Managerial Economics &

Business Strategy
Chapter 4
The Theory of Individual
Behavior

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Overview
I. Consumer Behavior
Q Indifference Curve Analysis
Q Consumer Preference Ordering
II. Constraints
Q The Budget Constraint
Q Changes in Income
Q Changes in Prices
III. Consumer Equilibrium
IV. Indifference Curve Analysis & Demand Curves
Q Individual Demand
Q Market Demand

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Consumer Behavior
• Consumer Opportunities
Q The possible goods and services consumer can afford to
consume.
• Consumer Preferences
Q The goods and services consumers actually consume.
• Given the choice between 2 bundles of
goods a consumer either
Q Prefers bundle A to bundle B: A f B.
Q Prefers bundle B to bundle A: A p B.
Q Is indifferent between the two: A ∼ B.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Indifference Curve Analysis
Indifference Curve Good Y
Q A curve that defines the III.
combinations of 2 or more goods
II.
that give a consumer the same
level of satisfaction. I.

Marginal Rate of
Substitution
Q The rate at which a consumer is
willing to substitute one good for
another and maintain the same
satisfaction level.
Good X

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Consumer Preference Ordering
Properties
• Completeness
• More is Better
• Diminishing Marginal Rate of Substitution
• Transitivity

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Complete Preferences
• Completeness Property Good Y
Q Consumer is capable of
expressing preferences (or III.
indifference) between all possible II.
bundles. (“I don’t know” is NOT
I.
an option!)
A
• If the only bundles available B

to a consumer are A, B, and

C, then the consumer
– is indifferent between A and C
C (they are on the same
indifference curve).
– will prefer B to A.
– will prefer B to C. Good X

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 More Is Better!
• More Is Better Property
Q Bundles that have at least as much of Good Y
every good and more of some good
III.
are preferred to other bundles.
• Bundle B is preferred to A since II.
B contains at least as much of
good Y and strictly more of good I.
X.
• Bundle B is also preferred to C A B
100
since B contains at least as much
of good X and strictly more of
good Y.
C
• More generally, all bundles on 33.33
ICIII are preferred to bundles on
ICII or ICI. And all bundles on
ICII are preferred to ICI. 1 3
Good X

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Diminishing Marginal Rate of
Substitution
• Marginal Rate of Substitution
Q The amount of good Y the consumer is Good Y
willing to give up to maintain the same
satisfaction level decreases as more of
good X is acquired. III.
The rate at which a consumer is willing to
II.
Q
substitute one good for another and
maintain the same satisfaction level.
I.
• To go from consumption bundle A to
B the consumer must give up 50 units 100 A
of Y to get one additional unit of X.
• To go from consumption bundle B to B
C the consumer must give up 16.67 50
units of Y to get one additional unit of C
X. 33.33 D
25
• To go from consumption bundle C to
D the consumer must give up only
8.33 units of Y to get one additional
unit of X. 1 2 3 4 Good X

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Consistent Bundle Orderings
• Transitivity Property Good Y
Q For the three bundles A, B, and C,
the transitivity property implies III.
that if C f B and B f A, then C f II.
A.
I.
Q Transitive preferences along with
A
the more-is-better property imply 100
C
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

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 The Budget Constraint
• Opportunity Set Y The Opportunity Set

Q The set of consumption bundles

that are affordable. Budget Line
• PxX + PyY ≤ M. M/PY
Y = M/PY – (PX/PY)X

• Budget Line
Q The bundles of goods that exhaust a
consumers income.
• PxX + PyY = M.
• Market Rate of Substitution M/PX
X
Q The slope of the budget line
• -Px / Py
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Changes in the Budget Line
Y
M1/PY
• Changes in Income
Q Increases lead to a parallel, M0/PY
outward shift in the budget
line (M1 > M0).
M2/PY
Q Decreases lead to a parallel,
downward shift (M2 < M0).
• Changes in Price M2/PX M0/PX M1/PX
X
Y
Q A decreases in the price of New Budget Line for
good X rotates the budget M0/PY a price decrease.
line counter-clockwise (PX >
0
PX ).
1
Q An increases rotates the
budget line clockwise (not
shown). X
M0/PX M0/PX
0 1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Consumer Equilibrium
Y
• The equilibrium
consumption bundle is M/PY
Consumer
the affordable bundle Equilibrium
that yields the highest
level of satisfaction.
Q Consumer equilibrium
occurs at a point where
MRS = PX / PY. III.
Q Equivalently, the slope of II.
the indifference curve
equals the budget line. I.
M/PX
X

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Price Changes and Consumer
Equilibrium
• Substitute Goods
Q 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 T-Mobile.
• Complementary Goods
Q 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.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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. (PX > PX )
1 2

B
Y2

Y1 A II

I
0 X1 M/PX X2 M/PX Beer (X)
1 2

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Income Changes and Consumer
Equilibrium
• Normal Goods
Q Good X is a normal good if an increase (decrease) in
income leads to an increase (decrease) in its
consumption.
• Inferior Goods
Q Good X is an inferior good if an increase (decrease) in
income leads to a decrease (increase) in its
consumption.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Decomposing the Income and
Substitution Effects
Initially, bundle A is consumed. Y
A decrease in the price of good
X expands the consumer’s
opportunity set.
The substitution effect (SE) C
causes the consumer to move
from bundle A to B. A II
A higher “real income” allows B
the consumer to achieve a
higher indifference curve. I
The movement from bundle B to
C represents the income effect IE X
0
(IE). The new equilibrium is SE
achieved at point C.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Individual Demand Curve
Y

• An individual’s
demand curve is
derived from each new II

equilibrium point I

found on the $ X

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

X0 X1 X

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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)

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Conclusion
• Indifference curve properties reveal information
about consumers’ preferences between bundles of
goods.
Q Completeness.
Q More is better.
Q Diminishing marginal rate of substitution.
Q Transitivity.
• Indifference curves along with price changes
determine individuals’ demand curves.
• Market demand is the horizontal summation of
individuals’ demands.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006