1. CHAPTER 4 The Theory of Individual Behavior Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. Chapter Outline Consumer behavior Constraints – Budget constraint – Changes in income – Changes in prices Consumer equilibrium Comparative statics – Price changes and consumer behavior – Income changes and consumer behavior – Income and substitution effects Applications of indifference curve analysis – Choices by consumers – Choices by workers and managers Relationship between indifference curves and demand curves – Individual demand – Market demand 4-2 Chapter Overview

3. Introduction Chapter 3 focused on quantitatively measuring demand. – By how much will a 5 percent increase in price reduce quantity demanded? – By how much will a 3 percent decline in income reduce demand for a normal good? This chapter examines the theory of consumer behavior that underlies individual and market demand curves. 4-3 Chapter Overview

4. Consumer Behavior Consumer opportunities – Set of possible goods and services consumers can afford to consume. Consumer preferences – Determine which set goods and services will be consumed. 4-4 Consumer Behavior

5. Properties of Consumer Preferences 4-5 Consumer Behavior

6. Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved. 2-6

7. Constraints While any decision-making environment faces a host of constraints, the focus of managerial economics is to examine the role prices and income play in constraining consumer behavior. 4-7 Constraints

8. The Budget Constraint 4-8 Constraints

9. The Budget Constraint In Action 4-9 0 Slope Bundle G Bundle H Constraints

10. The Market Rate of Substitution 4-10 0 Constraints

11. Income Changes 4-11 0 Constraints

12. Price Changes 4-12 0 New budget line Initial budget line Constraints

13. The Budget Constraint in Action 4-13 Constraints

14. Consumer Equilibrium 4-14 Consumer Equilibrium

15. Consumer Equilibrium in Action 4-15 0 Consumer equilibrium A B C I II III Consumer Equilibrium D

16. Consumer Equilibrium in Action 4-16 Consumer Equilibrium

17. Comparative Statics Price and income changes impact a consumer’s budget set and level of satisfaction that can be achieved. – This implies that price and income changes will lead to consumer equilibrium changes. This section explores how price and income changes impact consumer equilibrium. 4-17 Comparative Statics

18. Price Changes and Consumer Equilibrium Price increases (decreases) reduce (expand) a consumer’s budget set. The new consumer equilibrium resulting from a price change depends on consumer preferences: – Goods X and Y are: substitutes when an increase (decrease) in the price of X leads to an increase (decrease) in the consumption of Y. complements when an increase (decrease) in the price of X leads to a decrease (increase) in the consumption of Y. 4-18 Comparative Statics

19. Price Changes and Consumer Equilibrium in Action 4-19 0 Point A: Initial consumer equilibrium A B Point B: New consumer equilibrium I II Comparative Statics

20. Income Changes and Consumer Equilibrium Income increases (decreases) expands (reduces) a consumer’s budget set. The new consumer equilibrium resulting from an income change depends on consumer preferences: – Good X is: a normal good when an increase (decrease) in income leads to an increase (decrease) in the consumption of X. an inferior good when an increase (decrease) in income leads to a decrease (increase) in the consumption of X. 4-20 Comparative Statics

21. Income Changes and Consumer Equilibrium in Action 4-21 0 A B II I Point A: Initial consumer equilibrium Point B: New consumer equilibrium Comparative Statics

22. Consumer Choice with a Gift Certificate 4-22 Good X 0 Point A: Initial consumer equilibrium A II I C B Good Y Applications of Indifference Curves

23. Labor-Leisure Choice Model 4-23 0 E I Leisure (hours per day) Income (per day) 16 hours of leisure8 hours of work Worker equilibrium Applications of Indifference Curves II III

24. Labor-Leisure Budget Set in Action 4-24 Applications of Indifference Curves

25. Indifference and Demand Curves The indifference curves and consumers’ reactions to changes in prices and income are the basis of the demand functions in chapters 2 and 3. 4-25 The Relationship Between Indifference Curve Analysis and Demand Curves

26. From Indifference Curves to Individual Demand 4-26 0 A B II I Demand The Relationship Between Indifference Curve Analysis and Demand Curves

27. 4-27 0 A Demand mkt BABA+B Demand B Demand A From Individual to Market Demand The Relationship Between Indifference Curve Analysis and Demand Curves

28. Conclusion Indifference curve properties reveal information about consumers’ preferences between bundles of goods. – Completeness – More is better – Diminishing rate of substitution – Transitivity Indifference curves along with price changes determine individuals’ demand curves. Market demand is the horizontal summation of individuals’ demands. 4-28