Consumer Behaviour

Have you ever wondered why people switch goods or cut back on spending when prices increase or their income drops? In this section, you will uncover the reasons behind these choices through two powerful ideas, the substitution effect and the income effect.

You will also see how simple maths can help explain these everyday decisions. In your earlier studies, you explored utility, that is, the satisfaction people derive from goods and learned that the more people consume, the less joy they get from each extra unit.

That was the Law of Diminishing Marginal Utility. Later, you took it further by working out total, average and marginal utility and how they guide consumer equilibrium using utility graphs. Now, you are set to connect it all and explain how real consumers react to changes in price and income, using utility as your lens.

KEY IDEAS

• Economists use mathematical models to show how consumers maximise satisfaction (utility), illustrating how substitution and income effects influence decisions.

• Substitution and income effects explain how consumers adjust their choices when there is a change in prices by switching goods or feeling richer or poorer.

• The income effect shows how a change in a consumer’s income (purchasing power) affects what they buy. If a consumer’s income increases, they may buy more of normal goods and fewer of inferior goods.

• The substitution effect shows that when a good becomes more expensive, consumers buy cheaper alternatives instead.

Introduction In Ghana, whenever the prices of goods or services change, consumers also change the quantity they buy. This behaviour is explained by two important concepts. These concepts help us understand why consumers may buy more or less of a commodity when prices change, holding all other factors constant. These concepts are the substitution effect and the income effect.

Substitution Effect

The substitution effect happens when consumers stop buying a more expensive commodity and switch to a cheaper alternative as a result of a change in the price. This increases consumers’ satisfaction without increasing their spending.

For example, if the price of Cindy rice increases, many families in Ghana might stop buying it and rather increase their demand for local rice like “Anloga rice”. This is because the local rice becomes the cheaper option, so they substitute it for the expensive one. Again, if prices of clothes in boutiques in Accra increase, shoppers might choose second-hand clothes “foose” from Kantamanto or Madina markets instead. The substitution effect allows consumers to still enjoy similar goods or services without increasing their spending.

Tip: Have you ever stopped buying something because it got too expensive and chose a cheaper option instead?

Income Effect

The income effect shows how a change in the price of goods affects the quantity consumers buy with their income. When prices decrease, consumers become richer since they can buy more commodities even though their income has not increased.

This increases the consumers’ satisfaction(utility). This is known as the income effect.

For instance, if the price of maize decreases in the local markets, low-income families can now buy more maize-related food or save money to pay for other services like mobile credit. Even though salaries have not increased, the decrease in prices increases the real incomes of consumers.

Again, if the government reduces electricity tariffs, people may increase their usage of power for refrigeration, ironing and Air conditioning because they feel they have more money left at the end of the month to pay for it. This rise in consumption, caused by an increase in real income, is known as the income effect.

Suppose the telecommunication companies reduce charges on internet data for students on university campuses in Ghana:

• Substitution Effect: Students at the University of Ghana may start streaming live football matches instead of going to the DSTV Centre to watch football matches, since mobile data becomes cheaper.

• Income Effect: Because they now spend less on data, they have more money to buy other stuff like second-hand clothes.

So, the students’ change in what they buy is influenced by both the income effect (feeling richer or poorer) and the substitution effect (switching to cheaper alternatives).

Application in Economic Decision Making in Ghana

The knowledge of income and substitution effects helps

1. Businesses set prices to attract consumers.

Example: In Ghana, telecommunication companies like MTN and Vodafone offer cheaper night data bundles to get more customers to use their services during the night.

2. The government uses taxation and subsidy policies to increase consumption levels in the economy. For example, whenever the government decreases VAT on local food items like gari and rice, they become cheaper, especially for low-income families. This boosts their purchasing power and increases the consumption of local goods.

3. Households to make decisions about their spending habits.

For example, when food prices increase, households in Ghana might reduce how often they buy meat and instead buy more fish to stay within their budget.

Importance of Substitution and Income Effect in Ghana’s Development Context

1. Supports the growth and strength of local industries When people buy more locally made goods instead of expensive imported ones, it boosts local businesses and creates jobs. For instance, choosing locally made clothes like “Smock” (batakari) instead of imported second-hand clothes supports local tailors and textile producers.

2. Promoting equity (Fairness) Understanding how income affects spending helps the government to support the people who need help the most. The government can grant food subsidies to low- income households that spend more of their income on food.

3. Improving consumer satisfaction and welfare If people can find cheaper alternatives without reducing their satisfaction, their standard of living improves. For example, a family in Tamale switching from imported rice to local rice might still enjoy their meals while saving money.

Activity 2.1 Choose or Switch?

Objective: To explore how a change in the price of a good influences consumers to switch to a cheaper substitute, illustrating the substitution effect.

