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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.

Consumer behavior

§ Model of utility maximizing consumer…

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


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

and possibly many more
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.

Consumer’s problem


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

different goods.

…we will get back to this later.

Consumer behavior: 3 distinct steps

§ Consumer’s preference

§ Consumer’s budget constraints

§ Consumer’s choices

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.
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.

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

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

Indifference curves cannot intersect

Not possible (why?).

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.

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.

Perfect Substitutes and Perfect
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

Bad: Good for which less is preferred rather than more

(any contradiction here?).

Perfect Substitutes and Perfect
Indifference curves:

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

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

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.