Presentation on theme: "Managerial Economics & Business Strategy"— Presentation transcript:
1 Managerial Economics & Business Strategy Chapter 4The Theory of Individual Behavior
2 Price Changes and Consumer Equilibrium Substitute GoodsAn 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 GoodsAn 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 GoodsWhen the price of good X falls and the consumption of Y falls, then X and Y are substitute goods. (PX1 < PX2)Pretzels (Y)M/PY1M/PX2IIIAY1BX1Y2X2M/PX1Beer (X)
4 Complementary GoodsWhen the price of good X falls and the consumption of Y rises, then X and Y are complementary goods. (PX1 > PX2)Pretzels (Y)M/PY1IIM/PX2IBY2X2AY1X1M/PX1Beer (X)
5 Income Changes and Consumer Equilibrium Normal GoodsIncrease (decrease) in income leads to an increase (decrease) in its consumption.Inferior GoodsIncrease (decrease) in income leads to a decrease (increase) in its consumption.
6 Normal GoodsYAn increase in income increases the consumption of normal goods.(M0 < M1).M1/YM1/XIIBIY1X1M0/YM0/XAY0X0X
7 Inferior GoodsYAn increase in income decreases the consumption of inferior goods.(M0 > M1).IIM1/YM1/XBY1X1IM0/YM0/XAY0X0X
8 When price of a good decreases Two things happenRelative price of the good decreasesBuy more of the cheaper goodSubstitution EffectReal income or purchasing power increasesIf buy same bundle of goods bought previously have money left overIncome Effect
9 To graphically break up the effects Price decrease causes a rotation on the BCNew optimal bundleLook at what would we have bought with this new income level (new BC) at our old Utility levelTake money away from consumer to keep original Utility levelPrice 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 EFFECTOld optimal bundle to new tangency on original IC is SUBSTITUTION EFFECTSame indifference curveNew tangency on original IC to new optimal bundle is INCOME EFFECTSame budget constraint