The Theory of Individual Behavior

Murat Issabayev, PhD, Associate Professor of Economics

Date: October 4 - 7, 2022
 Consumer Behavior

Normative Consumer Theory

• Any theory about individual behavior must be an
abstraction of reality
• A consumer is an individual who purchases goods and
services from firms for the purpose of consumption
• Consumer opportunities
• Set of possible goods and services consumers can afford to
consume.
• Consumer preferences
• Determine which set of goods and services will be
consumed.

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 Constraints
Constraints
• Opportunities are determined by constraints
• While any decision-making environment faces a host of
constraints, the focus of managerial economics is to
examine the role prices and income play in
constraining consumer behavior.

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 Constraints

The Budget Constraint

• Budget constraint
• Restriction set by prices and income that limits bundles of
goods affordable to consumers.
• Budget set:
𝑃𝑋 𝑋 + 𝑃𝑌 𝑌 ≤ 𝑀
• Budget line:
𝑃𝑋 𝑋 + 𝑃𝑌 𝑌 = 𝑀

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 Constraints

The Budget Constraint In Action

Good 𝑌

𝑀
𝑃𝑌 Slope
Bundle H
𝑃𝑋 𝑀 𝑃𝑋
Budget set: 𝑌 ≤ − 𝑋
𝑃𝑌 𝑃𝑌
𝑀 𝑃
𝑃𝑌 Budget line: 𝑌 = − 𝑋𝑋
𝑃𝑌 𝑃𝑌

Bundle G

𝑀 Good 𝑋
0
𝑃𝑋

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 Constraints

The Market Rate of Substitution

Good 𝑌

5
(Slope: Px/Py)
4−3 1
Market rate of substitution : =−
2−4 2
4

1
Budget line: 𝑌 = 5 − 𝑋
2
3

0 2 4 10 Good 𝑋

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 Constraints
Changes in Income Shrink or Expand
Good 𝑌
Opportunities
𝑀1
𝑃𝑌

𝑀0
𝑃𝑌

𝑀2 𝑀↑
𝑀↓
𝑃𝑌

0 𝑀2 𝑀0 𝑀1 Good 𝑋
𝑃𝑌 𝑃𝑌 𝑃𝑌

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 Constraints

A Decrease in the Price of Good X

Good 𝑌
𝑃𝑋 0 > 𝑃𝑋 1
𝑀
𝑃𝑌

New budget line

Initial budget
line

0 𝑀 𝑀
Good 𝑋
0 1
𝑃𝑋 𝑃𝑋

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 Constraints
The Budget Constraint in Action
• Consider the following budget line:
100 = 1𝑋 + 5𝑌
• What is the maximum amount of X that can be consumed?
• What is the maximum amount of Y that can be consumed?
• What is rate at which the market trades goods X and Y?

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 Constraints
The Budget Constraint in Action
• Answers:
100
• Maximum X is: 𝑋 = = 100 units
1
100
• Maximum Y is: 𝑌 = = 20 units
5
𝑃 1
• Market rate of substitution: − 𝑋 = −
𝑃𝑌 5

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 Consumer Behavior

Normative Consumer Theory

•Utility maximization
•What factors effect our decisions?
• Prices
• Incentives
• Information

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 Consumer Behavior

Normative Consumer Theory:Properties of Consumer

Preferences

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 Consumer Behavior
Normative Consumer Theory:Properties of
Consumer Preferences

• Property 1 - Complete Preferences: Any two options can be

compared, so either x ≥ y or y ≥ x or both

• Suppose you have a choice: 2 Big Mac and 1 Whopper OR 1 Big Mac
and 2 Whoppers

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 Consumer Behavior

Normative Consumer Theory:Properties of Consumer

Preferences
• Property 2 - More is better

< +

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 Consumer Behavior

Normative Consumer Theory:Properties of Consumer

Preferences
• Property 2 - More is better (Choice overload)

• Are 2 Big Mac and 1 Whopper preferable to 1 Big Mac

and 1 Whopper?
• Similarly,
• Are 1 Big Mac and 2 Whoppers preferable to 1 Big Mac
and 1 Whopper?
 Consumer Behavior

Normative Consumer Theory:Properties of Consumer

Preferences
• Property 3 - Diminishing Marginal Rate of Substitution

As you obtain more of orange, the amount of apple

you are willing to give up to obtain another unit of
orange decreases.

