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Econ01 Chapter 5 - Theory of Consumer Behavior

Theory of Consumer Behavior

Our analysis of demand permits us to determine the underlying factors affecting the level of consumer demand of a given commodity. An increase in the price of a commodity, we expect consumers to react by decreasing the quantity they want to buy. Our discussion of elasticity of demand further develop our understanding of demand by showing to us the extent of how consumers react to adjustment in price.

In this chapter, we further explain the behavior of demand by analyzing consumer behavior. The theory of consumer behavior describes how consumers buy different goods and services. Furthermore, consumer behavior also explains how a consumer allocates its income in relation to the purchase of different commodities and how price affects his or her decision. There are two theories that seek to explain consumer behavior. These are the utility theory and the indifference preference theory.

Consumer Behavior-Assumptions

1. Rational Consumer
2. Budget Constraints
3. Consumer Preferences

The Utility Theory of Demand

The utility theory explains consumer behavior in relation to the satisfaction that a consumer gets the moment he consumes a good. This theory was developed and introduced in 1870 by a British Economist, William Stanley Jevons. When we speak of utility in economics, we refer to the satisfaction or benefit that a consumer derives of his consumption. The utility theory of demand assumes that satisfaction can be measured. The unit of measure of utility is called utils.

Law of Diminishing Marginal Utility

The fundamental assumption of utility theory of demand is that the satisfaction that a person derives in consuming a particular product diminishes or declines as more and more of a good is consumed. In other words, as successive quantity of goods is consumed, the utility we derive diminishes. This is called the law of diminishing marginal utility.

Indifference Preference Theory

Another theory explaining consumer behavior is the indifference preference theory. Economist Vilfredo Pareto developed this modern approach to consumer behavior. Under this, that analysis of consumer behavior is described in terms of consumer preferences of various combinations of goods and services depending on the nature, rather than from the measurability of satisfaction in our previous discussion of the utility theory. Under the latter theory, consumer's taste and preferences were presented by the way of total and marginal utility.

Indifference Curve

An indifference curve is a locus of points each of which represents a combination of goods and services that will give equal level of satisfaction to a consumer. To illustrate this, we consider an individual who prefer a combination of 2 goods, say, food and clothing. Table 3 shows the combination of the quantities of the commodities that a consumer prefers. Let us assume that he is indifferent to any of the combination of food and clothing.

Table 3. Indifference Schedule (Food and Clothing)

Budget Line

The income of an individual acts as constraints on the qualities of bundles of goods he can purchase. We can buy commodities only up to the extent that our income allows us. In the same manner, do prices also constraints our ability to buy. With a fixed income, the higher the level of prices, the less will be the quantity we can purchase. These two constraints can be explained through the concept of a budget line. A budget line shows the combination of commodities that can be purchased at a given level of income.

Budget Schedule and Changes in Income

Consumer Equilibrium

Consumer equilibrium refers to the combination of goods that will give the highest level of satisfaction to a consumer that is within his purchasing power.