ECON 212 EU Consumer Demand Theory & Consumer Behavior Notes

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EGERTON UNIVERSITY

ECONOMICS 212

1.0 CONSUMER DEMAND THEORY/ CONSUMER BEHAVIOR

Consumer behavior theory is concerned with how consumers make decisions about consumption of

commodities given their prices and consumer’s limited income so as to maximize utility.

WHO IS A CONSUMER?

A consumer is a decision making unit about consumption.

PRINCIPALS OF CONSUMERS DEMAND THEORY

(a) Limited income (scarcity) necessitates choice.

(b) Consumers make decisions purposely. That is consumers are careful shoppers

(d) Consumers make decisions without perfect information.

(e) The law of diminishing marginal utility applies to consumer behavior.

THEORIES OF CONSUMER BEHAVIOR

a) Cardinal/Neo-classical utility theory

The theory holds that utility derived from consumption of a good or service is measurable subjectively

using cardinal numbers (e.g. 1, 2, 3 …) by units of measurements called utils.

Consumer equilibrium

Analyses of consumer equilibrium entails answering the question ‘‘how does a consumer allocates his

money income among the various goods and services he/she consumes to maximize utility?’’.

The cardinal utility approach to consumer’s equilibrium is based on the following assumption,

▪ Consumer is assumed to be rational

▪ Consumer possesses perfect knowledge of obtainable utilities

▪ Marginal utility of money is constant at whatever the level of income and each unit of money has

utility equal to one.

▪ Units of commodities are homogeneous

▪ Commodities are divisible

▪ Utility is additive- If a basket of goods and services consumed by a consumer contains n items and

their quantities are,

XXXX ,.........,,

321

, the utility function of the consumer may be expressed as,

),.........,,(

321 n

XXXXfU =

Given the utility function, the TU obtained from n items may be expressed as,

)()........()()(

332211 nnn

XUXUXUXUTU ++=

▪

Consumer Equilibrium-The General Case (Several Commodity Case)

Suppose a consumer consumes only two commodities one and two with quantities X

and X

The corresponding utility function is,

)(

XXfU =

……………………………………………. {1}

To buy these commodities, the consumer will pay prices P

and P

for X

and X

respectively.

To maximize utility,

For each unit of X

the consumer buys, his utility increases by

.The same applies to X

To maximize utility,

PMU



, the consumer will reduce the quantity of X

consumed.

PMU



, the consumer will increase the quantity of X

consumed.

Thus, when

PMU

, or

,the consumer will be indifferent and is said to be in equilibrium.

The same can be said for X

. That is the consumer will be in equilibrium when,

PMU

Since

and

hence

11 =

.Thus,

( )

2..................................................

This is the condition for consumer equilibrium when consuming two commodities.

Since a consumer does not consume only two commodities but several commodities. The above condition

for consumer equilibrium can be extended to any number of commodities with ease

( )

3..................................................

XnX

====

Since the consumer has a limited, the total expenditure on both commodities at which the ratio of marginal

utilities to prices of the two commodities are equal cost exactly equal to the consumer’s income.

That is,

( )

4..........................................................

2211

MXPXP =+

This is the sufficient condition for consumer equailibrium

This again can extended to any number of commodities as follows,

Example

Consider the table below showing Total Utility for commodities X1 and X2

TUX

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EGERTON UNIVERSITY ECONOMICS 212 1.0 CONSUMER DEMAND THEORY/ CONSUMER BEHAVIOR Consumer behavior theory is concerned with how consumers make decisions about consumption of commodities given their prices and consumer’s limited income so as to maximize utility. WHO IS A CONSUMER? A consumer is a decision making unit about consumption. PRINCIPALS OF CONSUMERS DEMAND THEORY (a) Limited income (scarcity) necessitates choice. (b) Consumers make decisions purposely. That is consumers are careful shoppers (c) One good or service can be substituted for another. (d) Consumers make decisions without perfect information. (e) The law of diminishing marginal utility applies to consumer behavior. THEORIES OF CONSUMER BEHAVIOR a) Cardinal/Neo-classical utility theory The theory holds that utility derived from consumption of a good or service is measurable subjectively using cardinal numbers (e.g. 1, 2, 3 …) by units of measurements called utils. Consumer equilibrium Analyses of consumer equilibrium entails answering the question ‘‘how does a consumer allocates his money income among the various goods and services he/she consumes to maximize utility?’’. The cardinal utility approach to consumer’s equilibrium is based on the following assumption, ▪ Consumer is assumed to be rational ▪ Consumer possesses perfect knowledge of obtainable utilities ▪ Marginal utility of money is constant at whatever the level of income and each unit of money has utility equal to one. ▪ Un ...
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