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 Consumer Behavior

Normative Consumer Theory:Properties of Consumer

Preferences

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 Consumer Behavior

Normative Consumer Theory:Properties of Consumer

Preferences

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 Consumer Behavior

Normative Consumer Theory:Properties of Consumer

Preferences
• Property 4 - Transitive Preferences: If x ≥ y and
y ≥ z, then x ≥ z.

If ≥ ≥

then ≥

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 Consumer Behavior
Normative Consumer Theory:Properties of
Consumer Preferences
• Property 1- Completeness: For any two bundles of goods
either:
• 𝐴 ≻ 𝐵.
• 𝐵 ≻ 𝐴.
• 𝐴 ∼ 𝐵.
• Property 2- More is better
• If bundle 𝐴 has at least as much of every good as bundle 𝐵 and
more of some good, bundle 𝐴 is preferred to bundle 𝐵.
• Property 3- Diminishing marginal rate of substitution
• As a consumer obtains more of good X, the amount of good Y
the individual is willing to give up to obtain another unit of good
X decreases.
• Property 4- Transitivity: For any three bundles, 𝐴, 𝐵, and 𝐶,
either:
• If 𝐴 ≻ 𝐵 and 𝐵 ≻ 𝐶, then 𝐴 ≻ 𝐶.
• If 𝐴 ∼ 𝐵 and 𝐵 ∼ 𝐶, then 𝐴 ∼ 𝐶.

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Normative Consumer Theory
• The marginal rate of substitution (MRS)
I, II, III: Indifference curves is the absolute value of the slope of an
indifference curve. MRS: the rate at
which a consumer is willing to
substitute one good for the other and
still maintain the same level of
satisfaction

• MUx: Marginal utility of X: Additional

utility you get from an additional unit of
good X

• Diminishing MU

• Diminishing MU implies diminishing

MRS
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 Consumer Equilibrium

Consumer Equilibrium
• Consumer equilibrium
• Consumption bundle that is affordable and yields the
greatest satisfaction to the consumer.
• Consumption bundle where the rate a consumer chooses
(marginal rate of substitution) to trade between goods X and
Y equals the rate at which these goods are traded in the
market (market rate of substitution).

𝑷𝑿
𝑴𝑹𝑺 =
𝑷𝒀

MUy/MUx =

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 Consumer Equilibrium

Consumer Equilibrium
Good 𝑌 Max U(X,Y) subject to the budget constraint 𝑴 = 𝑷𝑿 𝑿 + 𝑷𝒀 𝒀

A
B Consumer equilibrium

C
y*

III
II
I

0 x* Good 𝑋

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 Consumer Equilibrium
• The utility function of two goods X and Y is given by 𝑼 = 𝑼(𝑿, 𝒀).
• The Budget Constraint (line) is 𝑴 = 𝑷𝑿 𝑿 + 𝑷𝒀 𝒀.
• Graphically, the optimum consumption bundle is at the tangency of
the indifference (utility) curve and the budget line.
• In other words, the slopes (derivatives) of the indifference curve and
the budget line must be equal.
• The slope of the budget line is clear from previous slides, which is
𝑷𝑿
−
𝑷𝒀

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 Consumer Equilibrium
• But, how to find the slope of the indifference curve?
• Recall, moving along the indifference curve, the utility level for
different consumption bundle is the same. Hence,
𝒅𝑼 = 𝑼𝑿 𝒅𝑿 + 𝑼𝒀 𝒅𝒀 = 𝟎
𝝏𝑼 𝝏𝑼
• Here 𝑼𝑿 = and 𝑼𝒀 =
𝝏𝑿 𝝏𝒀
𝒅𝒀 𝑼𝑿
• Then, = − , which is the slope of the indifference curve. It is
𝒅𝑿 𝑼𝒀
called the marginal rate of substitution, MRS.

