MANAGERIAL ECONOMICS &

BUSINESS STRATEGY
The Theory of Individual
Behavior

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
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OVERVIEW

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
 4-3
CONSUMER BEHAVIOR
• 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.
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INDIFFERENCE CURVE ANALYSIS

Indifference Curve Good Y

• A curve that defines the
III.
combinations of 2 or more goods
that give a consumer the same level II.
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
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CONSUMER PREFERENCE ORDERING PROPERTIES

• Completeness
• More is Better
• Diminishing Marginal Rate of Substitution
• Transitivity
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COMPLETE PREFERENCES

• Completeness Property
• Consumer is capable of expressing Good Y
preferences (or indifference) III.
between all possible bundles. (“I
don’t know” is NOT an option!) II.
• If the only bundles available to a consumer I.
are A, B, and C, then the consumer A
B
• is indifferent between A and C (they are
on the same indifference curve).
• will prefer B to A.
C
• will prefer B to C.

Good X
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MORE IS BETTER!

• More Is Better Property

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

1 3
Good X
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DIMINISHING MARGINAL RATE OF SUBSTITUTION

• Marginal Rate of Substitution

• The amount of good Y the consumer is Good Y
willing to give up to maintain the same
satisfaction level decreases as more of good X III.
is acquired.
• The rate at which a consumer is willing to II.
substitute one good for another and maintain
the same satisfaction level. I.
• To go from consumption bundle A to B the 100 A
consumer must give up 50 units of Y to get
one additional unit of X.
• To go from consumption bundle B to C the B
50
consumer must give up 16.67 units of Y to C
get one additional unit of X. 33.33 D
• To go from consumption bundle C to D the 25
consumer must give up only 8.33 units of
Y to get one additional unit of X.
1 2 3 4 Good X
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CONSISTENT BUNDLE ORDERINGS

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

1 2 5 7 Good X
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THE BUDGET CONSTRAINT

• Opportunity Set
Y The Opportunity Set
• The set of consumption bundles that are affordable.

• PxX + PyY  M. Budget Line

• Budget Line M/PY Y = M/PY – (PX/PY)X
• The bundles of goods that exhaust a
consumers income.
• PxX + PyY = M.
• Market Rate of Substitution
• The slope of the budget line
M/PX
• -Px / Py X
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CHANGES IN THE BUDGET LINE

Y
M1/PY
• Changes in Income
• Increases lead to a parallel,
M0/PY
outward shift in the budget line
(M1 > M0).
M2/PY
• Decreases lead to a parallel,
downward shift (M2 < M0).
• Changes in Price M2/PX M0/PX M1/PX
X
Y
• A decreases in the price of good New Budget Line for
X rotates the budget line M0/PY a price decrease.
counter-clockwise (PX0 > PX1).

• An increases rotates the budget

line clockwise (not shown).

M0/PX M0/PX
X
0 1
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CONSUMER EQUILIBRIUM

• The equilibrium consumption bundle is the Y

affordable bundle that yields the highest level of
satisfaction. M/PY
Consumer
Equilibrium
• Consumer equilibrium occurs at a point
where
MRS = PX / PY.
• Equivalently, the slope of the indifference
curve equals the budget line. III.
II.
I.
M/PX
X
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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.
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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

DE COMPOSING T HE INCOME AND SUBST ITUT ION

E FFECT S

Initially, bundle A is consumed. Y

A decrease in the price of good
X expands the consumer’s
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
0 X
(IE). The new equilibrium is SE
achieved at point C.
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A CLASSIC MARKETING APPLICATION

Other
goods
(Y)

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

0 0.5 1 2 B F Pizza
(X)
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INDIVIDUAL DEMAND CURVE

Y
• An individual’s demand curve is
derived from each new equilibrium
point found on the indifference
curve as the price of good X is
II
varied.
I

$ X

P0

P1 D

X0 X1 X
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MARKET DEMAND

• The market 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
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CONCLUSION

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