Managerial & Business Strategy

Chapter 4 The Theory of Individual Behavior

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. Overview I. Consumer Behavior – Indifference Curve Analysis. – Consumer Ordering. II. Constraints – The Budget Constraint. – Changes in Income. – Changes in . III. Consumer Equilibrium IV. Indifference Curve Analysis & Curves – Individual Demand. – Demand. 4-2 Consumer Behavior  Consumer Opportunities – The possible and services consumer can afford to consume.  Consumer Preferences – The consumers actually consume.  Given the choice between 2 bundles of goods a consumer either: – Prefers bundle A to bundle B: A f B. – Prefers bundle B to bundle A: A p B. – Is indifferent between the two: A ∼ B. 4-3 Indifference Curve Analysis

Indifference Curve Good Y – A curve that defines the III. combinations of 2 or more II. goods that give a consumer the same level of satisfaction. I. Marginal Rate of Substitution – The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level. Good X

4-4 Consumer Preference Ordering Properties  Completeness  More is Better  Diminishing Marginal Rate of Substitution  Transitivity

4-5 Complete Preferences  Completeness Property Good Y – Consumer is capable of expressing preferences (or III. indifference) between all II. possible bundles. (“I don’t know” I. is NOT an option!) A • If the only bundles available B to a consumer are A, B, and C, then the consumer

 is indifferent between A C and C (they are on the same indifference curve).  will prefer B to A.  will prefer B to C. Good X

4-6 More Is Better!  More Is Better Property – Bundles that have at least as Good Y much of every good and more of III. some good are preferred to other bundles. II. • Bundle B is preferred to A since B contains at least as I. much of good Y and strictly more of good X. A B • Bundle B is also preferred to 100 C since B contains at least as much of good X and strictly C more of good Y. 33.33 • More generally, all bundles on IC III are preferred to bundles on IC II or IC I. And all bundles 1 3 on IC II are preferred to IC I. Good X

4-7 Diminishing MRS  MRS – The amount of good Y the consumer is willing to give up to maintain the Good Y same satisfaction level decreases as more of good X is acquired. III. – The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level. II.  To go from consumption bundle A I. to B the consumer must give up 50 units of Y to get one additional 100 A unit of X.  To go from consumption bundle B B to C the consumer must give up 50 C 16.67 units of Y to get one 33.33 D additional unit of X. 25  To go from consumption bundle C to D the consumer must give up only 8.33 units of Y to get one 1 2 3 4 Good X additional unit of X.

4-8 Consistent Bundle Orderings

 Transitivity Property Good Y – For the three bundles A, B, and C, the transitivity property III. implies that if C f B and B f A, II. then C A. f I. – Transitive preferences along with the more-is-better 100 A C property imply that 75 B • indifference curves will not 50 intersect. • the consumer will not get caught in a perpetual cycle of indecision. 1 2 5 7 Good X

4-9 The Budget Constraint

 Opportunity Set Y The Opportunity Set – The set of consumption bundles that are affordable. Budget Line ≤ •PxX + P yY M. M/P Y Y = M/P – (P /P )X  Budget Line Y X Y – The bundles of goods that exhaust a consumers income.

•PxX + P yY = M.  Market Rate of

Substitution M/P X X – The slope of the budget line

• -Px / P y.

4-10 Changes in the Budget Line Y M /P  Changes in Income 1 Y – Increases lead to a M /P parallel, outward shift in 0 Y

the budget line (M 1 > M 0).

– Decreases lead to a M2/P Y parallel, downward shift

(M 2 < M 0). X M2/P X M0/P X M1/P X  Changes in Y – A decreases in the price of New Budget Line for a price decrease. good X rotates the budget M0/P Y line counter-clockwise (P X0 > P ). X1 – An increases rotates the budget line clockwise (not X shown). M /P M /P 0 X0 0 X1 4-11 Consumer Equilibrium

 The equilibrium Y consumption bundle Consumer is the affordable M/P Y bundle that yields Equilibrium the highest level of satisfaction. – Consumer equilibrium occurs at a point where III. MRS = P X / P Y. – Equivalently, the slope of II. the indifference curve I. equals the budget line. M/P X X

4-12 Price Changes and Consumer Equilibrium  Substitute Goods – An increase (decrease) in the price of good X leads to an increase (decrease) in the consumption of good Y. • Examples:  Coke and Pepsi.  Verizon Wireless or AT&T.  Complementary Goods – An increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y. • Examples:  DVD and DVD players.  Computer CPUs and monitors.

4-13 Complementary Goods

When the price of Pretzels (Y) good X falls and the consumption of Y rises, then X and Y M/P Y are complementary 1 goods. (P > P ) X1 X2

B Y2 A II Y1

I 0 X M/P X M/P 1 X1 2 X2 Beer (X)

4-14 Income Changes and Consumer Equilibrium  Normal Goods – Good X is a normal good if an increase (decrease) in income leads to an increase (decrease) in its consumption.  Inferior Goods – Good X is an inferior good if an increase (decrease) in income leads to a decrease (increase) in its consumption.

4-15 Normal Goods

Y An increase in income increases M /Y the consumption of 1 normal goods.

(M 0 < M 1).

B Y1 M0/Y II A Y0 I

X0 M0/X 0 X1 M1/X X

4-16 Decomposing the Income and Substitution Effects Y Initially, bundle A is consumed. A decrease in the price of good X expands the consumer’s opportunity set. The substitution effect (SE) causes the C consumer to move from bundle A to B. A higher “real income” allows the A II consumer to achieve a higher indifference curve. B

The movement from bundle B to C I represents the income effect (IE). The new equilibrium is achieved at point C. 0 IE X SE

4-17 A Classic Marketing Application

Other goods (Y)

A A buy-one, get-one free C E pizza deal. D II I

0 0.5 1 2 BF Pizza (X)

4-18 Individual

Y  An individual’s demand curve is derived from each II new equilibrium I

point found on the $ X indifference curve as the price of good P0 X is varied. P1 D

X0 X1 X

4-19 Market Demand

 The market demand curve is the horizontal summation of individual demand curves.  It indicates the total quantity all consumers would purchase at each price point.

$ Individual Demand $ Market Demand Curve Curves 50

40

D1 D2 DM 1 2 Q 1 2 3 Q

4-20 Conclusion

 Indifference curve properties reveal information about consumers’ preferences between bundles of goods. – Completeness. – More is better. – Diminishing marginal rate of substitution. – Transitivity.  Indifference curves along with price changes determine individuals’ demand curves.  Market demand is the horizontal summation of individuals’ .

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