Materials Needed (prepare before class) Each group should create a scenario card and a decision sheet (both can be handwritten or printed).

Scenario Card (Example for Each Group)

You and your groupmates have GH¢10 each for snacks this week. Normally, you all buy meat pie (GH¢5 each). Suddenly, the price of meat pie increases to GH¢8, while bofrot remains GH¢3. Decide how each of you will respond.

Decision Sheet Template

Name Original Choice

(before price change) New Choice (after price change) Why did you switch or not switch?

Meat Pie Bofrot / Meat Pie Instructions (Student-led)

1. Work in groups made up of four members (consider gender and your abilities)

2. Read your group’s scenario card together.

3. Fill out the decision sheet based on what each person in the group would do if this happened in real life.

4. Discuss the following questions as a group.

a. Who switched and why?

b. Who didn’t switch and why?

c. What does this tell us about how price affects choice?

5. Prepare one sentence as a group to explain the substitution effect in your own words (2 minutes).

6. Share your sentence with other groups in the class.

Activity 2.2 Price Change, Same Income

Objective: To understand the income effect by observing how a change in the price of a good affects what consumers can afford, even when their income remains the same.

Scenario Imagine that each of you receives a weekly allowance of GH¢30. Last week, a bottle of fruit juice cost GH¢10. This week, the price has dropped to GH¢6, but your allowance is still GH¢30. Now you have an extra GH¢4 – does it make you feel a little richer even though you have the same allowance? What can you now afford? Will you spend on something you can now afford?

Instructions

1. Work in groups of three members (Consider gender and ability).

2. One of you should read the scenario.

3. Fill in the table below to show what each person could afford before and after the price change.

Group Member’s

Name What you could afford before (GH¢10 per juice) What you can now afford (GH¢6 per juice) How has your choice changed?

4. Reflect on these questions as a group

a. What could you buy before the price changed? What can you buy now?

b. Even though your income did not change, did your ability to buy more improve? Why?

c. What does this tell you about how price changes affect what people can afford?

5. Write your findings in a sentence and share with other groups.

Hicksian decomposition is a way economists break down how people change what they buy when prices change. It involves both the income and substitution effect.

Substitution Effect

This represents the change in quantity demanded resulting from the good becoming relatively cheaper or more expensive, while holding the consumer’s utility constant.

That is, Consumers substitute for the cheaper good.

Income Effect

This represents the change in quantity demanded resulting from a change in real income or purchasing power, while holding prices constant.

1. If the good is normal, a price fall feels like an increase in income and more is bought.

2. If the good is inferior, the income effect may reduce the quantity demanded.

This is mathematically captured using the Hicksian Decomposition:

Total Effect = Substitution Effect + Income Effect When the price of good X falls:

1. Original Demand: X₀

2. New Demand after Price Change: X₂

3. Hypothetical Demand (same utility at new price): X₁ Then:

Substitution Effect = X₁- X₀ Income Effect = X₂- X₁ Total Effect = X₁- X₀

Example

Yaw is a shop attendant in Cape Coast. He spends GH₵90 each week on Kenkey (Good

X) and Fried Fish (Good Y). Initially, Kenkey costs GH₵9 per ball and Fried Fish costs GH₵6 per piece. After a price reduction, the price of Kenkey drops to GH₵6, while the price of Fried Fish remains at GH₵6.00 Yaw’s weekly consumption changes as follows:

Situation Quantity of Kenkey (X) Quantity of Fried Fish (Y) Before the price change 5 balls 5 pieces After the price change 8 balls 5 pieces Hypothetical (same utility at new price) 6 balls 5 pieces Questions

a. Calculate the Total Effect of the price change on Yaw’s consumption of Kenkey.

b. Calculate the Substitution Effect of the price change.

c. Calculate the Income Effect of the price change.

d. In your own words, explain:

i. What does the substitution effect mean in this case?

ii. What does the income effect mean in this case?

iii. Which effect was stronger for Yaw?

e. Suppose Kenkey were an inferior good for Yaw. How would the income effect change?

Solution

Yaw’s weekly food budget = GH₵90 Goods: Kenkey (Good X) and Fried Fish (Good Y) Prices:

- Kenkey drops from GH₵9 to GH₵6 per ball

- Fried Fish stays at GH₵6 per piece Yaw’s Weekly Consumption Situation Quantity of Kenkey (X) Quantity of Fried Fish (Y) Before the price change 5 balls 5 pieces After the price change 8 balls 5 pieces Hypothetical (same utility at new price) 6 balls 5 pieces

a. Total Effect (TE) Total Effect = New Quantity - Original Quantity Calculation: 8 - 5 = 3 balls Yaw buys 3 more balls of Kenkey after the price drops.

b. Substitution Effect (SE) Substitution Effect = Hypothetical Quantity - Original Quantity = 6 – 5 = 1 ball Yaw buys 1 more ball because Kenkey has become relatively cheaper.

c. Income Effect (IE) Income Effect = New Quantity - Hypothetical Quantity = 8 - 6 = 2 balls Yaw buys 2 more balls because his real income has increased.

