+Managerial Economics & Business Strategy

Chapter 4
The Theory of Individual Behavior

1. Anindita Tanaya Orasaputri (34P17007)

2. Asep Yusup Mamun (34P17008)
3. Bambang Chrisantoro (34P17009)
+ Overview
4-2

I. Consumer Behavior
Indifference Curve Analysis
Consumer Preference Ordering

II. Constraints
The Budget Constraint
Changes in Income
Changes in Prices

III. Consumer Equilibrium

IV. Indifference Curve Analysis & Demand
Curves
Individual Demand
Market Demand
+ Consumer Behavior
4-3

Consumer Opportunities
The possible goods and services consumer can afford to consume.

Consumer Preferences
The goods and services consumers actually consume.

Given the choice between 2 bundles of goods a consumer

either
Prefers bundle A to bundle B: A B.
Prefers bundle B to bundle A: A B.
Is indifferent between the two: A B.
 4-4

Indifference Curve Analysis

Indifference Curve Good Y

A curve that defines the
III.
combinations of 2 or more
goods that give a consumer the II.
same level of satisfaction. I.
Marginal Rate of Substitution
The rate at which a consumer is
willing to substitute one good
for another and maintain the
same satisfaction level.

Good X
 4-5
+
Consumer Preference Ordering
Properties
Completeness

More is Better

Diminishing Marginal Rate of Substitution

Transitivity
 4-6

Complete Preferences
Completeness Property
Consumer is capable of Good Y
expressing preferences (or III.
indifference) between all
possible bundles. (I dont II.
know is NOT an option!) I.
If the only bundles available A B
to a consumer are A, B, and C,
then the consumer
is indifferent between A and C
(they are on the same C

indifference curve).
will prefer B to A.
will prefer B to C. Good X
 4-7

More Is Better!

More Is Better Property

Bundles that have at least as much Good Y
of every good and more of some III.
good are preferred to other
bundles. II.
Bundle B is preferred to A since B
contains at least as much of good
I.
Y and strictly more of good X.
Bundle B is also preferred to C 100
A B
since B contains at least as much
of good X and strictly more of
good Y. C
More generally, all bundles on 33.33
ICIII are preferred to bundles on
ICII or ICI. And all bundles on ICII
are preferred to ICI. 1 3
Good X
 4-8

Diminishing Marginal Rate of

Substitution
Marginal Rate of Substitution
The amount of good Y the consumer is
willing to give up to maintain the same Good Y
satisfaction level decreases as more of
good X is acquired.
The rate at which a consumer is willing to III.
substitute one good for another and
maintain the same satisfaction level.
II.
To go from consumption bundle A
to B the consumer must give up 50 I.
units of Y to get one additional unit
of X. 100 A

To go from consumption bundle B to

C the consumer must give up 16.67
units of Y to get one additional unit 50
B
of X.
C
33.33 D
To go from consumption bundle C 25
to D the consumer must give up
only 8.33 units of Y to get one
additional unit of X.
1 2 3 4 Good X
 4-9

Consistent Bundle Orderings

Transitivity Property
For the three bundles A, B, and Good Y
C, the transitivity property III.
implies that if C B and B A,
then C A. II.
Transitive preferences along I.
with the more-is-better property 100 A
imply that C
75
indifference curves will not B
50
intersect.
the consumer will not get
caught in a perpetual cycle of
indecision.
1 2 5 7 Good X
 4-10

The Budget Constraint

Opportunity Set The Opportunity Set
Y
The set of consumption bundles that are
affordable.
Budget Line
PxX + PyY M.
M/PY
Y = M/PY (PX/PY)X
Budget Line
The bundles of goods that exhaust
a consumers income.
PxX + PyY = M.

Market Rate of Substitution M/PX

The slope of the budget line X

-Px / Py
 4-11

Changes in the Budget Line

Y

Changes in Income
M1/PY

Increases lead to a parallel,

outward shift in the budget M0/PY

line (M1 > M0).

Decreases lead to a parallel, M2/PY
downward shift (M2 < M0).

Changes in Price X
M2/PX M0/PX M1/PX
A decreases in the price of Y
good X rotates the budget New Budget Line for
line counter-clockwise (PX0 > M0/PY a price decrease.
PX1).
An increases rotates the
budget line clockwise (not
shown).

M0/PX0 M0/PX1
X
 4-12

Consumer Equilibrium

The equilibrium Y
consumption bundle Consumer
is the affordable M/PY
Equilibrium
bundle that yields
the highest level of
satisfaction.
Consumer equilibrium
occurs at a point where
MRS = PX / PY. III.
Equivalently, the slope of II.
the indifference curve
equals the budget line. I.
M/PX
X
 4-13
+
Price Changes and Consumer
Equilibrium
Substitute Goods
An increase (decrease) in the price of good X leads to an increase
(decrease) in the consumption of good Y.
Examples:
Coke and Pepsi.
Verizon Wireless or AT&T.

Complementary Goods
An increase (decrease) in the price of good X leads to a decrease
(increase) in the consumption of good Y.
Examples:
DVD and DVD players.
Computer CPUs and monitors.
 4-14
+
Complementary Goods

When the price of

Pretzels (Y)
good X falls and the
consumption of Y
rises, then X and Y M/PY
1
are complementary
goods. (PX1 > PX2)

B
Y2

Y1 A II

I
0 X1 M/PX1 X2 M/PX2 Beer (X)
 4-15
+
Income Changes and Consumer
Equilibrium
Normal Goods
Good X is a normal good if an increase (decrease) in income leads
to an increase (decrease) in its consumption.

Inferior Goods
Good X is an inferior good if an increase (decrease) in income
leads to a decrease (increase) in its consumption.
 4-16
+
Normal Goods

Y
An increase in
income increases
the consumption of M1/Y

normal goods.

(M0 < M1).

B
Y1
M0/Y
II
A
Y0
I
X0 M0/X X1 M1/X X
0
 4-17
+
Decomposing the Income and
Substitution Effects
Initially, bundle A is consumed. Y
A decrease in the price of good
X expands the consumers
opportunity set.
The substitution effect (SE) C
causes the consumer to move
from bundle A to B. A II
A higher real income allows B
the consumer to achieve a
higher indifference curve. I
The movement from bundle B to
C represents the income effect IE X
0
(IE). The new equilibrium is SE
achieved at point C.
 4-18
+
A Classic Marketing Application

Other
goods
(Y)

A
A buy-one,
C E
get-one free
D
pizza deal. II
I

0 0.5 1 2 B F Pizza
(X)
 4-19
Individual Demand Curve
Y

An individuals
demand curve is
derived from each II

new equilibrium I

point found on the $ X

indifference curve
as the price of good P0
X is varied. P1 D

X0 X1 X
 4-20

Market Demand
Themarket demand curve is the horizontal
summation of individual demand curves.
It
indicates the total quantity all consumers
would purchase at each price point.

$ Individual Demand $ Market Demand Curve

Curves
50

40

D1 D2 DM
1 2 Q 1 2 3 Q
 4-21
+
Conclusion

Indifferencecurve properties reveal

information about consumers preferences
between bundles of goods.
Completeness.
More is better.
Diminishing marginal rate of substitution.
Transitivity.

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