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 Consumer Equilibrium
𝑼𝑿 𝑷𝑿
• Therefore, 𝑴𝑹𝑺 = − =− .
𝑼𝒀 𝑷𝒀
• Alternatively, the utility-maximizing level of consumption bundle can
be solved by the constrained optimization (Lagrange method).
• Our goal is to maximize 𝑼(𝑿, 𝒀) subject to the constraint 𝑴 =
𝑷𝑿 𝑿 + 𝑷𝒀 𝒀. We can combine the objective function with constraint
as follows:

𝓛(𝑿, 𝒀, 𝝀) = 𝑼 𝑿, 𝒀 + 𝝀(𝑴 − 𝑷𝑿 𝑿 − 𝑷𝒀 𝒀)

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 Consumer Equilibrium
• Now, take the derivatives with respect to 𝑿, 𝒀, and 𝝀. That is,
𝓛𝑿 = 𝑼𝑿 − 𝝀𝑷𝑿 = 𝟎 (𝟏)
𝓛𝒀 = 𝑼𝒀 − 𝝀𝑷𝒀 = 𝟎 (𝟐)
𝓛𝝀 = 𝑴 − 𝑷𝑿 𝑿 − 𝑷𝒀 𝒀 = 𝟎 (𝟑)
𝑼𝑿 𝑼𝒀 𝑼𝑿 𝑷𝑿
• From (1) and (2), we receive 𝝀 = = => 𝑴𝑹𝑺 = =
𝑷𝑿 𝑷𝒀 𝑼𝒀 𝑷𝒀
• Whatever you obtain from the last expression, you plug it into
equation (3).

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 Utility maximization problem
• Suppose the utility
𝟏 𝟏
function is a function of two goods (X and Y) given
by 𝑼 𝑿, 𝒀 = 𝑿𝟐 𝒀𝟐 . The respective prices of goods are 𝑷𝑿 = $𝟏 and
𝑷𝒀 = $𝟐. The money income is M=$100. Find the utility-maximizing
levels of consumption bundle, 𝑿∗ and 𝒀∗ .
𝟏 𝟏
𝓛(𝑿, 𝒀, 𝝀) = 𝑿𝟐 𝒀𝟐 + 𝝀(𝟏𝟎𝟎 − 𝑿 − 𝟐𝒀)
𝟏
𝟏 𝒀 𝟐
𝓛𝑿 = −𝝀=𝟎 (𝟏)
𝟐 𝑿
𝓛𝒀 = 𝑼𝒀 − 𝝀𝟐 = 𝟎 (𝟐)
𝓛𝝀 = 𝑴 − 𝑷𝑿 𝑿 − 𝑷𝒀 𝒀 = 𝟎 (𝟑)
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Utility maximization problem
𝟏
𝟏 𝒀 𝟐
𝓛𝑿 = −𝝀=𝟎 (𝟏)
𝟐 𝑿
𝟏
𝟏 𝑿 𝟐
𝓛𝒀 = − 𝝀𝟐 = 𝟎 (𝟐)
𝟐 𝒀

𝓛𝝀 = 𝟏𝟎𝟎 − 𝑿 − 𝟐𝒀 = 𝟎 (𝟑)

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 Consumer Equilibrium
𝒀 𝟏 𝟏
• From (1) and (2), we receive = or 𝒀 = 𝑿
𝑿 𝟐 𝟐
• Now, plug the last expression into equation (3). That is,
𝟏
𝟏𝟎𝟎 = 𝑿 + 𝟐 𝑿 = 𝟐𝑿
𝟐
𝟏𝟎𝟎
• Hence, the optimal bundle of consumptions is 𝑿∗ = = 𝟓𝟎 and
𝟐
𝟏 𝟏
𝒀∗ = 𝑿∗ = 𝟓𝟎 = 𝟐𝟓. That is, the utility is maximized at 50
𝟐 𝟐
units of X and 25 units of Y.

