The Theory of Individual Behavior

© 2017 by McGraw-Hill Education. All Rights Reserved. 1

Coverage
1. Explain four basic properties of a consumer’s preference ordering and their effects
for a consumer’s indifference curves.
2. Illustrate how changes in prices and income impact an individual’s opportunities.
3. Illustrate a consumer’s equilibrium choice and how it changes in response to changes
in prices and income.
4. Separate the impact of a price change into substitution and income effects.
5. Deriving an individual’s demand curve from indifference curve analysis and market
demand from a group of individuals’ demands.
6. Illustrate how “buy one, get one-free” deals and gift certificates impact a consumer’s
purchase decisions.
7. Apply the income-leisure choice framework to illustrate the opportunities, incentives,
and choices of workers and managers.

© 2017 by McGraw-Hill Education. All Rights Reserved. 2

Introduction

© 2017 by McGraw-Hill Education. All Rights Reserved. 3

Introduction

• Recall one of the Ten Principles from Chapter 1: People face tradeoffs.
– Buying more of one good leaves less income to buy other goods.
– Working more hours means more income and more consumption, but less
leisure time.
– Reducing saving allows more consumption today but reduces future
consumption.
• This chapter explores how consumers make choices like these.

© 2017 by McGraw-Hill Education. All Rights Reserved. 4

Introduction
This chapter develops tools that help a manager understand the behavior
of individuals, such as consumers and workers, and the impact of
alternative incentives on their decisions.

• Despite the complexities of human thought processes, managers need a

model that explains how individuals behave in the marketplace and in the
work environment.

• Of course, attempts to model individual behavior cannot capture the full

range of real-world behavior. Life would be simpler for managers of firms if
the behavior of individuals were not so complicated.

• If you achieve an understanding of individual behavior, you will gain a

marketable skill that will help you succeed in the business world.

We must begin with a simple model that focuses on essentials

© 2017 by McGraw-Hill Education. All Rights Reserved. 5

Consumer Behavior

© 2017 by McGraw-Hill Education. All Rights Reserved. 6

 Consumer Behavior
Definition: 2 Points of concerns:
A consumer is an individual who purchases goods and who purchases the good
services from firms for the purpose of consumption who consumes the good

Example:
• A six-month-old baby consumes goods but is not responsible
for purchase decisions.
• If you are employed by a manufacturer of baby food, it is the
parent’s (consumer) behavior you must understand, not the
baby’s

What the In characterizing consumer behavior, there are two important factors to consider:
Consumer a. Consumer preferences
Wants
– Determine which set goods and services will be consumed
Budget b. Consumer opportunities
Constraint – Set of possible goods and services consumers can afford to consume.

© 2017 by McGraw-Hill Education. All Rights Reserved. 7

 Consumer Behavior
What the In characterizing consumer behavior, there are two important factors to consider:
Consumer a. Consumer preferences
Wants
– Determine which set goods and services will be consumed
Budget b. Consumer opportunities
Constraint
– Set of possible goods and services consumers can afford to consume.

Assumption:
• Only two goods exist in the economy. This assumption is made purely to
simplify our analysis:
All of the conclusions that we draw from this two-good setting remain valid when
there are many goods.

© 2017 by McGraw-Hill Education. All Rights Reserved. 8

 Consumer Behavior

4 Properties of Consumer Preferences

Property 1- Completeness: By assuming that preferences are complete, we assume that

the consumer is capable of expressing a preference for any two bundles of goods either:
– 𝐴 ≻ 𝐵.
– 𝐵 ≻ 𝐴.
– 𝐴 ∼ 𝐵.
• If preferences were not complete, there might be cases where a consumer would
claim not to know whether he or she preferred bundle A to B, preferred B to A, or
was indifferent between the two bundles.

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-9

 Consumer Behavior

4 Properties of Consumer Preferences

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.
• A is preferred to bundle D because it has the same amount of good X and
more of good Y.
• Bundle C is also preferred to bundle D because it has more of both goods.
• Similarly, bundle B is preferred to bundle D.

THIS curve does not reveal whether bundle B is preferred to

bundle A or bundle A is preferred to bundle B.

An indifference curve defines the combinations of

goods X and Y that give the consumer the same level
of satisfaction; that is, the consumer is indifferent
between any combination of goods along an
indifference curve.

Explain later
4-10
 Consumer Behavior

4 Properties of Consumer Preferences

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.

