MANAGERIAL ECONOMICS

BUS 525 [4 &5]: FALL 2021

NSU, SBE
CHAPTER: 3+4 CONSUMER CHOICE

 Topics to discuss
 Consumer Preferences

 Budget Constraints

 Consumer Choice

 Revealed Preference

 Marginal Utility and Consumer Choice

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 CONSUMER BEHAVIOR
 Theory of consumer behavior: Description of how
consumers allocate incomes among different goods and
services to maximize their well-being or utility or
satisfaction.
 Consumer behavior is best understood in three distinct
steps:
1. Consumer preferences (willingness factor)
2. Budget constraints (ability factor)
3. Consumer choices (demanding for the goods)

3
 CONSUMER PREFERENCES

Market Baskets
● Market basket (or bundle) List with specific quantities
of one or more goods.

TABLE 3.1 Alternative Market Baskets

Market Basket Units of Food Units of Clothing

A 20 30
B 10 50
Chapter 3: Consumer Behavior

D 40 20
E 30 40
G 10 20
H 10 40

To explain the theory of consumer behavior, we will ask

whether consumers prefer one market basket to another.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 8e. 4 of 37
 Consumer Theory
 Assumes buyers are completely informed
about:
 Range of products available
 Prices of all products
 Capacity of products to satisfy
 Their income
 Requires that consumers can rank all
consumption bundles based on the level of
satisfaction they would receive from
consuming the various bundles

5-5
CONSUMER PREFERENCES
 Few assumptions
 Completeness: Preferences are assumed to be complete. In other
words, consumers can compare and rank all possible baskets. Thus,
for any two market baskets A and B, a consumer will prefer A to B,
will prefer B to A, or will be indifferent between the two. [ A and B
give same utility; indifferent giving same satisfaction ]
 Transitivity: Preferences are transitive. Transitivity means that if
a consumer prefers basket A to basket B and basket B to basket C,
then the consumer also prefers A to C.
 More is better than less: Goods are assumed to be socially
desirable. Consumer would prefer a basket of 4X and 3Y basket over
a basket of 2X and 2Y.

[Goods: Higher is better than lower] 6

[Bads: less is better than more].
 Consumption Choice

Preferences
The choice that Lisa makes depends on her preferences
—her likes and dislikes.
Her benefit or satisfaction from consuming a good or
service is called utility.
Total Utility
Total utility ( TB :Total Benefit) is the total benefit a
person gets from the consumption of goods. Generally,
more consumption gives more total utility.

© 2010 Pearson Addison-Wesley

© 2010 Pearson Addison-Wesley
 Maximizing Utility

Marginal Utility
Marginal utility from a good is the change in total utility
that results from a unit-increase in the quantity of the good
consumed.
As the quantity consumed of a good increases, the
marginal utility from it decreases.
We call this decrease in marginal utility as the quantity of
the good consumed increases the principle of diminishing
marginal utility.

© 2010 Pearson Addison-Wesley

 Utility-Maximizing Choice
Assume Budget = $ 40;
In row C,
[ Pm*m+Ps*S = M= budget line]

MUm/Pm. = MUS/PS

Lisa is maximizing utility.

© 2010 Pearson Addison-Wesley

M/Pm = $40/$8 = 5
M/Ps = $40/$4 = 10
M/Ps / M/Pm = Pm/Ps = price ratio of two products
Px/Py

© 2010 Pearson Addison-Wesley

 Utility Maximization
Two products: X, Y
Px = Taka 5 , Py = Taka10 [ Px*X+Py*Y = M = Taka 200= Budget line]
U( X, Y) = 0.4x^2*y^2 [ Indifferent curve (same satisfaction at each point); utility
curve]
Slope of Budget line = Px/Py= Price ratio of two products = Taka5/Taka10 = 1/2

Slope of Indifference Curve = MUx/MUy = Utility ratio of two goods/services

MUx/MUy = 0.8Xy^2/0.8x^2y = y/x = utility ratio
dU/dX = MUx = 0.8XY^2 ; dU/dY = MUy= 0.8X^2Y
Px/Py = MUx/MUy [ budget line slope = indifference curve slope]
In general rule: Px/Py = MUx/Muy [ Budget line slope = Indifference curve slope

