Managerial Economics & Business

Strategy
Chapter 4
The Theory of Individual Behavior
 4-2
Overview
I. Consumer Behavior
– Indifference Curve Analysis
– Consumer Preference Ordering
II. Constraints
– The Budget Constraint
– Changes in Income
– Changes in Prices
III. Consumer Equilibrium
IV. Indifference Curve Analysis & Demand Curves
– Individual Demand
– Market Demand
 4-3

Consumer Behavior
• Consumption Possibilities
– The possible goods and services 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.
 4-4

Indifference Curve Analysis

Indifference Curve Good Y
– A curve that defines the III.
combinations of 2 or more goods
II.
that give a consumer the same
level of satisfaction. I.

Marginal Rate of
Substitution
– The rate at which a consumer is
willing to substitute one good for
another and maintain the same
satisfaction level.
Good X
 4-5
Consumer Preference Ordering
Properties

• Completeness
• More is Better
• Diminishing Marginal Rate of Substitution
• Transitivity
 4-6

Complete Preferences
• Completeness Property Good Y
– Consumer is capable of
expressing preferences (or III.
indifference) between all possible II.
bundles.
I.
– If the only bundles available to a
A
consumer are A, B, and C, then B

the consumer
– is indifferent between A and
C (they are on the same C
indifference curve).
– will prefer B to A.
– will prefer B to C.
Good X
 4-7

More Is Better!
• More Is Better Property
– Bundles that have at least as much of Good Y
every good and more of some good
are preferred to other bundles. III.
• Bundle B is preferred to A since B II.
contains at least as much of
good Y and strictly more of good I.
X.
• Bundle B is also preferred to C A B
since B contains at least as much 100
of good X and strictly more of
good Y.
C
• More generally, all bundles on 33.33
ICIII are preferred to bundles on
ICII or ICI. And all bundles on ICII
are preferred to ICI.
1 3
Good X
 4-8
Diminishing Marginal Rate of
Substitution
• Marginal Rate of Substitution
– The amount of good Y the consumer is Good Y
willing to give up to maintain the same
satisfaction level decreases as more of
good X is acquired. III.
– The rate at which a consumer is willing to
substitute one good for another and II.
maintain the same satisfaction level.
I.
• To go from consumption bundle A to
B the consumer must give up 50 units 100 A
of Y to get one additional unit of X.
• To go from consumption bundle B to B
C the consumer must give up 16.67 50
units of Y to get one additional unit C
of X. 33.33 D
25
• 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. 1 2 3 4 Good X
 4-9

Consistent Bundle Orderings

• Transitivity Property Good Y
– For the three bundles A, B, and C,
the transitivity property implies III.
that if C  B and B  A, then C  II.
A.
I.
– Transitive preferences along with
A
the more-is-better property imply 100
C
that 75
B
• indifference curves will not 50
intersect.
• the consumer will not get
caught in a perpetual cycle of
indecision.
1 2 5 7 Good X
 4-10

The Budget Constraint

• Opportunity Set Y The Opportunity Set

– The set of consumption

bundles that are affordable.
• PxX + PyY  M.
M/PY

• Budget Line
– The bundles of goods that exhaust a
consumers income.
• PxX + PyY = M.
• Market Rate of Substitution M/PX
X
– The slope of the budget line
• -Px / Py
 4-11

Changes in the Budget Line

Y

• Changes in Income
M1/PY

– Increases lead to a parallel,

M0/PY
outward shift in the budget
line (M1 > M0).
– Decreases lead to a parallel, M2/PY
downward shift (M2 < M0).
• Changes in Price
X
– A decreases in the price of Y
M2/PX M0/PX M1/PX
good X rotates the budget New Budget Line for
line counter-clockwise (PX0 > a price decrease.
M0/PY
PX1).
– An increases rotates the
budget line clockwise (not
shown).

M0/PX0 M0/PX1
X
 4-12

Consumer Equilibrium
• The equilibrium Y
consumption bundle Consumer
is the affordable M/PY
Equilibrium
bundle that yields the
highest level of
satisfaction.
– Consumer equilibrium
occurs at a point where
MRS = PX / PY. III.
– Equivalently, the slope of II.
the indifference curve
equals the budget line. I.
M/PX
X
 4-13
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 AT&T.
• Complementary Goods
– An increase (decrease) in the price of good X leads
to a decrease (increase) in the consumption of
good Y.
• Examples:
– DVD and DVD players.
– Computer CPUs and monitors.
 4-14

Complementary Goods

When the price of

Pretzels (Y)
good X falls and the
consumption of Y
rises, then X and Y M/PY
1
are complementary
goods. (PX1 > PX2)

B
Y2

Y1 A II

I
0 X1 M/PX1 X2 M/PX2 Beer (X)
 4-15
Income Changes and Consumer
Equilibrium
• 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 an inferior good if an increase
(decrease) in income leads to a decrease
(increase) in its consumption.
 4-16

Normal Goods
Y
An increase in
income increases
the consumption of M1/Y

normal goods.

(M0 < M1).

B
Y1
M0/Y
II
A
Y0
I
X0 M0/X X1 M1/X X
0
 4-17

Decomposing the Income and

Substitution Effects
Initially, bundle A is consumed. Y
A decrease in the price of good
X expands the consumer’s
opportunity set.
The substitution effect (SE) C
causes the consumer to move
from bundle A to B. A II
A higher “real income” allows B
the consumer to achieve a
higher indifference curve. I
The movement from bundle B to
C represents the income effect IE X
0
(IE). The new equilibrium is SE
achieved at point C.
Substitution effect: The movement along a given indifference curve
that results from a change in the relative prices of goods, holding real
income constant.

Income effect: The movement from one indifference curve to another

that results from the change in real income caused by a price change.
 4-19

Individual Demand Curve

Y

• An individual’s
demand curve is
derived from each II

new equilibrium point I

found on the $ X

indifference curve as
the price of good X is P0
varied. P1 D

X0 X1 X
 4-20

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.

$ Individual Demand $ Market Demand Curve

Curves
50

40

D1 D2 DM
1 2 Q 1 2 3 Q
 4-21

Conclusion
• Indifference curve properties reveal information
about consumers’ preferences between bundles of
goods.
– Completeness.
– More is better.
– Diminishing marginal rate of substitution.
– Transitivity.
• Indifference curves along with price changes
determine individuals’ demand curves.
• Market demand is the horizontal summation of
individuals’ demands.
Applications of Indifference curve
analysis