Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Managerial Economics & Business Strategy

Chapter 4The 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 EquilibriumIV. Indifference Curve Analysis & Demand

Curves– Individual Demand.– Market Demand.

4-3

Consumer Behavior Consumer Opportunities

– The possible goods and services consumer can afford to consume.

Consumer Preferences– The goods and services consumers actually

consume.

4-4

Indifference Curve Analysis

Indifference Curve– A curve that defines the

combinations of 2 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 maintain the same satisfaction level.

I.

II.

III.

Good Y

Good X

4-5

Consumer Preference Ordering Properties

Completeness More is Better Diminishing Marginal Rate of Substitution Transitivity

4-6

Complete Preferences Completeness Property

– Consumer is capable of expressing preferences (or indifference) between all possible bundles. (“I don’t know” is NOT an option!)• If the only bundles available

to a consumer are A, B, and C, then the consumer

is indifferent between A and C (they are on the same indifference curve).

will prefer B to A. will prefer B to C.

I.

II.

III.

Good Y

Good X

A

C

B

4-7

More Is Better! More Is Better Property

– Bundles that have at least as much of every good and more of some good are preferred to other bundles.

• Bundle B is preferred to A since B contains at least as much of good Y and strictly more of good X.

• Bundle B is also preferred to C since B contains at least as much of good X and strictly more of good Y.

• More generally, all bundles on ICIII are preferred to bundles on ICII or ICI. And all bundles on ICII are preferred to ICI.

I.

II.

III.

Good Y

Good X

A

C

B

1

33.33

100

3

4-8

Diminishing MRS MRS

– The amount of good Y the consumer is willing to give up to maintain the same satisfaction level decreases as more of good X is acquired.

– The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level.

To go from consumption bundle A to B the consumer must give up 50 units of Y to get one additional unit of X.

To go from consumption bundle B to C the consumer must give up 16.67 units of Y to get one additional unit of X.

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.

I.

II.

III.

Good Y

Good X1 3 42

100

50

33.33 25

A

B

CD

4-9

Consistent Bundle Orderings

Transitivity Property– For the three bundles A, B,

and C, the transitivity property implies that if C B and B A, then C A.

– Transitive preferences along with the more-is-better property imply that• indifference curves will not

intersect.• the consumer will not get

caught in a perpetual cycle of indecision.

I.

II.

III.

Good Y

Good X21

100

5

50

7

75

A

B

C

4-10

The Budget Constraint Opportunity Set

– The set of consumption bundles that are affordable.• PxX + PyY M.

Budget Line– The bundles of goods that exhaust

a consumers income.• PxX + PyY = M.

Market Rate of Substitution– The slope of the budget line

• -Px / Py.

Y

X

The Opportunity Set

Budget Line

Y = M/PY – (PX/PY)XM/PY

M/PX

4-11

Changes in the Budget Line Changes in Income

– Increases lead to a parallel, outward shift in the budget line (M1 > M0).

– Decreases lead to a parallel, downward shift (M2 < M0).

Changes in Price– A decreases in the price of

good X rotates the budget line counter-clockwise (PX0

> PX1).

– An increases rotates the budget line clockwise (not shown).

X

Y

X

YNew Budget Line for a price decrease.

M0/PY

M0/PX

M2/PY

M2/PX

M1/PY

M1/PX

M0/PY

M0/PX0M0/PX1

4-12

Consumer Equilibrium

The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction.– Consumer equilibrium

occurs at a point where

MRS = PX / PY.

– Equivalently, the slope of the indifference curve equals the budget line.

I.

II.

III.

X

Y

Consumer Equilibrium

M/PY

M/PX

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

One Extreme Case: Perfect SubstitutesPerfect substitutes: two goods with straight-line indifference curves, constant MRS

Example: nickels & dimes

Consumer is always willing to trade two nickels for one dime.

4-15

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)

Beer (X)

II

I0

Y2

Y1

X1 X2

A

B

M/PX1M/PX2

M/PY1

4-16

Another Extreme Case: Perfect Complements

Perfect complements: two goods with right-angle indifference curves

Example: left shoes, right shoes{7 left shoes, 5 right shoes}is just as good as {5 left shoes, 5 right shoes}

4-17

Optimization: What the Consumer ChoosesThe optimal bundle is at the point where the budget constraint touches the highest indifference curve.

MRS = relative priceat the optimum:

The indiff curve and budget constraint

have the same slope.

4-18

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.

