Managerial Economics &

Business Strategy
Chapter 4
The Theory of Individual
Behavior

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
 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
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
 Consumer Behavior
• Consumer Opportunities

The possible goods and services consumer can afford to
consume.
• Consumer Preferences

The goods and services consumers actually consume.
• Given the choice between 2 bundles of
goods a consumer either

Prefers bundle A to bundle B: A  B

Prefers bundle B to bundle A: A  B

Is indifferent between the two: A  B

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
 Indifference Curve Analysis
Indifference Curve Good Y

A curve that defines the
combinations of 2 or more goods III.
that give a consumer the same II.
level of satisfaction.
I.
Marginal Rate of
Substitution

The rate at which a consumer is
willing to substitute one good for
another and stay at the same
satisfaction level.
Good X

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Consumer Preference Ordering
• Completeness

The consumer is capable of expressing a preference for
all bundles of goods.
• More is Better
• Diminishing Marginal Rate of Substitution
• Transitivity

Given 3 bundles of goods: A, B & C.

If A  B and B  C, then A  C.

If A  B and B  C, then A  C.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
 The Budget Constraint
• Opportunity Set Y The Opportunity Set

The set of consumption bundles
that are affordable.
• PxX + PyY  M.
Budget Line
• Budget Line

The bundles of goods that exhaust a
consumers income. Px
• PxX + PyY = M. Py

• Market Rate of Substitution

X

The slope of the budget line
• -Px / Py
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
 Consumer Equilibrium
Y
• The equilibrium
consumption bundle is Consumer
Equilibrium
the affordable bundle
that yields the highest
level of satisfaction.
III.

II.
I.
X

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
 Changes in the Budget Line
Y
• Changes in Income

Increases lead to a parallel,
outward shift in the budget
line.

Decreases lead to a parallel,
downward shift.
X
• Changes in Price Y
New Budget Line for

A decreases in the price of a price decrease.
good X rotates the budget line
counter-clockwise.

An increases rotates the
budget line clockwise.
X
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
 Changes in Price
• Substitute Goods

An increase (decrease) in the price of good X leads to
an increase (decrease) in the consumption of good Y.
• Complementary Goods

An increase (decrease) in the price of good X leads to a
decrease (increase) in the consumption of good Y.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
 Complementary Goods
Pretzels (Y)
When the price of
good X falls, the
consumption of
complementary
good Y rises.

B
Y2
A II
Y1
I

0 X1 X2 Beer (X)

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
 Changes in Income
• 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 a inferior good if an increase (decrease) in
income leads to an decrease (increase) in its
consumption.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
 Normal Goods
Y
An increase in
income increases
the consumption of
normal goods.

A II

0 X

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
 Individual Demand Curve
Y
• An individual’s
demand curve is
derived from each new II
equilibrium point I

found on the $ X
indifference curve as
the price of good X is P0
varied. P1 D
X0 X1 X

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
 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 $ Market Demand Curve

Curves
50

40

D1 D2 DM
1 2 Q 1 2 3 Q

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
 A Classic Marketing
Application
Other
goods
(Y)

A
A buy-one,
C E
get-one free
D
pizza deal. II
I

0 0.5 1 2 B F Pizza
(X)

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999