Chapter 4

The Theory of Individual Behavior

 Learning Objectives

Explain Explain four basic properties of a consumer’s preference ordering and their ramifications for a consumer’s indifference curve.

Illustrate Illustrate how changes in prices and income impact an individual’s opportunities.

Illustrate Illustrate a consumer’s equilibrium choice and how it changes in response to changes in prices and income.

Separate Separate the impact of a price change into substitution and income effects.

Show how to derive an individual’s demand curve from indifference curve analysis and market demand from a group of individuals’
Show demands.

Illustrate Illustrate how “buy one, get one-free” deals and gift certificates impact a consumer’s purchase decisions.

Apply Apply the income-leisure choice framework to illustrate the opportunities, incentives, and choices of workers and managers.

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 Consumer Behavior

• Consumer opportunities
– Set of possible goods and services consumers can afford to consume.
• Consumer preferences
– Determine which set of possible goods and services will be consumed.

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 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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Indifference Curves

Indifference curve -
A curve that defines the
combinations of two goods
that give a consumer the
same level of satisfaction.

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 Constraints

While any decision-making environment presents 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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 The Budget Constraint

Restriction set by prices and income that limits bundles of goods

affordable to consumers.

–Budget set: defines the combinations of goods X and Y that are affordable for the
consumer
𝑃! 𝑋 + 𝑃" 𝑌 ≤ 𝑀

–Budget line: defines all combinations of goods X and Y that exactly exhauset the
consumer’s income
𝑃! 𝑋 + 𝑃" 𝑌 = 𝑀

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The Budget Constraint In Action (Figure 4-3)
Good 𝑌

𝑀
𝑃#
Slope
Bundle H
𝑃$ ! "
Budget set: 𝑌 ≤ " − "" 𝑋
! !
! "
𝑃# Budget line: 𝑌 = "!
− "" 𝑋
!

Bundle G

0 𝑀 Good 𝑋
𝑃$

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 The Market Rate of Substitution (Figure 4-4)
Good 𝑌

'() %
Market rate of substitution : =−
&(' &
4
%
Budget line: 𝑌 = 5 − & 𝑋
3

0 2 4 10 Good 𝑋

The slope of the budget line represents the market rate of substitution between goods X and Y.

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Changes in Income Shrink or Expand Opportunities
(Figure 4-5)
Good 𝑌

𝑀%
𝑃#

𝑀*
𝑃#

𝑀& 𝑀↑
𝑀↓
𝑃#

0 𝑀& 𝑀* 𝑀% Good 𝑋
𝑃# 𝑃# 𝑃#

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A Decrease in the Price of Good X (Figure 4-6)
Good 𝑌
𝑃$ * > 𝑃$ %
𝑀
𝑃#

New budget line

Initial budget
line

0 𝑀 𝑀
Good 𝑋
* %
𝑃$ 𝑃$

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 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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 The Budget Constraint in Action

Answers:
122
– Maximum X is: 𝑋 = = 100 units
1
122
– Maximum Y is: 𝑌 = = 20 units
3
4! 1
– Market rate of substitution: − 4 = − 3
"

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 Consumer Equilibrium

Consumer equilibrium
– Consumption bundle that is affordable and yields the greatest satisfaction to the
consumer.
– Consumption bundle where the rate a consumer choses (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).
#!
𝑀𝑅𝑆 =
#"

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 Consumer Equilibrium (Figure 4-8)
Good 𝑌

A
B Consumer equilibrium

C
Optimal qty Good Y

III
II
I

0 Optimal qty Good X Good 𝑋

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 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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 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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Price Changes and Equilibrium in Action (Figure 4-9)
Good 𝑌

𝑀 Point A: Initial consumer equilibrium

𝑃# Price of good X decreases: 𝑃$ ↓, budget set expands
Point B: New consumer equilibrium
Since 𝑌% < 𝑌* when 𝑃$ ↓:
Conclude that goods 𝑋 and 𝑌 are
A substitutes
𝑌* B
𝑌%

II
I

0 𝑋* 𝑀 𝑋 𝑀
% Good 𝑋
* %
𝑃$ 𝑃$

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 Income Changes and Consumer Behavior

• Income increases (decreases) expand (reduce) 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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Income Changes and Consumption (Figure 4-11)

Good 𝑌

𝑀% Point A: Initial consumer equilibrium

𝑃# Income increases: 𝑀 ↑, budget line expands
Point B: New consumer equilibrium
Since more of both goods are consumed
𝑀*
when 𝑀 ↑: Conclude that goods 𝑋
𝑃# B and 𝑌 are normal goods.

A
II

0 𝑀* 𝑀% Good 𝑋
𝑃$ 𝑃$
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 Substitution and Income Effects

Moving from one equilibrium to another when the price of one good
changes can be broken down into two 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.

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Substitution and Income Effects in Action (Figure 4-13)
*Notice the two effects of a price change
Good 𝑌 on consumer choice.
J
Point A: Initial consumer equilibrium
Price of good X increases: 𝑃$ ↑,new budget line FH
JI has the same slope as FH and represents hypothetical
income to isolate substitution
F Point B: substitution effect
Point C: income effect and new consumer
B
equilibrium
C A

H
0 𝑋% 𝑋! 𝑋* I G Good 𝑋
Income Substitution
effect effect

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 Applications of Indifference Curve Analysis

• Choices by consumers
– Buy one, get one free
– Cash gifts, in-kind gifts, and gift certificates
• Choices by workers and managers
– Income-leisure choice
– Manager’s preferences

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Consumer Choice with a Gift Certificate (Figure 4-16)
Point A: Initial consumer equilibrium
Good Y Receive a $10 gift certificate for good 𝑋:
𝑀 + $10
Point B: higher utility holding 𝑌
consumption at initial level
𝑀*
Point C: new consumer equilibrium
𝑃# when 𝑋and 𝑌 are normal
C goods
𝑌&
A
𝑌%
B III
II
I Budget line
with gift card

0 𝑋% 𝑋& 𝑀* 𝑀* + $10
𝑃$ 𝑃$
Good X

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Labor-Leisure Choice Model (Figure 4-18)
Income III
(per day) II
I

$240

E Worker equilibrium
$80

0 16 24 Leisure
(hours per day)
16 hours of leisure 8 hours of work

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 Labor-Leisure Budget Set in Action

What is the budget set for a worker who receives $5 per hour of work and
a fixed payment of $40? Let 𝐸 denote the worker’s total earnings and 𝐿
the number of leisure hours in a 24-hour day.

𝐸 = $40 + $5 24 − 𝐿 = $160 − $5L

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 Indifference and Demand Curves

• Indifference curves along with price changes determine individuals’

demand curves.
• Market demand is the horizontal summation of individuals’ demands.

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From Indifference Curves to Individual Demand (Figure 4-20)
Good 𝑌 Price of
good 𝑋

𝑃$#

A
𝑃$$
B

I II
New budget line Demand
after Px decreases

0 𝑋% 𝑋& Good 𝑋 𝑋% 𝑋& Good 𝑋

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From Individual to Market Demand (Figure 4-21)
Price of (a) Individual Demand Curves Price of (b) Market Demand Curve
good 𝑋 good 𝑋
$60

B A B A+B
A
$40

Demandmkt

DemandA DemandB

0 10 20 Good 𝑋 10 20 30 Good 𝑋

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