Managerial Economics &
Business Strategy
Chapter 4
The Theory of Individual
Behavior
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Overview
I. Consumer Behavior
Q
Q
Indifference Curve Analysis
Consumer Preference Ordering
II. Constraints
Q
Q
Q
The Budget Constraint
Changes in Income
Changes in Prices
III. Consumer Equilibrium
IV. Indifference Curve Analysis & Demand Curves
Q
Q
Individual Demand
Market Demand
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Consumer Behavior
• Consumer Opportunities
Q
The possible goods and services consumer can afford to
consume.
• Consumer Preferences
Q
The goods and services consumers actually consume.
• Given the choice between 2 bundles of
goods a consumer either
Q
Q
Q
Prefers bundle A to bundle B: A f B.
Prefers bundle B to bundle A: A p B.
Is indifferent between the two: A ∼ B.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Indifference Curve Analysis
Indifference Curve
Q
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
Q
The rate at which a consumer is
willing to substitute one good for
another and maintain the same
satisfaction level.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Good X
Consumer Preference Ordering
Properties
•
•
•
•
Completeness
More is Better
Diminishing Marginal Rate of Substitution
Transitivity
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Complete Preferences
• Completeness Property
Q
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
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Good X
More Is Better!
• More Is Better Property
Q
Bundles that have at least as much of Good Y
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
I.
good Y and strictly more of good
X.
• Bundle B is also preferred to C
100
since B contains at least as much
of good X and strictly more of
good Y.
33.33
• More generally, all bundles on
ICIII are preferred to bundles on
ICII or ICI. And all bundles on
ICII are preferred to ICI.
III.
II.
A
B
C
1
3
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Good X
Diminishing Marginal Rate of
Substitution
• Marginal Rate of Substitution
Q
Q
•
•
•
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 100
of Y to get one additional unit of X.
To go from consumption bundle B to
C the consumer must give up 16.67
50
units of Y to get one additional unit of
33.33
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
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Good X
Consistent Bundle Orderings
• Transitivity Property
Q
Q
Good Y
For the three bundles A, B, and C,
the transitivity property implies
that if C f B and B f A, then C f
A.
Transitive preferences along with
the more-is-better property imply 100
75
that
• 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
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
7 Good X
The Budget Constraint
• Opportunity Set
Q
The set of consumption bundles
that are affordable.
• PxX + PyY ≤ M.
Y
The Opportunity Set
Budget Line
M/PY
Y = M/PY – (PX/PY)X
• Budget Line
Q
The bundles of goods that exhaust a
consumers income.
• PxX + PyY = M.
• Market Rate of Substitution
Q
The slope of the budget line
• -Px / Py
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
M/PX
X
Changes in the Budget Line
Y
• Changes in Income
Q
Q
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
Q
Q
M1/PY
M0/PY
M2/PY
Y
A decreases in the price of
good X rotates the budget
M0/PY
line counter-clockwise (PX >
0
PX ).
1
An increases rotates the
budget line clockwise (not
shown).
M2/PX
M0/PX
X
M1/PX
New Budget Line for
a price decrease.
M0/PX
0
M0/PX
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
1
X
Consumer Equilibrium
• The equilibrium
consumption bundle is
the affordable bundle
that yields the highest
level of satisfaction.
Q
Q
Y
M/PY
Consumer
Equilibrium
Consumer equilibrium
occurs at a point where
MRS = PX / PY.
Equivalently, the slope of
the indifference curve
equals the budget line.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
III.
II.
I.
M/PX
X
Price Changes and Consumer
Equilibrium
• Substitute Goods
Q
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
Q
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.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Complementary Goods
When the price of
Pretzels (Y)
good X falls and the
consumption of Y
rises, then X and Y M/P
Y1
are complementary
goods. (PX > PX )
1
2
B
Y2
II
A
Y1
I
0
X1 M/PX
1
X2
M/PX
2
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Beer (X)
Income Changes and Consumer
Equilibrium
• Normal Goods
Q
Good X is a normal good if an increase (decrease) in
income leads to an increase (decrease) in its
consumption.
• Inferior Goods
Q
Good X is an inferior good if an increase (decrease) in
income leads to a decrease (increase) in its
consumption.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
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
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
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.
Y
C
The substitution effect (SE)
causes the consumer to move
from bundle A to B.
A
II
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.
B
I
0
IE
SE
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
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.
II
I
$
X
P0
D
P1
X0
X1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
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
Individual Demand
Curves
$
Market Demand Curve
40
D1
1 2
D2
Q
1 2 3
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
DM
Q
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
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Pizza
(X)
Conclusion
• Indifference curve properties reveal information
about consumers’ preferences between bundles of
goods.
Q
Q
Q
Q
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.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006