Managerial Economics & Business Strategy

Chapter 4

The Theory of Individual Behavior

Can we do it??

•

On the next slide are schedules which show the total utility measured in terms of utiles which President Strassburger would get by purchasing various amounts of product Apples, Bananas, Carrots, and Donuts. Assume that the price of Bananas is $4, the price of Donuts is $18, the price of Apples is $1, the price of Carrots is $6, and that President Strassburger’s income is $135. What quantities of Bananas, Donuts, Apples, and Carrots will President Strassburger purchase?

2 3 B 1 4 5 6 7 8 TU 24 MU MU /P D 1

Can you do it??

TU 126 MU MU /P A 1 TU 7 MU MU /P C 1 234 44 2 2 13 2 324 60 3 3 18 3 396 72 4 4 22 4 450 82 5 5 25 27.5

5 90 6 486 6 6 513 96 100 7 8 531 7 8 29 30 7 8 TU MU MU /P 36 66 90 108 120 129 135 138

3 4 B 1 2 5 6 7 8 TU MU MU /P 24 -- D 1 44 20 2

Can you do it??

TU MU MU /P 126 -- A 1 234 108 2 TU 7 MU MU /P -- C 1 13 6 2 60 16 72 12 82 10 90 8 96 6 100 4 3 4 5 6 7 8 324 90 396 72 450 54 486 36 513 27 531 18 3 4 5 6 7 8 18 5 22 4 25 3 27.5

2.5

29 1.5

30 1 3 4 5 6 7 8 TU 36 MU MU /P -- 66 30 90 24 108 18 120 12 129 9 135 6 138 3

2 3 B 1 4 5 6 7 8 TU MU MU /P D 24 --- --- 1

Can you do it??

TU MU MU /P A 126 --- --- 1 TU 7 MU MU /P C --- --- 1 44 20 5 60 16 4 72 12 3 82 10 2.5

5 90 8 96 6 100 4 2 1 2 3 4 6 1.5

7 8 234 108 6 324 90 5 396 72 4 450 54 3 2 3 4 5 486 36 2 513 27 1.5

7 531 18 1 6 8 13 6 18 5 22 4 30 1 6 5 4 1 2 3 4 25 3 3 5 27.5

2.5 2.5

6 29 1.5 1.5

7 8 TU 36 MU MU /P --- -- 66 30 5 90 24 4 108 18 3 120 12 2 129 9 1.5

135 6 138 3 1 0.5

2 3 B 1 4 5 6 7 8 TU MU MU /P D 24 --- --- 1

Can you do it??

TU MU MU /P A 126 --- --- 1 TU 7 MU MU /P C --- --- 1 44 20 5 60 16 4 72 12 3 82 10 2.5

5 90 8 96 6 100 4 2 1 2 3 4 6 1.5

7 8 234 108 6 324 90 5 396 72 4 450 54 3 2 3 4 5 486 36 2 513 27 1.5

7 531 18 1 6 8 13 6 18 5 22 4 30 1 6 5 4 1 2 3 4 25 3 3 5 27.5

2.5 2.5

6 29 1.5 1.5

7 8 TU 36 MU MU /P --- -- 66 30 5 90 24 4 108 18 3 120 12 2 129 9 1.5

135 6 138 3 1 0.5

Consumer Preference Ordering Properties

• Completeness   Every individual can state their preferences NO  “I don’t know” • More is Better • Diminishing Marginal Rate of Substitution   As you get more good X the rate at which you are willing to substitute good X for good Y decreases Have too much X  don’t want more  Shows indifference curves are CONVEX • Transitivity   If prefer A to B and B to C then prefer A to C IC cannot cross

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.

Slope Good Y I.

II.

III.

Good X

Diminishing Marginal Rate of Substitution

• Marginal Rate of Substitution  slope • 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 Good Y 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.

100 50 33.33

25 I.

A II.

B III.

C D 1 2 3 4 Good X

What was???

• The slope of the indifference curve?

  Marginal rate of substitution • MRS MRS = MU x /MU y Along an indifference curve  

X

*

MU x

  

Y

*

MU y



Y



X

 

MU MU y x

Likes risk!! FLAT Indifference Curve Will give up a lot of safety for a little Increase in return Doesn’t like risk!! STEEP indifference curve Need BIG increase in return to give up a little risk

The Budget Constraint

• Opportunity Set  The set of consumption bundles that are affordable.

• P x X + P y Y  M.

• Budget Line M/P Y Y  The bundles of goods that exhaust a consumers income.

• P x X + P y Y = M.

• Market Rate of Substitution  The slope of the budget line • -P x / P y

The Opportunity Set

Budget Line Y = M/P Y – (P X /P Y ) X M/P X X

•

Market Rate of Substitution

income



Y



X

 

P

y

income P

x



Y



X

 

income P

y

*

P

x

income



Y



X

 

P x P y

Changes in the Budget Line

• Changes in Income  Increases lead to a parallel, outward shift in the budget line (M 1 > M 0 ).

 Decreases lead to a parallel, downward shift (M 2 < M 0 ).

• Changes in Price   A decreases in the price of good X rotates the budget line counter-clockwise (P X0 P X1 ).

An increases rotates the > budget line clockwise Y M 1 /P Y M 0 /P Y M 2 /P Y Y M 0 /P Y M 2 /P X M 0 /P X M 1 /P X

New Budget Line for a price decrease.

X

New Budget Line for a price increase.

M 2 /P X2 M 0 /P X0 M 0 /P X1 X

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

= P X / P Y.

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

Y M/P Y

Consumer Equilibrium

I.

III.

II.

M/P X X