Theory of Consumer Behaviour

Theory of Consumer Behaviour explains how a consumer with limited income chooses between different goods to get the maximum satisfaction. In this chapter you will study the cardinal utility approach, with total utility, marginal utility and the law of diminishing marginal utility, and the condition for consumer's equilibrium, MUx/Px = MUy/Py. You will then use the ordinal approach: the budget set and budget line p1x1 + p2x2 = M, how the line shifts with changes in income and prices, and the consumer's preferences shown by indifference curves with a diminishing marginal rate of substitution. The consumer's optimum lies where the budget line is tangent to the highest attainable indifference curve, so that MRS equals the price ratio. From this you will derive the demand curve and the law of demand, distinguish normal and inferior goods, substitutes and complements, and separate movements along from shifts of the demand curve. The chapter ends with market demand and price elasticity of demand, its measurement by the percentage and geometric methods, its determinants, and its link with total expenditure.

Detailed Worksheet: Theory of Consumer Behaviour Section A - Definitions (10 marks) 1. Define marginal utility. State the law of diminishing marginal utility. (2 marks) 2. What is a budget line? Write its equation and slope. (2 marks) 3. Define the marginal rate of substitution. Why does it diminish along an indifference curve? (2 marks) 4. Distinguish between normal goods and inferior goods with one example of each. (2 marks) 5. Define price elasticity of demand. When is demand said to be elastic? (2 marks) Section B - Calculations and Applications (15 marks) 6. A consumer's total utility from 1 to 5 units of a good is 20, 36, 48, 56 and 60 utils. Calculate marginal utility at each unit and state the law it illustrates. (3 marks) 7. A consumer has an income of Rs 100. The price of good X is Rs 5 and of good Y is Rs 10. Write the budget line equation, find the maximum quantity of each good she can buy and the slope of the budget line. (3 marks) 8. The marginal utility of 1 to 5 units of good X is 40, 32, 24, 16, 8 and of good Y is 20, 18, 16, 12, 8 utils. The price of X is Rs 4, of Y is Rs 2 and income is Rs 20. Find the consumer's equilibrium combination and verify that the income is fully spent. (3 marks) 9. When the price of a good falls from Rs 10 to Rs 8, quantity demanded rises from 40 to 52 units. Calculate the price elasticity of demand by the percentage method and verify the result using the total expenditure method. (3 marks) 10. The demand function is q = 100 - 5p. Calculate the price elasticity of demand at p = 10 and at p = 12. Interpret each value. (3 marks) Section C - Diagrams (10 marks) 11. Draw a diagram showing the consumer's optimum with a budget line and three indifference curves. Show why points on lower or higher curves are not chosen. (4 marks) 12. Draw diagrams showing a parallel shift of the budget line due to an increase in income and a rotation due to a fall in the price of good X. (3 marks) 13. Draw a diagram showing the measurement of price elasticity of demand at different points on a straight line demand curve by the geometric method. (3 marks) Section D - Analysis and Higher-order Thinking (15 marks) 14. Explain the properties of indifference curves: they slope downward, are convex to the origin, higher curves give higher satisfaction and two curves never intersect. Prove the last property with a diagram. (5 marks) 15. Explain the effect on the demand for a good of (i) a rise in income if it is inferior, (ii) a rise in the price of a substitute, (iii) a rise in the price of a complement and (iv) a favourable change in tastes. Distinguish between change in quantity demanded and change in demand. (5 marks) 16. Explain the determinants of price elasticity of demand with examples. Why is the demand for salt inelastic while the demand for air travel is elastic? Explain how a firm's revenue changes with price in each case. (5 marks) Instructions: Time allowed 2 hours. Attempt all sections. Show schedules and formulae in calculations. Draw neat, labelled diagrams.