Managerial Economics:

MANAGERIAL
ECONOMICS
Theory of Consumer
 PRESENTATION OUTLINE
•Consumer Behaviour
•Constraints to Consumer Behaviour
•Consumer Equilibrium
•Comparative Statics of Consumer Equilibrium
•Application of Indifference Curve Analysis
•Utility Maximization

1-2
 CONSUMER BEHAVIOUR
•A consumer is an individual or group who
purchases goods or services from firms for
consumption.
•Although consumers purchase goods and
services with the motive of consumption, it is
not always direct.
•For example, if a parent buys pizza for his child,
the child only consumes but is not responsible
for the purchase decision.
1-3
 CONSUMER BEHAVIOUR
(CONT’D)
•It is the parent’s behavior that we must therefore
understand, not the child’s.
•Behavior pertains to the aggregate of acts or
reactions that an organism, an individual, or a
system produces in response to a particular
circumstance.
•Consumer behavior therefore refers to the actions
and decisions that people or households make
when they choose, buy, use, and dispose of a
product or service.
1-4
 FACTORS THAT AFFECT
CONSUMER BEHAVIOR
Different factors affect consumer behavior namely:
•Psychological Factors (eg. perception, motivation,
attitudes, and beliefs).
•Social Factors (eg. social environment, including
family, peers, culture, and social class).
•Personal Factors (eg. age, gender, personality, etc.).
•Economic Factors (eg. income, prices, and
availability of credit).

1-5
 OPPORTUNITIES AND
PREFERENCES
There are two important but distinct factors
to consider in the area of consumer behavior
•Consumer Opportunities: The possible
goods and services consumers can afford
to consume.
•Consumer Preferences: The goods and
services consumers actually consume.
1-6
 ASSUMPTIONS
Let assume that there are two goods in this world
•Good Y and Good X
Assume a consumer is able to order his or her
preferences for alternative combinations or bundles of
good from best to worst. 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.
1-7
 REFLECTING REALITY
•Consumers are faced with choices among
multiple goods.
•Preferences are subjective and can vary among
individuals.
•Preferences are not always clear-cut.
•Preferences can change over time.
•External factors influence preferences.
1-8
 INDIFFERENCE CURVE
ANALYSIS
 It is a curve that defines the Good Y
combinations of 2 or more goods that III.
give a consumer the same level of
satisfaction. II.
• Because consumers prefer more I.
consumption to less, higher
indifference curves are preferred to
lower ones
• The idea that buyers can rank
preferences from best to worst (or
vice versa) is captured by expected
utility theory
• Any point on III is preferred to any Good X
points on I and II .
1-9
 PREFERENCE ORDERING
PROPERTIES
The preference ordering is assumed to
satisfy four fundamental properties.
•Completeness
•More is Better
•Diminishing Marginal Rate of Substitution
•Transitivity
1-10
 COMPLETENESS
Consumer is capable of expressing Good Y
preferences (or indifference) III.
between all possible bundles. (“I
don’t know” is NOT an option!) II.
I.
If the only bundles available to a
consumer are A, B, and C, then the A B
consumer
•is indifferent between A and C
(they are on the same indifference C

curve).
•will prefer B to A.
Good X
•will prefer B to C.
1-11
 MORE IS BETTER
•Bundles that have at least as much of Good Y
every good and more of some good
are preferred to other bundles. III.

