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

2. Can we do it?? On the next slide are schedules which show the total utility measured in terms of utiles which President Strassburger would get by purchasing various amounts of product Apples, Bananas, Carrots, and Donuts. Assume that the price of Bananas is $4, the price of Donuts is $18, the price of Apples is $1, the price of Carrots is $6, and that President Strassburger’s income is $135. What quantities of Bananas, Donuts, Apples, and Carrots will President Strassburger purchase?

3. Can you do it?? B TU MUMU /P D TU MUMU /P A TU MUMU /P C TU MUMU /P 1241 126 171 36 2442 234 2132 66 3603 324 3183 90 4724 396 4224 108 5825 450 5255 120 6906 486 6 27.5 6 129 7967 513 7297 135 8 100 8 531 8308 138

4. Can you do it?? B TU MUMU /P D TU MUMU /P A TU MUMU /P C TU MUMU /P 124---1 126 ---17 1 36 --- 244202 234108 21362 66 30 360163 324 9031853 90 24 472124 396 7242244 108 18 582105 450 5452535 120 12 69086 486 366 27.5 2.5 6 129 9 79667 513 27729 1.5 7 135 6 8 100 48 531 1883018 138 3

5. Can you do it?? B TU MUMU /P D TU MUMU /P A TU MUMU /P C TU MUMU /P 124--- 1 126 --- 17 1 36 --- 2442052 234108 6213662 66 305 3601643 324 905318553 90 244 4721234 396 724422444 108 183 58210 2.5 5 450 543525335 120 122 690826 486 3626 27.5 2.5 6 129 9 1.5 7966 1.5 7 513 27 1.5 729 1.5 7 135 61 8 100 418 531 181830118 138 3 0.5

6. Can you do it?? B TU MUMU /P D TU MUMU /P A TU MUMU /P C TU MUMU /P 124--- 1 126 --- 17 1 36 --- 2442052 234108 6213662 66 305 3601643 324 905318553 90 244 4721234 396 724422444 108 183 58210 2.5 5 450 543525335 120 122 690826 486 3626 27.5 2.5 6 129 9 1.5 7966 1.5 7 513 27 1.5 729 1.5 7 135 61 8 100 418 531 181830118 138 3 0.5

7. Consumer Preference Ordering Properties Completeness n Every individual can state their preferences n NO  “I don’t know” More is Better Diminishing Marginal Rate of Substitution n As you get more good X the rate at which you are willing to substitute good X for good Y decreases n Have too much X  don’t want more n Shows indifference curves are CONVEX Transitivity n If prefer A to B and B to C then prefer A to C n IC cannot cross

8. Indifference Curve Analysis Indifference Curve n A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction. Marginal Rate of Substitution n The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level. n Slope I. II. III. Good Y Good X

9. Diminishing Marginal Rate of Substitution Marginal Rate of Substitution n slope 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 16.67 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. I. II. III. Good Y Good X 1 3 4 2 100 50 33.33 25 A B C D

10. What was??? The slope of the indifference curve? n Marginal rate of substitution MRS n MRS = MU x /MU y Along an indifference curve 

11. Doesn’t like risk!! STEEP indifference curve Need BIG increase in return to give up a little risk Likes risk!! FLAT Indifference Curve Will give up a lot of safety for a little Increase in return

12. The Budget Constraint Opportunity Set n The set of consumption bundles that are affordable. P x X + P y Y  M. Budget Line n The bundles of goods that exhaust a consumers income. P x X + P y Y = M. Market Rate of Substitution n The slope of the budget line -P x / P y Y X The Opportunity Set Budget Line Y = M/P Y – (P X /P Y ) X M/P Y M/P X

13. Market Rate of Substitution

14. Changes in the Budget Line Changes in Income n Increases lead to a parallel, outward shift in the budget line (M 1 > M 0 ). n Decreases lead to a parallel, downward shift (M 2 < M 0 ). Changes in Price n A decreases in the price of good X rotates the budget line counter-clockwise (P X 0 > P X 1 ). n An increases rotates the budget line clockwise X Y X Y New Budget Line for a price decrease. M 0 /P Y M 0 /P X M 2 /P Y M 2 /P X M 1 /P Y M 1 /P X M 0 /P Y M 0 /P X 0 M 0 /P X 1 M 2 /P X2 New Budget Line for a price increase.

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