (Q2 to Q1.). In this case of a normal good, the income and
substitution effect reinforce each other leading to lower demand.

Effect of a rise in the price of an inferior good. The substitution effect (using a budget line B-3) causes a
fall from a to b. But, income effect leads to an increase in demand (Q1 to Q2). Overall demand falls but
the substitution effect is partly offset by the income effect. This is because when income falls, consumers
buy more inferior goods because they cannot afford normal or luxury goods.

Giffen goods. A Giffen good occurs when the income effect outweighs the substitution effect. This is
quite rare, but it is theoretically possible for poor peasants who have a choice between expensive meat
and cheap rice. We start at Q2, the rise in the price of rice, reduces the budget line for rice to B2. But, the
fall in income causes a large income effect that outweighs the substitution effect. Demand for rice rises to
Q3 with a big fall in demand for meat.

Marginal Rate of Substitution (MRS). The marginal rate of substitution is the rate at which a consumer is
willing to forgo a number of units good X for one more of good Y at the same utility. It is used to analyze the
indifference curve. The MRS is the same as the utility gained for good Y as the utility lost for good X. One
can calculate the marginal rate of substitution as MRSY X = - Δ X / Δ Y, on any point on the indifference
curve. The negative of the slope is the marginal rate of substitution of x1 for x2.
Assumptions of MRS. 1) The consumer is logical and knowledgeable to consume every unit of goods. 2)
Goods are equal in size and shape. 3) No time gap between consumption. 4) No change in income, 5)
preference, taste, and fashion. 6) Utility is cardinal. 7) Marginal unit of money is constant.

Limitations of MRS. This law does not apply to dissimilar units, unreasonable quantity, unsuitable time
period, rare collections like coins, stamps etc, change in taste and fashion of the consumer, abnormal
person, changing income of the consumer, normal goods, and durable and valuable goods.

Types of Marginal Rate of Substitution

Diminishing. One can obtain it if the consumer is willing to give up less and less unit of good Y for every
additional unit of good X.
Constant. One can obtain this if, for one more unit of Y, only one unit of X is given up. It is constant for
perfect substitution.
Increasing. Suppose a consumer substitutes a commodity X for the other commodity Y at an increasing rate
to maintain the same level of satisfaction.

Summary

1. Consumer buying behavior refers to the study of customers and how they behave while deciding to
buy a product that satisfies their needs. It is a study of the actions of the consumers that drive them to
buy and use certain products. The study of consumer buying behavior is most important for
marketers as they can understand the expectation of the consumers. It helps to understand what makes
a consumer to buy a product. It is important to assess the kind of products liked by consumers so that
they can release it to the market. Marketers can understand the likes and dislikes of consumers and
design their marketing efforts based on the findings.
2. The want-satisfying quality of a good is called utility. More units of a good increase total utility (TU)
but the extra or marginal utility (MU) declines. The saturation point is reached when TU is maximum
and MU is zero. Afterwards, TU declines and MU is negative. The decline in MU is known as the law
of diminishing marginal utility. Cardinal utility actually provides an index of satisfaction for a
consumer, whereas ordinal utility only ranks various consumption bundles.
3. The tastes of a consumer can be represented by indifference curves. These are based on the
assumptions that the consumer can rank baskets of goods according to individual preferences, tastes
are consistent and transitive, and the consumer prefers more of a good to less. An indifference curve
shows the various combinations of two goods that give the consumer equal satisfaction. Higher
indifference curves refer to more satisfaction and lower indifference curves to less. Indifference
curves are negatively sloped, cannot intersect, and are convex to the origin. The marginal rate of
substitution (MRS) measures how much of a good the consumer is willing to give up for one
additional unit of the other good and remain on the same indifference curve. Indifference curves also
generally exhibit diminishing MRS.
4. A rapid convergence of tastes is taking place in the world today. Tastes in the Philippines affect tastes
around the world, and tastes abroad strongly influence tastes in the Philippines. With the tremendous
improvement in telecommunications, transportation, and travel, the convergence of tastes can only be
expected to accelerate with important implications for consumers, for firms as producers, and for the
study of microeconomics.
5. The budget line shows the various combinations of two goods (X and Y) that a consumer can
purchase by spending all income (I) on the two goods at the given prices (P X and PY). The vertical or
Y-intercept of the budget line is given by I/PY and −PX/PY is the slope. The budget line shifts up if I
increases and down if I decreases, but the slope remains unchanged. The budget line rotates upward if
PX falls and downward if PX rises.
6. A rational consumer maximizes utility when reaching the highest indifference curve possible with the
budget line. This occurs where an indifference curve is tangent to the budget line so that their slopes
are equal (MRSXY = PX/PY). Government warnings or new information may change the shape and
location of a consumer’s indifference curves and the consumption pattern. If indifference curves are
everywhere either flatter or steeper than the budget line or if they are concave, utility maximization
requires the consumer to spend all income on either good Y or good X. These are called corner
solutions. The marginal utility approach postulates that the consumer maximizes utility when he or
she spends all income and the marginal utility of the last dollar spent on X and Y are the same. Since
MRSXY = MUX/MUY = PX/PY, the marginal utility and the indifference curve approaches are
equivalent. Indifference curves can also be derived by the theory of revealed preference.

