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

Price Changes and Consumer Equilibrium Substitute Goods 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 An increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y. DVD and DVD players. Computer CPUs and monitors.

Substitute Goods When the price of good X falls and the consumption of Y falls, then X and Y are substitute goods. (PX1 < PX2) Pretzels (Y) M/PY1 M/PX2 I II A Y1 B X1 Y2 X2 M/PX1 Beer (X)

Complementary Goods When the price of good X falls and the consumption of Y rises, then X and Y are complementary goods. (PX1 > PX2) Pretzels (Y) M/PY1 II M/PX2 I B Y2 X2 A Y1 X1 M/PX1 Beer (X)

Income Changes and Consumer Equilibrium Normal Goods Increase (decrease) in income leads to an increase (decrease) in its consumption. Inferior Goods Increase (decrease) in income leads to a decrease (increase) in its consumption.

Normal Goods Y An increase in income increases the consumption of normal goods. (M0 < M1). M1/Y M1/X II B I Y1 X1 M0/Y M0/X A Y0 X0 X

Inferior Goods Y An increase in income decreases the consumption of inferior goods. (M0 > M1). II M1/Y M1/X B Y1 X1 I M0/Y M0/X A Y0 X0 X

When price of a good decreases Two things happen Relative price of the good decreases Buy more of the cheaper good Substitution Effect Real income or purchasing power increases If buy same bundle of goods bought previously have money left over Income Effect

To graphically break up the effects Price decrease causes a rotation on the BC New optimal bundle Look at what would we have bought with this new income level (new BC) at our old Utility level Take money away from consumer to keep original Utility level Price has changed though so cannot keep the slope of the original BC

The Result is Three Points Old optimal bundle to new optimal bundle is the TOTAL EFFECT Old optimal bundle to new tangency on original IC is SUBSTITUTION EFFECT Same indifference curve New tangency on original IC to new optimal bundle is INCOME EFFECT Same budget constraint

A-C=SUBSTITUTION EFFECT A-B=TOTAL EFFECT A-C=SUBSTITUTION EFFECT C-B=INCOME EFFECT Clothing A B C Food A C B