• The marginal rate of substitution (MRS) is

the absolute value of the slope of an
indifference curve.
• The marginal rate of substitution between
two goods is the rate at which a consumer
is willing to substitute one good for the
other and still maintain the same level of
satisfaction
Example: Moving from point A to point B, the
marginal rate of substitution between goods X
and Y is 2.

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-11

 Consumer Behavior

4 Properties of Consumer Preferences

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.

Example:
Moving from point A to point B, the
consumption Y decreases as the consumption
of X increases

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-12

 Consumer Behavior

4 Properties of Consumer Preferences

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.

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-13

 Consumer Behavior

Indifference Curve

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-14

 Preferences: What the Consumer Wants
Indifference curve: Quantity One of Hurley’s
shows consumption bundles of Mangos indifference curves
that give the consumer the
same level of satisfaction

B
A, B, and all other bundles on I1
make Hurley equally happy – he is
indifferent between them. A
I1

Quantity
of Fish
THE THEORY OF
CONSUMER CHOICE 15
 Four Properties of Indifference Curves

1. Indifference curves are Quantity One of Hurley’s

downward-sloping. of Mangos indifference curves
If the quantity of fish is reduced,
the quantity of mangos must be
increased to keep Hurley equally
happy.
B

A
I1

Quantity
of Fish
THE THEORY OF
CONSUMER CHOICE 16
 Four Properties of Indifference Curves

Quantity A few of Hurley’s

2. Higher indifference of Mangos indifference curves
curves are preferred
to lower ones.

Hurley prefers every

bundle on I2 (like C) C
D
to every bundle on I1
A I2
(like A).
I1
He prefers every
bundle on I1 (like A) I0
to every bundle on I0 Quantity
(like D). of Fish
THE THEORY OF
CONSUMER CHOICE 17
 Four Properties of Indifference Curves

Quantity Hurley’s
3. Indifference curves of Mangos indifference curves
cannot cross.
Suppose they did.
Hurley should prefer B to C, since B has more of both goods.
Yet, Hurley is indifferent between B and C:
He likes C as much as A (both are on I4).
He likes A as much as B (both are on I1).
B

C A
I1 I4

Quantity
of Fish

18
 Four Properties of Indifference Curves

Quantity
4. Indifference curves of Mangos
are bowed inward.

A
Hurley is willing to give
up more mangos for a 6
fish if he has few fish
1
(A) than if he has
B
many (B). 2
1 I1

Quantity
of Fish
THE THEORY OF
CONSUMER CHOICE 19
 The Marginal Rate of Substitution

Quantity MRS = slope of

Marginal rate of of Mangos indifference curve
substitution (MRS):
the rate at which a consumer
is willing to trade one good for another. A
Hurley’s MRS is the amount of mangos
he would substitute for another fish. MRS = 6
MRS falls as you move down along an
indifference curve. 1
B
MRS = 2
1 I1

Quantity
of Fish
THE THEORY OF
CONSUMER CHOICE 20
 One Extreme Case: Perfect Substitutes
Perfect substitutes:
two goods with straight-line indifference curves, constant MRS
Example: nickels & dimes
Consumer is always willing to trade two nickels for one dime.

THE THEORY OF
CONSUMER CHOICE 21
 Another Extreme Case: Perfect Complements

Perfect complements:
two goods with right-angle indifference curves
Example: Left shoes, right shoes
{7 left shoes, 5 right shoes}
is just as good as
{5 left shoes, 5 right shoes}

THE THEORY OF
CONSUMER CHOICE 22
 Less Extreme Cases:
Close Substitutes and Close Complements

Quantity Indifference Quantity Indifference

of Pepsi curves for close of hot curves for
dog buns close
substitutes are
not very bowed complements
are very
bowed

Quantity Quantity
of Coke of hot dogs
Constraints

© 2017 by McGraw-Hill Education. All Rights Reserved. 24

 Consumer Behavior
What the In characterizing consumer behavior, there are two important factors to consider:
Consumer a. Consumer preferences
Wants
– Determine which set goods and services will be consumed
Budget b. Consumer opportunities
Constraint
– Set of possible goods and services consumers can afford to consume.

Assumption:
• Only two goods exist in the economy. This assumption is made purely to
simplify our analysis:
All of the conclusions that we draw from this two-good setting remain valid when
there are many goods.

© 2017 by McGraw-Hill Education. All Rights Reserved. 25

 Constraints
Constraints
• In any decision-making environment faces
constraints such as:
legal constraints, time constraints, physical constraints,
and, of course, budget constraints.

