BUS 525: Managerial Economics

Lecture 4

The Theory of Individual Behavior

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

Consumer Behavior

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

• Consumer Preferences – The goods and services consumers actually consume.

• You might afford something but actually may not consume something due to personal preference

Consumer Preference Ordering Properties

• Completeness – 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.

• More is Better – If bundle A has at least as much of every good as bundle B and more of some good, bundle A is preferred to bundle B • Diminishing Marginal Rate of Substitution • Transitivity

Definitions

• Indifferent – when a consumer finds two options to be equally satisfactory • Economic “bads” – commodities of which less is preferred to more over all possible ranges of consumption • Economics “goods” – commodities of which more is better than less

Indifference Curve

Indifference Curve – A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction.

Good Y I.

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

A II.

B III.

C Good X

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 I.

A II.

III.

B C Good X

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 IC III are preferred to bundles on IC II or IC I . And all bundles on IC II are preferred to IC I .

Good Y 100 33.33

I.

A II.

1 III.

3 B C Good X

Diminishing Marginal Rate of Substitution

• Marginal Rate of Substitution – 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.

Good Y 100 50 33.33

25 I.

1 A II.

2 B III.

3 C 4 D Good X

Curvature of Indifference Curves

• Indifference curves are convex to the origin.

• Why?

– Diminishing marginal rate of substitution: a consumer’s willingness to give up less and less of some other good to obtain still more of the first good

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.

Good Y 100 75 50 I.

A II.

III.

1 2 5 B C 7 Good X

The Budget Constraint

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

• P x X + P y Y  • Budget Line M.

– The bundles of goods that exhaust a consumers income.

M/P Y Y • P x X + P y Y = M.

• Market Rate of Substitution – The rate at which one good may be traded for another in the market – 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

Changes in the Budget Line

Y • Changes in Income M 1 /P Y – 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 ).

M 0 /P Y M 2 /P Y • Changes in Price Y – A decreases in the price of good X rotates the budget line counter clockwise (P shown).

X0 > P X1 ).

– An increases rotates the budget line clockwise (not M 0 /P Y M 2 /P X M 0 /P X M 1 /P X

New Budget Line for a price decrease.

X X M 0 /P X0 M 0 /P X1

Class Exercise

• M=100, P

price change change x =1, P price change y = 5, P x 1 =5

• Find initial horizontal intercept • Find initial vertical intercept • Find slope of the initial budget line • Find horizontal intercept following • Find vertical intercept following price • Find slope of the budget line following

Consumer Equilibrium

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

– Consumer equilibrium occurs at a point where line.

MRS = P X / P Y.

– Equivalently, the slope of the indifference curve equals the budget Y M/P Y

A

Consumer Equilibrium

I.

M/P X X

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.

– GP or Banglalink 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.

Complementary Goods

When the price of good X falls and the consumption of Y rises, then X and Y are complementary goods. (P X1 > P X2 )

DVD (Y) M/P Y1 Y 2 Y 1 0 B A X 1 M/P X1 X 2 I II M/P X2 DVD Player (X)

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.

Normal Goods

Y

An increase in income increases the consumption of normal goods.

M 1 /Y

(M 0 < M 1 ) .

Y 1 M 0 /Y Y 0 0 A X 0 M 0 /X X 1 B I M 1 /X II X

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 0 A C B SE IE II I X

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.

$ P 0 P 1 D I II X X 0 X 1 X

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.

$ 50 40

Individual Demand Curves

$

Market Demand Curve

1 2 D 1 D 2 Q 1 2 3 D M Q

A Classic Marketing Application

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

Other goods (Y) A C D E I II 0 0.5

1 2 B F Pizza (X)

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.

• Market demand is the horizontal summation of individuals’ demands.