Theory of Consumer Behaviour

Law of Demand: Other things remaining constant (ceteris paribus), as the price of a good increases, the quantity demanded of that good decreases, and vice versa. In other words, price and quantity demanded are inversely related. Why does the demand curve slope downward? 1. Substitution effect: When a good's price rises, it becomes relatively more expensive than its substitutes. Consumers substitute cheaper alternatives for it. 2. Income effect: A price rise reduces the real purchasing power of consumers — they can afford to buy less of all goods, including this one. 3. New buyers: A lower price brings in new buyers who could not afford the good at the higher price. 4. Multiple uses: Some goods have multiple uses; at lower prices, consumers use them for more purposes. Exceptions to the Law of Demand (upward-sloping demand): 1. Giffen goods: Very inferior goods where the income effect outweighs the substitution effect — e.g., a staple food (coarse grain) in very poor households. When its price falls, the real income effect is so large that consumers shift to better foods, actually buying less of the Giffen good. 2. Veblen goods (conspicuous consumption): Luxury goods whose demand rises when price rises because higher price signals higher status — e.g., designer handbags, luxury cars. 3. Speculation: If consumers expect prices to rise further, they may demand more now at a higher price (e.g., shares, gold). Factors causing a shift in the demand curve (change in demand): 1. Income of consumers: A rise in income increases demand for normal goods (rightward shift), decreases demand for inferior goods. 2. Prices of related goods: A rise in the price of a substitute increases demand; a rise in the price of a complement decreases demand. 3. Tastes and preferences: Change in fashion, advertising, or social trends shifts demand. 4. Expectations of future price: Expectation of a future price rise increases current demand. 5. Number of consumers in the market: More consumers = higher market demand.

Elasticity of demand measures the responsiveness of quantity demanded to a change in a determinant of demand (price, income, or price of related goods). Price Elasticity of Demand (PED): PED = (% change in quantity demanded) ÷ (% change in price) Since price and quantity are inversely related, PED is normally negative — but we usually take the absolute value. Types of price elasticity: 1. Perfectly elastic (PED = ∞): A tiny price change causes an infinitely large change in quantity demanded. The demand curve is horizontal. 2. Perfectly inelastic (PED = 0): Quantity demanded does not change at all with a price change. The demand curve is vertical. (e.g., life-saving medicines) 3. Unitary elastic (PED = 1): A 1% price change causes exactly a 1% change in quantity demanded. 4. Relatively elastic (PED > 1): Quantity demanded changes proportionately more than price change. 5. Relatively inelastic (PED < 1): Quantity demanded changes proportionately less than price change. Determinants of price elasticity of demand: 1. Nature of the good — necessities vs. luxuries: Necessities (salt, insulin) tend to have inelastic demand; luxuries (jewellery, foreign holidays) tend to have elastic demand. 2. Availability of substitutes: Goods with many close substitutes (e.g., a specific brand of soft drink) have more elastic demand; goods with few substitutes (petrol) have less elastic demand. 3. Proportion of income spent: Goods on which consumers spend a small fraction of income (salt, matchsticks) tend to have inelastic demand. 4. Time period: Demand tends to be more elastic in the long run — consumers have more time to find alternatives and adjust behaviour. 5. Number of uses: Goods with multiple uses (electricity, coal) tend to have more elastic demand — when prices are low, they are used for more purposes. 6. Habit and addiction: Goods that are addictive (tobacco, alcohol) tend to have inelastic demand.

Budget Constraint (Budget Line): • The budget line shows all combinations of two goods (say, X and Y) that a consumer can afford by spending their entire income at given prices. • Equation: Px·Qx + Py·Qy = M, where M is income, Px and Py are prices of X and Y. • The slope of the budget line = −Px/Py (the price ratio), representing the rate at which the market requires the consumer to give up Y to get one more unit of X. • The budget line shifts outward (parallel) when income rises or when both prices fall proportionately. • The budget line rotates when the price of one good changes. Indifference Curves: • An indifference curve shows all combinations of X and Y that give the consumer the same level of satisfaction (utility). • Properties: (i) Downward sloping — to have more of X, the consumer must give up some Y; (ii) Convex to the origin — reflecting diminishing marginal rate of substitution (MRS); (iii) Higher indifference curves represent greater satisfaction; (iv) Two indifference curves never intersect. Consumer Equilibrium: • The consumer seeks to reach the highest possible indifference curve within their budget constraint. • Equilibrium is achieved at the point where the budget line is tangent to the highest attainable indifference curve. • At this point: MRS (slope of the IC) = Price Ratio (slope of the budget line) i.e., MRS(xy) = Px/Py • Interpretation: At equilibrium, the rate at which the consumer is willing to substitute X for Y (MRS) equals the rate at which the market allows them to substitute (the price ratio). • If MRS > Px/Py: the consumer values X more than the market does → buy more X (and less Y) → move along the budget line until MRS = Px/Py. • If MRS < Px/Py: buy more Y (and less X) until equilibrium is restored.