•Bundle B is preferred to A since B II.

contains at least as much of good Y I.
and strictly more of good X.
A B
•Bundle B is also preferred to C since 100

B contains at least as much of good

X and strictly more of good Y. C
33.33
•More generally, all bundles on ICIII
are preferred to bundles on ICII or
1 3
ICI. And all bundles on ICII are Good X
preferred to ICI
1-12
 DIMINISHING MRS
•The rate at which a consumer is Good Y
willing to substitute one good for
another and maintain the same III.
satisfaction level. II.
•To go from consumption bundle A to I.
B the consumer must give up 50 units 100 A
of Y to get one additional unit of X.
•To go from consumption bundle B to 50
B
C the consumer must give up 16.67 C
units of Y to get an 1 more of X. 33.33 D
25
•To go from consumption bundle C to
D the consumer must give up only
8.33 units of Y to get one more of X. 1 2 3 4 Good X
This explains why IC curves are
convex from the origin. 1-13
 DIMINISHING MRS
•The rate at which a consumer is Good Y
willing to substitute one good for
another and maintain the same III.
satisfaction level. II.
•To go from consumption bundle A to I.
B the consumer must give up 50 units 100 A
of Y to get one additional unit of X.
•To go from consumption bundle B to 50
B
C the consumer must give up 16.67 C
units of Y to get an 1 more of X. 33.33 D
25
•To go from consumption bundle C to
D the consumer must give up only
8.33 units of Y to get one more of X. 1 2 3 4 Good X
This explains why IC curves are
convex from the origin. 1-14
 TRANSITIVITY
•For the three bundles A, B, and Good Y
C, the transitivity property III.
implies that if C  B and B 
II.
A, then C  A..
I.
Transitive preferences along 100 A
with the more-is-better property 75
C

imply that 50
B

•indifference curves will not

intersect.
•the consumer will not get
1 2 5 7 Good X
caught in a perpetual cycle of
indecision. 1-15
 STANDARD ECONOMIC
MODEL
•When you walk into a shop, you are invariably
confronted with wide range of goods.
•Most people have limited financial resources and
cannot buy everything they want.
•Therefore, how are purchasing choices made?
One assumption might be that, you consider
• the constraint; that is your income
• the prices of the various goods being offered for sale and
• the value they represent; value is the worth of an individual of owning
an item represented by the satisfaction derived from its consumption
1-16
 STANDARD ECONOMIC
MODEL (CONT’D)
There are some key assumptions of the standard
economic model which is important to keep in mind.
These assumptions are:
•Buyers (or economic agents) are rational
•More is preferred to less
•Buyers seek to maximize their utility
•Utility is the satisfaction derived from consumption.
•Consumers act in self-interest and do not consider
the utility of others.
1-17
 TOTAL AND MARGINAL
UTILITY
• Given the assumption that, consumers prefer more to less,
intuition might tell us that total utility increases as
consumption increases.
• However, this may be true up to a point.
For instance:
• You have walked for 15 hours. You are hot, sweaty and very
thirsty.
• After some few minutes, you came across ‘an ice water
seller’ and decided to buy some.
• If you were asked to rate the satisfaction derived from
consuming the 1st sachet out of 10 (utils) at that time you
might rate it at 10. 1-18
 TOTAL AND MARGINAL
UTILITY (CONT’D)
• You order a 2nd sachet as you are still thirsty; the 2 nd sachet
still brings some satisfaction, but if asked to rate it you
might give it 8
• Total utility now is 18 utils – the second sachet has
increased total utility
• However, you did not rate the 2nd sachet quite as high as
the 1st because some of your thirst has been quenched
• Marginal utility measures the addition to total utility as a
result of the consumption of an extra unit.
• The marginal utility of the 1st sachet was 10 but for the 2nd sachet
marginal utility was 8.
1-19
TOTAL AND MARGINAL
UTILITY (CONT’D)

