Managerial Economics

Consumer’s
Behavior
By: Christine M. Perez
 Learning Outcome

To develop competence through

Knowledge, Sensitivity, Skills and
Values in Managerial Economics
through Consumer’s Behavior Theory
 Topic Outline:
• Definition of Consumer Behavior Theory
• Two Utility Approaches used in Consumer Behavior Theory
• Definition of Utility
• Basic Assumption
• The Utility Function
• LAW OF Diminishing MARGINAL UTILITY
• Budget Line and Indifference Curve Analysis
• Utility Maximization
• Marginal rate of substitution
• Optimum Combination and the Marginal Rate of Substitution
• An Individual Consumer’s Demand Curve
• Substitution and Income Effects
• Why demand slopes downward
• Market Demand Curves
• Paradox of value/ Water-Diamond Theory
 References
• Carlos Manapat and Fernando Pedrosa. Economics, Taxation and Agrian Reform (Revised Edition).
C & E Publishing, Inc Quezon City Philippines.

• Dominick Salvatore PhD. Microeconomics: Theory and Applications 4th edition McGraw-Hill
Companies, Inc. (2003), NY USA.

• Evan J. Douglas. Managerial Economics and strategy 4th edition. A. Simon and Schuster Company,
Prentice Hall Inc(1993). NJ USA

• James McGuigan, R. Charles Mayer, Frederick deB Harris. Managerial Economics: Applications,
Strategy and tactics 9th edition, South-Western Thomson (2006), OH USA.

• Keeney, R.L. and H. Raiffa. Decisions with Multiple Objectives: Preference and Value
Tradeoffs. Cambridge University Press (1993), Cambridge.
•
• Mark Hirschey. Fundamentals of Managerial Economics 9th edition, South-Western Cengage
Learning (2013), OH, USA.
 References
• Michael R. Baye, Managerial Economics and Business Strategy, 3rd edition. The McGraw-Hill
Companies, Inc.(1999), NY USA.

• R. H. Frank, Microeconomics and Behaviour, 9th edition, McGraw-Hill Companiess, Inc. (2014), NY
USA.

• S. Charles Maurice and Christopher R Thomas. Managerial Economics 9th edition McGraw-Hill
(2008), NY USA.

• Wayne D. Hoyer; Rik Pieters; Deborah J MacInnis Mason. Managerial Economics 6th edition. South-
Western Cengage Learning (2003). OH USA.

• http://www.referenceforbusiness.com/management/ Utility-Theory.html

• http://www.mymba.com/management/ economics-definition.html
 Managerial Economics
• provides a useful framework for
understanding how consumers make trade-off.
Every consumer decision involves trade-offs
between price, quantity, timeliness and host
of related factors. The consideration of such
trade-offs and the methods used by the
consumers to make consumption decisions
are called the study of consumer behavior
(Hirschey).
 Consumer Behavior Theory
psychology

sociology

Consumer Behavior
social anthropology

marketing

economics
 Consumer Behavior Theory
• The study of individuals, groups, or organizations
and the processes they use to select, secure, use,
and dispose of products, services, experiences, or
ideas to satisfy needs and the impacts that these
processes have on the consumer and society.

• The theory of consumer behavior provides the

foundation for the study of consumer demand

• Follows directly from the theory of maximization

 Consumer Behavior Theory
Trade-off

Opportunity Cost
principles to
describe consumer
behavior
Marginal Changes

Incentives
 Consumer Behavior Theory
• Utility – the satisfaction of individual receives
from goods or combination of goods.

• Utility approach provides

a methodological framework for
the evaluation of alternative choices made by
individuals, firms and organizations
 Consumer Behavior Theory - Utility
Approach
Nonsatiation
Principle

Preferences are
complete

Basic Assumption
Preferences are
transitive

Consumers are
rational
 Consumer Behavior Theory -
Utility Function
• utility function is an equation that shows an
individual’s perception of the level of utility
that would be attained from consuming each
conceivable bundle (or combination) of goods.

U = index of utility depending on the

quantities consumed of goods or services
X, Y = amount goods or services consumed
f = function of
 Consumer Behavior Theory
LAW OF Diminishing MARGINAL UTILITY

LAW OF Diminishing MARGINAL UTILITY is

the law of economics stating that as a person
increases consumption of a product - while
keeping consumption of other products constant -
there is a decline in the marginal utility that
Two Utility person derives from consuming each additional
unit of that product.
Approaches
Budget Line and Indifference Curve
Analysis

budget line is the locus of all combinations indifference curve is a graph

or bundles of goods that can be purchased showing combination of two
at given prices if the entire money income goods that give the consumer
is spent. equal satisfaction and utility
 LAW OF Diminishing MARGINAL UTILITY
 As a consumer has more of
a ‘good’, the extra
(marginal) utility they enjoy
from each successive extra
unit of the good declines
LAW OF Diminishing
MARGINAL UTILITY
MU  U X
Total utility
1. The number of units of utility that a
consumer gains from consuming a
given quantity of a good, service, or
activity during a particular time period.
2. The higher a consumer’s total utility, the
greater that consumer’s level of
satisfaction.
Marginal utility
The amount by which total utility rises with
consumption of an additional unit of a
good, service, or activity, all other things
unchanged
LAW OF Diminishing MARGINAL
UTILITY: illustration
 The Budget Line
• Opportunity Set Y The Opportunity Set

