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

2. Price Changes and Consumer Equilibrium
Substitute Goods
An increase (decrease) in the price of good X leads to an increase (decrease) in the consumption of good Y.
Examples:
Coke and Pepsi.
Verizon Wireless or T-Mobile.
Complementary Goods
An increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y.
DVD and DVD players.
Computer CPUs and monitors.

3. Substitute Goods
When the price of good X falls and the consumption of Y falls, then X and Y are substitute goods. (PX1 < PX2)
Pretzels (Y)
M/PY1
M/PX2 I II A Y1 B X1 Y2 X2
M/PX1
Beer (X)

4. Complementary Goods
When the price of good X falls and the consumption of Y rises, then X and Y are complementary goods. (PX1 > PX2)
Pretzels (Y)
M/PY1 II
M/PX2 I B Y2 X2 A Y1 X1
M/PX1
Beer (X)

5. Income Changes and Consumer Equilibrium
Normal Goods
Increase (decrease) in income leads to an increase (decrease) in its consumption.
Inferior Goods
Increase (decrease) in income leads to a decrease (increase) in its consumption.

6. Normal Goods Y
An increase in income increases the consumption of normal goods.
(M0 < M1).
M1/Y
M1/X II B I Y1 X1
M0/Y
M0/X A Y0 X0 X

7. Inferior Goods Y
An increase in income decreases the consumption of inferior goods.
(M0 > M1). II
M1/Y
M1/X B Y1 X1 I
M0/Y
M0/X A Y0 X0 X

8. When price of a good decreases
Two things happen
Relative price of the good decreases
Buy more of the cheaper good
Substitution Effect
Real income or purchasing power increases
If buy same bundle of goods bought previously have money left over
Income Effect

9. To graphically break up the effects
Price decrease causes a rotation on the BC
New optimal bundle
Look at what would we have bought with this new income level (new BC) at our old Utility level
Take money away from consumer to keep original Utility level
Price has changed though so cannot keep the slope of the original BC

10. The Result is Three Points
Old optimal bundle to new optimal bundle is the TOTAL EFFECT
Old optimal bundle to new tangency on original IC is SUBSTITUTION EFFECT
Same indifference curve
New tangency on original IC to new optimal bundle is INCOME EFFECT
Same budget constraint

11. A-C=SUBSTITUTION EFFECT
A-B=TOTAL EFFECT
A-C=SUBSTITUTION EFFECT
C-B=INCOME EFFECT
Clothing A B C
Food A C B