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

2. Maximize utility subject to constraints
Consumer Behavior
The Consumer Problem
Maximize utility subject to constraints
Different people with different tastes and preferences, but have a common goal:
Make the most of what we have or to maximize utility
Economic goods versus economic bads
The constraint defines consumer opportunities
The possible goods and services consumer can afford to consume.

3. Consumer Preference Ordering
Completeness
The consumer is capable of expressing a preference for all bundles of goods.
Given the choice between 2 bundles of goods a consumer either
Prefers bundle A to bundle B: A  B
Prefers bundle B to bundle A: A  B
Is indifferent between the two: A  B
More is Better
Transitivity
Given 3 bundles of goods: A, B & C.
If A  B and B  C, then A  C.
If A  B and B  C, then A  C.
Diminishing marginal utility, then the rate of substitution between two goods is also diminishing (Diminishing Marginal Rate of Substitution) (more later)

4. Indifference Curve Analysis
Indifference Curve (IC)
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 stay at the same satisfaction level.
The negative of the slope of IC.
Diminishes
= the ratio of MU’s, MUX / MUY (refer to appendix to chapter 4)
Good Y U3 U2 U1
Good X

5. Examples Good Y Good X Good Y Good X Good Y Good X Good Y Good X

6. Examples (answers)
Good Y offers no gain in utility (neutral). Person’s utility increases when more X is consumed
Good X & Y are perfect complements. One operating system and one computer. Having an additional computer without an operating system will not increase utility.
Good X & Y are perfect substitutes. E.g., Jolt and Pepsi. Constant MRS.
Person has relatively large MRS for Good X. They have strong preferences for Good X.
Person has relatively large MRS for Good Y. They have strong preferences for Good Y.
One good is an economic bad (e.g., risk, or allergic to one good if get close to it).

7. 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; re-arrange
Y=M/PY – (PX / PY)X
Market Rate of Substitution
The slope of the budget line
-PX / PY
The Opportunity Set Y
M/PY
Budget Line PX PY
M/PX X

8. Consumer Equilibrium Max U s.t. budget.
At point c, MRS>PX / PY, which basically indicates that the benefit of an additional X exceeds the cost, so increase consumption of X.
At equilibrium
MRS=PX / PY or
MUX / MUY = PX / PY
MUX / PX = MUY / PY
“equal bang per buck”
At point c, more bang per buck from good X
Point c U1 U2 U3 X Y
Consumer Equilibrium

9. Changes in the Budget LineY
Changes in Income
Increases lead to a parallel, outward shift in the budget line.
Decreases lead to a parallel, downward shift.
Changes in Price
A decreases in the price of good X rotates the budget line counter-clockwise.
An increases rotates the budget line clockwise. B0 X Y
New Budget Line for a price decrease.
PX falls B0 X

10. Changes in Price RECALL Substitute Goods Complementary Goods
An increase (decrease) in the price of good X leads to an increase (decrease) in the consumption of good Y.
Complementary Goods
An increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y.

11. Complementary Goods B1 B0 Pretzels (Y)
When the price of good X falls, the consumption of complementary good Y rises. B Y2 A U2 Y1 U0 B1 B0 X1 X2
Beer (X)

12. Changes in Income Normal Goods Inferior 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 a inferior good if an increase (decrease) in income leads to an decrease (increase) in its consumption.

13. Normal Goods Y
An increase in income increases the consumption of normal goods. B U1 A B1 U0 B0 X

14. Individual Demand CurveX Y $ D U2 U1
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

15. 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

16. A Classic Marketing Application
Other goods (Y) F
III E A
Buy 3 tires, get the fourth free (limit 1 per customer)
*Not drawn to scale C D II I 2 3 4 B
Tires

17. Another Marketing Example
Gift Certificates….
Cash gift is generally preferred to an in-kind gift of equal value (see Figures 4-15 & 4-17)
Gift certificate may yield the same choice as cash. It allows consumer to spend more of their own income at another store. (see Figure 4-16)
Benefits to the firm that sells gift certificates
Reduce strains on refund department
If firm sells an inferior good, then gift certificates get people into the store that otherwise wouldn’t.

18. Public Policy Example
Suppose the goal of the government is for consumers to reduce their consumption of some good (e.g., gasoline, cigarettes, water).
Tax plus rebate programs
Government imposes a tax on a good
Government promises to rebate consumers to make them “whole.”
Whole means maintain original level of utility

19. Worker Behavior
Suppose mechanics for an auto repair shop are paid based on the number of repairs they recommend. A typical mechanic gets utility from money and integrity (i.e., being an honest loyal employee).
U = F (Money, Integrity).
When a worker is slightly dishonest, she sells more auto repairs (even if not needed), but eventually this could lead to lower profits for the firm.

20. Worker Behavior
Money
Management lowers the commission rate and offers fixed daily wage.
Mmax M0 I0 M1 U1
Mmin U0
Integrity
Imax

21. Labor-Leisure Choices of Workers
Assume that workers get utility from leisure and earning money to spend on other goods.
U = f (M, Leisure), where the price of leisure is the wage rate (i.e., the opportunity cost of leisure is foregone wages).
Model is especially helpful when analyzing worker’s compensation programs or tax programs such as the EITC.

22. Labor-Leisure Choices of Workers
Wage = $20
Assume 16 hours available for discretionary time.
NOTE:
M = w(T-L), where T is total time available for work and L is leisure. Thus, wT is y-intercept and –w is the slope
$320
Income per day
$180
Play 7 hours
Work 9 hours
Leisure per day 7 16

23. Labor-Leisure Choices of Workers
Overtime pay vs. increasing the wage rate
Wage = $20
Assume 16 hours available for discretionary time
$320
Income per day
$180
Play 7 hours
Work 9 hours
Leisure per day
7 8 16

24. Labor-Leisure Choices of Workers
A worker’s earnings are based on the number of units produced, where on an hourly basis a worker makes approximately $P in wages. The firm’s inventories are building up and firm needs to cut production:
Cut daily work hours.
Set quota.
Decrease piece-rate, and offer fixed daily salary $M 9
Lower Utility
Income per day
Leisure per day 7 16

25. Choices by Managers and Workers
Lessons to be learned:
provide right incentives so that
Interests of worker are aligned with interests of firm.
Interests of manager are aligned with interests of firm