1. Managerial Economics & Business Strategy
Chapter 4
The Theory of Individual Behavior

2. Overview I. Consumer Behavior II. Constraints
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.

3. Consumer Behavior Consumer Opportunities
The possible goods and services consumer can afford to consume.
Consumer Preferences
The goods and services consumers actually consume.

4. Indifference Curve Analysis
A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction.
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 Y
III.
II. I.
Good X

5. Consumer Preference Ordering Properties
Completeness
More is Better
Diminishing Marginal Rate of Substitution
Transitivity

6. Complete Preferences Completeness Property
Consumer is capable of expressing preferences (or indifference) between all possible bundles. (“I don’t know” is NOT an option!)
If the only bundles available to a consumer are A, B, and C, then the consumer
is indifferent between A and C (they are on the same indifference curve).
will prefer B to A.
will prefer B to C.
Good Y
III.
II. I. A B C
Good X

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

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

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

10. The Budget Constraint Opportunity Set Budget Line
The set of consumption bundles that are affordable.
PxX + PyY  M.
Budget Line
The bundles of goods that exhaust a consumers income.
PxX + PyY = M.
Market Rate of Substitution
The slope of the budget line
-Px / Py.
The Opportunity Set Y
Budget Line
Y = M/PY – (PX/PY)X
M/PY
M/PX X

11. Changes in the Budget LineY
Changes in Income
Increases lead to a parallel, outward shift in the budget line (M1 > M0).
Decreases lead to a parallel, downward shift (M2 < M0).
Changes in Price
A decreases in the price of good X rotates the budget line counter-clockwise (PX0 > PX1).
An increases rotates the budget line clockwise (not shown).
M1/PY
M1/PX
M0/PY
M2/PY
M2/PX X
M0/PX Y
New Budget Line for a price decrease.
M0/PY
M0/PX0
M0/PX1 X

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

13. 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.
DVD and DVD players.
Computer CPUs and monitors.

14. One Extreme Case: Perfect Substitutes
Perfect substitutes: two goods with straight-line indifference curves, constant MRS
Example: nickels & dimes
Consumer is always willing to trade two nickels for one dime.
It is hard to think of examples of perfect substitutes. But it’s easy to think of examples that are close substitutes, and therefore are likely to have indifference curves that are not very bowed:
1) Movies (at the movie theater) and videos at home. A consumer might be willing to trade two videos for one night at the movies.
2) Coke and Pepsi (for consumers that do not perceive much difference between them).
3) Vacations in Hawaii and vacations in the Bahamas

15. Complementary Goods
When the price of good X falls and the consumption of Y rises, then X and Y are complementary goods. (PX1 > PX2)
Pretzels (Y)
M/PY1 II
M/PX2 I B Y2 X2 A Y1 X1
M/PX1
Beer (X)

16. Another Extreme Case: Perfect Complements
Perfect complements: two goods with right-angle indifference curves
Example: left shoes, right shoes
{7 left shoes, 5 right shoes}
is just as good as
{5 left shoes, 5 right shoes}
Again, It is hard to think of examples of perfect complements. But it’s easy to think of examples that are good though not perfect complements, and therefore are likely to have indifference curves that are very bowed:
1) tickets to rock concerts and parking at the arena in which the concert takes place
2) hot dogs and hot-dog buns
3) brewed Starbucks coffee and 20 spoons of sugar (Anyone who’s tried brewed Starbucks coffee, except the heartiest souls, will be able to relate to this example!)

17. Optimization: What the Consumer Chooses
The optimal bundle is at the point where the budget constraint touches the highest indifference curve.
MRS = relative price at the optimum:
The indiff curve and budget constraint have the same slope.
The optimal bundle must satisfy this condition:
MRS = relative price
Intuition: The relative price is the price of an additional pizza in terms of Pepsi.
The MRS is the marginal value of pizza in terms of Pepsi.
At the margin, these must be equal; otherwise, a different bundle would make the consumer happier.
Suppose, for example, that MRS > relative price. The value of an additional pizza is higher than the price of an additional pizza (in terms of Pepsi). Hence, the consumer would be better off buying more pizza and less Pepsi.
Or, if MRS < relative price, then the value of the marginal pizza is smaller than its relative price. The consumer would be happier if she bought one fewer pizza and used the savings to buy more Pepsi.

