Theory of Individual Behavior Chapter 4.pptx

Theory of Individual Behavior explains about the willingness of someone to let go a thing to trade with other things

1. 1 The Theory of Individual Behavior © 2017 by McGraw-Hill Education. All Rights Reserved.

2. Describing four basic properties of a consumer’s preference ordering and their effects for a consumer’s indifference curves. Illustrating how changes in prices and income impact an individual’s opportunities . Illustrating a consumer’s equilibrium choice and how it changes in response to changes in prices and income. Distinguishing the impact of a price change into substitution and income effects . Deriving an individual’s demand curve from indifference curve analysis and market demand from a group of individuals’ demands. 2 Contents

3. 3 Introduction © 2017 by McGraw-Hill Education. All Rights Reserved.

4. © 2017 by McGraw-Hill Education. All Rights Reserved. 4 Recall one of the Ten Principles from Chapter 1: People face tradeoffs . Buying more of one good leaves less income to buy other goods. Working more hours means more income and more consumption, but less leisure time. Reducing saving allows more consumption today but reduces future consumption. Introduction This chapter explores how consumers make choices

5. 5 Introduction Despite the complexities of human thought processes , managers need a model that explains how individuals behave in the marketplace and in the work environment . Of course, model of individual behavior cannot capture the full range of real-world behavior . Life would be simpler for managers of firms if the behavior of individuals were not so complicated. If you achieve an understanding of individual behavior, you will gain a marketable skill that will help you succeed in the business world. We must begin with a simple model that focuses on essentials

6. 6 Model of Consumer Behavior © 2017 by McGraw-Hill Education. All Rights Reserved.

7. Example: A six-month-old baby consumes goods but is not responsible for purchase decisions. If you are employed by a manufacturer of baby food, it is the parent’s (consumer) behavior you must understand , not the baby’s Consumer Definition: A consumer is an individual who purchases goods and services from firms for the purpose of consumption 2 Points of concerns: who purchases the good who consumes the good Model of Consumer Behavior

8. There are two important factors to characterize consumer behavior : What the Consumer Wants Budget Constraint Consumer preferences Determine which set goods and services will be consumed Consumer opportunities Set of possible goods and services consumers can afford to consume Model application: Indiferrence curve Model application: Budget set Budget line Model of Consumer Behavior

9. 9 Consumer Preferences

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11. 12 In characterizing consumer behavior, there are two important factors to consider: a. Consumer preferences Determine which set goods and services will be consumed b. Consumer opportunities Set of possible goods and services consumers can afford to consume . Assumption: Only two goods exist in the economy. This assumption is made purely to simplify our analysis: All of the conclusions that we draw from this two-good setting remain valid when there are many goods. What the Consumer Wants Budget Constraint Consumer Behavior: Consumer Preferences

12. Property 1- Completeness : By assuming that preferences are complete, we assume that the consumer is capable of expressing a preference for any two bundles of goods either: . . . If preferences were not complete, there might be cases where a consumer would claim not to know whether he or she preferred bundle A to B, preferred B to A, or was indifferent between the two bundles.   4- 13 Consumer Behavior 4 Properties of Consumer Preferences

13. 4 Properties of Consumer Preferences 4- 14 Consumer Behavior Property 2- More is better If bundle has at least as much of every good as bundle and more of some good, bundle is preferred to bundle .   A is preferred to bundle D because it has the same amount of good X and more of good Y. Bundle C is also preferred to bundle D because it has more of both goods. Similarly, bundle B is preferred to bundle D. THIS curve does not reveal whether bundle B is preferred to bundle A or bundle A is preferred to bundle B. An indifference curve defines the combinations of goods X and Y that give the consumer the same level of satisfaction; that is, the consumer is indifferent between any combination of goods along an indifference curve. Explain later

14. 4 Properties of Consumer Preferences 4- 15 Consumer Behavior Property 2- More is better If bundle has at least as much of every good as bundle and more of some good, bundle is preferred to bundle .   A is preferred to bundle D because it has the same amount of good X and more of good Y. Bundle C is also preferred to bundle D because it has more of both goods. Similarly, bundle B is preferred to bundle D. THIS curve does not reveal whether bundle B is preferred to bundle A or bundle A is preferred to bundle B. An indifference curve defines the combinations of goods X and Y that give the consumer the same level of satisfaction; that is, the consumer is indifferent between any combination of goods along an indifference curve. Explain later A, B, and C are indifference Why?

