Managerial Economics &
Business Strategy
Chapter 4
The Theory of Individual
Behavior
Consumer Behavior
The Consumer Problem
Maximize utility subject to constraints
• Different people with different tastes and
preferences, but have a common goal:
n
Make the most of what we have or to maximize utility
• Economic goods versus economic bads
• The constraint defines consumer opportunities
n
The possible goods and services consumer can afford to
consume.
Consumer Preference Ordering
• Completeness
n
n
The consumer is capable of expressing a preference for all bundles of
goods.
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
• Transitivity
n
n
n
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.
• Diminishing marginal utility, then the rate of
substitution between two goods is also diminishing
(Diminishing Marginal Rate of Substitution) (more
later)
Indifference Curve Analysis
Indifference Curve (IC)
n
A curve that defines the combinations
of 2 or more goods that give a
consumer the same level of
satisfaction.
Marginal Rate of Substitution
n
n
n
n
The rate at which a consumer is
willing to substitute one good for
another and stay at the same
satisfaction level.
The negative of the slope of IC.
Diminishes
= the ratio of MU’s, MUX / MUY
(refer to appendix to chapter 4)
Good Y
U3
U2
U1
Good X
Good X
Good X
Good Y
Good X
Good Y
Good Y
Good X
Good Y
Good Y
Good Y
Examples
Good X
Good X
Examples (answers)
Good Y offers no
gain in utility
(neutral). Person’s
utility increases when
more X is consumed
Good X & Y are
perfect complements.
One operating system
and one computer.
Having an additional
computer without an
operating system will
not increase utility.
Good X & Y are
perfect substitutes.
E.g., Jolt and
Pepsi. Constant
MRS.
Person has relatively
large MRS for Good
X. They have strong
preferences for Good
X.
Person has relatively
large MRS for Good
Y. They have strong
preferences for Good
Y.
One good is an
economic bad (e.g.,
risk, or allergic to
one good if get
close to it).
The Budget Constraint
• Opportunity Set
n
Y
Budget Line
The bundles of goods that exhaust a
consumers income.
• PXX + PYY = M; re-arrange
• Y=M/PY – (PX / PY)X
• Market Rate of Substitution
n
The Opportunity Set
The set of consumption bundles
that are affordable.
• PXX + PYY  M.
M/P
• Budget Line
n
Y
The slope of the budget line
• -PX / PY
PX
PY
M/PX
X
Consumer Equilibrium
• Max U s.t. budget.
• At point c, MRS>PX / PY, which
basically indicates that the benefit of an
additional X exceeds the cost, so increase
consumption of X.
• At equilibrium
MRS=PX / PY or
MUX / MUY = PX / PY
MUX / PX = MUY / PY
“equal bang per buck”
• At point c, more bang per
buck from good X
Y
Point c
Consumer
Equilibrium
U3
U2
U1
X
Changes in the Budget Line
Y
• Changes in Income
n
n
Increases lead to a parallel,
outward shift in the budget
line.
Decreases lead to a parallel,
downward shift.
• Changes in Price
n
n
A decreases in the price of
good X rotates the budget
line counter-clockwise.
An increases rotates the
budget line clockwise.
B0
X
Y
New Budget Line for
a price decrease.
PX falls
B0
X
Changes in Price
• RECALL
n
Substitute Goods
• An increase (decrease) in the price of good X leads to an
increase (decrease) in the consumption of good Y.
n
Complementary Goods
• An increase (decrease) in the price of good X leads to a
decrease (increase) in the consumption of good Y.
Complementary Goods
Pretzels (Y)
When the price of
good X falls, the
consumption of
complementary
good Y rises.
B
Y2
A
Y1
U2
B0
0
X1
X2
U0
B1
Beer (X)
Changes in Income
• Normal Goods
n
Good X is a normal good if an increase (decrease) in
income leads to an increase (decrease) in its
consumption.
• Inferior Goods
n
Good X is a inferior good if an increase (decrease) in
income leads to an decrease (increase) in its
consumption.
Normal Goods
An increase in
income increases
the consumption of
normal goods.
Y
B
U1
A
B0
0
U0
B1
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.
U2
U1
X
$
P0
P1
D
X0 X1
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.
$
Individual Demand
Curves
$
Market Demand Curve
50
40
D1
1 2
D2
Q
1 2 3
DM
Q
A Classic Marketing
Application
Other
goods
(Y)
Buy 3 tires, get the
fourth free (limit 1
per customer)
A
C
E
D
III
I
*Not drawn to
scale
0
2
3
4
B
II
F
Tires
Another Marketing Example
• Gift Certificates….
n
n
Cash gift is generally preferred to an in-kind gift of equal value
(see Figures 4-15 & 4-17)
Gift certificate may yield the same choice as cash. It allows
consumer to spend more of their own income at another store. (see
Figure 4-16)
• Benefits to the firm that sells gift certificates
n
n
Reduce strains on refund department
If firm sells an inferior good, then gift certificates get
people into the store that otherwise wouldn’t.
Public Policy Example
• Suppose the goal of the government is for
consumers to reduce their consumption of
some good (e.g., gasoline, cigarettes,
water).
• Tax plus rebate programs
n
n
Government imposes a tax on a good
Government promises to rebate consumers to make
them “whole.”
• Whole means maintain original level of utility
Worker Behavior
• Suppose mechanics for an auto repair shop are
paid based on the number of repairs they
recommend. A typical mechanic gets utility from
money and integrity (i.e., being an honest loyal
employee).
n
n
U = F (Money, Integrity).
When a worker is slightly dishonest, she sells more auto repairs
(even if not needed), but eventually this could lead to lower
profits for the firm.
Money
Worker Behavior
Management lowers the
commission rate and offers
fixed daily wage.
Mmax
M0
M1
U1
Mmin
U0
I0
Imax
Integrity
Labor-Leisure Choices of Workers
• Assume that workers get utility from leisure
and earning money to spend on other goods.
n
U = f (M, Leisure), where the price of leisure is the
wage rate (i.e., the opportunity cost of leisure is
foregone wages).
• Model is especially helpful when analyzing
worker’s compensation programs or tax
programs such as the EITC.
Labor-Leisure Choices of Workers
Wage = $20
Assume 16 hours
available for
discretionary time.
Income per day
$320
NOTE:
M = w(T-L), where T is
total time available for
work and L is leisure.
Thus, wT is y-intercept
and –w is the slope
$180
Play 7 hours
Work 9 hours
7
16
Leisure per day
Labor-Leisure Choices of Workers
Overtime pay vs.
increasing the wage rate
Assume 16 hours
available for
discretionary time
$320
Income per day
Wage = $20
$180
Play 7 hours
Work 9 hours
7 8
16
Leisure per day
Labor-Leisure Choices of Workers
A worker’s earnings are based on
the number of units produced,
where on an hourly basis a worker
makes approximately $P in wages.
The firm’s inventories are building
up and firm needs to cut
production:
Income per day
$M
1.Cut daily work hours.
2.Set quota.
Lower
Utility
3.Decrease piece-rate, and offer
fixed daily salary
7
9
16
Leisure per day
Choices by Managers and Workers
• Lessons to be learned:
n
provide right incentives so that
• Interests of worker are aligned with interests of firm.
• Interests of manager are aligned with interests of firm