CHAPTER 4

The Theory of Individual Behavior

© 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 Learning Objectives
1. Explain four basic properties of a consumer’s preference
ordering and their ramifications 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. Show how to derive 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. 2
© 2017 by McGraw-Hill Education. All Rights Reserved.
 Consumer Behavior

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

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-3

 Consumer Behavior

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

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-5

 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

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-6

 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

0 𝑀 Good 𝑋
𝑃𝑋

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-7

 Constraints

The Market Rate of Substitution

Good 𝑌

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

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-8

 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

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

 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

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-10

 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?

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

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

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

 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
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. 4-13

 Consumer Equilibrium

Consumer Equilibrium
Good 𝑌

A
B Consumer equilibrium

III
II
I

0 Good 𝑋

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

 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.

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-15

 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.

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-16

 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

II
I

0 𝑋0 𝑀 𝑋 𝑀
1 Good 𝑋
0 1
𝑃𝑋 𝑃𝑋

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-17

 Comparative Statics
Income Changes and Consumer
Behavior
• Income increases (decreases) reduce (expand)
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. 4-18
 Comparative Statics

Income Changes and Consumption

Good 𝑌

𝑀1 Point A: Initial consumer equilibrium

Price of income increases: 𝑀 ↑
𝑃𝑌
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
© 2017 by McGraw-Hill Education. All Rights Reserved. 4-19
 Comparative Statics

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.

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-20

 Comparative Statics
Substitution and Income Effects in
Good 𝑌
J
Action
Point A: Initial consumer equilibrium
Price of good X increases: 𝑃𝑋 ↑
Point B: substitution effect
F Point C: income effect and new
consumer equilibrium
B

C A

H
0 𝑋1 𝑋𝑀 𝑋0 I G Good 𝑋
Income Substitution
effect effect
© 2017 by McGraw-Hill Education. All Rights Reserved. 4-21
 Applications of Indifference Curves Analysis

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
– Managers preferences

© 2017 by McGraw-Hill Education. All Rights Reserved. 22

 Consumer Choice with a Gift Applications of Indifference Curves

Certificate
Good Y
Point A: Initial consumer equilibrium
Receive a $10 gift certificate for good 𝑋:
𝑀 + $10
Point B: higher utility holding 𝑌
consumption at initial level
𝑀0
Point C: new consumer equilibrium
𝑃𝑌 when 𝑋and 𝑌 are normal
C goods
𝑌2
A
𝑌1
B II
I

0 𝑋1 𝑋2 𝑀0 𝑀0 + $10 Good X
𝑃𝑋 𝑃𝑋

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-23

 Applications of Indifference Curves

Labor-Leisure Choice Model

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

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-24

 Applications of Indifference Curves

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

© 2017 by McGraw-Hill Education. All Rights Reserved. 4-25

 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. 4-26

 The Relationship Between Indifference
Curve Analysis and Demand Curves

From Indifference Curves to Individual Demand

Good 𝑌 Price of
good 𝑋

𝑃𝑋1

A
𝑃𝑋2
B

I II
Demand

0 𝑋1 𝑋2 Good 𝑋 𝑋1 𝑋2 Good 𝑋

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

 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. 28