1-20
 CONSTRAINTS
In making decisions, individuals face
constraints. These include:
•Legal constraints
•Time constraints
•Physical constraints
•Budget constraints
1-21
 BUDGET CONSTRAINT
•Simply stated, the budget constraint restricts
consumer behavior by forcing the consumer
to select a bundle of goods that is affordable.
•If a consumer has only GHS30 in his or her
pocket when reaching the checkout line in
the supermarket, the total value of the goods
the consumer presents to the cashier cannot
exceed GHS30.
1-22
 BUDGET CONSTRAINT
(CONT’D)
•Because the consumer is restricted by his
budget.
•Thus budget constraint restricts consumer
behavior by forcing the consumer to select a
bundle of goods that is affordable.
•Let; M = Consumer’s income, Px = Price of
good X, Py = Price of good Y
1-23
 BUDGET CONSTRAINT
(CONT’D)
Opportunity Set (Budget set) Y Opportunity Set
• The set of consumption bundles that
are affordable. Budget Line
PxX + PyY  M. M/PY Y = M/PY – (PX/PY)X
Budget Line
• The bundles of goods that exhaust a
consumers income. Px B
PxX + PyY = M. H Py
Unaffordable

Market Rate of Substitution

• The slope of the budget line Affordable
M/PX
X
-Px / Py.
1-24
 MARKET RATE OF
SUBSTITUTION
This figure represents a budget line for
a consumer who has Ȼ 10 in income
and faces the following: Price of good Y
Y is Ȼ2, Price of good X is Ȼ1 5
B
4

The slope of the budget line is -1/2. 3

A

The reason the budget line represents

substitution between two goods is as
follows: 2 4
10 X

At bundle A; 3 units of Y, 4 units of X

At bundle B; 4 units of Y, 2 units of X

1-25
 CHANGES IN THE BUDGET
LINE Y
M1/PY
Changes in Income
• Increases lead to a parallel, outward M0/PY

shift in the budget line (M1 > M0).

• Decreases lead to a parallel, M2/PY

downward shift (M2 < M0).

M2/PX M0/PX M1/PX X
Changes in Price Y
• A decrease in the price of good X New Budget Line
M0/PY for a price
rotates the budget line counter- decrease.
clockwise (PX0 > PX1).
• An increase rotates the budget line
clockwise (not shown). X
M0/PX0 M0/PX1
1-26
 ILLUSTRATION 1
A consumer has initial income of Ȼ100 and faces
prices of Px = Ȼ1 and Py = Ȼ5. Graph the budget line,
compute the slope of the budget line and show how it
changes when the price of good X increases to Px =
Ȼ5.

1-27
 CONSUMER EQUILIBRIUM
The equilibrium consumption Y
bundle is the affordable
Consumer
bundle that yields the highest M/PY A Equilibrium
level of satisfaction. B
•Consumer equilibrium •D
occurs at a point where C
MRS = PX / PY. III.

•Equivalently, the slope of II.

I.
the indifference curve M/PX
equals the budget line. X
1-28
 EQULIBRIUM AND PRICE
CHANGES
•A change in the price of a good will lead to a
change in the equilibrium consumption
bundle.
•A fall in price of any good rotates the budget
constraint outward and changes the slope of
the budget constraint and vice versa.
•The opportunity set either expands or shrinks.
1-29
 SUBSTITUTE/
COMPLEMENTARY GOODS
Substitute Goods
•An increase (decrease) in the price of good X leads to an
increase (decrease) in the consumption of good Y.
•Examples: Coke and Pepsi, Delay Mackerel and Geisha.
Complementary Goods
•An increase (decrease) in the price of good X leads to a
decrease (increase) in the consumption of good Y.
•Examples: Herb Afrik and Lime, Computer CPUs and
monitors.
1-30
 SUBSTITUTE GOODS
Pepsi (Y)
When the price of
good Coke (X) falls
and the consumption M/PY1

of Pepsi (Y) falls,

then X and Y are Y A
B
substitute goods. 1
Y2

(PX1 > PX2) I II

0 X1 M/PX X2 M/PX Coke (X)

1 2

1-31
 COMPLEMENTARY GOODS
When the price of Credit (Y)
Phones (X) falls
and the M/PY
1

consumption of
Credit (Y) rises,
then Phones and B
Y2
Credit are II
A
complementary Y1

goods. I
0 X1 M/PX X2 M/PX2 Phones
(PX1 > PX2)
1

(X)

1-32
 EQULIBRIUM AND INCOME
CHANGES
•A change in income also will lead to a
change in the consumption patterns of
consumers.
•An increase in income shifts the budget
constraint outward and vice versa.
•The consumer is able to choose a better
combination of goods on a higher
indifference curve.
1-33
 NORMAL VERSUS INFERIOR
GOODS
•If a consumer buys more of a good when
his or her income rises, the good is called a
normal good and the opposite is true.
•If a consumer buys less of a good when his
or her income rises, the good is called an
inferior good and vice versa.

