Lecture Managerial economics (Ninth edition): Chapter 5 – Thomas, Maurice

Chapter 5 - Theory of consumer behavior. In this chapter, you learned to: Explain the concept of utility and the basic assumptions underlying consumer preferences; explain the equilibrium condition for an individual consumer to be maximizing utility subject to a budget constraint; use indifference curves to derive a demand curve for an individual consumer;...

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The Consumer’s Optimization Problem

• Individual consumption decisions

are made with the goal of maximizing total satisfaction from consuming various goods and

services

• Subject to the constraint that spending on goods  exactly equals the individual’s money income

• Requires that consumers can rank all

consumption bundles based on the level of satisfaction they would receive from consuming the various bundles

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Typical Consumption Bundles for Two Goods, X & Y (Figure 5.1)

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Properties of Consumer Preferences

• Completeness

• For every pair of consumption bundles, A and B, the  consumer can say one of the following:

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Utility

• Benefits consumers obtain from

goods & services they consume is

utility

• A utility function shows an

individual’s perception of the utility level attained from consuming

each conceivable bundle of goods

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Indifference Curves

• Locus of points representing

different bundles of goods, each of which yields the same level of total utility

• Negatively sloped & convex

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Typical Indifference Curve

(Figure 5.2)

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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

X Y

MU

Y MRS

X MU

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Marginal Utility

• Addition to total utility attributable

to the addition of one unit of a good to the current rate of

consumption, holding constant the amounts of all other goods

consumed

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Consumer’s Budget Line

• Shows all possible commodity

bundles that can be purchased at given prices with a fixed money income

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Consumer’s Budget Constraint

X

M P

X

Y Y

P M

P P

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Utility Maximization

• Utility maximization subject to a

limited money income occurs at the combination of goods for which the indifference curve is just tangent to the budget line

Y MRS

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Utility Maximization

• Consumer allocates income so that

the marginal utility per dollar spent

on each good is the same for all commodities purchased

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Individual Consumer Demand

• An individual’s demand curve for a

specific commodity relates maximizing quantities purchased to market prices

utility-• Money income & prices held constant

• Slope of demand curve illustrates law of demand— quantity demanded varies inversely with price

100 0

0

Px=$10

Px=$5 Px=$8

90 65 50

90 65 50

5

8 10

Demand for X

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Market Demand & Marginal Benefit

• List of prices & quantities consumers are

willing & able to purchase at each price, all else constant

• Derived by horizontally summing

demand curves for all individuals in market

• Because prices along market demand

measure the economic value of each unit

of the good, it can be interpreted as the marginal benefit curve for a good

5 4 3

3

12 13

5 8 10

0

7 10

1 3 5

0

6 8

0 1 4

3

25 31

6 12 19

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Derivation of Market Demand

Figure (5.10)

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Substitution & Income Effects

• When price changes, total change in

quantity demanded is composed of two parts

• Substitution effect

• Income effect

original indifference curve

• Income effect

• Change in consumption of a good resulting strictly  from a change in purchasing power

decrease

= Substitution effect + Income effect

9 = 5 + 4

Total effect of price

decrease

= Substitution effect + Income effect

3 = 5 + (-2)

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Substitution & Income Effects

• Consider the substitution effect

alone:

• Amount of good consumed must vary inversely with  price

• Income effect reinforces the

substitution effect for a normal good & offsets it for an inferior good

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Summary of Substitution &