Managerial Economics & Business Strategy Chapter 4

The Theory of Individual Behavior

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Overview
I. Consumer Behavior

Indifference Curve Analysis Consumer Preference Ordering The Budget Constraint Changes in Income Changes in Prices

II. Constraints

III. Consumer Equilibrium IV. Indifference Curve Analysis & Demand Curves

Individual Demand Market Demand

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Consumer Behavior
Consumer Opportunities

The possible goods and services consumer can afford to consume. The goods and services consumers actually consume.

Consumer Preferences

Given the choice between 2 bundles of goods a consumer either

Prefers bundle A to bundle B: A B Prefers bundle B to bundle A: A B Is indifferent between the two: A B
Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Indifference Curve Analysis

Indifference Curve

Good Y III. II. I.

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

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
Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Consumer Preference Ordering

Completeness

The consumer is capable of expressing a preference for all bundles of goods.

More is Better Diminishing Marginal Rate of Substitution Transitivity

Given 3 bundles of goods: A, B & C. If A B and B C, then A C. If A B and B C, then A C.

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

The Budget Constraint

Opportunity Set

The Opportunity Set

The set of consumption bundles that are affordable. PxX + PyY M.

The bundles of goods that exhaust a consumers income.

Budget Line

Budget Line

Px Py

PxX + PyY = M.

Market Rate of Substitution

The slope of the budget line -Px / Py

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Consumer Equilibrium
The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction.
Y
Consumer Equilibrium

III.

II.
I. X
Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

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 Y New Budget Line for a price decrease.

Changes in Price

A decreases in the price of good X rotates the budget line counter-clockwise. An increases rotates the budget line clockwise.

X
Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Changes in Price
Substitute Goods

An increase (decrease) in the price of good X leads to an increase (decrease) in the consumption of good Y. An increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y.

Complementary Goods

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Complementary Goods
When the price of good X falls, the consumption of complementary good Y rises.
Y2 Y1 A I 0 X1 X2

Pretzels (Y)

B II

Beer (X)

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Changes in Income
Normal Goods

Good X is a normal good if an increase (decrease) in income leads to an increase (decrease) in its consumption.
Good X is a inferior good if an increase (decrease) in income leads to an decrease (increase) in its consumption.

Inferior Goods

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

Normal Goods
An increase in income increases the consumption of normal goods.
Y

B A I 0
Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

II

Individual Demand Curve

Y

An individuals demand curve is derived from each new equilibrium point found on the indifference curve as the price of good X is varied.

II I $ X

P0

P1
X0 X1

D
X

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

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.
$ 50
40

Individual Demand Curves

Market Demand Curve

D1 1 2

D2 Q 1 2 3

DM Q

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003

A Classic Marketing Application

Other goods (Y) A C D I E II

A buy-one, get-one free pizza deal.

0.5

Pizza (X)

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2003