THEORY OF CONSUMER BEHAVIOUR
The Consumer’s Budget
The consumer’s budget is the real purchasing power of consumer from which he/she can purchase
the certain quantitative bundles of two goods at a given price.
Budget set
Budget set refers to attainable bundles of a set of two goods, given the prices of goods and income
of the consumer.
Budget line
A budget line shows set of bundles of good x1 and good x2 which a consumer can buy at the given
income M and the prices of two goods p1 and p2.
Quantity of good 1 is measured on the X-axis and the quantity of good 2 is measured on Y-axis. Any point
in the given diagram shows the bundle of two goods. The budget set is represented in the figure which consists
of all points on or below the straight line having the equation p1x1 + p2x2 = M. This line consists of all bundles
whose cost is equal to
M. This line is called budget line. This budget line is drawn on the assumptions that the consumers budget is Rs
30, price of a good 1 = Rs 2 per unit and price of good 2 = Re 1 per unit. Accordingly, maximum 15 units of good
1 are purchased when entire budget is spent on good 1 and maximum 30 units of good 2 can be purchased when
entire amount is spent on good 2.
Equation of the budget line p1x1 + p2x2 = M
Slope of the budget line = -p1/p2
i.e. the ratio of prices of two commodities
Preferences of the Consumer
Consumer’s behaviour is governed by monotonic preferences. It means that a rational consumer always prefers
more of a good as it offers the consumer a higher level of satisfaction.
Indifference curve
An indifference curve is the curve which represents all those combinations of two commodities which give the
same level of satisfaction to a consumer. It slopes downward because an increase in the amount of good 1
along the indifference curve is associated with a decrease in the amount of good 2 as the preferences are monotonic.
Marginal Rate of Substitution (MRS) means the rate at which the consumer is willing to substitute one commodity for
the other commodity.
MRSxy = Quantity of the good sacrificed / Quantity of the good obtained.
Properties of indifference curves
• Higher indifference curve offers higher preferences to consumers
• ICs are convex to the origin because MRS tends to diminish
• ICs are sloped downwards or negatively sloped
• ICs never touch or intersect each other
Indifference map
Indifference map refers to a set of indifference curves corresponding to different income levels of the consumer.
An indifference curve which is to the right shows a higher level of satisfaction to the consumer. Here, IC3 shows
higher level of satisfaction than IC2. Thus, the indifference curve relates to a higher level of income of the consumer.
Utility
Utility is the amount of satisfaction which a consumer derives from the consumption of a commodity. A utility function
means assigning numbers to all the available bundles. Let us consider any two bundles, if one is preferred to the other,
then the preferred bundle gets assigned a higher utility and if the two bundles are indifferent, they are assigned the
same utility number.
Equality of the marginal rate of substitution and the ratio of prices
The optimum bundle of the consumer is located at the point where the budget line is tangent to an indifference curve.
When the budget lines is tangent to an indifference curve at a point, the absolute value of the slope of the indifference
curve and of the budget line are equal at that point i.e. MRS is equal to the price ratio. The slope of the budget line is
the rate at which the consumer is able to substitute one good for the other in the market. At the optimum, the two rates
should be the same. Thus, a point at which the MRS is greater, the price ratio cannot be the optimum as well as when the
MRS is less then the price ratio cannot be the optimum.
Concept of Demand
Demand for a good refers to the desire to buy a good, backed with sufficient purchasing power and the willingness to spend.
Individual Demand and Market Demand
Individual demand for a commodity is the quantity of a commodity which an individual household is willing to buy at a
particular price during a specific period.
Market demand is the horizontal summation of individual demands in the market. It indicates various quantities of a
commodity which all consumers in the market are willing to buy at different possible prices of that commodity during
a specific period.
Law of Demand
The Law of Demand states that while other things remaining constant, the quantity of a good demanded increases with
a fall in the price and diminishes when the price increases.
Main Assumptions of the Law of Demand
• Prices of related goods do not change
• Incomes of consumers do not change
• Tastes and preferences of consumers remain constant
• No expectations from the consumer to make a change in the price of a commodity in the near future
Demand Schedule and Market Schedule
Demand schedule is a chart or a table showing the quantities of a commodity, demanded at various prices.
Market demand schedule shows the total demand for the commodity in the market at various prices.
Individual Demand Curve and Market Demand Curve
The individual demand curve is a curve showing different quantities of a commodity which one particular buyer
is willing to buy at different possible prices of the commodity at a point of time. In the diagram, the quantity of
a commodity is given on the x-axis and the price on the y-axis. DD is the demand curve representing the individual
demand schedule. The demand curve slopes downward from left to right, indicating an inverse relationship between
the price and the quantity demanded.
The market demand curve is the horizontal summation of the individual demand curves. It indicates various quantities
of a commodity which all consumers in the market are willing to buy at different possible prices ofthe commodity at a
point of time. The diagram below shows that the market demand curve represents the market demand schedule assuming
two consumers A and B in the market. The market demand curve also slopes downward indicating an inverse relationship
between the price and quantity demanded.
Why does the demand curve slopes downward to the right?
The demand curve slopes downward because more goods are purchased in response to a fall in price. Thus, there is a
inverse relationship between the price of a good and its quantity demanded.
Factors responsible for the downward sloping demand curve:
• Law of diminishing marginal utility: The additional utility which the consumer derives from the additional consumption
of any commodity is known as marginal utility. A consumer gets maximum satisfaction from the consumption of a commodity
when the price paid for the commodity is just equal to its marginal utility. If the consumer consumes more of that commodity
at any given time period, the marginal utility will gradually fall. This is called the law of diminishing marginal utility.