Rearrange: MUx/Px = MUy/Py = Equal marginal principle[ per Taka spent on X

or Y give same satisfaction]

© 2010 Pearson Addison-Wesley

 Solve it
Apply two step approach:
Step 1: Px/Py = MUx/Muy [ This is utility maximization principle]
½ = y/x; X = 2Y [1]
Step 2: Write the budget equation
Px*X+Py*Y = M
5X + 10Y = 200
5*2y + 10Y = 200
20Y = 200; Y = 10
X = 2Y = 2*10 = 20
Bundle is: 20X, 10Y [ Px*X+Py*Y = 200; [5*20+ 10*10 = 200]
U( x, y) = 0.4x^2*y^2 = 0.4*20^2*10^2 = 16000 = UTIL (Util is a unit of
measurement of satisfaction]

© 2010 Pearson Addison-Wesley

 MARGINAL UTILITY AND CONSUMER CHOICE

● Marginal utility (MU) Additional satisfaction obtained from consuming

one additional unit of a good.
● diminishing marginal utility Principle that as more of a good is
consumed, the consumption of additional amounts will yield smaller
additions to utility*.
0  MU (F )  MU (C )
F C
(C / F )  MU  MU (C )
F C
MRS  MU /MU (3.5)
F C
MRS  P / P (3.6)
F C
MU / MU  P / P
F C F C
MU / P  MU / P (3.7)
F F C C
● Equal marginal principle: Principle that utility is maximized
when the consumer has equalized the marginal utility per dollar of
expenditure across all goods.
* Please read right hand side of equation two as: MUf/MUc
 Utility Maximization

 Consumer allocates income so that the

marginal utility per dollar spent on each good
is the same for all commodities purchased
MUx/MUy = Px/Py
MUx/Px = MUy/Py
MU X MUY

PX PY

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 Example

The price of television ads is $400 per ad, the price of Radio Ad. is $ 300
MUt/Pt = MUrad/Prad [ 0.75 ; 2T, 4Rad ; PtT + Prad*Rad = $400*2+
$300*4 = 2000 [ 0.5; 6T, 5R; PtT + Prad*Rad = $400*6+$300*5 = 3900;
Optimum Combination for Budget $2000 is 2T, 4Radio]
 Example

A] If the decision maker chooses to use one unit of X, one unit of Y, and one unit of Z,
the total benefit [TB] that results is $ . [TB = 10*$1 + 22*$2 + 14*$3 = $96]
b.] For the fourth unit of activity Y, each dollar spent increases total benefit by
$ . The fourth unit of activity Y increases total benefit by $ . [ 10; TB = 10*$2 = $20]
c ]. Suppose the decision maker can spend a total of only $18 on the three activities.
What is the optimal level of X, Y, and Z? Why is this combination optimal? Why is
the combination 2X, 2Y, and 4Z not optimal? [1x, 4Y, 3Z; Px*X +Py*Y +Pz*Z = Taka 18; Mux/Px
=Muy/Py = Muz/Pz = 10; same benefit per $; 2X, 2Y, and 4Z not optimal because utility ratio are not
same; MUx/Px = 9; Muy/Py = 18; Muz/Pz = 9 ]
d.] Now suppose the decision maker has $33 to spend on the three activities. What is
the optimal level of X, Y, and Z? [ 5X, 5Y, 6Z : Px*X +Py*Y +Py*Z = Taka 33; for per Taka benefit =4;
 3.1 CONSUMER PREFERENCES

Ordinal versus Cardinal Utility

● Ordinal utility function Utility function that
generates a ranking of market baskets in order of
most to least preferred. [ A= 20 util, B = 35, C =15]

● Cardinal utility function Utility function

Chapter 3: Consumer Behavior

describing by how much one market basket is

preferred to another.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 8e. 19 of 37
 CONSUMER PREFERENCES: MEASURING UTILITY

 Indifference curve (IC): Curve

representing all combinations of
market baskets that provide a
consumer with the same level of
satisfaction.
[ -20C/10F = MRS = -2; Slope (-) of IC is

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known as MRS (Marginal rate of substitution:
Rate at which we substitute one product over
another while keeping the utility/satisfaction
fixed);
at A & D: MRS = -10C/20F = -0.5