15. 4 Properties of Consumer Preferences 4- 16 Consumer Behavior Property 2- More is better If bundle has at least as much of every good as bundle and more of some good, bundle is preferred to bundle .   A is preferred to bundle D because it has the same amount of good X and more of good Y. Bundle C is also preferred to bundle D because it has more of both goods. Similarly, bundle B is preferred to bundle D. THIS curve does not reveal whether bundle B is preferred to bundle A or bundle A is preferred to bundle B. A, B, and C are indifference. Why? Coz: A has more Y than B and C, but A has less X than B and C B has more X than A, but B has less Y than A C has more X than A and B, but C has less Y than A and B Thus, amongst A, B, and C can’t be decided which one is better  indifference A, B, and C are indifference Why?

16. 4 Properties of Consumer Preferences 4- 17 Consumer Behavior Property 2- More is better If bundle has at least as much of every good as bundle and more of some good, bundle is preferred to bundle .   The marginal rate of substitution (MRS) is the absolute value of the slope of an indifference curve.  dY / dX The marginal rate of substitution between two goods is the rate at which a consumer is willing to substitute one good for the other and still maintain the same level of satisfaction Example: Moving from point A to point B, the marginal rate of substitution between goods X and Y is 2.

17. 4 Properties of Consumer Preferences 4- 18 Consumer Behavior Property 2- More is better If bundle has at least as much of every good as bundle and more of some good, bundle is preferred to bundle .   The marginal rate of substitution (MRS) is the absolute value of the slope of an indifference curve.  dY / dX The marginal rate of substitution between two goods is the rate at which a consumer is willing to substitute one good for the other and still maintain the same level of satisfaction Example: Moving from point A to point B, the marginal rate of substitution between goods X and Y is 2. marginal rate of substitution (MRS) vs Marginal Rate of Technical Substitution ( MRTS) ?

18. Isoquants and Marginal Rate of Technical Substitution Isoquants defines the combinations of inputs (K and L) that yield the producer the same level of output ; that is, any combination of capital and labor along an isoquant produces the same level of output. 5- 19 The Production Function The Optimal Input Choices The basic tool for understanding how alternative inputs can be used to produce output is an isoquant . Marginal rate of technical substitutions (MRTS) The rate at which a producer can substitute between two inputs and maintain the same level of output. Absolute value of the slope of the isoquant.   The isoquants are convex  inputs such as capital and labor typically are not perfectly substitutable

19. 4 Properties of Consumer Preferences Property 3- Diminishing marginal rate of substitution As a consumer obtains more of good X, the amount of good Y the individual is willing to give up to obtain another unit of good X decreases. 4- 20 Consumer Behavior Example: Moving from point A to point B, the consumption Y decreases as the consumption of X increases

20. 4 Properties of Consumer Preferences 4- 21 Consumer Behavior Property 4- Transitivity: For any three bundles, , , and , either: If and , then . If and , then .   The assumption of transitive preferences, together with the more-is-better assumption, implies that indifference curves do not intersect one another.

21. 4- 22 Indifference Curve Consumer Behavior

22. Preferences: What the Consumer Wants THE THEORY OF CONSUMER CHOICE 23 Quantity of Fish Quantity of Mangos Indifference curve : shows consumption bundles that give the consumer the same level of satisfaction A , B , and all other bundles on I 1 make Hurley equally happy – he is indifferent between them. I 1 One of Hurley’s indifference curves B A

23. 4 Properties of Indifference Curves 24 Quantity of Fish Quantity of Mangos If the quantity of fish is reduced, the quantity of mangos must be increased to keep Hurley equally happy. A One of Hurley’s indifference curves I 1 1. Indifference curves are downward-sloping. B

24. Four Properties of Indifference Curves 25 Quantity of Fish Quantity of Mangos Hurley prefers every bundle on I 2 (like C ) to every bundle on I 1 (like A ). A few of Hurley’s indifference curves I 1 I 2 I D 2. Higher indifference curves are preferred to lower ones. He prefers every bundle on I 1 (like A ) to every bundle on I (like D ). C A

25. Four Properties of Indifference Curves 26 Quantity of Fish Quantity of Mangos Suppose they did. Hurley should prefer B to C , since B has more of both goods. Yet, Hurley is indifferent between B and C : He likes C as much as A (both are on I 4 ). He likes A as much as B (both are on I 1 ). Hurley’s indifference curves I 1 3. Indifference curves cannot cross. B C I 4 A

