1. Managerial Economics & Business Strategy
Chapter 4
The Theory of Individual Behavior
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and Business Strategy
Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Overview I. Consumer Behavior II. Constraints
4-2
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

3. Consumer Behavior Consumer Opportunities Consumer Preferences
4-3
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.

4. Indifference Curve Analysis
4-4
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.
Marginal Rate of Substitution
The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level.
Good Y
III.
II. I.
Good X

5. Consumer Preference Ordering Properties
4-5
Consumer Preference Ordering Properties
Completeness
More is Better
Diminishing Marginal Rate of Substitution
Transitivity

6. Complete Preferences Completeness Property
4-6
Complete Preferences
Completeness Property
Consumer is capable of expressing preferences (or indifference) between all possible bundles. (“I don’t know” is NOT an option!)
If the only bundles available to a consumer are A, B, and C, then the consumer
is indifferent between A and C (they are on the same indifference curve).
will prefer B to A.
will prefer B to C.
Good Y
III.
II. I. A B C
Good X

7. More Is Better! More Is Better Property Good Y III. II. I. Good X
4-7
More Is Better!
More Is Better Property
Bundles that have at least as much of every good and more of some good are preferred to other bundles.
Bundle B is preferred to A since B contains at least as much of good Y and strictly more of good X.
Bundle B is also preferred to C since B contains at least as much of good X and strictly more of good Y.
More generally, all bundles on ICIII are preferred to bundles on ICII or ICI. And all bundles on ICII are preferred to ICI.
Good Y
III.
II. I. A B
100 1 3 C
33.33
Good X

8. Diminishing Marginal Rate of Substitution
4-8
Diminishing Marginal Rate of Substitution
Marginal Rate of Substitution
The amount of good Y the consumer is willing to give up to maintain the same satisfaction level decreases as more of good X is acquired.
The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level.
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.
Good Y
III.
II. I.
100 A 1 B 50 2 C
33.33 D 25 3 4
Good X

9. Consistent Bundle Orderings
4-9
Consistent Bundle Orderings
Transitivity Property
For the three bundles A, B, and C, the transitivity property implies that if C  B and B  A, then C  A.
Transitive preferences along with the more-is-better property imply that
indifference curves will not intersect.
the consumer will not get caught in a perpetual cycle of indecision.
Good Y
III.
II. I. 1
100 A C 7 75 B 5 50 2
Good X

10. The Budget Constraint Opportunity Set Budget Line
4-10
The Budget Constraint
Opportunity Set
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
Y = M/PY – (PX/PY)X
M/PY
M/PX X

11. Changes in the Budget Line
4-11
Changes in the Budget Line Y
M1/PY
M1/PX
Changes in Income
Increases lead to a parallel, outward shift in the budget line (M1 > M0).
Decreases lead to a parallel, downward shift (M2 < M0).
Changes in Price
A decreases in the price of good X rotates the budget line counter-clockwise (PX0 > PX1).
An increases rotates the budget line clockwise (not shown).
M0/PY
M2/PY
M2/PX X
M0/PX Y
New Budget Line for a price decrease.
M0/PY
M0/PX0
M0/PX1 X

12. 4-12
Consumer Equilibrium Y
The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction.
Consumer equilibrium occurs at a point where
MRS = PX / PY.
Equivalently, the slope of the indifference curve equals the budget line.
Consumer Equilibrium
M/PY
III.
II. I.
M/PX X

13. Price Changes and Consumer Equilibrium
4-13
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 AT&T.
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.

14. 4-14
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)

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

16. Income Changes and Consumer Equilibrium
4-16
Income Changes and Consumer Equilibrium
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 an inferior good if an increase (decrease) in income leads to a decrease (increase) in its consumption.

17. 4-17
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

18. Decomposing the Income and Substitution Effects
4-18
Decomposing the Income and Substitution Effects
Initially, bundle A is consumed. A decrease in the price of good X expands the consumer’s opportunity set.
The substitution effect (SE) causes the consumer to move from bundle A to B.
A higher “real income” allows the consumer to achieve a higher indifference curve.
The movement from bundle B to C represents the income effect (IE). The new equilibrium is achieved at point C. Y II C A B I IE X SE

19. A Classic Marketing Application
4-19
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.

20. Individual Demand Curve
4-20
Individual Demand Curve X 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

21. 4-21
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

22. 4-22
Conclusion
Indifference curve properties reveal information about consumers’ preferences between bundles of goods.
Completeness.
More is better.
Diminishing marginal rate of substitution.
Transitivity.
Indifference curves along with price changes determine individuals’ demand curves.
Market demand is the horizontal summation of individuals’ demands.