Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Managerial Economics &
Business Strategy
Chapter 4
The Theory of Individual
Behavior
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
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
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
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
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Indifference Curve Analysis
Indifference Curve
? A curve that defines the
combinations of 2 or more goods
that give a consumer the same
level of satisfaction,
Marginal Rate of
Substitution
? The rate at which a consumer is
willing to substitute one good for
another and stay at the same
satisfaction level,
I,
II,
III,
Good Y
Good X
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Consumer Preference Ordering
? Completeness
? The consumer is capable of expressing a preference for
all bundles of goods,
? More is Better
? Diminishing Marginal Rate of Substitution
? Transitivity
? Given 3 bundles of goods,A,B & C,
? If A ? B and B ? C,then A ? C,
? If A ? B and B ? C,then A ? C,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
The Budget Constraint
? Opportunity Set
? The set of consumption bundles
that are affordable,
? PxX + PyY ? M,
? Budget Line
? The bundles of goods that exhaust a
consumers income,
? PxX + PyY = M,
? Market Rate of Substitution
? The slope of the budget line
? -Px / Py
Y
X
The Opportunity Set
Px
Py
Budget Line
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Consumer Equilibrium
? The equilibrium
consumption bundle is
the affordable bundle
that yields the highest
level of satisfaction,
I,
II,
III,
X
Y
Consumer
Equilibrium
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Changes in the Budget Line
? Changes in Income
? Increases lead to a parallel,
outward shift in the budget
line,
? Decreases lead to a parallel,
downward shift,
? Changes in Price
? A decreases in the price of
good X rotates the budget
line counter-clockwise,
? An increases rotates the
budget line clockwise,
X
Y
X
Y
New Budget Line for
a price decrease,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Changes in Price
? Substitute Goods
? An increase (decrease) in the price of good X leads to
an increase (decrease) in the consumption of good Y,
? Complementary Goods
? An increase (decrease) in the price of good X leads to a
decrease (increase) in the consumption of good Y,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Complementary Goods
When the price of
good X falls,the
consumption of
complementary
good Y rises,
Pretzels (Y)
Beer (X)
II
I
0
Y2
Y1
X1 X2
A
B
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Changes in Income
? 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 a inferior good if an increase (decrease) in
income leads to an decrease (increase) in its
consumption,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Normal Goods
An increase in
income increases
the consumption of
normal goods,
Y
II
I
0
A
B
X
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Individual Demand Curve
? An individual’s
demand curve is
derived from each new
equilibrium point
found on the
indifference curve as
the price of good X is
varied,
X
Y
$
X
D
II
I
P0
P1
X0 X1
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
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,
Q
$ $
Q
50
40
D2 D1
Individual Demand
Curves
Market Demand Curve
1 2 1 2 3
DM
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
A Classic Marketing
Application
Other
goods
(Y)
II
I
0
A
C
B F
D
E
Pizza
(X)
0.5 1 2
A buy-one,
get-one free
pizza deal,