Module 4A – Theory of Individual Behavior
Consumer
- individual who purchases goods and services from firms for the purpose of consumption
- As a manager of a firm, you are interested not only in who consumes the good but in who
purchases it.
Consumer Behavior
Consumer Preferences - determines which set of goods and services will be consumed
(subjective taste of individual measured by their satisfaction).
Consumer Opportunities - possible goods and services consumers can afford to consume.
4 Basic Properties of Consumer Preference
Property 1: Completeness
- The consumer is capable of expressing a preference for, or indifference among all
bundles (A ≻ B or B ≻ A )
- If preference were not complete there might cases where a consumer would claim not to know
whether he or she preferred bundle A to bundle B, or preferred bundle B to A or was
indifferent between the two bundles. (A ~ B)
Note: If the consumer cannot their own preferences/indifferences among good, manger can hardly predict
individual consumption pattern with reasonable accuracy.
Managers should know what their consumer’s preferences.
Property 2: More is Better
- Indeed, economists define a good as a commodity for which more is preferred to less, at
least at some levels of consumption. In contrast, a bad is something for which less is
preferred to more.
Indifference Curve
- shows combination of goods X and Y that gives the consumer the same level of
satisfaction. Consumer is indifferent between any combination of goods along the
indifference curve.
Shape of the curve depends on the consumers preference.
- A, B, C are the goods that the consumer views as being
better
- Bundle A is preferred to Bundle D because it has same
amount of good X and more of good Y
- Bundle C is preferred because it has more of both goods
- Points along the indifference curve is preferable.
Marginal Rate of Substitution
- The MRS between 2 goods is the rate in which a consumer is willing to substitute one for
the other and still maintain the same level of satisfaction.
o For example:
The consumer is indifferent between bundles A and B. moving from A to B, the
consumer gains 1 unit of X and to remain on the same Indifference Curve (IC),
the consumer gives up 2 units of good Y. Thus, in moving from point A to B the
MRS between goods X and Y is 2.
Property 3: Diminishing Marginal Rate of Substitute
- As a consumer obtains more of good X, the amount of good Y the consumer is willing to
give up to obtain another unit of good X decreases.
- It implies that indifference curve is convex from the origin. (Curve will never intersect)
Property 4: Transitivity
- The assumption of transitive preferences, together with the more-is-better assumption,
implies that indifference curve do not intersect one another.
- It also eliminates the possibility that the consumer is caught in a perpetual cycle in which
he or she never makes a choice.
A ≻ B and B≻C , then A ≻ C .
A ∼ B and B∼C , then A ∼ C .
Constraints
- The focus of this subject is to examine the role of prices and income play in constraining
consumer behavior
Budget Constraints
- Restriction set by prices and income that limits bundles of goods affordable to
consumers.
- Restricts consumer behavior by forcing the consumer to select a bundle of goods that is
affordable.
o Budget set:
Where:
PX X + PY Y ≤ M M - consumer’s income
o Budget line: Px - price of good x
Py – price of good y
P X X + P Y Y =M
If we multiply both sides of the budget line by 1/Py, we get:
PxX PyY M
+ =
Py Py Py
M PxX
Y= −
Py Py
Note: Y is a linear function of X with a vertical
intercept of M/Py and a slope of –Px/Py.
If the consumer spent his/ her entire income on good Y, expenditures on Y would exactly equals
income: Py Y = M
Consequently, the maximum quantity of good Y is affordable is: Y = M/Py
- Will not affect the slope of the budget line
- Vertical and horizontal intercept both
increase/decrease.
- Increase in income (M1) = shift to the right
(more goods are affordable)
- Decrease in income (M2) = shift to the left
- Decrease in Price of good X will result
to a counter-clockwise (left) movement
of the BL
- Increase in price of good X will result to
a clockwise (right) movement of the BL
Consumer Equilibrium
- Shows the consumption bundle that is affordable and yields the greatest satisfaction to
the consumer.
- Consumption bundle where the rate a consumer choses (marginal rate of substitution) to
trade between goods X and Y equals the rate at which these goods are traded in the
PX
market (market rate of substitution). MRS=
PY
Price Changes and Consumer Behavior
- Price and income changes impact a consumer’s budget set and level of satisfaction that
can be achieved.
- This implies that price and income changes will lead to consumer equilibrium changes.
Price Changes and Equilibrium
- Price increases (decreases) reduce (expand) a consumer’s budget set.
- The new consumer equilibrium resulting from a price change depends on consumer
preferences:
• Goods X and Y are:
o substitutes when an increase (decrease) in the price of X leads to an
increase (decrease) in the consumption of Y.
o complements when an increase (decrease) in the price of X leads to a
decrease (increase) in the consumption of Y.
Income Changes and Consumer Behavior
- Income increases (decreases) reduce (expand) a consumer’s budget set.
- The new consumer equilibrium resulting from an income change depends on consumer
preferences:
• Good X is:
o a normal good when an increase (decrease) in income leads to an increase
(decrease) in the consumption of X.
o an inferior good when an increase (decrease) in income leads to a decrease
(increase) in the consumption of X.