The set of consumption bundles that are

affordable.
• PxX + PyY  M.
Budget Line
• Budget Line
Shows all possible commodity bundles that
can be purchased at given prices with a Px
fixed money income
Py
• PxX + PyY = M
• Market Rate of Substitution M  PX X  PY Y X
– The slope of the budget line or
M PX
• -Px / Py Y   X
PY PY
The Budget Line: illustration
Given:
Px = P 5.00
Py = P 10.00
M = P1,000.00

PxX + PyY = M
Consumer’s Budget Constraint
 Changes in the Budget Line
Y
• Changes in Income
– Increases lead to a parallel,
outward shift in the budget
line.
– Decreases lead to a parallel,
downward shift.

X
• Changes in Price Y
– A decreases in the price of New Budget Line for
good X rotates the budget a price decrease.
line counter-clockwise.
– An increases rotates the
budget line clockwise.

X
 Shifting Budget Lines:
Change in Money (increase)
Original Given New Given:
Budget line AB M = P2,000.00
Px = P 5.00 Slope of the line = 1/2
Py = P 10.00
M = P1,000.00 Formula: M / PxX
M / PyY
Formula:
PxX + PyY = M Budget line RN
 Shifting Budget Lines:
Change in Money (decrease)
Original Given New Given:
Budget line AB M = P 800.00
Px = P 5.00 Slope of the line = 1/2
Py = P 10.00
M = P1,000.00 Formula: M / PxX
M / PyY
Formula:
PxX + PyY = M Budget line FZ
 Shifting Budget Lines : Graph

R
120
A A

Quantity of Y
Quantity of Y

100 100
F
80

Z B N C B D
160 200 240 125 200 250

Quantity of X Quantity of X

Panel A – Changes in money income Panel B – Changes in price of X

 Shifting Budget Lines:
Change in Price (decrease)
Original Given New Given:
Budget line AB
Px = P 5.00 Px = P 4.00
Py = P 10.00 Vertical intercept = same
M = P1,000.00 (M / PyY = 100 units)

Formula: Budget line AD

PxX + PyY = M M / PXX= 250 units
 Shifting Budget Lines:
Change in Price (increase)
Original Given New Given:
Budget line AB
Px = P 5.00 Px = P 8.00
Py = P 10.00 Vertical intercept = same
M = P1,000.00 (M / PyY = 100 units)

Formula: Budget line AC

PxX + PyY = M M / PXX= 125 units
 Shifting Budget Lines Graph

R
120
A A

Quantity of Y
Quantity of Y

100 100
F
80

Z B N C B D
160 200 240 125 200 250

Quantity of X Quantity of X

Panel A – Changes in money income Panel B – Changes in price of X

 Indifference Curve Analysis
Indifference Curve Good Y
– A curve that defines the
combinations of 2 or more goods III.
that give a consumer the same II.
level of satisfaction.
I.
Marginal Rate of
Substitution
– The rate at which a consumer is
willing to substitute one good for
another and stay at the same
satisfaction level.
Good X
 Indifference curve
Locus of points representing
different bundles of goods, each downward-sloping /
of which yields the same level of negatively sloped
total utility

The properties of convex

indifference curve

cannot intersect
Indifference Curve
All combination in the
indifference curve yield
the consumer the same
level of utility
 Indifference Curve
Indifference Curve I
Product X Product Y
1 12
2 10
3 8
4 7
5 6
6 5
Indifference Curve II
Product X Product Y
2 12
3 8
4 4
5 2
 Indifference curve : illustration
Indifference Curve I Indifference Curve II Indifference Curve III
Qx1 Qy1 Qx2 Qy2 Qx3 Qy3
1 10 3 10 5 12
2 5 4 7 6 9
3 3 5 5 7 7
4 2.3 6 4.2 8 6.2
5 1.7 7 3.5 9 5.5
6 1.2 8 3.2 10 5.2
7 0.8 9 3 11 5
8 0.5 10 2.9 12 4.9
9 0.3
10 0.2
Utility maximization

Maximizing utility subject to

a limited money income

Utility Marginal utility

interpretation of equilibrium
maximization
(constraint/ tools
to analyze) expanded maximization
principle

Marginal rate of substitution

Maximizing utility subject to a limited
money income
Utility maximization subject to a
limited money income occurs at
the combination of goods for which Y MU X PX
the indifference curve is just MRS    
tangent to the budget line X MUY PY
Consumer allocates income so that the
marginal utility per dollar spent on
each good is the same for all
commodities purchased

MU X MUY

PX PY
 Utility Maximization:
Given :

Budget = P 400.00
50
45 •A Ppizza = P 8.00
40 •B Pburger = P 4.00
•D
Quantity of pizzas

•
R E IV
30

III
20

•
C
15 II
T
10
I

0 10 20 30 40 50 60 70 80 90 100

Quantity of burgers
Marginal utility interpretation of
equilibrium
• The equilibrium Y
consumption bundle
Consumer
is the affordable Equilibrium
bundle that yields the
highest level of
satisfaction.
III.