18. 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.

19. Normal Goods Y
An increase in income increases the consumption of normal goods.
(M0 < M1).
M1/Y
M1/X II B I Y1 X1
M0/Y
M0/X A Y0 X0 X

20. Decomposing the Income and Substitution EffectsY
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 consumer to move from bundle A to B.
A higher “real income” allows the consumer to achieve a higher indifference curve.
The movement from bundle B to C represents the income effect (IE). The new equilibrium is achieved at point C. II C A B I IE X SE

21. Giffen Goods substitution effect: buy less potatoes
Do all goods obey the Law of Demand?
Suppose the goods are potatoes and meat, and potatoes are an inferior good.
If price of potatoes rises,
substitution effect: buy less potatoes
income effect: buy more potatoes
If income effect > substitution effect, then potatoes are a Giffen good, a good for which an increase in price raises the quantity demanded.

22. Giffen Goods
An increase in the price of potatoes rotates the budget line inward.
The substitution effect would cause the consumer to buy fewer potatoes. Imagine moving down along indifference curve I1 until reaching the point where its slope just equals the slope of the new budget line. At that point, demand for potatoes is lower, because consumers are substituting meat for potatoes.
But if potatoes are an inferior good, the income effect causes demand for potatoes to rise: the price increase makes the consumer generally worse off. The consumer responds by buying less meat (the normal good) and more potatoes (the inferior good).
If potatoes are a Giffen good, the income effect exceeds the substitution effect, so the net effect of a price increase on demand for potatoes is positive!!!
As the book notes, Giffen goods are extremely rare – if they exist at all!

23. Wages and Labor Supply Budget constraint Indifference curve
Shows a person’s tradeoff between consumption and leisure.
Depends on how much time she has to divide between leisure and working.
The relative price of an hour of leisure is the amount of consumption she could buy with an hour’s wages.
Indifference curve
Shows “bundles” of consumption and leisure that give her the same level of satisfaction.

24. Wages and Labor Supply
At the optimum, the MRS between leisure and consumption equals the wage.
Here, the marginal rate of substitution measures the marginal value of an hour of leisure, in terms of (dollars’ worth of) consumption.
The slope of the budget line simply equals the wage: each additional hour of leisure requires working one fewer hour, which causes consumption to fall by an hour’s wages.
At the optimum, the marginal value of leisure (in terms of consumption) must equal the relative price of leisure (in terms of consumption), or the wage.
If MRS > wage, then the value of leisure is greater than its price, so take more leisure (and work fewer hours) to raise happiness.
If MRS < wage, then the value of leisure is less than its price, so take less leisure (and work more hours) to raise happiness.

25. Wages and Labor Supply
An increase in the wage has two effects on the optimal quantity of labor supplied.
Substitution effect (SE): A higher wage makes leisure more expensive relative to consumption.
The person chooses less leisure, i.e., increases quantity of labor supplied.
Income effect (IE): With a higher wage, she can afford more of both “goods.”
She chooses more leisure, i.e., reduces quantity of labor supplied.
The relative magnitude of the substitution and income effects determine the slope of the labor supply curve, as the following slides show.

26. Wages and Labor Supply For this person, SE > IE
So her labor supply increases with the wage
A person with the preferences depicted in the left graph will have a positively-sloped labor supply curve, as shown in the right graph.

27. Wages and Labor Supply For this person, SE < IE
So his labor supply falls when the wage rises
A person with the preferences depicted in the left graph will have a negatively-sloped labor supply curve, as shown in the right graph.