Key Terms

 Budget. The amount of money the consumer has available for the purchase of two or more goods.
 Budget Line. All combinations of two (or more) goods that just exhaust the consumer's budget. If
each good has a positive price, the budget line will be downward‐sloping. If the consumer can
purchase as much or as little of each good as desired at a constant per‐unit price, the budget line will
have a constant slope. Suppose that good A is on the horizontal axis of the graph, and good B is on
the vertical axis. Then the budget line will have a slope equal to the negative value of the price of
good A divided by the price of good B. The negative sign indicates that the budget line has a
downward slope.
 Concave to the Origin. A curve that is bowed outward away from the origin of the graph. Indifference
curves are usually assumed to be convex, not concave to the origin.
 Consumer Equilibrium. A study of the actions of the consumers that drive them to buy and use certain
products.
 Convex to the Origin. A curve that is bowed inward toward the origin of the graph. Because of
diminishing marginal utility, indifference curves are usually assumed to be convex to the origin.
 Diminishing Marginal Utility. Each additional unit of a good provides a consumer with less and less
additional satisfaction.
 Feasible Combination. A combination of quantities of two goods (or perhaps more than 2 goods) that
could be purchased with the consumer's available income or budget.
 Indifference Curve. Suppose that a consumer can choose between units of two different goods. An
indifference curve is a line connecting all possible combinations of quantities of the two goods that
produce the same level of utility or satisfaction. Thus, the consumer is "indifferent" to any point on
the same indifference curve, since each point provides the same level of satisfaction. The consumer
does not prefer one point on an indifference curve over another point on the same curve.
 Indifference Map. A series of indifference curves. Each indifference curve represents a different level
of utility or satisfaction.
 Marginal Rate of Substitution. The slope of an indifference curve at a particular point.
 Marginal Utility. The amount of additional satisfaction a consumer obtains from consuming one
additional unit of a good.
 Optimum Combination. Assuming the indifference curve is convex to the origin, the point of
tangency between the budget line and the indifference curve. This point represents the greatest utility
or satisfaction that can be achieved from the specific budget.
 Tangency (point of). A point at which a line which has a constant slope, just touches (comes tangent
to) another line that has a changing slope. The combination of goods that generates the maximum
utility for the consumer given a specific budget is the point of tangency between the indifference
curve and the budget line. Note that at the point of tangency, the slope of the indifference curve is the
same as the slope of the budget line.
 Utility. A measure of the amount of satisfaction a consumer derives from consuming units if a good.
Generally, for purposes of comparison, the amount of satisfaction or utility is not measured with
numbers. However, suppose there are two goods, A and B. A consumer might face a choice of two
bundles. The first bundle consists of 2 units of good A and 3 units of good B. As an alternative, the
second bundle consists of 4 units of good A and 2 units of good A. If the consumer prefers bundle 1
to bundle 2, then bundle 1 produces more utility or satisfaction than bundle 2. If the preference is for
bundle 2, then bundle 2 produces more utility than bundle 1. If the consumer does not have a
preference among the two bundles, both bundles are on the same indifference curve.