Managerial Economics & Business Strategy Chapter 4 The Theory of Individual Behavior

Can we do it?? On the next slide are schedules which show the total utility measured in terms of utiles which President Strassburger would get by purchasing various amounts of product Apples, Bananas, Carrots, and Donuts. Assume that the price of Bananas is $4, the price of Donuts is $18, the price of Apples is $1, the price of Carrots is $6, and that President Strassburger’s income is $135. What quantities of Bananas, Donuts, Apples, and Carrots will President Strassburger purchase?

Can you do it?? B TU MUMU /P D TU MUMU /P A TU MUMU /P C TU MUMU /P

Can you do it?? B TU MUMU /P D TU MUMU /P A TU MUMU /P C TU MUMU /P

Can you do it?? B TU MUMU /P D TU MUMU /P A TU MUMU /P C TU MUMU /P

Can you do it?? B TU MUMU /P D TU MUMU /P A TU MUMU /P C TU MUMU /P

Consumer Preference Ordering Properties Completeness n Every individual can state their preferences n NO  “I don’t know” More is Better Diminishing Marginal Rate of Substitution n As you get more good X the rate at which you are willing to substitute good X for good Y decreases n Have too much X  don’t want more n Shows indifference curves are CONVEX Transitivity n If prefer A to B and B to C then prefer A to C n IC cannot cross

Indifference Curve Analysis Indifference Curve 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 The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level. n Slope I. II. III. Good Y Good X

Diminishing Marginal Rate of Substitution Marginal Rate of Substitution n slope 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 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. I. II. III. Good Y Good X A B C D

What was??? The slope of the indifference curve? n Marginal rate of substitution MRS n MRS = MU x /MU y Along an indifference curve 

Doesn’t like risk!! STEEP indifference curve Need BIG increase in return to give up a little risk Likes risk!! FLAT Indifference Curve Will give up a lot of safety for a little Increase in return

The Budget Constraint Opportunity Set n The set of consumption bundles that are affordable. P x X + P y Y  M. Budget Line n The bundles of goods that exhaust a consumers income. P x X + P y Y = M. Market Rate of Substitution n The slope of the budget line -P x / P y Y X The Opportunity Set Budget Line Y = M/P Y – (P X /P Y ) X M/P Y M/P X

Market Rate of Substitution

Changes in the Budget Line Changes in Income n Increases lead to a parallel, outward shift in the budget line (M 1 > M 0 ). n Decreases lead to a parallel, downward shift (M 2 < M 0 ). Changes in Price n A decreases in the price of good X rotates the budget line counter-clockwise (P X 0 > P X 1 ). n An increases rotates the budget line clockwise X Y X Y New Budget Line for a price decrease. M 0 /P Y M 0 /P X M 2 /P Y M 2 /P X M 1 /P Y M 1 /P X M 0 /P Y M 0 /P X 0 M 0 /P X 1 M 2 /P X2 New Budget Line for a price increase.

Consumer Equilibrium The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction. n Consumer equilibrium occurs at a point where MRS = P X / P Y. n Equivalently, the slope of the indifference curve equals the budget line. I. II. III. X Y Consumer Equilibrium M/P Y M/P X