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UTILITY FUNCTION
 Formula that assigns a level of utility to individual
market basket. For example,

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U(F, C) = F + 2C is the utility function
8 units food (F) and 3 units clothing (C) would provide
utility = 8 + 2(3) = 14 = UTIL
6 unit foods and 4 units clothing will provide the same
utility. [ UTIL = F+2C = 14]
But 4 units of food and 4 units of clothing do not yield the
same utility. [ UTIL = F+2C = 12; not same]
More is preferred to less: GOODs
Less is preferred over more: BADS 21
INDIFFERENCE CURVE (IC)
 Features or characteristics of IC
1. IC is downward slopping (because, with the fixed
income, a consumer has to reduce consumption of a

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product when consumption of another product rises)
2. IC is convex to the origin (because of diminishing
marginal rate of substitution)
3. ICs can’t intersect each other (by doing so, it violates
transitivity rule)
4. Higher the indifference curve more is the satisfaction
(because in a higher IC, consumer gets more products
than a lower IC)
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 Four Properties of Indifference Curves

Cloth
1. Indifference curves
are downward-
sloping.

A
I1

Food

THE THEORY OF CONSUMER CHOICE 23

 Four Properties of Indifference Curves

Cloth
2. Higher indifference
curves are preferred
to lower ones.

C
D
A I2
I1
I0
Food

THE THEORY OF CONSUMER CHOICE 24

 Four Properties of Indifference Curves

Cloth
3. Indifference curves
cannot cross.
I1: B = A
I4: C = A
B
B =C [ not correct]
C A
I1 I4

Food

THE THEORY OF CONSUMER CHOICE 25

 Four Properties of Indifference Curves

4. Indifference curves are Cloth

bowed inward/ convex to
the origin.

Slope of IC = -Change of A
Cloth/Change of Food
6
= - 6/1 = (Negative) slope
of IC = MRS = Marginal 1
Rate of Substitution B
2
1 I1

Food

THE THEORY OF CONSUMER CHOICE 26

 Marginal Rate of Substitution

 MRS shows the rate at which one good can

be substituted for another while keeping
utility constant
 Negative of the slope of the indifference curve
 Diminishes along the indifference curve as X
increases & Y decreases
 Ratio of the marginal utilities of the goods

Y MU X
MRS   
X MUY
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 3.1 CONSUMER PREFERENCES

Indifference Maps
● indifference map Graph containing a set of indifference curves
showing the market baskets among which a consumer is indifferent.

Figure 3.3

An Indifference Map

An indifference map is a set of

indifference curves that
describes a person's
preferences.
Chapter 3: Consumer Behavior

Any market basket on

indifference curve U3, such as
basket A, is preferred to any
basket on curve U2 (e.g.,
basket B), which in turn is
preferred to any basket on U1,
such as D.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 8e. 28 of 37
 EXCEPTIONS OF IC
 Perfect Substitute products: Two goods for which the
marginal rate of substitution [MRS] of one for the other is
a constant.

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 perfect complements Two goods for which the MRS is
zero or infinite; the indifference curves are shaped as right
angles.

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COMPARE THESE 3 ICS [ COMPARE PERFECT COMPLEMENT AND
DOWNWARD SLOPING IC ( IMPERFECT SUBSTITUTE]

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 MATHEMATICAL EXAMPLES. PAGE 120. EX. 5

 Suppose that Rahim and Karim spend their incomes on two

goods, food (F) and clothing (C). Rahim’s preferences are
represented by the utility function U(F,C) = 10FC , while

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Karim’s preferences are represented by the utility function
U(F,C)= 0.20F2C2.
 With food on the horizontal axis and clothing on the vertical
axis, identify on a graph the set of points that give Rahim the
same level of utility as the bundle (10,5). Do the same for
Karim on a separate graph.
 On the same two graphs, identify the set of bundles that give
Rahim and Karim the same level of utility as the bundle (15,8).
 Do you think Rahim and Karim have the same preferences or
different preferences? Explain.
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DRAWING OF INDIFFERENCE CURVE: MATH EXAMPLE

 Suppose that Rahim and Karim spend their incomes on

two goods, food (F) and clothing (C). Rahim’s
preferences are represented by the utility function U(F,C)
= 10FC , while Karim’s preferences are represented by

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the utility function U(F,C)= 0.20F2C2.
 With food on the horizontal axis and clothing on the
vertical axis, identify on a graph the set of points that
give Rahim the same level of utility as the bundle (10,5).
Do the same for Karim on a separate graph.

