Theory of consumer behaviour

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1. Theory of consumer behavior

2. Muhammad Shahzaib khan harris bin shahid Arslan malik Muhammad sammad saqib azad najam ul saqib BBA 6 th A MANAGERIAL ECONOMICS

3. Contents: Introduction Marginal Utility Analysis, Law of marginal utility graphical representation Ordinal Utility and Cardinal Utility Approach Concept of Consumer Behavior – Budget Line and Budget Set Indifference Curve Analysis:- Meaning, Map and Properties Consumer's Equilibrium Marginal rate of substitution

4. introduction The purpose of the theory of demand is to determine the various factors that affect demand. Determinants: 1. The price of the commodity 2. Other prices 3. Income 4. Tastes 5. Income distribution 6. Total population 7. Wealth 8. Government policy

5. Introduction: the traditional theory of demand emphasis on consumer’s demand for durable and non-durable goods. It does not deal with investment goods. It is only a fraction of the total demand in the economy as a whole. The market demand is assumed to be the summation of the demands of individual consumers. If a consumer gets more utilities from a commodity, he would be willing to pay a higher price and vice-versa

6. Definitions: utility: Utility is wants satisfying power of a commodity which varies from person to person. The concept of utility is ethically neutral as harmful and useful things are both considered. The value-in-use of a commodity is the satisfaction which we get from the consumption of a commodity. Marginal utility: The additional utility derived from additional unit of a commodity. It refers to net addition made to the total utility by the consumption of an extra unit of a commodity. Total utility: The sum of utility derived from the different units of a commodity consumed by a consumer. The amount of utility derived from consumption of all units of a commodity which are at the disposal of the consumer

7. Marginal Utility Analysis: This theory is formulated by Alfred Marshall, a British Economist, seeks to explain how a consumer spends his income on different goods and services so as to attain maximum satisfaction. Assumptions of utility analysis: 1. Utility is based on the cardinal concept. 2. Utility is measurable and additive of goods. 3. The marginal utility of money is assumed to be constant 4. The hypothesis of independent utility

8. Marginal Utility Analysis: 5. The consumer is rational. 6. He has full knowledge of the availability of commodities and their technical qualities. 7. Possesses perfect knowledge of the choice of commodities. 8. There are no substitutes. 9. Utilities are not influenced by variations in their prices. 10. The theory ignores complementary between good

9. Law of diminishing marginal utility: The law of marginal utility is based on the human wants. The law was first developed by German Economist H.H Gossen which is known as “Gossen’s First law”. Later it was popularized by Prof. Alfred Marshal “The additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has”. - Alfred Marshall

10. Law of diminishing marginal utility Assumptions: 1. Tastes, preferences, etc. of the customer remain constant. 2. Income of the consumer also remain constant 3. Units of the goods are identical or similar 4. The process of consumption is continuous. 5. Units of the goods are not very small in size Importance: 1. Framing taxation policy by the government. 2. Useful to consumer to regulate his expenditure. 3. Useful to monopolist producer in fixing the prices of his products. 4. Basis for law of demand. 5. Differentiate value-in-use and value-in-exchange

11. Law of diminishing marginal utility Explanation of the law •Suppose a person consumes the first apple, he derives the highest level of utility and the intensity of his desire declines. •If he consumes the second apple, he will get lesser satisfaction than first apple. •The utility that he gets from the third apple will be still less. •If he continues to consume more and more apples, utility from each apple goes on diminishing as the intensity of his desire goes on diminishing. Thus, the law of diminishing marginal utility simply tells us that we obtain less and less marginal utility from the successive units of a commodity as we consume more and more of it

12. Explanation to the graph: The Total Utility (TU) declines in positive rate but the Marginal Utility (MU) declines in a negative rate. Total utility rises by smaller amounts. The negative slope of the marginal utility curve reflects the law of diminishing marginal utility. Saturation point is when the total utility is unchanged. Marginal utility declines from larger to smaller units

13. Limitations: 1. Different units consumed must be identical and the habit, taste, income and treatment of the consumer also remain unchanged .2. Different units consumed should be standard units. 3. Continuous consumption. I.e. no gap between two consumption of one unit and another unit. 4. Law does not apply to articles like gold, cash, money, music, hobbies, 5. The shape of the utility curve may be affected by the presence or absence of articles which are substitutes to it.

14. Conclusion: Utility reflects the tastes of a particular individual, uniqueness to the individual and reflects his or her own particular subjective preferences and perceptions. Utility remain unchanged so long as the individual’s tastes remain the same

15. Ordinal and cardinal approach: In order to attain this objective the consumer must be able to compare the utility of the various commodities which can buy with his income. There are two basic approaches to the problem of comparison of utilities Ordinal approach: The ordinalist school postulated that utility is not measurement, but is an ordinal magnitude. The consumer need not know in specific units the utility of various commodities to make his choice. It is needed for him to rank the various commodities. He must be able to determine his order of preference among the different bundles of goods. The main ordinal theories are the indifference-curves approach and the revealed preference hypothesis

16. Cardinal approach: 2. The cardinal approach The cardinalist school postulated that utility can be measured. Various suggestions have been made for the measurement of utility. Under certainty of full knowledge about the market conditions and income levels, some economists have suggested that utility can be measured by monetary units; utility, by the amount of money the consumer is willing to sacrifice for another unit of a commodity

