1. David Bryce © 1996-2002 Adapted from Baye © 2002 Individual Behavior MANEC 387 Economics of Strategy MANEC 387 Economics of Strategy David J. Bryce

2. David Bryce © 1996-2002 Adapted from Baye © 2002 The Structure of Industries Competitive Rivalry Threat of new Entrants Bargaining Power of Customers Threat of Substitutes Bargaining Power of Suppliers From M. Porter, 1979, “How Competitive Forces Shape Strategy”

3. David Bryce © 1996-2002 Adapted from Baye © 2002 “Can’t Get No Satisfaction” How Much Should I Consume? Consumers maximize satisfaction Diminishing marginal return – next unit consumed gives less satisfaction than the last Consume until marginal satisfaction equals marginal cost Consumers maximize satisfaction Diminishing marginal return – next unit consumed gives less satisfaction than the last Consume until marginal satisfaction equals marginal cost Satisfaction Consumption Cost = P c C S* C* Tangency means MS=MC

4. David Bryce © 1996-2002 Adapted from Baye © 2002 Consumer Behavior with Multiple Goods Consumer Opportunities – the possible goods and services a consumer can afford to consume Consumer Preferences – the goods and services consumers actually consume 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 Consumer Opportunities – the possible goods and services a consumer can afford to consume Consumer Preferences – the goods and services consumers actually consume 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

5. David Bryce © 1996-2002 Adapted from Baye © 2002 Consumer Preference Ordering Completeness – the consumer is capable of expressing a preference for all bundles of goods More is better Diminishing marginal rate of substitution 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 Completeness – the consumer is capable of expressing a preference for all bundles of goods More is better Diminishing marginal rate of substitution 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

6. David Bryce © 1996-2002 Adapted from Baye © 2002 Non-satiation – “more is better”

7. David Bryce © 1996-2002 Adapted from Baye © 2002 Indifference Curve Analysis Indifference Curve – a curve that defines the combinations of two 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. Indifference Curve – a curve that defines the combinations of two 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. Good Y Good X S1S1 S1S1 S2S2 S2S2 S3S3 S3S3 S 3 > S 2 > S 1

8. David Bryce © 1996-2002 Adapted from Baye © 2002 From Satisfaction to Indifference Indifference curves are a 2-dimensional view of a 3-dimensional concept The satisfaction curve is a “mountain of happiness” Looking down from above “Mount Satisfaction,” the contour (elevation) lines are indifference curves. Indifference curves are a 2-dimensional view of a 3-dimensional concept The satisfaction curve is a “mountain of happiness” Looking down from above “Mount Satisfaction,” the contour (elevation) lines are indifference curves. Satisfaction X X Y Y X X Y Y Irrational Region Irrational Region

9. David Bryce © 1996-2002 Adapted from Baye © 2002 The Budget Constraint Opportunity set – t he set of consumption bundles that are affordable P x X + P y Y  M Budget line – t he bundles of goods that exhaust a consumer’s income P x X + P y Y = M Market rate of substitution – t he slope of the budget line -P x / P y Opportunity set – t he set of consumption bundles that are affordable P x X + P y Y  M Budget line – t he bundles of goods that exhaust a consumer’s income P x X + P y Y = M Market rate of substitution – t he slope of the budget line -P x / P y Y Y X X PxPx PyPy Budget Line Opportunity Set

10. David Bryce © 1996-2002 Adapted from Baye © 2002 Consumption Decision The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction. Good Y Good X S1S1 S1S1 S2S2 S2S2 S3S3 S3S3 X* Y* Consumption Bundle Consumption Bundle

11. David Bryce © 1996-2002 Adapted from Baye © 2002 Changes in the Budget Constraint 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 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 X X Y Y X X Y Y

12. David Bryce © 1996-2002 Adapted from Baye © 2002 Effect of Changing Income on Consumption Bundle Normal 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 – 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.

13. David Bryce © 1996-2002 Adapted from Baye © 2002 Normal Goods An increase in income increases the consumption of normal goods. X X Y Y X1X1 X1X1 Y1Y1 Y1Y1 X2X2 X2X2 Y2Y2 Y2Y2

14. David Bryce © 1996-2002 Adapted from Baye © 2002 Decreasing Price Increases Quantity Demanded When the price of good X falls, the consumption of X rises – follows law of demand X X X1X1 X1X1 Y Y X2X2 X2X2 Y1Y1 Y1Y1 Y2Y2 Y2Y2

15. David Bryce © 1996-2002 Adapted from Baye © 2002 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 X Y Y $ $ X X D D P0P0 P0P0 P1P1 P1P1 X0X0 X0X0 X1X1 X1X1

16. David Bryce © 1996-2002 Adapted from Baye © 2002 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. 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 $ $ $ $ Q Q 50 40 D2D2 D2D2 D1D1 D1D1 Individual Demand Curves Market Demand Curve 1 2 1 2 3 DMDM DMDM