THE THEORY OF INDIVIDUAL

BEHAVIOR (CHAPTER 4)
LEARNING OBJECTIVES
After completing this chapter, you will be able to:
LO1 Explain four basic properties of a consumer’s preference ordering and their ramifications for a
consumer’s indifference curves.
LO2 Illustrate how changes in prices and income impact an individual’s opportunities.
LO3 Illustrate a consumer’s equilibrium choice and how it changes in response to changes in prices and
income.
LO4 Separate the impact of a price change into substitution and income effects.
LO5 Show how to derive an individual’s demand curve from indifference curve analysis and market
demand from a group of individuals’ demands.
LO6 Illustrate how “buy one, get one free” deals and gift certificates impact a consumer’s purchase
decisions.
LO7 Apply the income–leisure choice framework to illustrate the opportunities, incentives, and choices of
workers and managers.

2
CONSUMER BEHAVIOR
Consumer – is an individual who purchases goods and services from firms for
the purpose of consumption.

Two important factors to consider

1. Consumer Opportunities
- represent the possible goods and services consumers can afford to consume.

2. Consumer Preference
- determine which of these goods will be consumed.

3
LO#1: CONSUMER BEHAVIOR
Preference Ordering
four basic properties:
1. Completeness
- assume the consumer is capable of expressing a preference for, or indifference among, all
bundles

2. more is better,
3. diminishing marginal rate of substitution, and
- As a consumer obtains more of good X, the amount of good Y he or she is willing to give up
to obtain another unit of good X decreases.

4. transitivity.

4
INDIFFERENCE CURVE
A CURVE THAT DEFINES THE COMBINATIONS OF TWO GOODS THAT GIVE A CONSUMER
THE SAME LEVEL OF SATISFACTION.

5
MARGINAL RATE OF SUBSTITUTION (MRS)
- THE RATE AT WHICH A CONSUMER IS WILLING TO SUBSTITUTE ONE GOOD FOR
ANOTHER GOOD AND STILL MAINTAIN THE SAME LEVEL OF SATISFACTION.
- ABSOLUTE VALUE OF THE SLOPE OF AN INDIFFERENCE CURVE (PX/PY)

6
FAMILY OF INDIFFERENCE CURVE

7
 CONSTRAINTS
1. legal constraints,
2. time constraints,
3. physical constraints,
4. budget constraints.

8
CONSTRAINTS
budget constraints.
-restricts consumer behavior by forcing the consumer to select a bundle
of goods that is affordable
-Budget set (opportunity set) . The bundles of goods a consumer can
afford.
-Px X + Py Y ≤ M
-Budget line . The bundles of goods that exhaust a consumer’s income.
-Px X + Py Y = M
9
SAMPLE GRAPH FOR BUDGET SET

10
The slope of the budget line is given by −(Px /Py) and
represents the market rate of substitution between goods X and
Y.

market rate of substitution The rate at which one good may be

traded for another in the market; slope of the budget line.

11
BUDGET SET
-Budget Line: Px X + Py Y = M
PxX=M - Horizontal intercept X = M/Px
PyY= M - Vertical Intercept Y = M/Py

Slope of the Budget Line = -( Px/Py)

- this represent the market rate of substitution between goods X and Y.

12
SAMPLE SITUATION:
Consumers income = P10
Price of X = P1
Price of Y = P2
Y intercept = P5
X intercept = P10
Slope = -1/2
Assume that a consumer purchases 3 units of good Y and 4 units of good X.

13
CONTINUATION:
Consumers income (M) = P10
Price of X ( Px)= P1 horizontal intercept X = M/ PX= P10/ P1 = 10 QTY.
Price of Y ( PY) = P2 vertical intercept Y = M/ PY = P10/ P2 = 5 QTY.

Slope = - (Px/Py) = - (P1/ P2) = -1/2 = -0.50

MRS (from B to A) = Change of Y / Change of X = (3-4)/( 4-2) =-1/2 = -0.50

BUDGET LINE GRAPH

BUNDLE A ( X= 4, Y =3); BUNDLE B ( X= 2, Y =4)

14
LO#2: CHANGES IN INCOME
 Under the assumption that prices remain unchanged, the increase in income
will not affect the slope of the budget line
 The vertical and horizontal intercepts of the budget line both increase as
the consumer’s income increases because more of each good can be
purchased at the higher income or less at lower income
 Increase or decrease opportunity set

