CHAPTER 4

The Theory of Individual Behavior

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 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
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Education. All Rights workers and managers. 2
 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.

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 Consumer Behavior

Properties of Consumer Preferences

•• Property
  1- Completeness: For any two bundles of goods either:
–.
–.
–.
• Property 2- More is better
– If bundle has at least as much of every good as bundle and more of
some good, bundle is preferred to bundle .
• 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, , , and , either:
– If and , then .
– If and , then .

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 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.

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 Constraints

The Budget Constraint

•  Budget constraint
– Restriction set by prices and income that limits
bundles of goods affordable to consumers.
– Budget set:

– Budget line:

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 Constraints

The Budget Constraint In Action

  Good

 𝑀
𝑃𝑌 Slope
Bundle H
 𝑃 𝑋   Budget set:

 𝑃𝑌   Budget line:

Bundle G

0  𝑀   Good
𝑃𝑋

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 Constraints

The Market Rate of Substitution

  Good

 5

 
Market rate of substitution : Tại sao ra công
4
  thức v ~~

  Budget line:

 3

0  2 4
  1  0   Good

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 Constraints
Changes in Income Shrink or Expand
  Good
Opportunities
1
 𝑀
𝑃𝑌

0
 𝑀
𝑃𝑌

 𝑀 ↑
2
 𝑀
 𝑀 ↓
𝑃𝑌

2
0  𝑀  𝑀
0 1
 𝑀   Good
𝑃𝑌 𝑃𝑌 𝑃𝑌

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 Constraints

A Decrease in the Price of Good X

  Good
0
 𝑃 𝑋 > 𝑃 𝑋1
 𝑀
𝑃𝑌

New budget line

Initial budget
line

0  𝑀  𝑀   Good
0 1
𝑃𝑋 𝑃𝑋

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 Constraints

The Budget Constraint in Action

•  Consider the following budget line:

– 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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 Constraints

The Budget Constraint in Action

•  Answers:
– Maximum X is: units
– Maximum Y is: units
– Market rate of substitution:

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 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).

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 Consumer Equilibrium

Consumer Equilibrium
  Good

A
B Consumer equilibrium

III
II
I

0   Good

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 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.

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 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.

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 Comparative Statics

Price Changes and Equilibrium in

  Good Action
 𝑀 Point A: Initial consumer equilibrium
𝑃𝑌   Price of good X decreases:
Point B: New consumer equilibrium
  Since when :
Conclude that goods and are
A substitutes
𝑌
  0 B
𝑌
  1

II
I

0  𝑋 0   𝑀  𝑋   𝑀   Good
1
𝑃𝑋0 𝑃𝑋 1

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 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.
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 Comparative Statics

Income Changes and Consumption

  Good
1 Point A: Initial consumer equilibrium
 𝑀
  Price of income increases:
𝑃𝑌
Point B: New consumer equilibrium
 𝑀
0  Since more of both goods are consumed
when : Conclude that goods
𝑃𝑌 B and are normal goods.

A
II

I
0 1
0  𝑀  𝑀   Good
𝑃𝑋 𝑃𝑋
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 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. (áo khoác 20k-aoas khoác 1200k)
– Income effect: The movement from one indifference curve to
another that results from the change in real income caused by
a price change.

– The income effect is the change in the consumption of goods by consumers

based on their income.
– The substitution effect happens when consumers replace cheaper items with
more expensive ones when their financial conditions change.

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

C A

H
0  𝑋 1  𝑋 𝑀  𝑋 0 I G   Good
Income Substitution
effect effect
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 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

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 Consumer Choice with a Gift Applications of Indifference Curves

Certificate
Good Y
Point A: Initial consumer equilibrium
  Receive a $10 gift certificate for good :

  Point B: higher utility holding

0 consumption at initial level
 𝑀
 Point C: new consumer equilibrium
𝑃𝑌 when and are normal
C goods
𝑌
  2
A
𝑌
  1
B II
I

 𝑋 1  𝑋 2
0 0
0  𝑀  𝑀 + $ 10 Good X
𝑃𝑋 𝑃𝑋

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 Applications of Indifference Curves

Labor-Leisure Choice Model

Income III
(per day) II
I

$  240

E Worker equilibrium
$  80

0 1  6 2  4 Leisure
(hours per day)
16 hours of leisure 8 hours of work

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 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 denote the worker’s
total earnings and the number of leisure
hours in a 24-hour day.

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 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.

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 The Relationship Between Indifference
Curve Analysis and Demand Curves

From Indifference Curves to Individual Demand

  Good  Price of
good

 𝑃 𝑋1

A
 𝑃 𝑋2
B

I II
Demand

0  𝑋 1  𝑋 2   Good  𝑋 1  𝑋 2   Good

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 The Relationship Between Indifference
Curve Analysis and Demand Curves

From Individual to Market Demand

 Price of  Price of
good good
$  60

A B A B A+B
$  40

Demandmkt

DemandA DemandB

0 1  0 2  0   Good 1  0 2  0 30
    Good

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