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 Consumer Equilibrium

Consumer Equilibrium
Good 𝑌

50

Consumer equilibrium

A
25

𝟏 𝟏
𝑼 𝑿, 𝒀 = 𝑿𝟐 𝒀𝟐

0 50 100 Good 𝑋

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 Constraints

Normative Consumer Theory

• If you want to satisfy the mentioned axioms (completeness,
more is better, diminishing MRS, transitivity), then you must make
decisions according to this theory (maximizing utility under
budget constraint).
• If we had an important decision to make—whether to
refinance my mortgage, buy a car, to get an MBA or
invest in a new business.

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 Comparative Statics

Price Changes and Consumer Behavior

• Price and income changes impact a consumer’s budget
set and level of satisfaction that can be achieved.
• This implies that price and income changes will lead to
consumer equilibrium changes.

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 Comparative Statics

Price Changes and Equilibrium

• Price increases (decreases) reduce (expand) a
consumer’s budget set.
• The new consumer equilibrium resulting from a price
change depends on consumer preferences:
• Goods X and Y are:
• substitutes when an increase (decrease) in the price of X leads to an
increase (decrease) in the consumption of Y.
• complements when an increase (decrease) in the price of X leads to
a decrease (increase) in the consumption of Y.

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 Comparative Statics

Price Changes and Equilibrium in

Good 𝑌
Action
𝑀 Point A: Initial consumer equilibrium
𝑃𝑌 Price of good X decreases: 𝑃𝑋 ↓
Point B: New consumer equilibrium
Since 𝑌1 < 𝑌0 when 𝑃𝑋 ↓:
Conclude that goods 𝑋 and 𝑌 are
A substitutes
𝑌0 B
𝑌1

I II

0 𝑋0 𝑀 𝑋 𝑀
1 Good 𝑋
0 1
𝑃𝑋 𝑃𝑋

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 Comparative Statics
Income Changes and Consumer
Behavior
• An increase in income expands a consumer’s budget set.
• A decrease in income reduces a consumer’s budget set.
• The new consumer equilibrium resulting from an
income change depends on consumer preferences:
• Good X is:
• a normal good when an increase (decrease) in income
leads to an increase (decrease) in the consumption of X.
• an inferior good when an increase (decrease) in income
leads to a decrease (increase) in the consumption of X.

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 Comparative Statics

Income Changes and Consumption

Good 𝑌

𝑀1 Point A: Initial consumer equilibrium

𝑃𝑌 Price of income increases: 𝑀 ↑
Point B: New consumer equilibrium
Since more of both goods are consumed
𝑀0
when 𝑀 ↑: Conclude that goods 𝑋
𝑃𝑌 B and 𝑌 are normal goods.

A
II

0 𝑀0 𝑀1 Good 𝑋
𝑃𝑋 𝑃𝑋
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 The Relationship Between Indifference
Curve Analysis and Demand Curves

From Indifference Curves to Individual Demand

Indifference curves along with price changes determine
individuals’ demand curves.
Price of
Good 𝑌
good 𝑋

𝑃𝑋1 𝐴

A 𝐵
𝑃𝑋2
B

I
II
𝑋1 𝑋2

𝑋1 𝑋2 Good 𝑋 𝑋1 𝑋2 Demand of Good X

0
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 Utility maximization problem
• Suppose the utility function is a function of two goods (X and Y) given
𝟏 𝟏
by 𝑼 𝑿, 𝒀 = 𝑿 𝒀 . The respective prices of goods are 𝑷𝑿 = $𝟏 and
𝟐 𝟐
𝑷𝒀 = $𝟐. The money income is M=$100. Find the utility-maximizing
levels of consumption bundle, 𝑿∗ and 𝒀∗ .

39
 The Relationship Between Indifference
Curve Analysis and Demand Curves

From Individual to Market Demand

Market demand is the horizontal summation of
individuals’ demands.
Price of
Price of
good 𝑋
good 𝑋
$𝟔𝟎

$40
DemandA
A B A B A+B

Demandmkt
DemandB

10 20 10 20 30

Good 𝑋 Good 𝑋
0
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