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

2. Overview I. Consumer Behavior II. Constraints
Preferences and opportunities
Marginal Utility/Total Utility
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

3. Consumer Behavior Consumer Opportunities More is better
The possible goods and services consumer can afford to consume.
More is better
Concerned with the goods and services actually consumed.

4. Consumer Preference Ordering
Consumer Preferences
Completeness: The consumer is capable of expressing a preference for all bundles of goods.
Prefers bundle A to bundle B: A  B
Prefers bundle B to bundle A: A  B
Is indifferent between the two: A  B
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.
Diminishing Marginal Rate of Substitution

5. Utility & Behavior Utility Marginal utility
cardinal
ordinal
comparability
Marginal utility
Diminishing marginal utility
Negative marginal utility
Objective - make rational decisions to maximize own utility
rational
own

6. Indifference Curve Analysis
A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction.
Higher is more
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.
-MUX/MUY
Good Y
III.
II. I.
Good X

7. The Budget Constraint Opportunity Set Budget Line
The set of consumption bundles that are affordable.
PxX + PyY  M.
Budget Line
The bundles of goods that exhaust a consumers income.
PxX + PyY = M.
Market Rate of Substitution
The slope of the budget line
-Px / Py
The Opportunity Set Y
Budget Line Px Py X

8. Consumer Equilibrium Y
The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction.
Consumer Equilibrium
III.
II. I. X

9. Changes in the Budget LineY
Changes in Income
Increases lead to a parallel, outward shift in the budget line.
Decreases lead to a parallel, downward shift.
Changes in Price
A decreases in the price of good X rotates the budget line counter-clockwise.
An increases rotates the budget line clockwise. X Y
New Budget Line for a price decrease. X

10. Changes in Price Substitute Goods Complementary 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.

11. Changes in Price Substitution Effect Income Effect Net effect
An increase (decrease) in the price of a good leads people to by less (more) of that good and more (less) of a similar good
If the consumer has just as much utility then they are on the same indifference curve.
Income Effect
An increase (decrease) in the price of good X leads to a decrease (increase) in a person’s purchasing power.
A decrease (increase) in purchasing power leads to a decrease (increase) in purchases of normal goods and an increase (decrease in purchases of inferior goods.
Net effect
If substitution and income effect operate in the same direction, the good is normal
If substitution and income effect operate in opposite directions and the substitution effect is larger (in absolute value) then the good is inferior (consider elasticity)
If substitution and income effect operate in opposite directions and the income effect is larger (in absolute value) then the good is inferior and demand is upward sloping (Giffen good)

12. Complementary Goods Pretzels (Y)
When the price of good X falls, the consumption of complementary good Y rises. B Y2 A II Y1 I X1 X2
Beer (X)

13. Changes in Income Normal Goods Inferior 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.

14. Normal Goods Y
An increase in income increases the consumption of normal goods. B Y2 II A Y1 I X1 X2 X

15. Inferior Goods Y
An increase in incomedecreases the consumption of inferior goods. B Y2 II A Y1 I X2 X1 X

16. Individual Demand CurveX Y $ D II I
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. P0 P1 X0 X1

17. 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 D2 DM
1 2 Q Q

18. A Classic Marketing Application
Other goods (Y) II I A C B F D E
Pizza (X)
0.5 1 2
A buy-one, get-one free pizza deal.