28. Could This Happen in the Real World???
Over last 100 years, technological progress has increased labor demand and real wages.
The average workweek fell from 6 to 5 days.
Typically, we assume the substitution effect is at least as big as the income effect, and we draw labor supply curves as upward-sloping or perhaps vertical.
This slide notes examples from a case study in this chapter in which the income effect is very strong.
I would add an additional possibility (not mentioned in the book): A person’s labor supply curve may slope upward for low wages, become steeper, and bend backward at high wages. Here’s why:
The size of the substitution effect depends on a comparison of the wage to the marginal rate of substitution between leisure and consumption. The higher the wage relative to the MRS, the stronger the incentive to substitute away from leisure and toward consumption.
As a person works more hours, consumption becomes more plentiful while leisure becomes dearer. The marginal value of leisure rises relative to consumption. I.e., the MRS rises as the person moves up an indifference curve.
As this occurs, it takes increasingly large wage increases to make the person willing to sacrifice another hour of leisure. I.e., the substitution effect from a given increase in the wage gets weaker.
Meanwhile, the income effect is as strong as ever – a person with very high wages can afford to take more time off than a person with lower wages.

29. Interest Rates and Saving
A person lives for two periods.
Period 1: young, works, earns $100,000
consumption = $100,000 minus amount saved
Period 2: old, retired
consumption = saving from Period 1 plus interest earned on saving
The interest rate determines the relative price of consumption when young in terms of consumption when old.
Why the interest rate determines the relative price of current in terms of future consumption:
If you reduce current consumption by $1, and save this $1, then your future consumption will rise by $(1 + r), where r denotes the interest rate.
Similarly, if you wish to increase current consumption by $1, then you must sacrifice the $(1 + r) that you would have been able to consume in the future.
Notice that the slide does not say “the interest rate equals the relative price…”. In fact, the relative price of current in terms of future consumption (and also the slope of the budget constraint) equals (1 + r), not r.

30. Interest Rates and Saving
Budget constraint shown is for 10% interest rate.
At the optimum, the MRS between current and future consumption equals the interest rate.
The marginal rate of substitution is the marginal value of current consumption in terms of future consumption; it tells you how much future consumption the person is willing to give up for a unit of current consumption.
If the consumer is optimizing, then the MRS must equal (1 + r): the marginal value of current consumption must equal the relative price of current consumption (both in terms of future consumption).
If MRS were not equal to (1 + r), then the consumer could increase his satisfaction by changing his level of saving (and hence, his “bundle” of current and future consumption).

31. A C T I V E L E A R N I N G 5: Effects of an interest rate increase
Suppose the interest rate rises.
Determine the income and substitution effects on current and future consumption, and on saving.
This exercise gives students practice identifying and interpreting the income and substitution effects in a new context. 31

32. A C T I V E L E A R N I N G 5: Answers
The interest rate rises.
Substitution effect
Current consumption becomes more expensive relative to future consumption.
Current consumption falls, saving rises, future consumption rises.
Income effect
Can afford more consumption in both the present and the future. Saving falls.
After you display the full contents of the slide, point out that future consumption unambiguously rises. However, the effects on current consumption and saving depend on which of the income and substitution effects is bigger.
The following slides show the two cases. 32

33. Interest Rates and Saving
In this case, SE > IE and saving rises
The macro chapters of Mankiw’s Principles of Economics typically assume that saving is positively related to the interest rate, as depicted here.

34. Interest Rates and Saving
In this case, SE < IE and saving falls
If the income effect is bigger than the substitution effect, than an increase in the interest rate would reduce saving, not increase it. 34

35. A Classic Marketing Application
Other goods (Y) II I A C B F D E
Pizza (X)
0.5 1 2
A buy-one, get-one free pizza deal.

36. Individual Demand CurveX Y $ D II I
An individual’s demand curve is derived from each new equilibrium point found on the indifference curve as the price of good X is varied. P0 P1 X0 X1

37. 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 Curves $
Market Demand Curve 50 40 D1 D2 DM
1 2 Q Q

38. 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.

39. CONCLUSION: Do People Really Think This Way?
Most people do not make spending decisions by writing down their budget constraints and indifference curves.
Yet, they try to make the choices that maximize their satisfaction given their limited resources.
The theory in this chapter is only intended as a metaphor for how consumers make decisions.
It does fairly well at explaining consumer behavior in many situations, and provides the basis for more advanced economic analysis.