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Managerial Economics & Business
Strategy
Chapter 4
The Theory of
Individual Behavior
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
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.
4-2
Consumer Behavior
 Consumer Opportunities
– The possible goods and services consumer can
afford to consume.
 Consumer Preferences
– The goods and services consumers actually
consume.
4-3
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.
Good Y
III.
II.
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
4-4
Consumer Preference Ordering
Properties




Completeness
More is Better
Diminishing Marginal Rate of Substitution
Transitivity
4-5
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.
Good Y
III.
II.
I.
A
B
C
Good X
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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.
Good Y
III.
II.
I.
100
A
B
C
33.33
1
3
Good X
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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.
Good Y
 To go from consumption bundle A
to B the consumer must give up
50 units of Y to get one additional 100
unit of X.
 To go from consumption bundle B
50
to C the consumer must give up
16.67 units of Y to get one
33.33
additional unit of X.
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.
III.
II.
I.
A
B
C
1
2
3
D
4
Good X
4-8
Consistent Bundle Orderings
 Transitivity Property
Good Y
– 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
100
with the more-is-better
property imply that
75
• indifference curves will not
50
intersect.
• the consumer will not get
caught in a perpetual cycle
of indecision.
III.
II.
I.
A
C
B
1
2
5
7 Good X
4-9
The Budget Constraint
 Opportunity Set
– The set of consumption bundles
that are affordable.
• PxX + PyY  M.
 Budget Line
Y
The Opportunity Set
Budget Line
M/PY
Y = M/PY – (PX/PY)X
– The bundles of goods that exhaust
a consumers income.
• PxX + PyY = M.
 Market Rate of
Substitution
– The slope of the budget line
• -Px / Py.
M/PX
X
4-10
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).
Y
M1/PY
M0/PY
M2/PY
Y
M0/PY
M2/PX
M0/PX
M1/PX
X
New Budget Line for
a price decrease.
M0/PX0
M0/PX1
X
4-11
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.
Y
M/PY
Consumer
Equilibrium
III.
II.
I.
M/PX
X
4-12
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.
4-13
One Extreme Case: Perfect Substitutes
Perfect substitutes: two goods with straightline indifference curves,
constant MRS
Example: nickels & dimes
Consumer is always willing to trade
two nickels for one dime.
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
II
A
Y1
I
0
X1 M/PX1
X2
M/PX2
Beer (X)
4-15
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}
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Optimization: What the Consumer Chooses
The optimal bundle is at the point
where the budget constraint touches
the highest indifference curve.
MRS = relative price
at the optimum:
The indiff curve and
budget constraint
have the same slope.
4-17
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.
4-18
Normal Goods
An increase in
income increases
the consumption of
normal goods.
Y
M1/Y
(M0 < M1).
B
Y1
M0/Y
II
A
Y0
I
0
X0 M0/X
X1
M1/X
X
4-19
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.
Y
C
The substitution effect (SE) causes the
consumer to move from bundle A to B.
A
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.
II
B
I
0
IE
X
SE
4-20
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.
4-21
Giffen Goods
4-22
Wages and Labor Supply
Budget 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.
4-23
Wages and Labor Supply
At the optimum,
the MRS between
leisure and
consumption
equals the wage.
4-24
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.
4-25
Wages and Labor Supply
For this person, SE
> IE
So her labor supply
increases with the wage
4-26
Wages and Labor Supply
For this person, SE
< IE
So his labor supply falls
when the wage rises
4-27
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.
4-28
Interest Rates and Saving
 A person lives for two periods.
– Period 1: young, works, earns $100,000
consumption = $100,000 minus amount saved
– Period 2: old, retired
consumption = saving from Period 1
plus interest earned on saving
 The interest rate determines
the relative price of consumption when young
in terms of consumption when old.
4-29
Interest Rates and Saving
Budget constraint shown is for 10% interest rate.
At the optimum,
the MRS between
current and future
consumption equals
the interest rate.
4-30
5:
Effects of an interest rate increase
ACTIVE LEARNING
 Suppose the interest rate rises.
 Determine the income and substitution effects on
current and future consumption, and on saving.
4-31
31
ACTIVE LEARNING
5:
Answers
The 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.
4-32
32
Interest Rates and Saving
In this case, SE
> IE and
saving rises
4-33
Interest Rates and Saving
In this case, SE
< IE and
saving falls
4-34
34
A Classic Marketing Application
Other
goods
(Y)
A buy-one,
get-one free
pizza deal.
A
C
E
D
II
I
0
0.5
1
2
B
F
Pizza
(X)
4-35
Individual Demand Curve
Y
 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.
II
I
X
$
P0
D
P1
X0
X1
X
4-36
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
Curves
$
Market Demand Curve
50
40
D1
1 2
D2
Q
1 2 3
DM
Q
4-37
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.
4-38
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.
4-39