THEORY OF CONSUMER BEHAVIOUR

2.

The fundamental duty of micro economics is to determine the price of the commodity in the market. There are two agents in the markets they are sellers and consumers. The consumer purchase different quantity of commodity on the basis of following factors. Price of the commodity Income of the consumer Taste and preference of the consumer Time period Quality of the product etc.

• • • • •

The consumer behavior can be analyses with the assumption of the market with 2 goods. Suppose there are two goods in market they are good1 and good2. The price of the 2 goods are P1 and P2. The consumer can able purchase either good1 or good2 or both the goods. For example: The consumer Anil have an income of ₹ 40. Price of good1 and good2 is ₹ 10. The possible bundles of these goods are the following: (0,0) (0,1) (0,2) (0,3) (1,3) (0,4)

(1,0) (1,1) (1,2)

(2,0) (2,1) (2,2)

(3,0) (3,1)

(4,0) The consumption bundle of the 2 goods is the combination of the different goods made available to the consumers

Bundle: Any combination of the amount of good1 and good2 good1 is denoted by X1 and good2 is denoted by X2. Then (X1,X2) is a bundle of good1 and good2 The consumer budget: If the consumer’s income and price of two goods are given. Then consumers can buy only those bundles which cost less than or equal to his income.

Budget set: It is the sum total of consumption bundle available to the consumer with his available income. So the equation of the budget set is P1X1 + P2X2 ≤ M Example: The bundle (2,2) represent 2 unit of good1 and 2 unit of good2. In our example the consumer spends his entire income for the purchase of 2 goods equally, if the consumer spend his entire income , the possible bundles are (0,4) (1,3) (2,2) (3,1) (4,0). All the other bundles in the budget set spends only the income which is less than `M’ . Budget line: It is a graphical representation of all bundles, those cost exactly equal to consumer`s income. It is a straight line having the vertical intercept M/P2 and horizontal intercept M/P1. Equation of the budget line P1X1 + P2X2 = M

ISLA COMMERCE ACADEMY _ ICA

5

? Prepare budget line from the following

5 (0,5)

• • •

Good 2

information P1 = ₹ 2 P2 = ₹ 4 M = ₹ 20

4

(2,4)

3

(6,2)

2 A) Any combination along the budget line shows cost of bundle exactly equal to consumer income.

(8,2)

1 0

(0,5) (2,4) (4,3) (6,2) (8,2) (10,0)

1

2

3

4 5 Good1

6

7

8

9

(10,0) 10

Slope of budget line: The slope of budget line measures the amount of changes in good2 required per unit of change in good1 along the budget line. The equation of the slope of the budget line is – p1 / p2

Budget set

P1X1 + P2X2 ≤ M

Budget line

P1X1 + P2X2 = M

Slope of budget line

– P1/P2

Horizontal intercept

M/P1

Vertical intercept

M/P2

Changes in budget line: Budget line changes due to following reasons. • •

Changes in the consumer income Changes in the prices of the good

? Prepare budget set such that P1X1 + P2X2 = M. prepare budget line from the following cases, identify the changes happened in each cases and analyses the changes in the budget line. Initially the consumer has an income of ₹ 50 the price of good1 is ₹ 10 and the price of good2 is ₹ 5. The commodity are available at integer unit. Case 1 M = ₹ 100 P1 = ₹ 10 P2 = ₹ 5

Case 2 M = ₹ 30 P1 = ₹ 10 P2 = ₹ 5

Case 3 M = ₹ 50 P1 = ₹ 5 P2 = ₹ 5

Case 4 M = ₹ 50 P1 = ₹ 25 P2 = ₹ 5

Case 5 M = ₹ 50 P1 = ₹ 10 P2 = ₹ 10

Case 6 M = ₹ 50 P1 = ₹ 10 P2 = ₹ 2.5

6

A) Initial budget set (0,10) (1,8) (2,6) (3,4) (4,2) (5,0) Case 1

Case 2

- budget line shifts parallel to upward or rightward

20

10

- Slope of budget line is same - Vertical intercept increase

10

- Shift to downward or leftward - slope remain same

6

- V I decrease

- Horizontal intercept increase

0

5

10

- H I decrease

0

Case 3

10

- Budget line swing upward with same vertical intercept

10

- slope of budget line decrease

3

case 4 - swing downward - slope of B.line increase

- Vertical intercept remain same

5

- V I remain same

- Horizonta intercept increase

0

5

10

- H I decrease

0

Case 5

- slope of budget line decrease - Vertical intercept decrease - Horizontal intercept remain same

