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;...
Managerial Economics ninth edition Thomas Maurice Chapter Theory of Consumer Behavior McGrawHill/Irwin McGrawHill/Irwin Managerial Economics, 9e Managerial Economics, 9e Copyright © 2008 by the McGrawHill Companies, Inc. All rights reserved Managerial Economics 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 52 Managerial Economics 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 53 Managerial Economics Typical Consumption Bundles for Two Goods, X & Y (Figure 5.1) 54 Managerial Economics Properties of Consumer Preferences • Completeness • For every pair of consumption bundles, A and B, the consumer can say one of the following: A is preferred to B B is preferred to A The consumer is indifferent between A and B • Transitivity • If A is preferred to B, and B is preferred to C, then A must be preferred to C • Nonsatiation • More of a good is always preferred to less 55 Managerial Economics 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 56 Managerial Economics Indifference Curves • Locus of points representing different bundles of goods, each of which yields the same level of total utility • Negatively sloped & convex 57 Managerial Economics Typical Indifference Curve (Figure 5.2) 58 Managerial Economics 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 MRS 59 Y X MU X MUY Managerial Economics Slope of an Indifference Curve & the MRS (Figure 5.3) Quantity of good Y 600 A T C (360,320) 320 I T’ B 360 Quantity of good X 5 800 Managerial Economics Typical Budget Line Quantity of Y M PY (Figure 5.6) •A Y M PY PX X PY B • 5 Quantity of X M PX Managerial Economics Shifting Budget Lines (Figure 5.7) 100 80 R A Quantity of Y Quantity of Y 120 F A B N C B D 160 200 240 125 200 250 Z 5 100 Quantity of X Quantity of X Pane l A – Chang e s in mo ne y inc o me Pane l B – Chang e s in pric e o f X Managerial Economics 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 MRS 5 Y X MU X MUY PX PY Managerial Economics Utility Maximization • Consumer allocates income so that the marginal utility per dollar spent on each good is the same for all commodities purchased MU X PX 5 MUY PY Managerial Economics Constrained Utility Maximization (Figure 5.8) 50 45 •A 40 •B E IV • R 30 •D s azzi pf o ytit nau Q III 20 C • 15 10 10 20 30 40 50 60 Quantity of burgers 5 70 II T I 80 90 100 Managerial Economics Individual Consumer Demand • An individual’s demand curve for a specific commodity relates utilitymaximizing quantities purchased to market prices • Money income & prices held constant • Slope of demand curve illustrates law of demand— quantity demanded varies inversely with price 5 Managerial Economics Deriving a Demand Curve (Figure 5.9) Quantity of Y 100 Px=$10 Px=$8 Px=$5 Price of X ($) 50 65 90 100 125 200 Quantity of X 10 Demand for X 5 50 65 90 Quantity of X Managerial Economics Market Demand & Marginal Benefit 5 • 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 Managerial Economics Derivation of Market Demand (Table 5.1) Quantity demanded Consumer Consumer Consumer Market demand $6 0 5 12 10 19 12 25 13 10 31 Price 5 Managerial Economics Derivation of Market Demand Figure (5.10) 5 Managerial Economics Substitution & Income Effects • When price changes, total change in quantity demanded is composed of two parts • Substitution effect • Income effect 5 Managerial Economics Substitution & Income Effects • Substitution effect • Change in consumption of a good after a change in its price, when the consumer is forced by a change in money income to consume at some point on the original indifference curve • Income effect • Change in consumption of a good resulting strictly from a change in purchasing power 5 Managerial Economics Income & Substitution Effects: A Decrease in Px (Figure 5.12) Total effect of = Substitution+ Income price effect effect decrease = +4 5 Total effect of = Substitution+ Income price effect effect decrease = + (-2) Managerial Economics 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 5 Managerial Economics Summary of Substitution & Income Effects (Table 5.2) Substitution Effect Income Effect Price of X decreases: Normal Good X rises X rises Inferior Good X rises X falls Normal Good X falls X falls Inferior Good X falls X rises Price of X increases: 5 ... 5 Managerial Economics Deriving a Demand Curve (Figure 5. 9) Quantity of Y 100 Px=$10 Px=$8 Px= $5 Price of X ($) 50 65 90 100 1 25 200 Quantity of X 10 Demand for X 5 50 65 90 Quantity of X Managerial Economics. .. Managerial Economics Consumer’s Budget Constraint (Figure 5. 5) 5 Managerial Economics Typical Budget Line Quantity of Y M PY (Figure 5. 6) •A Y M PY PX X PY B • 5 Quantity of X M PX Managerial Economics. .. PX 5 MUY PY Managerial Economics Constrained Utility Maximization (Figure 5. 8) 50 45 •A 40 •B E IV • R 30 •D s azzi pf o ytit nau Q III 20 C • 15 10 10 20 30 40 50 60 Quantity of burgers 5