1. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Managerial Economics & Business Strategy Chapter 4 The Theory of Individual Behavior

2. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Overview I. Consumer Behavior n Indifference Curve Analysis n Consumer Preference Ordering II. Constraints n The Budget Constraint n Changes in Income n Changes in Prices III. Consumer Equilibrium IV. Indifference Curve Analysis & Demand Curves n Individual Demand n Market Demand

3. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Consumer Behavior Consumer Opportunities n The possible goods and services consumer can afford to consume. Consumer Preferences n The goods and services consumers actually consume. Given the choice between 2 bundles of goods a consumer either n Prefers bundle A to bundle B: A  B n Prefers bundle B to bundle A: A  B n Is indifferent between the two: A  B

4. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 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 stay at the same satisfaction level. I. II. III. Good Y Good X

5. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Consumer Preference Ordering Completeness n The consumer is capable of expressing a preference for all bundles of goods. More is Better Diminishing Marginal Rate of Substitution Transitivity n Given 3 bundles of goods: A, B & C. n If A  B and B  C, then A  C. n If A  B and B  C, then A  C.

6. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 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 PxPx PyPy Budget Line

7. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Consumer Equilibrium The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction. I. II. III. X Y Consumer Equilibrium

8. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Changes in the Budget Line Changes in Income n Increases lead to a parallel, outward shift in the budget line. n Decreases lead to a parallel, downward shift. Changes in Price n A decreases in the price of good X rotates the budget line counter-clockwise. n An increases rotates the budget line clockwise. X Y X Y New Budget Line for a price decrease.

9. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Changes in Price Substitute Goods n An increase (decrease) in the price of good X leads to an increase (decrease) in the consumption of good Y. Complementary Goods n An increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y.

10. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Complementary Goods When the price of good X falls, the consumption of complementary good Y rises. Pretzels (Y) Beer (X) II I 0 Y2Y2 Y1Y1 X1X1 X2X2 A B

11. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Changes in Income Normal Goods n Good X is a normal good if an increase (decrease) in income leads to an increase (decrease) in its consumption. Inferior Goods n Good X is a inferior good if an increase (decrease) in income leads to an decrease (increase) in its consumption.

12. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Normal Goods An increase in income increases the consumption of normal goods. Y II I 0 A B X

13. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Individual Demand Curve 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. X Y $ X D II I P0P0 P1P1 X0X0 X1X1

14. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 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. Q $$ Q 50 40 D2D2 D1D1 Individual Demand Curves Market Demand Curve 1 2 1 2 3 DMDM

15. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 A Classic Marketing Application Other goods (Y) II I 0 A C BF D E Pizza (X) 0.512 A buy-one, get-one free pizza deal.