Managerial Economics & 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 Preference Ordering. II. Constraints – The Budget Constraint. – Changes in Income. – Changes in Prices. III. Consumer Equilibrium IV. Indifference Curve Analysis & Demand Curves – Individual Demand. – Market Demand. 4-2 Consumer Behavior Consumer Opportunities – The possible goods and services consumer can afford to consume. Consumer Preferences – The goods and services 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 Price 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 Demand Curve
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’ demands.
4-21