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The Theory of Individual Behavior

This document discusses theories of individual consumer behavior, including: 1) Indifference curve analysis which graphs combinations of goods that provide the same level of satisfaction; 2) Budget constraints which define the set of affordable goods given prices and income; and 3) Consumer equilibrium which occurs where the highest indifference curve is tangent to the budget constraint. Changes in income or prices shift the budget constraint, impacting consumption of normal versus inferior goods. Individual demand curves are derived from tracing equilibrium points as prices vary.

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Kashif Raheem
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154 views21 pages

The Theory of Individual Behavior

This document discusses theories of individual consumer behavior, including: 1) Indifference curve analysis which graphs combinations of goods that provide the same level of satisfaction; 2) Budget constraints which define the set of affordable goods given prices and income; and 3) Consumer equilibrium which occurs where the highest indifference curve is tangent to the budget constraint. Changes in income or prices shift the budget constraint, impacting consumption of normal versus inferior goods. Individual demand curves are derived from tracing equilibrium points as prices vary.

Uploaded by

Kashif Raheem
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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The Theory of Individual Behavior

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

4-2

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.

4-3

4-7

Indifference Curve Analysis


Indifference Curve

A curve that defines the


combinations of 2 or more goods
that give a consumer the same
level of satisfaction.

Good Y
III.
II.
I.

Marginal Rate of
Substitution

The rate at which a consumer is


willing to substitute one good for
another and maintain the same
satisfaction level.

Good X

Consumer Preference Ordering


Properties

Completeness
More is Better
Diminishing Marginal Rate of Substitution
Transitivity

4-8

4-9

Complete Preferences
Completeness Property

Consumer is capable of
expressing preferences (or
indifference) between all possible
bundles. (I dont know is NOT
an option!)
If the only bundles available
to a consumer are A, B, and
C, then the consumer
is indifferent between A and
C (they are on the same
indifference curve).
will prefer B to A.
will prefer B to C.

Good Y
III.
II.
I.
A

Good X

4-10

More Is Better!
More Is Better Property

Bundles that have at least as much of


every good and more of some good
are preferred to other bundles.
Bundle B is preferred to A since
B contains at least as much of
good Y and strictly more of good
X.
Bundle B is also preferred to C
since B contains at least as much
of good X and strictly more of
good Y.
More generally, all bundles on
ICIII are preferred to bundles on
ICII or ICI. And all bundles on
ICII are preferred to ICI.

Good Y
III.
II.
I.
100

33.33

Good X

Diminishing Marginal Rate of


Substitution
Marginal Rate of Substitution

The amount of good Y the consumer is


willing to give up to maintain the same
satisfaction level decreases as more of good
X is acquired.
The rate at which a consumer is willing to
substitute one good for another and
maintain the same satisfaction level.

4-11

Good Y

To go from consumption bundle A to


B the consumer must give up 50 units 100
of Y to get one additional unit of X.
To go from consumption bundle B to
50
C the consumer must give up 16.67
units of Y to get one additional unit of
33.33
X.
25
To go from consumption bundle C to
D the consumer must give up only
8.33 units of Y to get one additional
unit of X.

III.
II.
I.
A

B
C

Good X

4-12

Consistent Bundle Orderings


Transitivity Property

Good Y

For the three bundles A, B, and C,


the transitivity property implies
that if C B and B A, then C
A.
Transitive preferences along with
the more-is-better property imply 100
75
that
50
indifference curves will not
intersect.
the consumer will not get
caught in a perpetual cycle of
indecision.

III.
II.
I.
A
C
B

7 Good X

4-13

The Budget Constraint


Opportunity Set

The set of consumption bundles


that are affordable.
PxX + PyY M.

The Opportunity Set

Budget Line
M/PY

Y = M/PY (PX/PY)X

Budget Line

The bundles of goods that exhaust a


consumers income.

PxX + PyY = M.

Market Rate of Substitution

The slope of the budget line


-Px / Py

M/PX

4-15

Changes in the Budget Line


Y

Changes in Income

Increases lead to a parallel,


outward shift in the budget
line (M1 > M0).
Decreases lead to a parallel,
downward shift (M2 < M0).

M1/PY

M0/PY

M2/PY

Changes in Price

A decreases in the price of


good X rotates the budget line
counter-clockwise (PX0 > PX1).

Y
M0/PY

M2/PX

M0/PX

M1/PX

New Budget Line for


a price decrease.

An increases rotates the


budget line clockwise (not
shown).
M0/PX0

M0/PX1

4-16

Consumer Equilibrium
The equilibrium
consumption bundle is
the affordable bundle
that yields the highest
level of satisfaction.

Consumer equilibrium
occurs at a point where
MRS = PX / PY.
Equivalently, the slope of
the indifference curve
equals the budget line.

Y
M/PY

Consumer
Equilibrium

III.
II.
I.
M/PX

Income Changes and Consumer


Equilibrium
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 an inferior good if an increase (decrease) in


income leads to a decrease (increase) in its
consumption.

4-17

4-18

Normal Goods
An increase in
income increases
the consumption of
normal goods.

Y
M1/Y

(M0 < M1).


B

Y1
M0/Y

II

Y0

I
0

X0 M0/X

X1

M1/X

4-19

Decomposing the Income and


Substitution Effects
Initially, bundle A is consumed.
A decrease in the price of good
X expands the consumers
opportunity set.

The substitution effect (SE)


causes the consumer to move
from bundle A to B.

II

A higher real income allows


the consumer to achieve a
higher indifference curve.
The movement from bundle B to
C represents the income effect
(IE). The new equilibrium is
achieved at point C.

B
I

IE
SE

4-20

Individual Demand Curve


Y

An individuals
demand curve is
derived from each new
equilibrium point
found on the
indifference curve as
the price of good X is
varied.

II
I
$

P0
P1

D
X0

X1

4-21

Conclusion
Indifference curve properties reveal information
about consumers preferences between bundles of
goods.

Completeness.
More is better.
Diminishing marginal rate of substitution.
Transitivity.

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