0

5

2

5

Case 6

10 - B.line swing downward with same horizontal intercept 20

5

5

- B. line swing upward - slope of B.line increase

10

- V I increase - H I remain same

5

7

Preference of consumer The budget set consist of all bundle that are available to the consumer. The consumer can choose his consumption bundle on the basis of his taste and preference over the bundles in the budget set. The consumer has well defined preference over the set of possible bundle. He can compare any 2 bundles inorder of his preference. Monotonic preference

Bundle

Rank

(2,2)

First

(1,3) (3,1)

Second

(1,2) (2,1)

Third

(1,1)

Forth

(0,0) (0,1) (1,0) (2,0) ….. Fifth Monotonic preference are the preference bundles which has more of atleast one of the good and no less of other good has compared to other. Suppose 2 bundles one consist of 2 apple and 3 lemon (2,3) and other bundle consist of 2 apple and 2 lemon (2,2) are available to consumer. He prefer bundle (2,3) than (2,2). Because one of the lemon is more than in this bundle, without reducing number of apple. Such preference is called Monotonic preference Substitution between the two goods The rate of the substitution is the amount of good2 that the consumer willing to give for an extra unit of good1, in the term of good2. The rate of substitution reward the consumer preference. The consumer is indifferent to the bundle (1,2) (2,1) at (1,2) the consumer is willing to give up 1 unit of good to get an extra unit of good1 the rate of substitution between good1 and good2 is 1.

Utility It means wants satisfying capacity of a commodity. Inorder to analyse the consumer behavior we must have a knowledge about the level of satisfaction from the consumption of goods and services. There are two different approaches they are 1. Cardinal approach 2. Ordinal approach 1. Cardinal approach • • • •

•

It was put forward by Alfred Marshall It measures the utility of a commodities by numerical terms Util is the unit of measurement of utility According to Alfred Marshall, a consumer consumes more and more unit of a commodity the marginal utility derived from this consumption is gradually diminishes this concept is popularly known as law of diminishing marginal utility The law can be explained by the following assumption: 1. The commodities are unique 2. No time gap between the consumption of 2 unit 3. The commodity is not a habitual commodity

8

The law can be explained by the following table Unit of consumption 0

Total utility/ satisfaction -

Marginal utility/ satisfaction -

1

10

10

2

18

8

3

24

6

4

28

4

5

30

2

6

30

0

7

28

-2

Total utility: Total satisfaction derived by the consumer from the consumption a particular unit of commodity

Marginal utility: It is the additional made to total satisfaction by the consumer from the consumption of an additional unit of commodity

2. Ordinal approach • •

It was put forward by J.K. Hicks. According to him utility cannot be measured in numerical terms it is possible only to compare the utilities from different units of consumption this approach is also called indifference curve approach

Indifference curve: It is a graphical representation of different bundles of good1 and good2 that give level of satisfaction Properties of indifference curve o o o o o o

Any bundle along the indifference curve give same level of satisfaction Indifference curve is convex to origin Higher indifference curve give higher level of satisfaction Indifference curve is a downward slopping curve Indifference curve never intersect each other Indifference curve never touch the both axis

IC

Implication of point above and below the indifference curve C is the bundle above the indifference curve, that have more atleast one good and no less of other good as compared to the bundle A and B along the indifference curve shows Monotonic preference. • • •

C is preferred bundle (monotonic preference) A and B – consumer is indifferent D is inferior bundle

D

IC A

C

B

9

Good 2

Indifference map: Consumer preference over all bundle can expressed in indifferent map. Indifferent map is a set of indifferent curves. Higher indifference curve shows higher level of satisfaction

IC1

IC2

IC3

Good1

Optimum choice of consumer • •

• •

• •

Budget line shows the set of available bundles with his available income The bundles on the budget line shows maximum quantity of commodity with his available income In the IC analysis we discuss the consumer preference over available bundles. The different bundles on the same IC gives equal level of satisfaction to the consumer that means the consumer is indifferent between the 2 bundles on the IC Higher IC shows higher level of satisfaction to the consumer So a rational consumer always try to get a bundle on a higher possible IC.