26. Four Properties of Indifference Curves 27 Quantity of Fish Quantity of Mangos Hurley is willing to give up more mangos for a fish if he has few fish ( A ) than if he has many ( B ). 4. Indifference curves are bowed inward. I 1 1 1 6 2 A B

27. The Marginal Rate of Substitution 28 Quantity of Fish Quantity of Mangos Hurley’s MRS is the amount of mangos he would substitute for another fish. I 1 1 1 6 2 A B Marginal rate of substitution (MRS) : the rate at which a consumer is willing to trade one good for another. MRS = slope of indifference curve MRS = MRS = MRS falls as you move down along an indifference curve.

28. THE THEORY OF CONSUMER CHOICE 29 One Extreme Case: Perfect Substitutes Perfect substitutes : two goods with straight-line indifference curves, constant MRS Example: meat & chicken Consumer is always willing to trade 2kg of chicken for 1 kg of meat M eat Chicken

29. THE THEORY OF CONSUMER CHOICE 30 Another Extreme Case: Perfect Complements Perfect complements : two goods with right-angle indifference curves Example: Left shoes, right shoes {7 left shoes, 5 right shoes} is just as good as {5 left shoes, 5 right shoes}

30. Less Extreme Cases: Close Substitutes and Close Complements Quantity of Coke Quantity of Pepsi Indifference curves for close substitutes are not very bowed Quantity of hot dogs Quantity of hot dog buns Indifference curves for close complements are very bowed

31. 32 Constraints © 2017 by McGraw-Hill Education. All Rights Reserved.

32. Consumer Behavior 33 In characterizing consumer behavior, there are two important factors to consider: a. Consumer preferences Determine which set goods and services will be consumed b. Consumer opportunities Set of possible goods and services consumers can afford to consume . Assumption: Only two goods exist in the economy. This assumption is made purely to simplify our analysis: All of the conclusions that we draw from this two-good setting remain valid when there are many goods. What the Consumer Wants Budget Constraint

33. Constraints In any decision-making environment faces constraints such as: legal constraints, time constraints, physical constraints, and, of course, budget constraints. However our focus is to examine the role prices and income play in constraining consumer behavior . 4- 34 Constraints

34. The Budget Constraint Budget constraint Restriction set by prices and income that limits bundles of goods affordable to consumers. Budget set : The bundles of goods a consumer can afford. Budget line: The bundles of goods that exhaust a consumer’s income.   4- 35 Constraints M = the consumer’s income Px and Py = the prices of goods X and Y, The combinations of goods X and Y that are affordable for the consumer all the combinations of goods X and Y that exactly exhaust the consumer’s income

35. The Budget Constraint Good   Good   Budget line:         the maximum affordable quantity of X consumed Bundle G Bundle H Budget set:   Constraints the maximum affordable quantity of Y consumed point G, represents an affordable combination of X and Y point H, represents an unaffordable combination of X and Y Slope = MRS   Budget set:  

36. Consumer Behavior 37 In characterizing consumer behavior, there are two important factors to consider: a. Consumer preferences Determine which set goods and services will be consumed b. Consumer opportunities Set of possible goods and services consumers can afford to consume . 2 main factors which affects consumer opportunities: Changes in income Changes in price What the Consumer Wants Budget Constraint

37. Increase in Income Expand Opportunities 4- 38 Good   Good             Constraints       2 main factors which affects consumer opportunities: Changes in income Changes in price Assumption: prices remain constant. Decrease in Income lowers Opportunities

38. A Decrease in the Px : More good X consumed 4- 39 Good   Good   New budget line     Initial budget line Constraints     2 main factors which affects consumer opportunities: Changes in income Changes in price Assumption: Py remains unchanged

39. The Budget Constraint in Action Consider the following budget line: What is the maximum amount of X that can be consumed? What is the maximum amount of Y that can be consumed?   4- 40 Constraints Answers: Maximum X is: units Maximum Y is: units  

40. 41 Consumer Equilibrium: Optimal Choice © 2017 by McGraw-Hill Education. All Rights Reserved.