II.
I.
X
 Marginal utility interpretation of
equilibrium : illustration
Given Suppose that the MU
Px = P 4.00 of last unit of X is
Py = P 2.00 20 and the MU of Y
Qx = 20 units is 16.
Qy = 30 units
M = P 140.00
5<8
 Expanded maximization
principle
• We have assumed that the consumer
purchases only two goods. The analysis is
easily extended to any number of goods.
 Marginal rate of substitution

• The marginal rate of substitution (MRS) is a

measure of the number of units of Y that
must be given up per unit of X added so as
to maintain a constant level of utility.
Marginal rate of substitution
A = 10X & 60Y
B = 20X & 40Y
C = 40X & 20Y
D = 50X & 15Y
 Optimum Combination

• The combination of the budget line and

indifference curve as shown in the graph
will shows the optimum combination or
optimal combination
 Optimum Combination : illustration
Budget Schedule Indifference Schedule
Point Point
Given:
s Product X Product Y s Product X Product Y Budget = P 8.00
A 8 0 J 2 8
B 7 1 K 3 6 Px = P 1.00
C 6 2 L 4 4
D 5 3 M 6 3 Py = P 1.00
E 4 4 N 7 2
F 3 5
G 2 6
H 1 7

Using the principle of marginal

rate of substitution, we can see
that at point L on the
indifference curve, the ratio of
product Y to product X is 4:4 or
1:1.
 Individual Demand Curve
Y
• An individual’s
demand curve is
derived from each II
new equilibrium point I

found on the P X
indifference curve as
the price of good X is P0
varied. P1 D
X0 X1 X
 Deriving a Demand Curve :
illustration
M = P 1,000.00 Price Quantity
PX = P 10.00 Demanded
Py = P 10.00
P 10.00 50
Budget line 1 = 100Y to 100X
Demand schedule for product X 8.00 65
5.00 90
Deriving a Demand Curve : illustration
100
Quantity of Y

Px=P10

Px=P8

Px=P5

0
50 65 90 100 125 200
Quantity of X

10
Price of X (P)

Demand for X

0 50 65 90
Quantity of X
 Market Demand & Marginal Benefit
• List of prices & quantities consumers are willing
& able to purchase at each price, all else
constant
• Derived by horizontally summing demand
curves for all individuals in market
• Because prices along market demand measure
the economic value of each unit of the good, it
can be interpreted as the marginal benefit curve
for a good
 Derivation of Market Demand
Quantity demanded
Market
Price Consumer 1 Consumer 2 Consumer 3
demand
P6 3 0 0 3

5 5 1 0 6

4 8 3 1 12

3 10 5 4 19

2 12 7 6 25

1 13 10 8 31
Derivation of Market Demand
 Substitution and Income Effects
Substitution Effects

When price changes, total The substitution effect is the change in

change in quantity demanded
is composed of two parts
the consumption of a good that would
result if the consumer remained on the
original indifference curve after the
price of the good changes.

Income Effects

The income effect from a price change is the

change in the consumption of a good resulting
strictly from the change in purchasing power. The
direction of the income effect is uncertain.
 Substitution Effects

Given: Given new:

Budget line (M) = P 150.00 Budget line (M) = P 150.00
PX = P 15.00 PX = P 6.00
Py = P 7.5 Py = P 7.5

Original Budget line : AB New Budget line : AD

 Income & Substitution Effects: A
Decrease in Px
Total effect of = Substitution+ Income Total effect of = Substitution+ Income
price effect effect price effect effect
decrease 9 = 5 + 4 decrease 3 = 5 + (-2)
Substitution & Income Effects
• Consider the substitution effect alone:
– Amount of good consumed must vary inversely
with price
• Income effect reinforces the substitution
effect for a normal good & offsets it for an
inferior good
Summary of Substitution & Income Effects

Substitution Effect Income Effect

Price of X decreases:

Normal Good X rises X rises

Inferior Good X rises X falls
Price of X increases:

Normal Good X falls X falls

Inferior Good X falls X rises
 Paradox of value/ Water-Diamond Theory

states that a good with more value in

use has less or little value in exchange
and a good with more value in exchange
has less or little in value in use.
Managerial Economics

Consumer’s
Behavior
By: Christine M. Perez