15
CHANGES IN INCOME
- INCREASE IN INCOME WILL EXPAND OPPORTUNITIES.
- DECREASE IN INCOME WILL SHRINK OPPORTUNITIES.

16
WHEN PRICE CHANGES
- Assumption Consumer income(M) is fixed , price changes, Slope of
the intercept will change.
- If price of good X or Y decrease, the maximum number of goods
will increase
-If price of good X or Y increase , the maximum number of goods
will decrease

17
DECREASE IN THE PRICE OF GOOD X

18
EX. INCREASE IN PRICE OF GOOD X

19
ANSWER
GRAPH: INCREASE IN PRICE OF GOOD X

20
LO#3: CONSUMER EQUILIBRIUM
equilibrium refers to the fact that the consumer has no incentive to change to a
different affordable bundle once this point is reached.
The equilibrium consumption bundle is the affordable bundle that yields the
greatest satisfaction to the consumer.
the slope of the indifference curve is equal to the slope of the budget line

21
SAMPLE GRAPH FOR CONSUMER EQUILIBRIUM

22
COMPARATIVE STATISTICS:
PRICE CHANGE AND CONSUMER BEHAVIOR
SUBSTITUTE : DECREASE OF PRICE OF X ------ LEADS TO DECREASE QUANTITY OF Y
INCREASE OF PRICE OF X ------ LEADS TO INCREASE QUANTITY OF Y
SAMPLE GRAPH: CHANGE IN CONSUMER EQUILIBRIUM DUE TO A DECREASE IN PRICE
OF GOOD X ASSUMING Y IS A SUBSTITUTE

23
COMPARATIVE STATISTICS:
PRICE CHANGE AND CONSUMER BEHAVIOR
COMPLEMENTARY :
DECREASE OF PRICE OF X ( QUANTITY OF X INCREASE)------ LEADS TO QUANTITY OF Y
INCREASE
INCREASE OF PRICE OF X ( QUANTITY OF X DECREASE)------ LEADS TO QUANTITY OF Y
DECREASE
SAMPLE GRAPH: CHANGE IN CONSUMER EQUILIBRIUM DUE TO A DECREASE IN PRICE OF GOOD X
ASSUMING Y IS A COMPLEMENTARY GOOD.

24
COMPARATIVE STATISTICS: INCOME CHANGE AND CONSUMER BEHAVIOR
SAMPLE GRAPH: CHANGE IN CONSUMER EQUILIBRIUM DUE TO AN INCREASE IN
INCOME ASSUMING A GOOD IS A NORMAL GOOD.

25
COMP. STATISTICS: INCOME CHANGE AND CONSUMER BEHAVIOR
SAMPLE GRAPH: CHANGE IN CONSUMER EQUILIBRIUM DUE TO AN INCREASE IN INCOME
ASSUMING A GOOD X IS AN INFERIOR GOOD.

26
LO#4: SUBSTITUTION AND INCOME EFFECTS
SUBSTITUTION EFFECT The movement along a given
indifference curve that results from a change in the relative
prices of goods, holding real income constant

INCOME EFFECT The movement from one indifference curve to

another that results from the change in real income caused by a
price change.

27
AN INCREASE IN THE PRICE OF GOOD X LEADS TO A
SUBSTITUTION EFFECT (A TO B) AND INCOME EFFECT (B
TO C)

28
AN INCREASE IN THE PRICE OF GOOD X LEADS TO A
SUBSTITUTION EFFECT (A TO B)
SUBSTITUTION EFFECT . IGNORE for the moment the fact that the price increase
leads to a lower indifference curve.
Suppose that after the price increase, the consumer is given enough income to
achieve the budget line connecting points J and I. This budget line has the same slope
as budget line FH, but it implies a higher income than budget line FH.
Given this budget line, the consumer will achieve equilibrium at point B, where less of
good X is consumed than in the initial situation, point A. The movement from A to B is
called the substitution effect; it reflects how a consumer will react to a different
market rate of substitution. The substitution effect is the difference X0 – Xm.

29
AN INCREASE IN THE PRICE OF GOOD X LEADS TO A
SUBSTITUTION EFFECT (A TO B)
The movement from A to B leaves the consumer on the
same indifference curve, so the reduction in the
consumption of good X implied by that movement reflects
the higher market rate of substitution, not the reduced
“real Income”.

30
AN INCREASE IN THE PRICE OF GOOD X LEADS TO A
SUBSTITUTION EFFECT (A TO B) AND INCOME EFFECT (B
TO C)

31
AN INCREASE IN THE PRICE OF GOOD X
LEADS TO A INCOME EFFECT (B TO C)
The consumer does not actually face budget line JI when the price increases
but instead faces budget line FH. Let us now take back the income we gave to
the consumer to compensate for the price increase. When this income is taken
back, the budget line shifts from JI to FH.