41. Consumer Equilibrium Consumer equilibrium Consumption bundle that is affordable and yields the greatest satisfaction to the consumer. Consumption bundle where the rate a consumer choses (marginal rate of substitution) to trade between goods X and Y equals the absolute value of the rate at which these goods are traded in the market (market rate of substitution). market rate of substitution = - Px / Py   4- 42 Consumer Equilibrium The objective of the consumer is to choose the consumption bundle that maximizes his or her utility , or satisfaction

42. The Market Rate of Substitution 4- 43 Good   Good   Budget line:               Market rate of substitution :   Constraints Px = 1 Py = 2   Slope Budget line: - Px / Py = - 1/2

43. Optimization: What the Consumer Chooses Quantity of X Quantity of Y 1200 600 300 150 A is the optimum  consumer equilibirum : the point on the budget constraint that touches the highest possible indifference curve. Consumer prefers B to A , but he cannot afford B . A C D Consumer can afford C and D , but A is on a higher indifference curve. B Consumer Equilibirum : The optimum is the bundle Hurley most prefers out of all the bundles he can afford.

44. Optimization: What the Consumer Chooses Quantity of X Quantity of Y 1200 600 300 150 At the optimum, slope of the indifference curve equals slope of the budget constraint :   A

45. 46 Comparative Statics: Price and Income Changes on Consumer Behaviour

46. Price Changes and Consumer Behavior Price and income changes affect on a consumer’s budget set and level of satisfaction that can be achieved . This implies that price and income changes will lead to consumer equilibrium changes . 4- 47 Comparative Statics

47. Price Changes and Equilibrium Price increases expand a consumer’s budget set OR Price decreases reduce a consumer’s budget set. The new consumer equilibrium resulting from a price change depends on consumer preferences : Goods X and Y are: substitutes when an increase (decrease) in the price of X leads to an increase (decrease) in the consumption of Y  positive relationship complements when an increase (decrease) in the price of X leads to a decrease (increase) in the consumption of Y  negative relationship 4- 48 Comparative Statics The Effects of a Price Change A change in the price of a good will lead to a change in the equilibrium consumption bundle.

48. Price Changes and Equilibrium 4- 49 Good   Good   Point A: Initial consumer equilibrium When : Consumption X increases Consumption Y decreases (coz substitution effect)   A B Point B: New consumer equilibrium         I II Comparative Statics       Example: Goods X and Y are substitutes

49. Price Changes and Equilibrium 4- 50 Point A: Initial consumer equilibrium When : Consumption X increases Consumption Y increases   Point B: New consumer equilibrium Comparative Statics Example: Goods X and Y are Complement

50. Price Changes and Consumer Behavior Conclusion: From a managerial perspective, the key thing to note is that changes in prices affect the behavior of consumers  price changes alter consumer incentives to buy different goods, thereby changing the mix of goods they purchase in equilibrium Price changes might occur because of: updated pricing strategies within your own firm. price changes made by rivals or firms in other industries. 4- 51 Comparative Statics The primary advantage of indifference curve analysis is to see how price changes affect the mix of goods that consumers purchase in equilibrium (maximum satisfaction)

51. Income Changes and Consumer Behavior Income increases (decreases) expand (reduce) a consumer’s budget set. The new consumer equilibrium resulting from an income change depends on consumer preferences: 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 . 4- 52 Comparative Statics

52. Income Changes and Consumption 4- 53 Good   Good   A B II I Point A: Initial consumer equilibrium income increases:  more consumption on X and Y   Point B: New consumer equilibrium   Comparative Statics       Example: goods and are normal goods  

53. Income Changes and Consumption Comparative Statics Point A: Initial consumer equilibrium Example: goods is inferior goods   Income increases:  Budget line increases, Good X inferior  Consumption good X ↓, but consumption good Y   Point B: New consumer equilibrium

54. 55 Substitution and Income Effects © 2017 by McGraw-Hill Education. All Rights Reserved.

55. Substitution and Income Effects When the price of one good changes can be broken down into two effects: Substitution effect : The movement along a given indifference curve that results from a change in the relative prices of goods, holding real income constant. A fall in P x makes Y more expensive relative to X, causes consumer to buy fewer Y & more X I ncome effect : The shift from one indifference curve to another that results from the change in real income caused by a price change. A fall in P X increases the purchasing power of consumer’s income, allows him to buy more Y and more X. 4- 56 Comparative Statics

56. The Income and Substitution Effects Initial optimum at A . Example: P X falls  Eq. will move from A to C. When Px falls, it has two effects: Substitution effect: from A to B , buy more X and fewer Y. Income effect: from B to C , buy more of both goods (X and Y)  boost purchasing power Quantity of X Quantity of Y A B C      

57. 58 Indifference and Demand Curves © 2017 by McGraw-Hill Education. All Rights Reserved.