Y M/P2

A IC3 IC2 IC1 0 M/P1

X

The rational consumer is the consumer, who tried to get a maximum satisfaction with limited income or resources. The optimum choice of the consumer is at a point were, the highest possible IC is tangent to the budget line In our diagram M/P1 is the horizontal intercept and M/P2 is the vertical intercept. The budget line shows the available bundles of good with his available income. IC1, IC2, IC3 are 3 indifference curve available to the consumer IC3 Gives higher level of satisfaction to the consumer but IC3 not desirable to the consumer because of limited income. Second possible higher IC is IC2. A is the point of optimum choice of the consumer. At point A the higher possible IC2 is tangent to the budget line. Thus the preference of the consumer and his choice rewards at the point A.

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Demand Generally demand means the desire or want for a thing, but in economics mere desire is not considered demand, only when the desire for a commodity is backed by the ability and willingness to pay for it, the desire become demand. So the demand is a desire backed by ability to pay and willingness to pay for a commodity Factors affecting the demand. 1. Price of the commodity: The price of the commodity is the most important factor that influencing demand. The price of the commodity and quantity demand for a commodity is inversely related. When price of the commodity increases the quantity demand will decrease and vice versa 2. Income of the household: It may directly influence the quantity demand for the commodity. When the income of the consumer increases the consumer is able to purchase more quantity, so demand increase and vice versa. There is a direct or positive relationship between the income of the consumer and the quantity demand for a commodity. a) Inferior good: In case of inferior good, quantity moves opposite direction of movement of income. A good can be inferior good for a consumer at some level of income and normal good for his at higher level of income b) Normal goods:

Normal good

Income

Income

Inferior good

0

0 Quantity DD Quantity DD Quantity that consumers choose increase with increase in the income and vice versa. Such good is called normal good

3. Taste and preference of the consumer: The taste and preference of the consumer directly influence their demand for a commodity. The taste and preference of the consumer may change according to the influence of advertisement, change in fashion, the eagerness of the people to imitate others etc. the change in these factors will change the preference of the consumer 4. Price of other related goods: Price of other commodity also effect quantity demand for a commodity. It can be explained by the following ways a) Substitute goods: • Substitute goods are those goods which are substituted in the place of other. • Eg: tea and coffee, bike and scooter, t-shirt and shirt, pen and pencil etc.

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There is a direct relationship between the demand for a commodity (Tea) and the price of its substitute goods (Coffee)

•

b) Complimentary goods: • Complimentary goods are those goods which are complimentary to each other to satisfy a particular wants • Eg: Teacher and student, vehicle and petrol, cycle and tire etc. • There is a inverse relationship between quantity demand of a commodity (Vehicle) and the price of its complimentary good (Petrol) 5.

Time period: It is also an important determination of quantity demand for a commodity. Time period mere means different seasons, climate condition etc.

6. Anticipation about future: Anticipation about the changes in the prices of the commodity in the market will influence the quantity demand of a commodity. The people expect a fall in prices in the future will lead to a decrease in the quantity demand and vice versa. 7. Taxes imposed by government 8. Natural calamities 9. Population of the market

Demand function: It explains the functional relationship between the quantity demand of a commodity and the factors influencing quantity demand. Let Dn is the quantity demand of a commodity and Pn, Y, T, P1, P2, ……. Pn-1, O be the factors influencing demand. Dn = F (Pn, Y, T, P1, P2, …. Pn-1,O) Where, Dn - Quantity demand of a commodity F - Functional relationship Pn - Price of the commodity Y - Income of the household T - Taste and preference of the consumer P1, P2, …. Pn-1 - Price of the related goods - Others

Law of demand •

Law of demand shows the relation between price and quantity demanded of a commodity in the market

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• • •

The law of demand state that the quantity demand of a commodity various inversely with his price and all other determinants of demand remains the same In the words of Marshall “the amount demanded increases with a fall in price and diminishes with a rise in price” According to Samuelson, “Law of Demand states that people will buy more at lower price and buy less at higher prices”. The concept of law of demand may be explained with the help of a demand schedules.