• Substitution effect: Substitution of one commodity for the other when it becomes relatively cheaper
• Income effect: A change in quantity demanded when real income of the buyer changes as a result of change in price
of the commodity.
Exceptions to the Law of Demand
• Giffen effect: A typical inferior commodity consumed by poor people may display an odd behaviour. When the price
of such a commodity rises, the poor people may cut down on their purchases of other expensive items and increase
their purchases of this commodity.
• Bandwagon effect: The bandwagon effect means that the consumer’s demand for a commodity is influenced by the
taste and preference of the social class to which the consumer belongs.
Changes in Demand
Demand for any commodity depends on several factors besides its price. These factors were categorised as price of the
commodity in category 1 and all factors other than price in category 2. Based on these categories of factors influencing
demand, changes in demand are divided into change in quantity demanded and change in demand.
Change in Quantity Demanded and Change in Demand:
Change in quantity demanded is the movement along the demand curve i.e. the extension of demand caused by a decrease
in the price of the same good and the contraction of demand caused by an increase in the price of the same good.
Change in demand means the shift in the demand curve i.e. the decrease in demand or the backward shift in the demand
curve caused by a change in factors other than the price of the good and an increase in demand or a forward shift in the
demand curve caused by a change in factors other than the price of the good.
Causes behind Shifts of Demand
• Change in income: If there is an increase in income of the consumers, they will usually buy more of any particular
commodity and the demand curve will shift to the right. A fall in income will usually shift the curve to the left. This is
applicable to most goods which are normal goods.
• Price of other commodities: If the price of substitute goods falls, consumers will be attracted to the other goods and
the demand for the good to consume will fall at any given price. Hence, the demand curve will shift to the left. Likewise,
a rise in the price of a substitute will shift the demand curve to the right. If the price of the complementary goods falls,
consumers will buy more of the complementary goods and the demand for the good to consume will also rise at any
given price. Hence, the demand curve will shift to the right. Similarly, a rise in the price of complementary goods will
shift the demand curve to the left.
• Consumer preference: If the producers spend more money on a product advertisement at any given price, consumers
will demand the commodity in greater quantities than before. Hence, the demand curve for the commodity will shift to
the right. Likewise, if consumers develop distaste for a commodity, the demand curve will shift to the left.
Elasticity of Demand
The elasticity of demand measures the responsiveness of the quantity demanded for a good to a change in its price,
price of other goods and changes in the consumer’s income. Alfred Marshall was the first economist to develop the
concept of price elasticity of demand as the ratio of a relative change in quantity demanded to a relative change in price.
Degrees of Price Elasticity of Demand:
• Perfectly inelastic demand: The demand curve will be parallel to the y-axis. If the price increases or decreases, the
quantity demanded remains fixed i.e. ed = 0.
• Inelastic demand: The slope of an inelastic demand curve is steep when a large change in the price does not bring
about a significant change in the demand i.e. ed < 1.
• Unit elastic demand: The demand curve will be a rectangular hyperbola as it extends to both axes.
• Percentage change in the demand is equal to percentage change in the price i.e. ed = 1.
• Elastic demand: The demand curve is a flat curve when the percentage change in the demand is much greater than the
percentage change in price i.e. ed > 1.
• Perfectly elastic demand curve: The demand curve is parallel to the x-axis. A small change in the price causes an infinitely
large change in the amount demanded i.e. ed 8 1.
Factors Affecting Elasticity of Demand
Method of Measurement
Total expenditure method, proportionate method and geometric method are the three different methods to measure the
price elasticity of demand.
The price elasticity of demand for a good is the percentage change in demand for the good divided by the percentage
change in its price. Price elasticity of demand is a pure number and it does not depend on the units in which the price
of the good and the quantity of the good are measured. Price elasticity of demand is a negative number as the demand
for a good is negatively related to the price of a good. ep = Percentage change in the demand for the good/Percentage
change in the price of the good.
Absolute changes in price and quantity are measured in original units, whereas relative changes are not based on units
of measurement. They are calculated as percentage changes in price and quantity.
• The total expenditure method measures the elasticity of demand. The changes in expenditure with a change in the
price of a good are measured by this method. Three possible situations in this method:
• If a rise or fall in the price of a good has no change in its total expenditure, then the elasticity of demand is unitary.
• If with a fall in the price of a good, the total expenditure increases, and if with a rise in the price of a good, the total
expenditure decreases, then the demand for this good is greater than unitary elastic.
• If with a fall in the price of a good, the total expenditure decreases, and if with a rise in the price of a good, the total
expenditure increases, then the demand for this good is less than unitary elastic.
Importance of Elasticity of Demand
The concept of elasticity of demand has been applied in a variety of fields in Economics such as price setting, wage
bargaining, determining the international terms of trade, indirect taxation and devaluation policy.
Types of Elasticity of Demand
• The price elasticity of demand for a good is the percentage change in the demand for the good divided
by the percentage change in its price.
• ep = Percentage change in the demand for the good/Percentage change in the price of the good
• The income elasticity of demand shows the tendency in quantity demanded for any commodity because
of 1% change in the money income of the consumer.
• ed = Percentage change in quantity demanded/Percentage change in money income
• The geometric method measures the elasticity of demand at different points on the demand curve and
is also known as the point method of measuring the elasticity of demand.
• eg = Lower segment of the demand curve/Upper segment of the demand curve
• The cross elasticity of demand measures the responsiveness of demand of a commodity to a change
in the price of other related commodity.
• ec = Percentage change in demand of commodity X / Percentage change in price commodity Y