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ECONOMICSECONOMICS

FOR MANAGERSFOR MANAGERS

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OVERVIEWOVERVIEW

Utility Theory 

Indifference Curves

Budget Constraints

Individual Demand

Demand Curves and Consumer Surplus

Consumer Choice

Optimal Consumption

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Chapter 4Chapter 4

KEY CONCEPTSKEY CONCEPTS utility  nonsatiation principle indifference ordinal utility  cardinal utility 

utility function utils market baskets marginal utility  law of diminishing marginal utility  indifference curves

substitutes complements perfect substitutes perfect complements

budget constraint income effect substitution effect price-consumption curve income-consumption curve

Engle curve normal goods inferior goods consumer surplus two-part pricing  bundle pricing 

optimal market basket revealed preference marginal rate of substitution consumption path

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Utility Theory

Assumptions  About Consumer Preferences More is better.

Consumers can rank preferences.

Consumers ran-order desirability of products. Utility Functions

Descriptive statement relates well-being and consumption.

Marginal Utility 

Added benefit is focus of consumers. Law of Diminishing Marginal Utility 

Marginal utility eventually declines for everything.

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Indifference Curves

Basic Characteristics of Indifference Curves

Higher indifference curves are better.

Indifference curves do not intersect. Indifference curves slope downward.

Indifference curves are concave to origin.

Perfect Substitutes and Perfect Complements

Perfect substitutes satisfy the same need.

Perfect complements are consumed together.

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Budget Constraints

Basic Characteristics of Budget Constraints

Shows affordable combinations of X and Y.

Slope of ²PX /P Y reflects relative prices. Effects of Changing Income and Changing 

Prices

Budget increase causes parallel outward shift.

Budget decrease causes parallel inward shift.

Income and Substitution Effects

Income (substitution) effect is change in overall

(relative) consumption.

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Individual Demand

Price-consumption Curve

Shows how consumption is affected by price changes

(movement along demand curve).

Income-consumption Curve Shows how consumption is affected by income changes

(shifts from one demand curve to another).

Engle Curves

Plot between income and quantity consumed.

Consumption of normal goods rises with income.

Consumption of inferior goods falls with income (rare).

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Consumer Choice

Marginal Utility and Consumer Choice

Optimal consumption maximizes utility.

Optimal consumption reflects marginal utility (benefits) and marginal costs.

Revealed Preference

Documented desire.

Buyer decisions can be used to infer consumerpreferences.

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Optimal Consumption

Marginal Rate of Substitution (MRS)

MRSXY = -MUX /MU Y and equals indifference curveslope.

MRSXY shows tradeoff in the amount of X and Y consumed, holding utility constant.

MRSXY diminishes as amount of substitution of X 

for Y increases. Utility Maximization

Optimality requires PX /P Y = MUX /MU Y .

Optimality requires MUX /PX = MU Y /P Y .

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