Individual demand Schedule

Price of Orange 10 8 6 4 2

Quantity demand 1 2 3 4 5

Price

An individual demand schedule is a list of quantities of a commodity purchased by an individual consumer at different prices. The following table shows the demand schedule of an individual consumer for Orange. Demand curve 10 8 6 4 2 1 Demand curve

2

3

4

5

Quantity DD

It is a graphical representation of demand schedule. It is a curve showing the various quantity of a commodity at different prices. The demand curve DD shows the inverse relation between price and demand of Orange. Due to this inverse relationship, demand curve is slopes downward from left to right. This kind of slope is also called “negative slope”

Market demand schedule Market demand refers to the total demand for a commodity by all the consumers. It is the aggregate quantity demanded for a commodity by all the consumers in a market. It can be expressed in the following schedule.

Price of Apple 10 8 6 4 2

A 1 2 3 4 5

Quantity demand by consumers B 2 3 4 5 6

C 1 3 5 7 9

Market demand 4 8 12 16 20

13

Market demand curve D

8 6 4 D

2 0

4

8

12

16

20

Quantity DD

Linear demand:

a/b

A linear demand can be written as d(p) = a-bp ; 0 ≤ P ≤ a/b d(p) = 0 when P > a/b

Price

Price

10

where, a = Horizontal intercept -b = slope of demand curve a/b = Vertical intercept

0

Quantity DD

a

At price `0` the quantity demand is `a` and price a/b the demand is 0. The slope of the demand is measures the rate at which demand changes with respect to its price.

Market demand function: • •

Market demand function is obtained by adding up to linear demand function or curves Assume, In a market there are 2 consumers, consumer A and consumer B The demand curve of consumer A- d(p) = 10 – p, 0 ≤ p ≤ 10 and d(p)=0 when p > 10 The demand curve of consumer B- d(p) = 15 – p, 0 ≤ p ≤ 15 and d(p)=0 when p > 15

• •

•

At any price greater than 10 the consumer A demands 0 unit of the commodity. That means the first function operate only when the price is less than or equal to 10. At any price greater than 15 the consumer B demands 0 unit of commodity. That means the second function operate only when the price is less than or equal to 15. The linear market demand curve is obtained by adding up 2 individual demand function. So linear market demand function. 10 – P + 15 – P 25 – 2P

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• • •

The market demand function 25- 2P operate only when the price is ≤ 10. For any price greater than 10 or equal to 15 market demand is 15 – P. For any price greater than 15 market demand is zero.

Why does demand curve slopes downward? Demand curve slopes downward from left to right (Negative Slope). There are many causes for downward sloping of demand curve:1. Law of Diminishing Marginal utility As the consumer buys more and more of the commodity, the marginal utility of the additional units falls. Therefore the consumer is willing to pay only lower prices for additional units. If the price is higher, he will restrict its consumption 2. Income effect When the price of the commodity falls, the real income of the consumer will increase. He will spend this increased income either to buy additional quantity of the same commodity or other commodity. 3. Substitution effect When the price of tea falls, it becomes cheaper. Therefore the consumer will substitute this commodity for coffee. This leads to an increase in demand for tea.

4. Different uses of a commodity Some commodities have several uses. If the price of the commodity is high, its use will be restricted only for important purpose. For e.g. when the price of tomato is high, it will be used only for cooking purpose. When it is cheaper, it will be used for preparing jam, pickle etc... Exceptions to the Law of Demand. (Exceptional Demand Curve). The basic feature of demand curve is negative sloping. But there are some exceptions to this. I.e... In certain circumstances demand curve may slope upward from left to right (positive slopes). These phenomena may due to; 1. Giffen paradox The Giffen goods are inferior goods is an exception to the law of demand. When the price of inferior good falls, the poor will buy less and vice versa. When the price of maize falls, the poor will not buy it more but they are willing to spend more on superior goods than on maize. Thus fall in price will result into reduction in quantity. This paradox is first explained by Sir Robert Giffen. 2. Veblen or Demonstration effect.

