Managerial Economics & Business Strategy

Chapter 4The Theory of Individual

Behavior

Can we do it??

• On the next slide are schedules which show the total utility measured in terms of utiles which President

Strassburger would get by purchasing various amounts of product Apples, Bananas, Carrots, and Donuts.

Assume that the price of Bananas is $4, the price of Donuts is $18, the price of Apples is $1, the price of

Carrots is $6, and that President Strassburger’s income is $135. What quantities of Bananas, Donuts, Apples,

and Carrots will President Strassburger purchase?

Can you do it??B TU MU MU

/PD TU MU MU

/PA TU MU MU

/PC TU MU MU

/P

1 24 1 126 1 7 1 36

2 44 2 234 2 13 2 66

3 60 3 324 3 18 3 90

4 72 4 396 4 22 4 108

5 82 5 450 5 25 5 120

6 90 6 486 6 27.5 6 129

7 96 7 513 7 29 7 135

8 100 8 531 8 30 8 138

Can you do it??B TU MU MU

/PD TU MU MU

/PA TU MU MU

/PC TU MU MU

/P

1 24 --- 1 126 --- 1 7 --- 1 36 ---

2 44 20 2 234 108 2 13 6 2 66 30

3 60 16 3 324 90 3 18 5 3 90 24

4 72 12 4 396 72 4 22 4 4 108 18

5 82 10 5 450 54 5 25 3 5 120 12

6 90 8 6 486 36 6 27.5 2.5 6 129 9

7 96 6 7 513 27 7 29 1.5 7 135 6

8 100 4 8 531 18 8 30 1 8 138 3

Can you do it??B TU MU MU

/PD TU MU MU

/PA TU MU MU

/PC TU MU MU

/P

1 24 --- --- 1 126 --- --- 1 7 --- --- 1 36 --- ---

2 44 20 5 2 234 108 6 2 13 6 6 2 66 30 5

3 60 16 4 3 324 90 5 3 18 5 5 3 90 24 4

4 72 12 3 4 396 72 4 4 22 4 4 4 108 18 3

5 82 10 2.5 5 450 54 3 5 25 3 3 5 120 12 2

6 90 8 2 6 486 36 2 6 27.5 2.5 2.5 6 129 9 1.5

7 96 6 1.5 7 513 27 1.5 7 29 1.5 1.5 7 135 6 1

8 100 4 1 8 531 18 1 8 30 1 1 8 138 3 0.5

Can you do it??B TU MU MU

/PD TU MU MU

/PA TU MU MU

/PC TU MU MU

/P

1 24 --- --- 1 126 --- --- 1 7 --- --- 1 36 --- ---

2 44 20 5 2 234 108 6 2 13 6 6 2 66 30 5

3 60 16 4 3 324 90 5 3 18 5 5 3 90 24 4

4 72 12 3 4 396 72 4 4 22 4 4 4 108 18 3

5 82 10 2.5 5 450 54 3 5 25 3 3 5 120 12 2

6 90 8 2 6 486 36 2 6 27.5 2.5 2.5 6 129 9 1.5

7 96 6 1.5 7 513 27 1.5 7 29 1.5 1.5 7 135 6 1

8 100 4 1 8 531 18 1 8 30 1 1 8 138 3 0.5

Consumer Preference Ordering Properties

• Completeness Every individual can state their preferences NO “I don’t know”

• More is Better• Diminishing Marginal Rate of Substitution

As you get more good X the rate at which you are willing to substitute good X for good Y decreases

Have too much X don’t want more Shows indifference curves are CONVEX

• Transitivity If prefer A to B and B to C then prefer A to C IC cannot cross

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 maintain the same satisfaction level.

Slope

I.

II.

III.

Good Y

Good X

Diminishing Marginal Rate of Substitution

• Marginal Rate of Substitution slope

• 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.

I.

II.

III.

Good Y

Good X1 3 42

100

50

33.33 25

A

B

CD

What was???

• The slope of the indifference curve?

Marginal rate of substitution

• MRS MRS = MUx/MUy

Along an indifference curve

yx MUYMUX **

y

x

MU

MU

X

Y

Doesn’t like risk!! STEEP indifference curveNeed BIG increase in return to give up a little risk

Likes risk!! FLAT Indifference CurveWill give up a lot of safety for a littleIncrease in return

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

Budget Line

Y = M/PY – (PX/PY)XM/PY

M/PX

Market Rate of Substitution

•

income

P

P

income

X

Y x

y

*

x

y

Pincome

Pincome

X

Y

y

x

P

P

X

Y

Changes in the Budget Line• 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

X

Y

X

YNew Budget Line for a price decrease.

M0/PY

M0/PX

M2/PY

M2/PX

M1/PY

M1/PX

M0/PY

M0/PX0M0/PX1

M2/PX2

New Budget Line for a price increase.

Consumer Equilibrium

• 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.

I.

II.

III.

X

Y

Consumer Equilibrium

M/PY

M/PX