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

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.

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)

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

Examples Good Y Good X Good Y Good X Good Y Good X Good Y Good X

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).

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

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

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. B0 X Y New Budget Line for a price decrease. PX falls B0 X

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.

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)

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 U1 A B1 U0 B0 X

Individual Demand Curve X 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

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) 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

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.

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

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.

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

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.

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

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

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

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