58. Indifference and Demand Curves Indifference curves along with price changes determine individuals’ demand curves. Market demand is the horizontal summation of individuals’ demands. 4- 59 The Relationship Between Indifference Curve Analysis and Demand Curves

59. From Indifference Curves to Individual Demand Indifference curves along with price changes determine individuals’ demand curves. Market demand is the horizontal summation of individuals’ demands. Good   Good   A B     II I Good   Price of good           Demand The Relationship Between Indifference Curve Analysis and Demand Curves When : Consumption X increases Consumption Y decreases (coz substitution effect)  

60. 61 Good   A     Good   Price of good         Demand mkt Price of good     B A B A+B   Demand B Demand A From Individual to Market Demand The Relationship Between Indifference Curve Analysis and Demand Curves

61. 62 Application

62. Choices by consumers Buy one, get one free Cash gifts, in-kind gifts, and gift certificates Choices by workers and managers Income-leisure choice Manager’s preferences © 2022 by McGraw-Hill Education. All Rights Reserved. 63 Applications of Indifference Curve Analysis

63. 4- 64 Consumer Choice with a Gift Certificate Good X Point A: Initial consumer equilibrium Receive a $10 gift certificate for good :   A Point B: higher utility holding consumption at initial level       III I C Point C: new consumer equilibrium when and are normal goods   B         Good Y   Budget line with gift card II

64. 4- 65 Labor-Leisure Choice Model (Figure 4-18) E   I       Leisure (hours per day) Income (per day) 16 hours of leisure 8 hours of work Worker equilibrium II III

65. What is the budget set for a worker who receives $5 per hour of work and a fixed payment of $40? Let denote the worker’s total earnings and the number of leisure hours in a 24-hour day.   © 2022 by McGraw-Hill Education. All Rights Reserved. 66 Labor-Leisure Budget Set in Action

66. 67 Practice It is common for supermarkets to carry both generic (store-label) and brand-name (producer-label) varieties of sugar and other products. Many consumers view these products as perfect substitutes, meaning that consumers are always willing to substitute a constant proportion of the store brand for the producer brand. Consider a consumer who is always willing to substitute four pounds of a generic store-brand sugar for two pounds of a brand-name sugar. Do these preferences exhibit a diminishing marginal rate of substitution between store-brand and producer-brand sugar? Assume that this consumer has $24 of income to spend on sugar, and the price of store-brand sugar is $1 per pound and the price of producer-brand sugar is $3 per pound. How much of each type of sugar will be purchased? How would your answer change if the price of store-brand sugar was $2 per pound and the price of producer-brand sugar was $3 per pound?

67. 68 These preferences do not exhibit a diminishing marginal rate of substitution since consumers are always willing to substitute the same amount of store-brand sugar for an additional pound of producer-brand sugar. When store-brand sugar is $1 per pound and producer-brand sugar is $3 per pound, the consumer will purchase 24 pounds of store-label sugar and no producer-brand sugar. This is because, at these prices, producer-brand sugar is three times as expensive but only twice as valuable. After the change, the consumer will purchase no store-label sugar and 8 pounds of producer-brand sugar. This is because, at these prices, producer brand sugar is 1.5 times as expensive but twice as valuable.

68. Exercise #1 A recent newspaper circular advertised the following special on tires: “Buy three, get the fourth tire for free—limit one free tire per customer.” If a consumer has $360 to spend on tires and other goods and each tire usually sells for $40, how does this deal impact the consumer’s opportunity set? (LO6) 69

69. Exercise #2 A consumer is in equilibrium at point A in the accompanying figure. The price of good X is $5. (LO2, LO3) What is the price of good Y? What is the consumer’s income? At point A, how many units of good X does the consumer purchase? Suppose the budget line changes so that the consumer achieves a new equilibrium at point B. What change in the economic environment led to this new equilibrium? Is the consumer better off or worse off as a result of the price change? © 2017 by McGraw-Hill Education. All Rights Reserved. 70

70. [email protected] Dea Yustisia