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Chapter 4 The Theory of Individual Behavior

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31 views4 pages

Chapter 4 The Theory of Individual Behavior

Uploaded by

Kyla Chelsey Bucasas
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 4:

The Theory of Individual Behavior

Consumer Behavior The Budget Constraint


❖ Consumer opportunities ❖ Budget constraint
o Set of possible goods and o Restriction set by prices and
services consumers can afford income that limits bundles of
to consume. goods affordable to consumers.

❖ Consumer preferences o Budget set:


o Determine which set goods and
services will be consumed. 𝑃𝑋 𝑋 + 𝑃𝑌 𝑌 ≤ 𝑀

Properties of Consumer Preferences o Budget line:


❖ Property 1 – Completeness: For any
two bundles of goods either: 𝑃𝑋 𝑋 + 𝑃𝑌 𝑌 = 𝑀
o 𝐴 ≻ 𝐵.
o 𝐵 ≻ 𝐴. The Budget Constraint in Action
o 𝐴 ∼ 𝐵.

❖ Property 2 – More is better.


o If bundle 𝐴 has at least as much
of every good as bundle 𝐵 and
more of some good, bundle 𝐴 is
preferred to bundle 𝐵.

❖ Property 3 – Diminishing marginal rate


of substitution.
o As a consumer obtains more of
good X, the amount of good Y The Market Rate of Substitution
the individual is willing to give
up to obtain another unit of
good X decreases.

❖ Property 4- Transitivity: For any three


bundles, 𝐴, 𝐵, and 𝐶, either:
o If 𝐴 ≻ 𝐵 and 𝐵 ≻ 𝐶, then 𝐴 ≻ 𝐶.
o If 𝐴 ∼ 𝐵 and 𝐵 ∼ 𝐶, then 𝐴 ∼ 𝐶.

Constraints
❖ While any decision-making
environment faces a host of
constraints, the focus of managerial
economics is to examine the role
prices and income play in constraining
consumer behavior.
Changes in Income Shrink or Expand Consumer Equilibrium
Opportunities ❖ Consumer equilibrium
o Consumption bundle that is
affordable and yields the
greatest satisfaction to the
consumer.

o Consumption bundle where the


rate a consumer choses
(marginal rate of substitution)
to trade between goods X and Y
equals the rate at which these
goods are traded in the market
A Decrease in the Price of Good X (market rate of substitution).

𝑃𝑋
𝑀𝑅𝑆 =
𝑃𝑌

Consumer Equilibrium

The Budget Constraint in Action


❖ Consider the following budget line:

100 = 1𝑋 + 5𝑌
Price Changes and Consumer Behavior
o What is the maximum amount of
❖ Price and income changes impact a
X that can be consumed?
consumer’s budget set and level of
o What is the maximum amount of
satisfaction that can be achieved.
Y that can be consumed?
o What is rate at which the market
o This implies that price and
trades goods X and Y?
income changes will lead to
consumer equilibrium changes.
❖ Answers:
100
o Maximum X is: 𝑋 = = 100 Price Changes and Equilibrium
1
units ❖ Price increases (decreases) reduce
o Maximum Y is: 𝑌 =
100
= 20 (expand) a consumer’s budget set.
5
units
❖ The new consumer equilibrium
o Market rate of substitution:
𝑃𝑋 1 resulting from a price change depends
− =− on consumer preferences:
𝑃𝑌 5
o Goods X and Y are: Income Changes and Consumption
▪ substitutes when an
increase (decrease) in
the price of X leads to an
increase (decrease) in
the consumption of Y.
▪ complements when an
increase (decrease) in
the price of X leads to a
decrease (increase) in
the consumption of Y.

Substitution and Income Effects


Price Changes and Equilibrium in
❖ Moving from one equilibrium to
Action
another when the price of one good
changes can be broken down into two
effects:

o Substitution effect: The


movement along a given
indifference curve that results
from a change in the relative
prices of goods, holding real
income constant.

Income Changes and Consumer o Income effect: The movement


Behavior from one indifference curve to
❖ Income increases (decreases) reduce another that results from the
(expand) a consumer’s budget set. change in real income caused
by a price change.
❖ The new consumer equilibrium
resulting from an income change Substitution and Income Effects in
depends on consumer preferences: Action

o Good X is:
▪ a normal good when an
increase (decrease) in
income leads to an
increase (decrease) in
the consumption of X.
▪ an inferior good when
an increase (decrease)
in income leads to a
decrease (increase) in
the consumption of X.
Applications of Indifference Curve Indifference and Demand Curves
Analysis ❖ Indifference curves along with price
❖ Choices by consumers changes determine individuals’
o Buy one, get one free demand curves.
o Cash gifts, in-kind gifts, and gift ❖ Market demand is the horizontal
certificates summation of individuals’ demands.

❖ Choices by workers and managers From Indifference Curves to Individual


o Income-leisure choice Demand
o Managers preferences

Consumer Choice with a Gift


Certificate

From Individual to Market Demand

Labor-Leisure Choice Model

Labor-Leisure Budget Set in Action


❖ What is the budget set for a worker
who receives $5 per hour of work and
a fixed payment of $40? Let 𝐸 denote
the worker’s total earnings and 𝐿 the
number of leisure hours in a 24-hour
day.

𝐸 = $40 + $5(24 − 𝐿) = $160 − $5L

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