sahid university managerial economics ch4 the theory of individual behavior

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Ch 4. The Theory of Ch 4. The Theory of Individual Behavior Individual Behavior 1

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Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

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Page 1: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Ch 4. The Theory of Ch 4. The Theory of Individual BehaviorIndividual Behavior

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Page 2: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Consumer BehaviorConsumer BehaviorAssume 2 goods exist in the

economy.

Assume a consumer is able to order his or her preferences for alternative bundles or combinations of goods from best to worst.

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Page 3: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Consumer BehaviorConsumer BehaviorA > B the consumer prefers bundle A

to bundle B.

A – B the consumers view the two

bundles as equally satisfying. He or she indifferent between bundles A and B.

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Page 4: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Consumer BehaviorConsumer BehaviorThe preference ordering is The preference ordering is

assumed to satisfy four basic assumed to satisfy four basic properties:properties:

1. Completeness. 2. More is better. 3. Diminishing marginal rate of substitution. 4. Transitivity.

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Page 5: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Consumer BehaviorConsumer BehaviorCompleteness:Completeness: - for any two bundles, say A and

B, either A > B, B > A, A – B.

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Page 6: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Consumer BehaviorConsumer BehaviorMore is better:More is better: - for any two bundles, say A and

B, either A > B, B > A, A – B.

Figure 4-1 Page 120.

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Page 7: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Consumer BehaviorConsumer BehaviorDiminishing marginal rate of Diminishing marginal rate of

substitution:substitution: - As a consumer obtains more of

good X, the rate at which he or she is willing to substitute good X for

good Y decreases.

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Page 8: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Consumer BehaviorConsumer BehaviorTransitivity:Transitivity: - For any three bundles, A, B,

and C, if A > B and B > C, then A > C. Similarly A – B, and B – C, then

A - C

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Page 9: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

The Budget ConstraintThe Budget ConstraintBudget set:Budget set: The bundles of goods a

consumer can afford.

Px X + Py Y equals or less M

The budget set.

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Page 10: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

The Budget ConstraintThe Budget ConstraintBudget line:Budget line: The bundles of goods that

exhaust a consumer’s income.

Px X + Py Y = M

The budget line.

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Page 11: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Changes In IncomeChanges In IncomeChanges in income shrink or

expand opportunities.

Figure 4-5 Page 126.

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Page 12: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Changes In PricesChanges In PricesFigure 4-6 Page 127.

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Page 13: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Consumer EquilibriumConsumer EquilibriumThe objective of the consumer is to

choose the consumption bundle that maximizes his or her utility, or satisfaction.

Consumer equilibrium:Consumer equilibrium: The affordable bundle that yields

the greatest satisfaction to the consumer.

Figure 4-8 Page 128.13

Page 14: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Consumer EquilibriumConsumer Equilibrium

Consumer equilibrium:Consumer equilibrium: MRS = (Px / Py) MRS = marginal rate of

substitution Px = price of good X Py = price of good Y

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Page 15: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Comparative StaticsComparative Statics(Price Changes and Consumer Behavior)(Price Changes and Consumer Behavior)

A change in the price of a good will lead to a change in the equilibrium consumption bundle.

Figure 4-9 Page 130. Change in consumer equilibrium

due to a decrease in the price of good X (Note: that good Y is a substitute for good X).

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Page 16: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Comparative StaticsComparative Statics(Price Changes and Consumer Behavior)(Price Changes and Consumer Behavior)

Figure 4-10 Page 131. When the price of good X falls,

the consumption of complementary good Y rises.

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Page 17: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Comparative StaticsComparative Statics(Income Changes and Consumer (Income Changes and Consumer Behavior)Behavior)

Figure 4-11 Page 132. An increase in income increases

the consumption of normal goods.

Figure 4-12 Page 133. An increase in income decreases

the equilibrium consumption of good X (an inferior good).

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Page 18: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Conceptual and Conceptual and Computational QuestionsComputational Questions1. A consumer has $400 to spend on goods X and Y. The market prices of these two

goods are Px = $10 and Py = $40. 1.a. Illustrate the consumer’s opportunity set in a carefully labeled diagram. 1.b. Show how the consumer’s opportunity set changes if income increases by $400. How does the $400 increases in income alter the market rate of substitution between goods X and Y?

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Page 19: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Conceptual and Conceptual and Computational QuestionsComputational Questions2. A consumer must divide $250 between the

consumption of product X and product Y. The relevant market prices are Px=$5 and Py=$10.

2.a. Write the equation for the consumer’s budget line. 2.b. Illustrate the consumer’s opportunity set

in a carefully labeled diagram. 2.c. Show how the consumer’s opportunity set

changes when the price of good X

increases to $10?

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Page 20: Sahid University Managerial Economics Ch4 the Theory of Individual Behavior

Conceptual and Conceptual and Computational QuestionsComputational Questions3. A consumer is in equilibrium at point A in the

accompanying figure (Figure at page 148). The price of good X is $5.

3.a. What is the price of good Y?

3.b. What is the consumer’s income?

3.c. At point A, how many units of good X does

the consumer purchase?

3.d. Suppose the budget line changes so that the

consumer achieves a new equilibrium at

point B. What change in the economic

environment led to this new equilibrium? Is

the consumer better off or worse off as a

result of the price change?

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