Summary The total increase in Kenkey consumption (3 balls) is made up of

i. 1 extra ball due to substitution (Kenkey became relatively cheaper)

ii. 2 extra balls due to income effect (Yaw’s real income increased) This breakdown helps to understand how much of consumer behaviour is driven by relative prices and how much by changes in purchasing power.

Activity 2.3 Budget Dilemma at the Canteen

Objective: To understand how a price increase affects what consumers can afford without a change in income and how this change involves both substitution and income effects, using simple numbers.

Scenario You and your partner are on a weekly lunch budget of GH¢60. At your school canteen, a plate of jollof rice used to cost GH¢8. You usually bought 7 plates per week. One day, the price of jollof rice increases to GH¢12. You decide to reduce how many plates you buy to stay within your GH¢60 budget. Now, you only buy 5 plates per week. You want to figure out how much of that decrease is due to the jollof becoming more expensive and how much is because your budget cannot stretch as far.

Instructions

1. Work in pairs.

2. From the scenario, write down:

a. Weekly Income = GH¢

b. Price before = GH¢

c. Quantity before =

d. Price after = GH¢

e. Quantity after =

3. Determine the total change in quantity:

Total change in quantity = After – Before =

4. Break It Down (Estimate the Two Effects):

a. Now use logic or rough estimates to divide the total change in quantity.

i. Substitution effect (You bought fewer because it became more expensive): ______ plate(s)

ii. Income effect (You feel poorer and can’t afford as much): ______ plate(s) NB: (The two numbers should add up to -2)

5. Discuss these questions with your partner:

a. Why does a price increase make you feel like your income is not enough?

b. How does this change in price affect your ability to buy other things (like water or fruit)?

c. What does this teach us about how people behave when prices go up, but income stays the same?

6. Write down your findings in a short paragraph and share them with other pairs.

Activity 2.4 Exploring the concept of utility Objective: Exploring how consumers make choices by calculating utility, identifying equilibrium and applying the substitution and income effects to real- life price changes.

Scenario: You and your partner are big fans of fried yams from the school canteen.

To study how satisfaction works in economics, you are going to act like consumer researchers, tracking how much satisfaction (utility) each plate gives and how your choices change with price or income.

Instructions

1. Work in pairs by considering gender where possible.

2. Estimate your utility

a. Imagine you ate one plate of fried yams, then a second, third and so on.

b. Fill out the table with estimated satisfaction from each plate. Start by imagining how satisfying one plate of fried yams would be, then estimate the marginal utility (MU) for each. It is going to be high to start with, 20 for example, then might decrease by 5 after each plate.

Plate Number

Total Utility

(TU) Marginal Utility (MU)

Average Utility (AU)

1 2 3 4 5

3. Use these formulas to determine your overall and average satisfaction from each plate.

• TU = MU for plate 1 then cumulative for each plate thereafter (plate 2 TU = MU1 + MU2 and so on)

• AU = TU ÷ Plate Number

4. Discuss:

• After which plate does MU start to fall?

• When is MU = 0? What does that mean?

5. Sketch 3 mini graphs on a blank page:

a. Total Utility Curve

b. Marginal Utility Curve

c. Average Utility Curve NB: Label axes: Quantity (x-axis), Utility (y-axis)

6. Reach Equilibrium

You have GH¢30. One plate costs GH¢6. That means you can buy a maximum of 5 plates.

a. Match the MU for each plate with its price.

b. At which plate does MU = Price (GH¢6)?

NB: That is your equilibrium, where you stop buying because satisfaction = cost.

7. Apply Substitution & Income Effects

a. Consider these;

i. Price of yam increases to GH¢10 → You now buy fewer plates

ii. Price of yam drops to GH¢4 → You buy more plates

b. Now discuss this:

i. What other food might you buy instead if yam gets expensive?

ii. If yam becomes cheaper, do you feel richer? What else might you buy?

c. Then, break this example mathematically: If you ate 5 plates before and now eat 7 (after a price drop), split the 2 extra plates into:

• Substitution effect = ___ plates

• Income effect = ___ plates

8. Note: (The total = 2 plates)

a. Write one sentence together for each of the following

b. What is utility?

c. What is diminishing marginal utility?

d. How does a consumer reach equilibrium?

e. What is the income effect?

f. What is the substitution effect?

9. Share your findings with other pairs in the class.