• However our focus is to examine the role

prices and income play in constraining
consumer behavior.

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-26

 Constraints

The Budget Constraint

• Budget constraint
– Restriction set by prices and income that limits
bundles of goods affordable to consumers.
– Budget set: The bundles of goods a consumer can afford. The combinations
of goods X and Y
that are
affordable for the
𝑃𝑋 𝑋 + 𝑃𝑌 𝑌 ≤ 𝑀 consumer

– Budget line: The bundles of goods that exhaust a consumer’s income.

𝑃𝑋 𝑋 + 𝑃𝑌 𝑌 = 𝑀 all the combinations of goods
X and Y that exactly exhaust
the consumer’s income
M = the consumer’s income
Px and Py = the prices of goods X and Y,

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-27

 Constraints

The Budget Constraint In Action

𝑃𝑋 𝑋 + 𝑃𝑌 𝑌 = 𝑀
Good 𝑌

𝑀 Slope = MRS
point H, represents an
𝑃𝑌 unaffordable combination of X
and Y
the maximum
Bundle H
affordable
quantity of Y 𝑃𝑋
consumed
𝑀 𝑃𝑋
𝑃𝑌 Budget line: 𝑌 = − 𝑋
𝑃𝑌 𝑃𝑌

Bundle G

0 point G, 𝑀 Good 𝑋
represents an
𝑀 𝑃𝑋 𝑃𝑋
affordable Budget set: 𝑌 ≤ − 𝑋 the maximum
𝑃𝑌 𝑃𝑌 affordable
combination of
X and Y quantity of X
© 2017 by McGraw-Hill Education. All Rights Reserved.
consumed
 Consumer Behavior
What the In characterizing consumer behavior, there are two important factors to consider:
Consumer a. Consumer preferences
Wants
– Determine which set goods and services will be consumed
Budget b. Consumer opportunities
Constraint
– Set of possible goods and services consumers can afford to consume.

2 main factors which affects consumer opportunities:

a. Changes in income
b. Changes in price

© 2017 by McGraw-Hill Education. All Rights Reserved. 29

 Constraints
2 main factors which affects consumer opportunities:
a. Changes in income
b. Changes in price

Good 𝑌
Assumption: prices remain constant.
𝑀1
𝑃𝑌

𝑀0
𝑃𝑌
Decrease in Income
Expand Opportunities Increase in Income
𝑀2 𝑀↑ Expand Opportunities
𝑀↓
𝑃𝑌

0 𝑀2 𝑀0 𝑀1 Good 𝑋
𝑃𝑌 𝑃𝑌 𝑃𝑌

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-30

 Constraints
2 main factors which affects consumer opportunities:
a. Changes in income
b. Changes in price

Good 𝑌
𝑃𝑋 0 > 𝑃𝑋1
𝑀
𝑃𝑌

New budget line

Initial budget
line Assumption: Py remains unchanged

A Decrease in the Px:

More good X consumed

0 𝑀 𝑀
Good 𝑋
0 1
𝑃𝑋 𝑃𝑋

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-31

 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?

• 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

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-32

Consumer Equilibrium: Optimal Choice

© 2017 by McGraw-Hill Education. All Rights Reserved. 33

 Consumer Equilibrium

Consumer Equilibrium
The objective of the consumer is to choose the consumption
bundle that maximizes his or her utility, or satisfaction

• 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).
𝑃𝑋
𝑀𝑅𝑆 =
𝑃𝑌

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-34

 Optimization: What the Consumer Chooses
Consumer Equilibirum:
Quantity The optimum
is the bundle Hurley most
of Y prefers out of all the
bundles he can afford.

A is the optimum  consumer equilibirum:

1200 the point on the budget constraint that
touches the highest possible indifference
curve.

Consumer prefers B to A, but he cannot afford B.

B
600
A

C
Consumer can afford C and D,
but A is on a higher indifference D
curve.

150 300 Quantity

of X
 Optimization: What the Consumer Chooses
Quantity
of Y

At the optimum,
slope of the indifference curve equals 1200
slope of the budget constraint:

MRS = PX/PY
600
A

150 300 Quantity

of X
Comparative Statics: Price and Income Changes on Consumer Behaviour

© 2017 by McGraw-Hill Education. All Rights Reserved. 37

 Comparative Statics

Price Changes and Consumer Behavior

• Price and income changes affect on 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.