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According to Veblen, rich people buy certain goods because of its social distinction or prestige. Diamonds and other luxurious article are purchased by rich people due to its high prestige value. Hence higher the price of these articles, higher will be the demand. 3. Ignorance. Sometimes consumers think that the product is superior or quality is high if the price of that product is high. As such they buy more at high price. 4. Speculative Effect. When the price of commodity is increasing, then the consumer buy more of it because of the fear that it will increase still further. 5. Necessaries In the case of necessaries like rice, vegetables etc., People buy more even at a higher price.

Changes in demand Demand of a commodity may change. It may increase or decrease due to changes in certain factors. These factors are called determinants of demand. Changes of demand is classified into 4 a) b) c) d)

Extension of demand Contraction of demand Increase in demand Shift in demand Decrease in demand

Extension and Contraction of Demand • • • •

Demand may change due to various factors. The change in demand due to change in price only, where other factors remaining constant, it is called extension and contraction of demand. A change in demand solely due to change in price is called extension and contraction. When the quantity demanded of a commodity rises due to a fall in price, it is called extension of demand. On the other hand, when the quantity demanded falls due to a rise in price, it is called contraction of demand. It can be understand from the following diagram. D P1

b Contraction a

P

Extension c

P0

In demand curve, the area a to c is extension of demand and the area a to b is contraction of demand. As result of change in price of a commodity, the consumer moves along the same demand curve.

D 0

Q0

Q

Q1 16

Shift in Demand (Increase or Decrease in demand) • • • •

When the demand changes due to changes in other factors, like taste and preferences, income, price of related goods etc... , it is called shift in demand. Due to changes in other factors, if the consumers buy more goods, it is called increase in demand or upward shift. On the other hand, if the consumers buy fewer goods due to change in other factors, it is called downward shift or decrease in demand. Shift in demand cannot be shown in same demand curve. The increase and decrease in demand (upward shift and downward shift) can be expressed by the following diagram.

DD is the original demand curve. Demand curve shift upward due to change in income, taste & preferences etc of consumer, where price remaining the same.

D2 D1

D

In the above diagram demand curve D2- D2 is showing upward shift or increase in demand and D1-D1 shows downward shift or decrease in demand.

P

D1 0

L

M

D

D2

N

Comparison between extension/contraction and shift in demand

•

Extension/Contraction of Demand Demand is varying due to changes in price

•

Shift in Demand Demand is varying due to changes in other factors (Non-price factors)

•

Other factors like taste, preferences, income etc... remaining the same

•

Price of commodity remain the same

•

Consumer moves along the same demand curve

•

Consumer may moves to higher or lower demand curve

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Elasticity of demand • • • •

This concept explains the relationship between a change in price and consequent change in quantity demanded Elasticity of demand can be defined as “the degree of responsiveness in quantity demanded to a change in price”. Thus it represents the rate of change in quantity demanded due to a change in price There are mainly three types of elasticity of demand:

1. Price Elasticity of Demand. 2. Income Elasticity of Demand. 3. Cross Elasticity of Demand. Price elasticity of demand: Price Elasticity of demand measures the change in quantity demanded to a change in price. It is the ratio of percentage change in quantity demanded to a percentage change in price. This can be measured by the following formula. Percentage change in demand for the good ep = Percentage change in price for the good • • • •

OR ep =

∆q p ∆p * q

∆q – change in quantity demand ∆p – change in price P – initial price q – initial quantity

Degree of elasticity of demand There are five types of price elasticity of demand a) b) c) d) e)

Perfectly elastic demand Perfectly inelastic demand Relatively elastic demand Relatively inelastic demand Unitary elastic demand.

Perfectly elastic demand (ep= ∞) When a small change in price leads to infinite change in quantity demanded, it is called perfectly elastic demand. In this case the demand curve is a horizontal straight line as given below.

Price

Demand curve

0

Quantity 18

Perfectly inelastic demand (ep= 0) In this case, even a large change in price fails to bring about a change in quantity demanded. I.e. the change in price will not affect the quantity demanded and quantity remains the same whatever the change in price. Here demand curve will be vertical line as follows

Demand curve

Price

0

Quantity

Relatively elastic demand (ep ≥ 1) Here a small change in price leads to very big change in quantity demanded. In this case demand curve will be fatter one

Price p

D

P1 D 0

Quantity Q

Q1

Relatively inelastic demand (ep ≤ 1) Here quantity demanded changes less than proportionate to changes in price. A large change in price leads to small change in demand. In this case demand curve will be steeper

Price

D

P1 p D 0

Unit elasticity of demand (ep=1) ( unitary elastic) Here the change in demand is exactly equal to the change in price. When both are equal, ep= 1, the elasticity is said to be unitary.