4-19

Normal Goods

An increase in income increases the consumption of normal goods.

(M0 < M1).

Y

II

I

0

A

B

X

M0/Y

M0/X

M1/Y

M1/XX0

Y0

X1

Y1

4-20

Decomposing the Income and Substitution Effects

Initially, bundle A is consumed. A decrease in the price of good X expands the consumer’s opportunity set.

The substitution effect (SE) causes the consumer to move from bundle A to B.

A higher “real income” allows the consumer to achieve a higher indifference curve.

The movement from bundle B to C represents the income effect (IE). The new equilibrium is achieved at point C.

Y

II

I

0

A

X

C

B

SE

IE

4-21

Giffen Goods Do all goods obey the Law of Demand? Suppose the goods are potatoes and meat,

and potatoes are an inferior good. If price of potatoes rises,

– substitution effect: buy less potatoes– income effect: buy more potatoes

If income effect > substitution effect, then potatoes are a Giffen good, a good for which an increase in price raises the quantity demanded.

4-22

Giffen Goods

4-23

Wages and Labor SupplyBudget constraint– Shows a person’s tradeoff between consumption

and leisure. – Depends on how much time she has to divide

between leisure and working. – The relative price of an hour of leisure is the amount

of consumption she could buy with an hour’s wages.

Indifference curve– Shows “bundles” of consumption and leisure

that give her the same level of satisfaction.

4-24

Wages and Labor Supply

At the optimum, the MRS between

leisure and consumption

equals the wage.

At the optimum, the MRS between

leisure and consumption

equals the wage.

4-25

Wages and Labor Supply

An increase in the wage has two effects on the optimal quantity of labor supplied. – Substitution effect (SE): A higher wage makes

leisure more expensive relative to consumption.The person chooses less leisure, i.e., increases quantity of labor supplied.

– Income effect (IE): With a higher wage, she can afford more of both “goods.” She chooses more leisure, i.e., reduces quantity of labor supplied.

4-26

Wages and Labor Supply

For this person, SE > IE

For this person, SE > IE

So her labor supply increases with the wage

So her labor supply increases with the wage

4-27

Wages and Labor Supply

For this person, SE < IE

For this person, SE < IE

So his labor supply falls when the wage rises

So his labor supply falls when the wage rises

4-28

Could This Happen in the Real World???

Over last 100 years, technological progress has increased labor demand and real wages.

The average workweek fell from 6 to 5 days.

4-29

Interest Rates and Saving A person lives for two periods.

– Period 1: young, works, earns $100,000consumption = $100,000 minus amount saved

– Period 2: old, retiredconsumption = saving from Period 1 plus interest earned on saving

The interest rate determinesthe relative price of consumption when young in terms of consumption when old.

4-30

Interest Rates and Saving

At the optimum, the MRS between current and future consumption equals the interest rate.

At the optimum, the MRS between current and future consumption equals the interest rate.

Budget constraint shown is for 10% interest rate.

4-31

A C T I V E L E A R N I N G 5: Effects of an interest rate increase Suppose the interest rate rises. Determine the income and substitution effects on

current and future consumption, and on saving.

31

4-32

A C T I V E L E A R N I N G 5: AnswersThe interest rate rises.

Substitution effect– Current consumption becomes more expensive

relative to future consumption. – Current consumption falls, saving rises,

future consumption rises.

Income effect– Can afford more consumption in both the

present and the future. Saving falls.

32

4-33

Interest Rates and SavingIn this case, SE

> IE and saving rises

In this case, SE > IE and

saving rises

4-34

Interest Rates and Saving

In this case, SE < IE and

saving falls

In this case, SE < IE and

saving falls

34

4-35

A Classic Marketing Application

Other goods (Y)

II

I

0

A

C

B F

D

E

Pizza (X)

0.5 1 2

A buy-one, get-one free pizza deal.

4-36

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

Y

$

X

D

II

I

P0

P1

X0 X1

4-37

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.

Q

$ $

Q

50

40

D2D1

Individual Demand Curves

Market Demand Curve

1 2 1 2 3

DM

4-38

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.

4-39

CONCLUSION: Do People Really Think This Way?

Most people do not make spending decisions by writing down their budget constraints and indifference curves.

Yet, they try to make the choices that maximize their satisfaction given their limited resources.

The theory in this chapter is only intended as a metaphor for how consumers make decisions.

It does fairly well at explaining consumer behavior in many situations, and provides the basis for more advanced economic analysis.