Managerial Economics & Business Strategy

1. Managerial Economics & Business Strategy Chapter 4 The Theory of Individual Behavior

2. 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.

3. Consumer Behavior • Consumer Opportunities • The possible goods and services consumer can afford to consume. • Consumer Preferences • The goods and services consumers actually consume.

4. Indifference Curve Analysis Good Y 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 maintain the same satisfaction level. III. II. I. Good X

5. Consumer Preference Ordering Properties • Completeness • More is Better • Diminishing Marginal Rate of Substitution • Transitivity

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

7. 100 33.33 1 3 More Is Better! Good Y • More Is Better Property • Bundles that have at least as much of every good and more of some good are preferred to other bundles. • Bundle B is preferred to A since B contains at least as much of good Y and strictly more of good X. • Bundle B is also preferred to C since B contains at least as much of good X and strictly more of good Y. • More generally, all bundles on ICIII are preferred to bundles on ICII or ICI. And all bundles on ICII are preferred to ICI. III. II. I. A B C Good X

8. 100 50 33.33 25 1 2 3 4 Diminishing MRS Good Y • MRS • The amount of good Y the consumer is willing to give up to maintain the same satisfaction level decreases as more of good X is acquired. • The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level. • To go from consumption bundle A to B the consumer must give up 50 units of Y to get one additional unit of X. • To go from consumption bundle B to C the consumer must give up 16.67 units of Y to get one additional unit of X. • To go from consumption bundle C to D the consumer must give up only 8.33 units of Y to get one additional unit of X. III. II. I. A B C D Good X

9. 100 75 50 1 7 5 Consistent Bundle Orderings Good Y • Transitivity Property • For the three bundles A, B, and C, the transitivity property implies that if C  B and B  A, then C  A. • Transitive preferences along with the more-is-better property imply that • indifference curves will not intersect. • the consumer will not get caught in a perpetual cycle of indecision. III. II. I. A C B 2 Good X

10. Budget Line Y = M/PY – (PX/PY)X The Budget Constraint The Opportunity Set Y • 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. M/PY M/PX X

11. M1/PY M2/PY M2/PX M1/PX New Budget Line for a price decrease. M0/PY M0/PX0 M0/PX1 Changes in the Budget Line Y • 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 (not shown). M0/PY X M0/PX Y X

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

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.

14. One Extreme Case: Perfect Substitutes Perfect substitutes: two goods with straight-line indifference curves, constant MRS Example: nickels & dimes • Consumer is always willing to trade two nickels for one dime.

15. Y2 II Y1 I X1 X2 M/PX2 Complementary Goods When the price of good X falls and the consumption of Y rises, then X and Y are complementary goods. (PX1 > PX2) Pretzels (Y) M/PY1 B A 0 M/PX1 Beer (X)

16. Another Extreme Case: Perfect Complements Perfect complements: two goods with right-angle indifference curves Example: left shoes, right shoes • {7 left shoes, 5 right shoes} • is just as good as • {5 left shoes, 5 right shoes}

17. Optimization: What the Consumer Chooses The optimal bundle is at the point where the budget constraint touches the highest indifference curve. MRS = relative priceat the optimum: The indiff curve and budget constraint have the same slope.

18. 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.

19. M1/Y Y1 M0/Y II Y0 I M0/X X0 X1 M1/X Normal Goods Y An increase in income increases the consumption of normal goods. (M0 < M1). B A X 0

20. C II B IE SE Decomposing the Income and Substitution Effects Y 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. A I X 0

21. GiffenGoods • Do all goods obey the Law of Demand? • Suppose the goods are potatoes and meat,and potatoes are an inferior good. • If price of potatoes rises, • substitution effect: buy less potatoes • income effect: buy more potatoes • If income effect > substitution effect, then potatoes are a Giffen good, a good for which an increase in price raises the quantity demanded.

22. GiffenGoods

23. Wages and Labor Supply Budget constraint • Shows a person’s tradeoff between consumption and leisure. • Depends on how much time she has to divide between leisure and working. • The relative price of an hour of leisure is the amount of consumption she could buy with an hour’s wages. Indifference curve • Shows “bundles” of consumption and leisure that give her the same level of satisfaction.

24. Wages and Labor Supply At the optimum, the MRS between leisure and consumption equals the wage.

25. Wages and Labor Supply An increase in the wage has two effects on the optimal quantity of labor supplied. • Substitution effect(SE): A higher wage makes leisure more expensive relative to consumption. The person chooses less leisure, i.e., increases quantity of labor supplied. • Income effect (IE): With a higher wage, she can afford more of both “goods.” She chooses more leisure, i.e., reduces quantity of labor supplied.

26. Wages and Labor Supply For this person, SE > IE So her labor supply increases with the wage

27. Wages and Labor Supply For this person, SE < IE So his labor supply falls when the wage rises

28. Could This Happen in the Real World??? Over last 100 years, technological progress has increased labor demand and real wages. The average workweek fell from 6 to 5 days.

29. Interest Rates and Saving • A person lives for two periods. • Period 1: young, works, earns $100,000 consumption = $100,000 minus amount saved • Period 2: old, retired consumption = saving from Period 1 plus interest earned on saving • The interest rate determinesthe relative price of consumption when young in terms of consumption when old.

30. Interest Rates and Saving Budget constraint shown is for 10% interest rate. At the optimum, the MRS between current and future consumption equals the interest rate.

31. ACTIVE LEARNING 5: Effects of an interest rate increase • Suppose the interest rate rises. • Determine the income and substitution effects on current and future consumption, and on saving. 31

32. ACTIVE LEARNING 5: Answers The interest rate rises. Substitution effect • Current consumption becomes more expensive relative to future consumption. • Current consumption falls, saving rises, future consumption rises. Income effect • Can afford more consumption in both the present and the future. Saving falls. 32

33. Interest Rates and Saving In this case, SE > IE and saving rises

34. Interest Rates and Saving In this case, SE < IE and saving falls 34

35. Other goods (Y) A A buy-one, get-one free pizza deal. C E D II I 0.5 1 2 0 B F Pizza (X) A Classic Marketing Application

36. Y II I X $ D X 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. P0 P1 X0 X1

37. 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 Curves $ Market Demand Curve 50 40 D1 D2 DM Q 1 2 3 1 2 Q

38. 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.

39. CONCLUSION:Do People Really Think This Way? • Most people do not make spending decisions by writing down their budget constraints and indifference curves. • Yet, they try to make the choices that maximize their satisfaction given their limited resources. • The theory in this chapter is only intended as a metaphor for how consumers make decisions. • It does fairly well at explaining consumer behavior in many situations, and provides the basis for more advanced economic analysis.