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Managerial Economics

PGP - 1, Section A
Term 1

Lecture 5
Instructor: Tirthatanmoy Das
Indian Institute of Management Bangalore
July 1, 2019
Previous class

§ Elasticity: supply and demand

§ Different ways of measuring elasticity.

§ Elasticity and revenue.

§ Elasticity in short-run and long-run.


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Consumer behavior

§ Model of utility maximizing consumer…

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But why would a manager care?

Because, understanding of consumer behavior helps


managers to exert control over demand by influencing its
determinants such as:

§ Pricing
§ Advertising
§ Product quality

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Objectives

To explain how individual consumer chooses and hence


creates demand for goods and services:
To factors:
§ Consumer’s preference.
§ Consumer’s (limited) budget or budget constraints.

Show how market demand is a summation of individual


consumer’s demand.
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Utility maximizing consumer
The model:
§ A set of consumption bundle or basket (what is that?) is
offered to a consumer (say 𝑿).

§ Out of these some of the bundles are available to the


consumer (say 𝑨). Why 𝑋 may differ from 𝐴?

§ Consumer chooses one specific bundle 𝒙 from 𝐴 that


has highest utility.
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Example: bundle or basket
Suppose these are only two goods: food & clothing:


and possibly many more
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Consumer’s problem

§ There are many available commodity bundles.

§ Each commodity has a price.

§ Consumer has limited wealth that she can spend on


her consumption bundle.

§ Consumer buys the best bundle she can afford.


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Consumer’s problem

Intuition…

Equating ‘bangs for the buck’ or value of money spent on


different goods.

…we will get back to this later.

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Consumer behavior: 3 distinct steps

§ Consumer’s preference

§ Consumer’s budget constraints

§ Consumer’s choices

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Consumer’s Preference
But preference must satisfy following assumptions:
§ Completeness: consumers can compare and rank all
possible baskets. For any 2 baskets A and B, a consumer
will prefer A to B, or will prefer B to A, or will be
indifferent between the two.
§ Transitivity: If a consumer prefers basket A to basket B
and basket B to basket C, then the consumer also
prefers A to C.
§ More is better than less.
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Which bundles are preferred
Basket A is clearly preferred to basket G, while E is
clearly preferred to A. But cannot compare B, D, or H
without more information.

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Indifference curve
Curve representing all combinations of market baskets
that provide a consumer with the same level of
satisfaction.

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Indifference map
Graph containing a set of indifference curves
showing the baskets among which a consumer is
indifferent.

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Indifference curves cannot intersect

Not possible (why?).

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Shape of indifference curves
Marginal rate of substitution: Maximum amount of a good
that a consumer is willing to give up in order to obtain
one additional unit of another good to stay on the same
indifference curve.

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Shape of indifference curves
Marginal rate of substitution: The magnitude of the slope
of an indifference curve measures the consumer’s
marginal rate of substitution (MRS) between two goods.

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Perfect Substitutes and Perfect
Complements
Perfect substitutes: Two goods for which the marginal rate
of substitution of one for the other is a constant.

Perfect complements: Two goods for which the MRS is zero


or infinite; the indifference curves are shaped as right
angles.

Bad: Good for which less is preferred rather than more


(any contradiction here?).

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Perfect Substitutes and Perfect
Complements
Indifference curves:

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Utility and utility functions

Utility function [u(x)]: Function that assigns a numerical


(level of utility) value to the bundle x.

Example: 𝑢 𝐹, 𝐶 = 𝐹×𝐶

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Utility function and indifference curves

Utility function [u(x)]: Function that assigns a numerical


(level of utility) value to the bundle x, typically for
ranking bundles.
Example: 𝑢 𝐹, 𝐶 = 𝐹×𝐶

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Marginal utility

Marginal utility (MU): Additional satisfaction obtained


from consuming one additional unit of a good.

Law of diminishing marginal utility: Principle that as more


of a good is consumed, the consumption of additional
amounts will yield smaller additions to utility.
…contd.

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