Transcript Managerial Economics & Business Strategy

Managerial Economics &
Business Strategy
Chapter 4
The Theory of Individual
Behavior
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 T-Mobile.
• 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.
Substitute Goods
When the price of
good X falls and the
consumption of Y
falls, then X and Y
are substitute goods.
(PX1 < PX2)
Pretzels (Y)
M/PY1
A
Y1
B
Y2
I
0
X1 M/PX1
II
X2
M/PX2
Beer (X)
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)
Income Changes and Consumer
Equilibrium
• Normal Goods

Increase (decrease) in income leads to an increase
(decrease) in its consumption.
• Inferior Goods

Increase (decrease) in income leads to a decrease
(increase) in its consumption.
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
Inferior Goods
An increase in
income decreases
the consumption of
inferior goods.
Y
M1/Y
B
Y1
(M0 > M1).
M0/Y
A
Y0
I
0
X1X0 M0/X
M1/X
X
When price of a good decreases
• Two things happen

Relative price of the good decreases
• Buy more of the cheaper good
• Substitution Effect

Real income or purchasing power increases
• If buy same bundle of goods bought previously have money left over
• Income Effect
To graphically break up the
effects
• Price decrease causes a rotation on the BC

New optimal bundle
• Look at what would we have bought with this new income
level (new BC) at our old Utility level


Take money away from consumer to keep original Utility level
Price has changed though so cannot keep the slope of the original BC
The Result is Three Points
• Old optimal bundle to new optimal bundle
is the TOTAL EFFECT
• Old optimal bundle to new tangency on
original IC is SUBSTITUTION EFFECT

Same indifference curve
• New tangency on original IC to new
optimal bundle is INCOME EFFECT

Same budget constraint