This shift in the budget line reflects only a reduction in income; the slopes of
budget lines JI and FH are identical. Thus, the movement from B to C is called
the income effect. The income effect is the difference Xm -X1.

32
AN INCREASE IN THE PRICE OF GOOD X
LEADS TO A INCOME EFFECT (B TO C)
The figure reflects the fact that when price increases, the consumer’s
“real income” falls. Since good X is a normal good, the reduction in
income leads to a further reduction in the consumption of X.

33
TOTAL EFFECT
The total effect of a price increase thus is composed of substitution and
income effects. The substitution effect reflects a movement along an
indifference curve, thus isolating the effect of a relative price change on
consumption. The income effect results from a parallel shift in the budget line;
thus, it isolates the effect of reduced “real income” on consumption and is
represented by the movement from B
to C.

34
LO#6: APPLICATIONS OF INDIFFERENCE CURVE
ANALYSIS: CHOICES BY CONSUMERS

Buy one get one free

Cash Gifts, In-Kind Gifts, Gift Certificates

35
BUY ONE, GET ONE FREE

36
CASH GIFTS, IN-KIND GIFTS, AND GIFT CERTIFICATES

37
GIFT CERTIFICATE AT STORE X
-NORMAL GOOD

38
GIFT CERTIFICATE AT STORE X
- INFERIOR GOODS
\

39
LO#7: CHOICES BY WORKERS AND MANAGERS:
A SIMPLIFIED MODEL OF INCOME–LEISURE CHOICE

40
41
THE DECISIONS OF
MANAGERS
William Baumolhas argued that many managers derive satisfaction
from the underlying output and profits of their firms. According to
Baumol, higher profits and sales lead to a larger firm, and larger firms
provide more “perks” like spacious offices, executive health clubs,
corporate jets, and the like.

Suppose a manager’s preferences are such that she or he views the

“profits” and the “output” of the firm to be “goods” so that more of each
is preferred to less.

42
THE DECISIONS OF
MANAGERS

43
THE RELATIONSHIP BETWEEN
INDIFFERENCE CURVE ANALYSIS AND
DEMAND CURVES
We have seen how the consumption patterns of an individual consumer depend on
variables that include the prices of substitute goods, the prices of complementary
goods, tastes (i.e., the shape of indifference curves), and income. The indifference
curve approach developed in this chapter, in fact, is the basis for the demand
functions. We conclude by examining the link between indifference curve analysis and
demand curves.

44
INDIVIDUAL DEMAND CURVES

45
INDIVIDUAL DEMAND CURVES
This relationship between the price of good X and the
quantity consumed of good X is graphed in Figure 4–20(b)
and is the individual consumer’s demand curve for good X.

This consumer’s demand curve for good X indicates that,

holding other things constant, when the price of good X P 0
x

is the consumer will purchase X units of X; when the price of

0

good X is P 1 the consumer will purchase X units of X.

x 1

46
MARKET DEMAND CURVES
The market demand curve is the horizontal summation of
individual demand curves and indicates the total quantity all
consumers in the market would purchase at each possible price

47
MARKET DEMAND CURVES
.

This concept is illustrated graphically in Figures 4–

21(a) and 4–21(b). The curves D and D represent
A B

the individual demand curves of two hypothetical

consumers, Ms. A and Mr. B, respectively. When the
price is $60, Ms. A buys 0 units and Mr. B buys 0
units. Thus, at the market level, 0 units are sold
when the price is $60, and this is one point on the
market demand curve (labeled D in Figure 4–21[b]).
M

48
MARKET DEMAND CURVES
The market demand curve is the horizontal summation of individual demand curves and
indicates the total quantity all consumers in the market would purchase at each possible price.

When the price is $40, Ms. A buys 10 units (point A) and Mr.
B buys 20 units (point B). Thus, at the market level (Figure
4–21[b]), 30 units are sold when the price is $40, and this is
another point (point A + B) on the market demand curve.
When the price of good X is zero, Ms. A buys 30 units and
Mr. B buys 60 units; thus, at the market level, 90 units are
sold when the price is $0. If we repeat the analysis for all
prices between $0 and $60, we get the curve labeled D in M

Figure 4–21(b).

49
END OF PRESENTATION

THANK YOU
50
SEE YOU NEXT TIME 

51