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

B, either A > B, B > A, A – B.

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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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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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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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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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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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Changes In IncomeChanges In IncomeChanges in income shrink or

expand opportunities.

Figure 4-5 Page 126.

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Changes In PricesChanges In PricesFigure 4-6 Page 127.

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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

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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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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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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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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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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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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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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