Managerial Economics & Business

Strategy

Chapter 4
The Theory of
Individual Behavior

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
 Overview
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.
4-2
 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 f B.
– Prefers bundle B to bundle A: A p B.
– Is indifferent between the two: A ∼ B.
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 Indifference Curve Analysis

Indifference Curve Good Y

– A curve that defines the III.
combinations of 2 or more
II.
goods that give a consumer
the same level of satisfaction. I.

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 X

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 Consumer Preference Ordering
Properties

Completeness

More is Better

Diminishing Marginal Rate of Substitution

Transitivity

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 Complete Preferences

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

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 More Is Better!

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

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 Diminishing MRS

MRS
– The amount of good Y the consumer
is willing to give up to maintain the Good Y
same satisfaction level decreases as
more of good X is acquired. III.
– The rate at which a consumer is willing
to substitute one good for another and II.
maintain the same satisfaction level.

To go from consumption bundle A I.
to B the consumer must give up A
50 units of Y to get one additional 100
unit of X.

To go from consumption bundle B B
to C the consumer must give up 50
C
16.67 units of Y to get one 33.33 D
additional unit of X. 25

To go from consumption bundle C
to D the consumer must give up
only 8.33 units of Y to get one 1 2 3 4 Good X
additional unit of X.
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 Consistent Bundle Orderings

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

4-9
 The Budget Constraint

Opportunity Set Y The Opportunity Set
– The set of consumption bundles
that are affordable.
Budget Line
• PxX + PyY ≤ M.
M/PY
Y = M/PY – (PX/PY)X

Budget Line
– The bundles of goods that exhaust
a consumers income.
• PxX + PyY = M.

Market Rate of
Substitution M/PX
X
– The slope of the budget line
• -Px / Py.

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 Changes in the Budget Line
Y

Changes in Income M1/PY

– Increases lead to a
M0/PY
parallel, outward shift in
the budget line (M1 > M0).
– Decreases lead to a M2/PY
parallel, downward shift
(M2 < M0).
X

Changes in Price Y
M2/PX M0/PX M1/PX

– A decreases in the price of New Budget Line for

good X rotates the budget M0/PY a price decrease.
line counter-clockwise (PX0
> PX1).
– An increases rotates the
budget line clockwise (not
shown). M0/PX0 M0/PX1
X
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 Consumer Equilibrium

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

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 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.
• Examples:
 DVD and DVD players.
 Computer CPUs and monitors.

4-13
 Complementary Goods

When the price of

Pretzels (Y)
good X falls and the
consumption of Y
rises, then X and Y M/P
Y1
are complementary
goods. (PX1 > PX2)

B
Y2

Y1 A II

I
0 X1 M/PX1 X2 M/PX2 Beer (X)

4-14
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.

4-15
 Normal Goods
Y
An increase in
income increases
the consumption of M1/Y

normal goods.

(M0 < M1).

B
Y1
M0/Y
II
A
Y0
I
X0 M0/X X1 M1/X X
0

4-16
 Decomposing the Income and
Substitution Effects
Y
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 C
consumer to move from bundle A to B.
A higher “real income” allows the A II
consumer to achieve a higher
indifference curve. B

The movement from bundle B to C I

represents the income effect (IE). The
new equilibrium is achieved at point
C. 0
IE X
SE

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 A Classic Marketing Application
Other
goods
(Y)

A
A buy-one,
C E
get-one free
D
pizza deal. II
I

0 0.5 1 2 B F Pizza
(X)

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 Individual Demand Curve
Y

An individual’s
demand curve is
derived from each II

new equilibrium I

point found on the $ X

indifference curve
as the price of good P0
X is varied. P1 D

X0 X1 X

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 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 $ Market Demand Curve
Curves
50

40

D1 D2 DM
1 2 Q 1 2 3 Q

4-20
 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.

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