1-34
 NORMAL GOODS
Y
An increase in
income increases M1/Y
the consumption of
normal goods.
(M0 < M1).
B
Y1
M0/Y
II
A
Y0
I
X0 M0/X X1 M1/X X
0

1-35
 INFERIOR GOODS
Y
If we assume that
good X is an M1/Y
inferior good. An Y1
increase in income
decreases the II
consumption of B
good X (inferior M0/Y
good).
A
Y0
(M0 < M1). I
X1 X0 M0/X M1/X X
0

1-36
 INCOME AND
SUBSTITUTION EFFECTS
•Initially, bundle A is consumed. A Y
decrease in the price of good X expands
the consumer’s opportunity set.
•The substitution effect (SE) causes the
consumer to move from bundle A to B. C

•A higher “real income” allows the A II

consumer to achieve a higher
indifference curve. B

•The movement from bundle B to C I

represents the income effect (IE). The
new equilibrium is achieved at point C.
IE X
0
SE

1-37
 INCOME AND
SUBSTITUTION EFFECTS
•Substitution effect is the movement along a given
indifference curve that results from a change in the
relative prices of goods, holding real income
constant.
•Income effect is the movement from one
indifference curve to another that results from the
change in real income caused by a price change.
•The total effect of a price increase thus is
composed of substitution and income effects.
1-38
 ILLUSTRATION 2
A consumer has $300 to spend on goods X and Y. The
market prices of these two goods are Px=$15 and Py=$5.
a. What is the market rate of substitution between goods X
and Y?
b. Illustrate the consumer’s opportunity set in a carefully
labeled diagram.
c. Show how the consumer’s opportunity set changes if
income increases by $300. How does the $300 increase in
income alter the market rate of substitution between goods
X and Y?
1-39
 APPLICATION
Model of Income and Leisure:
•Most workers view both leisure and income as goods
and substitute between them at a diminishing rate
along an indifference curve.
•Note that while workers enjoy leisure, they also enjoy
income.
•To induce workers to give up leisure, firms must
compensate them.
1-40
 ILLUSTRATION 3
Suppose a worker is offered a wage of Ȼ5 per hour,
plus a fixed payment of Ȼ40.
a.What is the equation for the worker’s opportunity set
in a given 24-hour day?
b.What are the maximum total earnings the worker can
earn in a day? The minimum?
c. What is the price to the worker of consuming an
additional hour of leisure?
1-41
 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
varied.
D

1-42
 MARKET DEMAND CURVE
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 30 60 Q 1 2 3 60 1-43
 UTILITY MAXIMIZATION
Given prices of Px and Py and a level of income M,
the consumer attempts to maximize utility subject to
the budget constraint. Formally, this problem can be
solved by forming the Lagrangian:
If you are given U=U(X,Y) and M= PxX+PyY
Then
L = U(X,Y) + λ [M – PxX – PyY]

1-44
 ILLUSTRATION 4
Suppose that a consumer’s utility function is
a.If Px = 5, Py = 10, and the consumer’s money income is M =
1,000, what are the optimal values of X and Y?
b.Derive the consumer’s demand equations for goods X and Y.
c.Prove that for a demand curve to be downward sloping, the
first derivative with respect to price must be negative.
d.Prove that for a demand curve to be convex with respect to
the origin, the second derivative with respect to price must be
positive.
1-45
THANK YOU