Managerial Economics and Business Strategy:

Ch. 4 - The Theory of

Individual Behavior
Rayhan Gunaningrat, SE., MM.
Department of Management
Faculty of Law and Business
Universitas Duta Bangsa
Outline
INTRODUCTION APPLICATIONS OF INDIFFERENCE CURVE
ANALYSIS
CONSUMER BEHAVIOR
THE RELATIONSHIP BETWEEN INDIFFERENCE
CONSTRAINTS CURVE ANALYSIS AND DEMAND CURVES

CONSUMER EQUILIBRIUM

COMPARATIVE STATICS
headLINE:
Packaging Firm Uses Overtime Pay to Overcome Labor Shortage
Uprint.id produces corrugated paper containers at a small plant in Grogol, West Jakarta. In 2016, the
labor shortage hampered Uprint.id’s ability to hire enough workers to meet its growing demand and
production targets. This is despite the fact that it pays IDR 16k per hour—almost 30 percent more than
the local average—to its workers.

Last year, Uprint.id hired a new manager who instituted an overtime wage plan at the firm. Under her
plan, workers earn IDR 16k per hour for the first eight hours worked each day, and IDR 24k per hour for
each hour worked in a day in excess of eight hours. This plan eliminated the firm’s problems, as the firm’s
production levels and profits are up by 20 percent this year.

Why did the new manager institute the overtime plan instead of simply raising the wage rate in an
attempt to attract more workers to the firm?
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. 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 instead of dwelling on behavioral features
that would do little to enhance our understanding.
CONSUMER BEHAVIOR
A consumer is an individual who purchases goods and services from firms for the purpose of
consumption. As a manager of a firm, you are interested not only in who consumes the good but in who
purchases it.

In characterizing consumer behavior, there are two important but distinct factors to consider:
Consumer opportunities represent the possible goods and services consumers can afford to consume.
Consumer preferences determine which of these goods will be consumed.

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.
Indifference Curve Analysis
Indifference curve is a curve that defines the
combinations of 2 or more goods that give a
consumer the same level of satisfaction.

Marginal Rate of Substitution (MRS) is the rate at

which a consumer is willing to substitute one good
for another and maintain the same satisfaction
level.
Consumer Preference Ordering Properties
To focus on the essential aspects of individual behavior and to keep things manageable, we will assume
that only two goods exist in the economy, X and Y.

Property 4–1: Completeness. For any two bundles—say, A and B—either A ≻ B, B ≻ A, or A ∼ B. By

assuming that preferences are complete, we assume the consumer is capable of expressing a preference
for, or indifference among, all bundles.

Property 4–2: 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.
Consumer Preference Ordering Properties (2)
Property 4–3: Diminishing Marginal Rate of Substitution. As a consumer obtains more of good X, the
amount of good Y he or she is willing to give up to obtain another unit of good X decreases.

Property 4–4: Transitivity. For any three bundles, A, B, and C, if A ≻ B and B ≻ C, then A ≻ C. Similarly, if A
∼ B and B ∼ C, then A ∼ C. The assumption of transitive preferences, together with the more-is-better
assumption, implies that indifference curves do not intersect one another.

For more details: https://www.youtube.com/watch?v=iOmDo5jLFw8

CONSTRAINTS
In making decisions, individuals face constraints. There are legal constraints, time constraints, physical
constraints, and budget constraints.

To maintain our focus, we will examine the role prices and income play “budget constraint” in
constraining consumer behavior.

The budget constraint restricts consumer behavior by forcing the consumer to select a bundle of goods
that is affordable.
Budget Constraint
The budget set (also called as opportunity set) defines the combinations of goods X and Y that are
affordable for the consumer:

The budget line is that if the consumer spends his or her entire income on the two goods:

The slope of the budget line is the market rate of substitution between goods X and Y:
Budget Set
Changes in the Budget Line
Changes in Income:
Increases lead to a parallel, outward shift in the
budget line (M1 > M0).
Decreases lead to a parallel, downward shift
(M2 < M0).

Changes in Price:
A decreases in the price of good X rotates the
budget line counter-clockwise (Px0 > Px1).
An increases rotates the budget line clockwise
CONSUMER EQUILIBRIUM
The equilibrium consumption bundle is the
affordable bundle that yields the highest level of
satisfaction.