Q1

Q Quantity

Price p P1 0

Q

Q1

Quantity

19

The above five types of elasticity can be summarized as follows Type Perfect elastic Perfectly inelastic Unitary elastic Relatively elastic Relatively inelastic

Numerical expression Α 0 1 >1 <1

Description Infinity Zero 1 More than 1 Less than 1

Shape of curve Horizontal Vertical Rectangular hyperbola Flat Sleep

Income Elasticity of Demand Income elasticity of demand shows the change in quantity demanded as a result of a change in consumers‟ income. Income elasticity of demand may be stated in the form of formula: ey=

Proportionate change in demand Proportionate change in income

Cross Elasticity of Demand • • • •

Cross elasticity of demand is the proportionate change in the quantity demanded of a commodity in response to change in the price of another related commodity. Related commodity may either substitutes or complements. Examples of substitute commodities are tea and coffee. Examples of compliment commodities are car and petrol. Cross elasticity of demand can be calculated by the following formula;

Cross elasticity=

Proportionate change in quantity demand of a commodity Proportionate change in the price of related commodity

Measurement of Elasticity There are various methods for the measurement of elasticity of demand. Following are the important methods: 1. Proportional or Percentage Method: Under this method the elasticity of demand is measured by the ratio between the proportionate or percentage change in quantity demanded and proportionate change in price. It is also known as formula method. It can be computed as follows: ED = Proportionate change in quantity demanded Proportionate change in price. (OR) ED= ∆ q p * ∆p q 20

2. Expenditure or Outlay Method: This method was developed by Marshall. Under this method, the elasticity is measured by estimating the changes in total expenditure as a result of changes in price and quantity demanded • • •

If the price changes, but total expenditure remains constant, unit elasticity exists. If the price changes, but total expenditure moves in the opposite directions, demand is elastic (>1). If the price changes and total revenues moves in the same direction, demand is inelastic (<1). Price of the commodity 10 9

Quantity demand 9 10

Total expenditure q*p 90 90

3. Geometric or Point method: This also developed by Marshall. This is used as a measure of the change in quantity demanded in response to a very small change in the price. In this method we can measure the elasticity at any point on a straight line demand curve by using the following formula; a Ep = ∞ ED = lower sector of the demand curve Ep > 1 b Price Upper sector of the demand curve Ep =1 c d Ep < 1 e Ep = 0 0 Quantity 4. Arc Method: The point method is applicable only when there are minute (very small) changes in price and demand. Arc elasticity measures elasticity between two points. It is a measure of the average elasticity ED =

∆q ∆p

p1 + p2 * q1 + q2

Determinants of elasticity. Elasticity of demand varies from product to product, time to time and market to market. This is due to influence of various factors. They are; 1. Nature of commodity- Demand for necessary goods (salt, rice,etc,) is inelastic. Demand for comfort and luxury good are elastic. 2. No. of close substitutes – A commodity against which lot of substitutes are available, the demand for that is elastic. But the goods which have no substitutes, demand is inelastic.

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3. Extent /variety of uses- a commodity having a variety of uses has a comparatively elastic demand. Eg.Demand for steel, electricity etc. 4. Postponement/urgency of demand- if the consumption of a commodity can be post pond, then it will have elastic demand. Urgent commodity has inelastic demand. 5. Income level- income level also influences the elasticity. E.g. Rich man will not curtail the consumption quantity of fruit, milk etc, even if their price rises, but a poor man will not follow it. 6. Durability of commodity- if the commodity is durable or repairable at a substantially less amount (eg.Shoes), the demand for that is elastic. 7. Purchase frequency of a product/time –if the frequency of purchase of a product is very high, the demand is likely to be more price elastic. 8. Others – the habit of consumers, demand for complimentary goods, distribution of income and wealth in the society etc., are other important factors affecting elasticity.

Elasticity along linear demand curve

a/b ep = ∞

Price

ep > 1

ep = 1 a/2b ep < 1

ep = 0 0 a

Quantity

22