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

Overview I. Consumer Behavior II. Constraints Preferences and opportunities Marginal Utility/Total Utility 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

Consumer Behavior Consumer Opportunities More is better The possible goods and services consumer can afford to consume. More is better Concerned with the goods and services actually consumed.

Consumer Preference Ordering Consumer Preferences Completeness: The consumer is capable of expressing a preference for all bundles of goods. Prefers bundle A to bundle B: A  B Prefers bundle B to bundle A: A  B Is indifferent between the two: A  B 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 Rate of Substitution

Utility & Behavior Utility Marginal utility cardinal ordinal comparability Marginal utility Diminishing marginal utility Negative marginal utility Objective - make rational decisions to maximize own utility rational own

Indifference Curve Analysis A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction. Higher is more 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. -MUX/MUY Good Y III. II. I. Good X

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 Px Py X

Consumer Equilibrium Y The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction. Consumer Equilibrium III. II. I. X

Changes in the Budget Line Y 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. X Y New Budget Line for a price decrease. X

Changes in Price 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.

Changes in Price Substitution Effect Income Effect Net effect An increase (decrease) in the price of a good leads people to by less (more) of that good and more (less) of a similar good If the consumer has just as much utility then they are on the same indifference curve. Income Effect An increase (decrease) in the price of good X leads to a decrease (increase) in a person’s purchasing power. A decrease (increase) in purchasing power leads to a decrease (increase) in purchases of normal goods and an increase (decrease in purchases of inferior goods. Net effect If substitution and income effect operate in the same direction, the good is normal If substitution and income effect operate in opposite directions and the substitution effect is larger (in absolute value) then the good is inferior (consider elasticity) If substitution and income effect operate in opposite directions and the income effect is larger (in absolute value) then the good is inferior and demand is upward sloping (Giffen good)

Complementary Goods Pretzels (Y) When the price of good X falls, the consumption of complementary good Y rises. B Y2 A II Y1 I X1 X2 Beer (X)

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.

Normal Goods Y An increase in income increases the consumption of normal goods. B Y2 II A Y1 I X1 X2 X

Inferior Goods Y An increase in incomedecreases the consumption of inferior goods. B Y2 II A Y1 I X2 X1 X

Individual Demand Curve X 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

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 1 2 3 Q

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.