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PAGE 120. EX 5

For Rahim: Cloth

U(F,C) = 10FC = 10*10*5 = 500
10FC = 500
F*C = 50 [ Imperfect substitute:
you consume both product, at
different combinations

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Indifference points
= (25,2), (10, 5), (5, 10), (2, 25)
Karim
U(F,C)= 0.20F2C2. =0.2*10^2*5^2
0.20F^2*C^2 = 500
F^2*C^2 = 500/ 0.2 = 2500
F*C = 50 [ Take route over]

Food

Both Rahim and Karim has same preference for food and cloth when the bundle is (10, 5)

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 BUDGET LINE
[ INCOME, BUDGET, MONEY]
 It shows different combinations of goods and services that an individual can
buy with his/her income.
 Show the impact of change in income on budget line

Slope of the budget line is the price

ratio of two goods under
consideration: Slope = M/Pc / M/Pf
= Pf/Pc. [ I/Pf = 40; 40/Pf = 40; Pf
= $1; I/Pc = 20, Pc = 2]

Income Change: Pf and Pc are

constant; Income increases, Budget
line shifts parallelly rightwards
(leftwards: income goes down)
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 CHANGE IN BUDGET LINE WITH A CHANGE IN PRICE
Price Changes A change in
the
price of one good (with income
unchanged) causes the budget
line
to rotate about one intercept.

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When the price of food falls
from $1.00 to $0.50, the budget
line
rotates outward from L1 to L2.
However, when the price
increases
from $1.00 to $2.00, the line
rotates
inward from L1 to L3.

Price Change: Budget is

constant, One of the product’s
price may change
( increase/decrease)
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MATHEMATICAL EXAMPLE. EX 10, PAGE 121

Samira buys five new college textbooks during his first

year at school at a cost of $80 each. Used books cost
only $50 each. When the bookstore announces that there
will be a 10 percent increase in the price of new books

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and a 5 percent increase in the price of used books,
Samira’s father offers her $40 extra.
A) What happens to Samira’s budget line? Illustrate
the change with new books on the vertical axis.
B) Is Samira worse or better off after the price change?
Explain.

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LET US SOLVE:
Pn*n+ Pu*u = M = $ 400 = $80*5
80*n + 50*u = 400 [ Budget equation]
M = $ 400; u = $400/50 = 8; n = $400/80 = 5
Draw the Budget line.

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Price of New Book = $80(1.10) = $88 = 80 + 80*10% = 80
(1+0.1) = 80(1.1)
Used Book = $50(1.05) = $ 52.5
Her father gives her additional $ 40:
New Budget = $400+ $40 = $440;
Now New book = $440/$88 = 5 New book
Used Book = $440/$52.5 = 8.38 Used Books
Income Change or Price Change? Condition improved with
37
respect to used book.
MATHEMATICAL EXAMPLE
 Sonia has a monthly income of $200 = M= Budget] that
she allocates among two goods: meat and potatoes.
Suppose meat costs $4 per pound and potatoes $2 per
pound. Draw her budget constraint.
 Suppose also that her utility function is given by the
equation U(m, P) = 0.20m2P2. What combination of meat
and potatoes should she buy to maximize her utility?
Pm/Pp =?
MUm = ? MUp =?
1) Pm/Pp = Mum/Mup
2) Pm*m+ Pp*P = M = $200

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LET US SOLVE
Utility Maximization Principle:
MUx/MUy = Px/Py [ slope of Indifference curve = Slope of Budget
Line]
Or: MUx/Px = MUy/Py
……………………………………………………………...

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U(m, P) = 0.20m2P2
dU/dm = MUm = 0.2*2m2-1 p^2 = 0.4mp^2
dU/dP = MPp = 0.2m^2*2*P2-1 = 04m^2p
Slope of IC = MUm/MUp = 0.4mp^2 / 04m^2p = p/m
Slope of Budget line = Pm/Pp = Taka 4/Taka 2 = 2

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CONT.

