7-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Chapter 7

Consumer behaviour

7-2Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Learning objectives• Develop further the two explanations of the

law of demand first presented in Chapter 3• Discuss the role of marginal utility in explaining

consumer behaviour• Describe the relationship between marginal

utility and the demand curve so that we may better analyse how consumers allocate their money incomes among various goods and services

7-3Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Learning objectives (cont.)

• Examine the implications of the addition of the time dimension to our explanation ofconsumer behaviour

7-4Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Two explanations of the law of demand1. Based on income and substitution effects:

– Income effect: the impact of a change in price on consumers real income and quantity demanded

– Substitution effect: the impact of a change in price on relative expenses and quantity demanded

7-5Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Two explanations of the law of demand (cont.)2. Based on utility theory: utility is the satisfaction

a consumer obtains from consuming a good or service

– Total utility (TU) is a measure (in units called utils) of the total satisfaction derived from the consumption of a good

– Marginal utility (MU) is the extra satisfaction derived from the consumption of one additional unit of a good

7-6Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Two explanations of the law of demand (cont.)

– Law of diminishing marginal utility: marginal utility will decline as the consumer acquires additional units of a particular product

7-7Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Units ofProduct A

TotalUtility(utils)

MarginalUtility(utils)

FirstSecondThirdFourthFifthSixthSeventh

8 7 5 3 1 0–2

815

2023242422

The law of diminishing marginal utility

7-8Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

7-9Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Theory of consumer behaviourConsumer choice and budget constraint• Assumptions

– Rational behaviour — consumers maximise total utility– Preferences (tastes) — clear cut preferences or tastes– Budget constraint — total money income is limited– Prices — prices are given for the consumer

• Utility maximising rule– Consumer should allocate money income so that

the last dollar spent on each product yields the same amount of extra (marginal) utility

– There will be no incentive to alter expenditure pattern. The consumer will be in equilibrium

7-10Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Product A: Price = $1 Product B: Price = $2

First 10 10 24 12 24Second 8 8 20 10 20Third 7 7 18 9 18Fourth 6 6 16 8 16Fifth 5 5 12 6 12Sixth 4 4 6 3 6Seventh 3 3 4 2 4

Unit ofproduct

Marginalutility(utils)

Marginalutility per

dollar(MU/price)

Marginalutility(utils)

Marginalutility per

dollar(MU/price)

Product B: Price = $1

Marginalutility per

dollar(MU/price)

The utility combination of products A & B

7-11Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Algebraic restatement of theutility-maximisation rule

MU of product A MU of product B

Price of A Price of B

=

7-12Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Marginal utility and the demand curve• Deriving the demand curve

– Preferences or tastes– Money income– Prices of other goods

• Create a demand schedule from the purchase decisions as the price of the product is varied

7-13Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Indifference curve analysis

Appendix to Chapter 7

7-14Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Learning objectives• Introduce the concept of the budget line and

explain its relationship to the prices of products and consumers' money income

• Develop the concept of indifference curves• Derive a demand curve using indifference curves

and budget lines

7-15Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Indifference curve analysis• Explanation of consumer behaviour and consumer

equilibrium based on:• Budget lines

– Describes the income and price constraints on consumer behaviour

• Indifference curves– Describes consumers taste pattern

7-16Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The budget line

• Shows the various combinations of two products that can be purchased with a given money income

• Assume two products, A and B. Price of A is $1.50 per unit; price of B is $1.00 per unit. Total money income = $12.00

• Various combinations of A and B obtainable with an income of $12.00, are illustrated in the following table

7-17Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

8 0 $12

6 3 12

4 6 12

2 9 12

0 12 12

Units of Aprice $1.50

Units of Bprice $1.00

Totalexpenditures

Combination of A and B obtainable

7-18Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The budget line• The budget line shows the combinations of

A and B obtainable given the money income and prices

• An increase in income makes the purchase of more of either or both items possible

• Price changes cause a change in the quantity demanded of the items

7-19Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

(Attainable)

A consumer’s budget line

Qu

anti

ty o

f A

Quantity of B

(Unattainable)

12

10

8

6

4

2

0

2 4 6 8 10 12

Income/PB = 12

Income/PA = 8

7-20Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Indifference curves• An indifference curve shows all combinations

of products A and B that will yield the same level of satisfaction or utility to the consumer

7-21Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

An indifference schedule

j 12 2k 6 4l 4 6m 3 8

Combination Units of A Units of B

7-22Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

I

A consumer’s indifference curve

Qua

ntity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12

m

j

k

l

7-23Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Characteristics of indifference curves• Down-sloping• Convex to origin• Slope of indifference curve is the marginal rate

of substitution (MRS)• Indifference map is a set of indifference curves • Curves further away from the origin indicate

a higher level of utility

7-24Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Indifference map12

10

8

6

4

2

02 4 6 8 10 12

Qu

anti

ty o

f A

Quantity of B

I1

I2

I3

I4

7-25Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Equilibrium• Equilibrium occurs at point of maximum

total utility (TU)• Tangency solution

– Maximum TU is where highest indifference curve just touches the budget line

7-26Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Consumer’s equilibrium

Qu

anti

ty o

f A

Quantity of B

I1

I2

I3

I4

12

10

8

6

4

2

02 4 6 8 10 12

Y

x

z

w

7-27Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Deriving the demand curve• Assume the price of one good falls

– The budget line pivots towards the origin of the axis whose price has fallen

– The equilibrium position changes

• The new equilibrium involves more of the good whose P has fallen

– This is the law of demand

7-28Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Deriving the demand curve (cont.)

Quantity of B

I1

I3

2 4 6 8 10 12

12

10

8

6

4

2

0

Quantity of B1 2 3 4 5 6 7 8 9 10 11 12

$1.50

1.00

0.50 D

Price of BQuantity of A

x’ x

7-29Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Next chapter:

An overview of market structures