17. concept of consumer behavior: • Consumer behavior is the study of how individual customers ,groups or organizations; select, buy, use, and dispose ideas, goods, and services to satisfy their needs and want It refers to the actions of the consumers in the market place and the underlying motives for those actions. "Consumer behavior is the decision process and physical activity, which individuals engage in when evaluating, acquiring, using or disposing of goods and services". - Louden and Bit

18. Nature of Consumer Behavior: 1. Influenced by various factors: Factors which influence consumer behavior Marketing factors such as product design, price, promotion, packaging, positioning and distribution.  Personal factors such as age, gender, education and income level.  Psychological factors such as buying motives, perception of the product and attitudes towards the product.  Situational factors such as physical surroundings at the time of purchase, social surroundings and time factor.  Social factors such as social status, reference groups and family.  Cultural factors, such as religion, class,

19. Nature of Consumer Behavior 2. Consumer behavior is not static 3. Varies from consumer to consumer 4. Varies from region to region and country to county 5. Information on consumer behavior is important to the marketers: Factors for marketing decisions: a) Product design/model b) Pricing of the product c) Promotion of the product d) Packaging e) Positioning f) Place of distribution Part

20. Nature of consumer behavior: 6.Leads to purchase decision 7. Varies from product to product 8. Improves standard of living 9. Reflects status of a customer

21. Budget line: A higher indifference curve shows a higher level of satisfaction than a lower one.• A consumer in his attempt to maximize satisfaction will try to reach the higher possible indifference curve• In pursuit of buying more and more goods, he will obtain more and more satisfaction .It includes two constraints:1. He has to pay the prices for the goods 2. He has a limited money income with which to purchase the good

22. Budget line: A budget line shows all those combinations of two goods. The consumer can buy spending his given money income at their given prices. All those combinations which are within the reach of the consumer will lie on the budget line. Consumer Budget states the real income or purchasing power of the consumer from which he can purchase certain quantitative bundles of two goods at given price

23. Indifference Curve Analysis: A very popular, easier and scientific method of explaining consumer’s demand is the indifference curve analysis. • This approach to consumer behavior is based on consumer preferences. • Human satisfaction is psychological phenomenon which cannot be measured in terms of monetary terms. • This approach is more realistic to order preferences. • Consumer preference approach is therefore an ordinal concept based on ordering of preferences compared with Marshall’s approach of cardinality

24. Indifference curve analysis: Indifference curve An indifference curve is the locus of points- particular combinations or bundles of goods- which yield the same utility(level of satisfaction) to the consumer, so that he is indifferent as to the particular combination he consumes. In other words, an indifference curve is a graph showing combination of two goods that give the consumer equal satisfaction and utility. Each point on an indifference curve indicates that a consumer is indifferent between the two and al points give him the same utility. U = F(X, Y) = K

25. Indifference map: Map shows all the indifference curves which rank the preferences of the consumer. Combinations of goods situated on an indifference curve yield higher level of satisfaction and are preferred. Combinations on the lower indifference curve yield a lower utility

26. Marginal Rate of Substitutie : MRS is the rate at which the consumer is prepared to exchange goods X and Y. Under the standard assumption of Neo-classical Economics, the goods and services are: Continuously divisible The marginal rates of substitution will be the same regardless of direction of exchange • It will correspond to the slope of an indifference passing through the consumption bundle

27. Marginal Rate of Substitution: Explanation of law •A person consumes1 unit of food and 12 units of clothing. • Then, he gives up 6 units of clothing to get an extra unit of food, his level of satisfaction remaining the same. The MRS is 6. • Hence, He moves from B to C and from C to D in his indifference schedule, the MRS is 2 and 1 respectively. • MRS of X for Y as the amount of Y whose loss can just be compensated by a unit gain of X, the level of satisfaction remains the same. • As the consumer have more and more units of food; he is prepared to give up less and less units of cloths. Thus MRS is diminishing

28. Optimal choice of the consumer/ Consumer’s equilibrium: After attaining the stage of indifference curve and budget constraint, consumer has to reach equilibrium position. A consumer derives maximum possible satisfaction from the goods at equilibrium position. A consumer cannot rearrange his purchase of goods at that level. Assumptions: 1. The consumer has given indifference map which shows his scale of preferences for various combinations of two goods X and Y. 2. He has a fixed money income which he has to spend wholly on goods X and Y. 3. The prices of goods X and Y are given fixed for him.

29. Consumer’s equilibrium According to the graph: • IC1, IC2, IC3, IC4, IC5 are the indifference curves • PL is the budget line for goods X and Y. • Combinations R, S, Q, T, H cost the same The customer’s aim is to reach highest indifference curve which maximises his satisfaction.R or H lies on a lower indifference curve IC1,S or T lies on a lower indifference curve IC2,Whereas IC4 and IC5 are beyond the consumer’s money income

30. Consumer’s equilibrium:

31. Consumer’s equilibrium: Conclusion: • Thus the consumer will be at equilibrium at point Q on IC3. • The consumer will buy OM of X and ON of Y. •Since there is a budget constraint, he will be forced to remain on the given budget line. • He will have to choose only combinations which lie on the given price line.