2 Step Approach:

1) MUm/MUp = Pm/Pp [ utility maximization rule]

p/m = 2; P = 2m
2) Write the budget equation: Pm*m+ Pp*P = M = Taka 200

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4m + 2*2m = 200; 8m = 200; m = 25; P = 2m = 50

M = Taka 200; Pm = Taka 4, Pp = Taka 2

U(m, P) = 0.20m2P2
= 0.2*25^2*50^2 = 312500 = UTIL ( UTIL is the unit of account of utility)

Utility Maximum Bundle :

Meat = 25 Unit
Potato = 50 Units

U(m, P) = 0.20m2P2= 0.2*25^2*50^2 = 312500 = UTIL

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I = Income ; M = Money; B = Budget
 EXAMPLE

Suppose a consumer has the indifference map shown below. The relevant budget line
is LZ. The price of good Y is $10.
a. What is the consumer’s income? [ M/Py = 50, M = Taka 500= Income]
b. What is the price of X? [ M/Px = 40, Px = 12.5]
c. Write the equation for the budget line LZ. [ PxX+PyY= 12.5X+ 10Y= M = Taka500]
d. What combination of X and Y will the consumer choose? Why? [20X = Taka 12.5* 20 = Taka 250,
Y = Taka 250/10 = 25Y]
e. What is the marginal rate of substitution at this combination? [ MRS = MUx/MUy = Px/Py =
12.5/10 = 1.25]
f. Explain in terms of the MRS why the consumer would not choose combinations designated by A or
B. [ At A, MUx/Muy< Px/Py; at B; Mux/Muy> Px/Py
g. Suppose the budget line pivots to LM, income remaining constant. What is the new
price of X? What combination of X and Y is now chosen?
h. What is the new MRS?

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BUDGET LINE LM , WHAT IS PX =? [M/PX = 80; 500/PX = 80; PX
= TAKA 6.25 ; MRS = PX/PY = TAKA 6.25/TAKA 10 = 0.625

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42
CHAPTER 4: PAGE 120, PROVE THAT PRICE EFFECT = SUBSTITUTION EFFECT +
INCOME EFFECT
INCOME AND SUBSTITUTION EFFECT

 When price of a product [ Normal product] declines, it

has two important effects
1) People can get that product at a cheaper price thus the
ability or purchasing power rises
2) People may not increase the consumption of the
product to maximum thus there is an income gain.

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PRICE, INCOME AND SUBSTITUTION EFFECT:
NORMAL GOODS [ PLEASE SEE TEXT BOOK: P. 120]

 Substitution effect: It shows

the change in consumption
of a product (whose price

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has changed) while keeping
the utility constant. For
example, even if the
consumer can consume F1F2
extra, they will actually
consume F2E. Thus EF2 is
income gain.

44
 Giffen Goods

THE THEORY OF CONSUMER CHOICE 45

PRICE CHANGE AND
INDIVIDUAL DEMAND CURVE
 Effect of price change:
When price of one
product decreases, that

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will rotate the budget
line, hence the demand
curve of the product can
be drawn.
 Price consumption curve:
curve tracking the utility
maximizing
combinations.
46
INCOME CHANGE AND
CONSUMER’S RESPONSE
 If income increases
with price constant,
the consumers will

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demand more of a
normal product

47
ENGEL CURVE
 Curve relating the
quantity of a good
consumed to income.

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 In (a), food is a normal
good and the Engel
curve is upward sloping.
In (b), however, rotten
rice is inferior good
after a certain income
level.

48
4.5 NETWORK EXTERNALITIES

● network externality When each individual’s

demand depends on the purchases of other
individuals.
A positive network externality exists if the quantity of a
good demanded by a typical consumer increases in
response to the growth in purchases of other
consumers. If the quantity demanded decreases, there
is a negative network externality.
The Bandwagon Effect
● bandwagon effect Positive network externality
in which a consumer wishes to possess a good in
part because others do.
Is a cash subsidy better than a Food stamps
Cash Subsidy vs food stamps
Cash subsidy vs Food stamp
Cash Subsidy vs Food stamps