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Managerial Economics &

Business StrategyChapter 4

The Theory of IndividualBehavior

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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

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Consumer Behavior

Consumer Opportunities 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

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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 foranother and stay at the same

satisfaction level.

I.

II.

III.

Good Y

Good X

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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.

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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

Px

Py

Budget Line

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Consumer Equilibrium

The equilibrium

consumption bundle is

the affordable bundlethat yields the highest

level of satisfaction.

I.

II.

III.

X

Y

Consumer

Equilibrium

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Changes in the Budget Line

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 ofgood X rotates the budget

line counter-clockwise.

An increases rotates the

budget line clockwise.

X

Y

X

YNew Budget Line for

a price decrease.

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Changes in Price

Substitute Goods An increase (decrease) in the price of good X leads to

an increase (decrease) in the consumption of good Y.

Complementary Goods An increase (decrease) in the price of good X leads to a

decrease (increase) in the consumption of good Y.

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Complementary Goods

When the price of

good X falls, the

consumption of

complementarygood Y rises.

Pretzels (Y)

Beer (X)

II

I

0

Y2

Y1

X1 X2

A

B

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Changes in Income

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.

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Normal Goods

An increase in

income increases

the consumption of

normal goods.

Y

II

I

0

A

B

X

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Individual Demand Curve

An individuals

demand curve is

derived from each new

equilibrium pointfound on the

indifference curve as

the price of good X is

varied.

X

Y

$

X

D

II

I

P0

P1

X0 X1

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Market Demand

The market demand curve is the horizontalsummation 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

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A Classic Marketing

ApplicationOthergoods

(Y)

II

I

0

AC

B F

D

E

Pizza

(X)

0.5 1 2

A buy-one,

get-one free

pizza deal.