Consumer equilibrium occurs at a point where:

MRS = P / P
X Y
Equivalently, the slope of the indifference curve
equals the budget line.
Price Changes and Consumer Behavior

Substitute Goods. An increase (decrease) in the

price of good X leads to an increase (decrease) in
the consumption of good Y. For instances: McD
and KFC, Coffee and Tea.

Complementary Goods. An increase (decrease) in

the price of good X leads to a decrease (increase)
in the consumption of good Y. For examples: Socks
and Shoes, Chip Processor and Laptop.
Income Changes and Consumer Behavior

Good X is a normal good if an increase (decrease)

in income leads to an increase (decrease) in the
consumption of good X. For example: Sate Buntel,
Mobil.

Good X is an inferior good if an increase

(decrease) in income leads to a decrease (increase)
in the consumption of good X. For instances: Bajai,
Mie instan.
Decomposing the Income and Substitution Effects
Initially, bundle A is consumed. A decrease in the
price of good X expands the consumer’s
opportunity set.

The substitution effect (SE) causes the consumer

to move from bundle A to B.

A higher “real income” allows the consumer to

achieve a higher indifference curve.

The movement from bundle B to C represents the

income effect (IE). The new equilibrium is
achieved at point C.
APPLICATIONS OF INDIFFERENCE
CURVE ANALYSIS
Buy One, Get One Free
Point C represents one-half of a large pizza (say, a
small pizza), so the consumer decides it is best to
buy a small pizza instead of a large one.

Point D represents the point at which she buys

one large pizza, but, as we can see, the consumer
prefers bundle C to bundle D since it lies on a
higher indifference curve.

When the consumer is offered the “buy one, get

one free” deal, her budget line becomes ADEF.
After the deal is offered, the opportunity set
increases. In fact, bundle E is now an affordable
bundle. Moreover, it is clear that bundle E is
preferred to bundle C, and the consumer’s optimal
choice is to consume bundle E
A Cash Gift Yields Higher Utility Than an In-Kind Gift

A consumer named Sri is in equilibrium,

consuming bundle A. She opens a package and, to
her surprise, it contains a $10 gethuk (good X).
Graphically, when Sri receives the gift, her
opportunity set expands to include point B.

While Sri likes gethuk and is better off after

receiving it, the gift is not what she would have
purchased had her parents given him the cash she
spent on the gethuk. Thus, the budget line after
the cash gift must go through point B—and, given
the cash gift, Sri would achieve a higher level of
satisfaction at point C compared to the gift of a
gethuk (point B).
Gift certificates are a happy medium

Gift certificates are able to eliminate both the

stigma associated with cash gifts and the
deadweight loss that stems from giving a gift that
doesn’t exactly match the recipient’s preferences.
When Sri receives the $10 gift certificate, the
budget constraint becomes the kinked blue line. In
effect, the gift certificate allows the consumer up
to $10 worth of good X without spending a dime
of her own money.
If both X and Y are normal goods, the consumer
will desire to spend more on both goods as income
increases. Thus, if both goods are normal goods,
the consumer moves from A to C.
A Simplified Model of Income–Leisure Choice

Suppose a firm offers to pay a worker $10 for each

hour of leisure the worker gives up (i.e., spends
working).

If the worker chooses to work 24-hour days, he or

she consumes no leisure but earns $10 × 24 =
$240 per day, which is the vertical intercept of the
line. If the worker chooses not to work, he or she
consumes 24 hours of leisure but earns no income.

The worker attempts to achieve a higher

indifference curve until he or she achieves one
that is tangent to the opportunity set at point E.
The Decisions of Managers
For Non-profit
Organization

An important issue for the firm’s owners is to induce managers to care solely about profits so that the
result is the maximization of the underlying value of the firm, as in Figure 4–19(c).
THE RELATIONSHIP BETWEEN
INDIFFERENCE CURVE ANALYSIS
AND DEMAND CURVES
Individual Demand
To see where the demand curve for a normal good
comes from, consider Figure 4–20(a).

The important thing to notice is that the only

change that caused the consumer to move from A
to B was a change in the price of good X; income
and the price of good Y are held constant in the
diagram.
Market Demand
ANSWERING THE headLINE

If this worker were paid a wage of $24 for every

hour worked, his budget line would be HF. This
worker would obtain a higher indifference curve
at point C, where 12 hours of leisure are
consumed (12 hours of work).

When leisure is a normal good, the $24 wage

yields fewer hours of work from each worker than
does the overtime system. In addition, labor costs
are lower with overtime pay (point B) than a $24
wage (point C).