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-38

 Comparative Statics

Price Changes and Equilibrium

The Effects of a Price Change
A change in the price of a good will lead to a change in the equilibrium consumption bundle.

• 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  positive relationship
• complements when an increase (decrease) in the price of X leads to a
decrease (increase) in the consumption of Y  negative relationship

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-39

 Comparative Statics
Price Changes and Equilibrium
Example: Goods X and Y are substitutes
Good 𝑌 Point A: Initial consumer equilibrium
𝑀
𝑃𝑌 When 𝑷𝑿 ↓ :
• Consumption X increases
• Consumption Y decreases (coz
substitution effect)
A
𝑌0 B Point B: New consumer equilibrium
𝑌1

II
I

0 𝑋0 𝑀 𝑋 𝑀
1 Good 𝑋
0 1
𝑃𝑋 𝑃𝑋

4-40
 Comparative Statics
Price Changes and Equilibrium
Example:
Goods X and Y are Complement
Point A: Initial consumer equilibrium

When 𝑷𝑿 ↓ :
• Consumption X increases
• Consumption Y increases

Point B: New consumer equilibrium

4-41
 Comparative Statics

Price Changes and Consumer Behavior

Conclusion:
• From a managerial perspective, the key thing to note is that changes in prices affect
the behavior of consumers price changes alter consumer incentives to buy
different goods, thereby changing the mix of goods they purchase in equilibrium
• Price changes might occur because of:
– updated pricing strategies within your own firm.
– Or they might arise because of price changes made by rivals or firms in other industries.

The primary advantage of indifference curve analysis

to see how price changes affect the mix of goods that
consumers purchase in equilibrium (maximum satisfaction)

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-42

 Comparative Statics

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.

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-43

 Comparative Statics

Income Changes and Consumption

Example: goods 𝑿 and 𝒀 are normal goods

Good 𝑌
Point A: Initial consumer equilibrium
𝑀1 income increases: 𝑀 ↑  more
𝑃𝑌 consumption on X and Y

Point B: New consumer equilibrium

𝑀0
𝑃𝑌 B

A
II

0 𝑀0 𝑀1 Good 𝑋
𝑃𝑋 𝑃𝑋
© 2017 by McGraw-Hill Education. All Rights Reserved. 4-44
 Comparative Statics

Income Changes and Consumption

Example: goods 𝑿 is inferior goods
Point A: Initial consumer equilibrium

Income increases:
𝑀 ↑  Budget line increases, Good X inferior 
Consumption good X ↓, but consumption good Y ↑

Point B: New consumer equilibrium

Substitution and Income Effects

© 2017 by McGraw-Hill Education. All Rights Reserved. 46

 Comparative Statics

Substitution and Income Effects

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.
A fall in Px makes Y more expensive relative to X, causes consumer to
buy fewer Y & more X
– Income effect:
The shift from one indifference curve to another that results from the
change in real income caused by a price change.
A fall in PX boosts the purchasing power of consumer’s income,
allows him to buy more Y and more X.

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-47

 The Income and Substitution Effects
Quantity
of Y Initial
optimum at A.
Example: PX falls Eq. will move
from A to C.
When Px falls, it has two effects:
Substitution effect:
A from A to B,
C buy more X and fewer Y.
Income effect:
B from B to C,
buy more of both goods (X and Y)
 boost purchasing power
𝑋1 𝑋2 𝑋3 Quantity
of X
Indifference and Demand Curves

© 2017 by McGraw-Hill Education. All Rights Reserved. 49

 The Relationship Between Indifference
Curve Analysis and Demand Curves

Indifference and Demand Curves

• Indifference curves along with price changes determine individuals’ demand curves.
• Market demand is the horizontal summation of individuals’ demands.

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-50

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

Good 𝑌 Price of
good 𝑋
When 𝑷𝑿 ↓ :
• Consumption X increases
𝑃𝑋1 • Consumption Y decreases
(coz substitution effect)
A
𝑃𝑋2
B

I II
Demand

0 𝑋1 𝑋2 Good 𝑋 𝑋1 𝑋2 Good 𝑋
 The Relationship Between Indifference
Curve Analysis and Demand Curves

From Individual to Market Demand

Price of Price of
good 𝑋 good 𝑋
$60

A B A B A+B
$40

Demandmkt

DemandA DemandB

0 10 20 Good 𝑋 10 20 30 Good 𝑋

© 2017 by McGraw-Hill Education. All Rights Reserved. 52

 Thank You

© 2017 by McGraw-Hill Education. All Rights Reserved. 53