Managerial Economics
ninth edition
Thomas
Maurice
Chapter 5
Theory of
Consumer Behavior
McGraw-Hill/Irwin
McGraw-Hill/Irwin
Managerial Economics, 9e
Managerial Economics, 9e
Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
Managerial Economics
The Consumer’s Optimization
Problem
• Individual consumption decisions
are made with the goal of
maximizing total satisfaction from
consuming various goods and
services
• Subject to the constraint that
spending on goods exactly equals the
individual’s money income
5-2
Managerial Economics
Consumer Theory
• Assumes buyers are completely
informed about:
•
•
•
•
Range of products available
Prices of all products
Capacity of products to satisfy
Their income
• Requires that consumers can rank all
consumption bundles based on the
level of satisfaction they would receive
from consuming the various bundles
5-3
Managerial Economics
Typical Consumption Bundles for
Two Goods, X & Y (Figure 5.1)
5-4
Managerial Economics
Properties of Consumer
Preferences
• Completeness
• For every pair of consumption bundles, A and
B, the consumer can say one of the following:



A is preferred to B
B is preferred to A
The consumer is indifferent between A and B
• Transitivity
• If A is preferred to B, and B is preferred to
C, then A must be preferred to C
• Nonsatiation
• More of a good is always preferred to less
5-5
Managerial Economics
Utility
• Benefits consumers obtain from
goods & services they consume is
utility
• A utility function shows an
individual’s perception of the utility
level attained from consuming
each conceivable bundle of goods
5-6
Managerial Economics
Indifference Curves
• Locus of points representing
different bundles of goods, each of
which yields the same level of total
utility
• Negatively sloped & convex
5-7
Managerial Economics
Typical Indifference Curve
(Figure 5.2)
5-8
Managerial Economics
Marginal Rate of Substitution
• MRS shows the rate at which one good
can be substituted for another while
keeping utility constant
• Negative of the slope of the indifference
curve
• Diminishes along the indifference curve as X
increases & Y decreases
• Ratio of the marginal utilities of the goods
Y MU X
MRS  

X MUY
5-9
Managerial Economics
Slope of an Indifference Curve &
the MRS (Figure 5.3)
Quantity of good Y
600
A
T
C (360,320)
320
I
T’
B
0
360
Quantity of good X
5-10
800
Managerial Economics
Indifference Map
Quantity of Y
(Figure 5.4)
IV
III
II
I
Quantity of X
5-11
Managerial Economics
Marginal Utility
• Addition to total utility attributable
to the addition of one unit of a
good to the current rate of
consumption, holding constant the
amounts of all other goods
consumed
MU  U X
5-12
Managerial Economics
Consumer’s Budget Line
• Shows all possible commodity
bundles that can be purchased at
given prices with a fixed money
income
M  PX X  PY Y
or
M PX
Y 

X
PY PY
5-13
Managerial Economics
Consumer’s Budget Constraint
(Figure 5.5)
5-14
Managerial Economics
Typical Budget Line
Quantity of Y
M
PY
(Figure 5.6)
•A
Y
M PX

X
PY PY
B
•
Quantity of X
5-15
M
PX
Managerial Economics
Shifting Budget Lines (Figure 5.7)
100
80
R
A
Quantity of Y
Quantity of Y
120
F
A
B
N
C
B
D
160 200
240
125
200
250
Z
5-16
100
Quantity of X
Quantity of X
Panel A – Changes in money income
Panel B – Changes in price of X
Managerial Economics
Utility Maximization
• Utility maximization subject to a
limited money income occurs at the
combination of goods for which the
indifference curve is just tangent to
the budget line
Y MU X PX
MRS  


X MUY
PY
5-17
Managerial Economics
Utility Maximization
• Consumer allocates income so that
the marginal utility per dollar spent
on each good is the same for all
commodities purchased
MU X MUY

PX
PY
5-18
Managerial Economics
Constrained Utility Maximization
(Figure 5.8)
50
Quantity of pizzas
45
•A
40
•B
•D
•
E
R
30
IV
III
20
•
C
15
10
0
10
20
30
40
50
60
Quantity of burgers
5-19
70
II
T
I
80
90
100
Managerial Economics
Individual Consumer Demand
• An individual’s demand curve for a
specific commodity relates utilitymaximizing quantities purchased to
market prices
• Money income & prices held constant
• Slope of demand curve illustrates law
of demand—quantity demanded varies
inversely with price
5-20
Managerial Economics
Deriving a Demand Curve
(Figure 5.9)
Quantity of Y
100
Px=$10
Px=$8
Px=$5
Price of X ($)
0
50 65
90 100
125
200
Quantity of X
10
8
5
Demand for X
0
5-21
50 65
90
Quantity of X
Managerial Economics
Market Demand & Marginal Benefit
• List of prices & quantities consumers are
willing & able to purchase at each price,
all else constant
• Derived by horizontally summing
demand curves for all individuals in
market
• Because prices along market demand
measure the economic value of each unit
of the good, it can be interpreted as the
marginal benefit curve for a good
5-22
Managerial Economics
Derivation of Market Demand
(Table 5.1)
Quantity demanded
5-23
Price
Consumer 1
Consumer 2
Consumer 3
Market
demand
$6
3
0
0
3
5
5
1
0
6
4
8
3
1
12
3
10
5
4
19
2
12
7
6
25
1
13
10
8
31
Managerial Economics
Derivation of Market Demand
Figure (5.10)
5-24
Managerial Economics
Substitution & Income Effects
• When price changes, total change in
quantity demanded is composed of
two parts
• Substitution effect
• Income effect
5-25
Managerial Economics
Substitution & Income Effects
• Substitution effect
• Change in consumption of a good after a
change in its price, when the consumer
is forced by a change in money income
to consume at some point on the
original indifference curve
• Income effect
• Change in consumption of a good
resulting strictly from a change in
purchasing power
5-26
Managerial Economics
Income & Substitution Effects:
A Decrease in Px (Figure 5.12)
Total effect of = Substitution+ Income
price
effect
effect
decrease 9 = 5
+ 4
5-27
Total effect of = Substitution+ Income
price
effect
effect
decrease 3 = 5
+ (-2)
Managerial Economics
Substitution & Income Effects
• Consider the substitution effect
alone:
• Amount of good consumed must vary
inversely with price
• Income effect reinforces the
substitution effect for a normal
good & offsets it for an inferior
good
5-28
Managerial Economics
Summary of Substitution &
Income Effects (Table 5.2)
Substitution Effect
Income Effect
Normal Good
X rises
X rises
Inferior Good
X rises
X falls
Normal Good
X falls
X falls
Inferior Good
X falls
X rises
Price of X decreases:
Price of X increases:
5-29