Managerial Economics &
Business Strategy
Chapter 4
The Theory of Individual
Behavior
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
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
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Consumer Behavior
• Consumer Opportunities

The possible goods and services consumer can afford to
consume.
• Consumer Preferences

The goods and services consumers actually consume.
• 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
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
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.
Good Y
III.
II.
I.
Marginal Rate of
Substitution

The rate at which a consumer is
willing to substitute one good for
another and stay at the same
satisfaction level.
Good X
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Consumer Preference Ordering
• Completeness

The consumer is capable of expressing a preference for
all bundles of goods.
• More is Better
• Diminishing Marginal Rate of Substitution
• Transitivity



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.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
The Budget Constraint
• Opportunity Set

Y
The Opportunity Set
The set of consumption bundles
that are affordable.
• PxX + PyY  M.
Budget Line
• Budget Line

The bundles of goods that exhaust a
consumers income.
• PxX + PyY = M.
Px
Py
• Market Rate of Substitution

The slope of the budget line
• -Px / Py
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
X
Consumer Equilibrium
• The equilibrium
consumption bundle is
the affordable bundle
that yields the highest
level of satisfaction.
Y
Consumer
Equilibrium
III.
II.
I.
X
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Changes in the Budget Line
Y
• Changes in Income


Increases lead to a parallel,
outward shift in the budget
line.
Decreases lead to a parallel,
downward shift.
X
• Changes in Price


A decreases in the price of
good X rotates the budget
line counter-clockwise.
An increases rotates the
budget line clockwise.
Y
New Budget Line for
a price decrease.
X
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Changes in Price
• Substitute Goods

An increase (decrease) in the price of good X leads to
an increase (decrease) in the consumption of good Y.
• Complementary Goods

An increase (decrease) in the price of good X leads to a
decrease (increase) in the consumption of good Y.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Complementary Goods
Pretzels (Y)
When the price of
good X falls, the
consumption of
complementary
good Y rises.
B
Y2
A
Y1
II
I
0
X1
X2
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Beer (X)
Changes in Income
• 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 a inferior good if an increase (decrease) in
income leads to an decrease (increase) in its
consumption.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Normal Goods
An increase in
income increases
the consumption of
normal goods.
Y
B
II
A
I
0
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
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
P1
D
X0 X1
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
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
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
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, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Pizza
(X)