Slide 1Chapter OutlineIntroductionConsumer BehaviorProperties of Consumer PreferencesConstraintsThe Budget ConstraintThe Budget Constraint In ActionThe Market Rate of SubstitutionIncome ChangesPrice ChangesThe Budget Constraint in ActionThe Budget Constraint in ActionConsumer EquilibriumConsumer Equilibrium in ActionConsumer Equilibrium in ActionComparative StaticsPrice Changes and Consumer EquilibriumPrice Changes and Consumer Equilibrium in ActionIncome Changes and Consumer EquilibriumIncome Changes and Consumer Equilibrium in ActionSubstitutions and Income EffectsSubstitution and Income Effects in ActionConsumer Choice with a Gift CertificateLabor-Leisure Choice ModelLabor-Leisure Budget Set in ActionIndifference and Demand CurvesFrom Indifference Curves to Individual DemandSlide 29ConclusionCHAPTER 4The Theory of Individual Behavior© 2014 by McGraw-Hill Education. All Rights Reserved.Chapter Outline•Consumer behavior•Constraints–Budget constraint–Changes in income–Changes in prices•Consumer equilibrium•Comparative statics–Price changes and consumer behavior–Income changes and consumer behavior–Income and substitution effects•Applications of indifference curve analysis–Choices by consumers–Choices by workers and managers•Relationship between indifference curves and demand curves–Individual demand–Market demandCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-2Chapter OverviewIntroduction•Chapter 3 focused on quantitatively measuring demand.–By how much will a 5 percent increase in price reduce quantity demanded?–By how much will a 3 percent decline in income reduce demand for a normal good?•This chapter examines the theory of consumer behavior that underlies individual and market demand curves.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-3Chapter OverviewConsumer Behavior•Consumer opportunities–Set of possible goods and services consumers can afford to consume.•Consumer preferences–Determine which set goods and services will be consumed.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-4Consumer BehaviorProperties of Consumer Preferences•Completeness: For any two bundles of goods either:–.–.–.•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 .•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.•Transitivity: For any three bundles, , , and , either:–If and , then .–If and , then .• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-5Consumer BehaviorConstraints•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. Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-6ConstraintsThe Budget Constraint•Budget constraint–Restriction set by prices and income that limits bundles of goods affordable to consumers.–Budget set:–Budget line• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-7ConstraintsThe Budget Constraint In ActionCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-8Good Good 0Budget line: ��� ��� �� �� SlopeBundle GBundle HBudget set: ConstraintsThe Market Rate of SubstitutionCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-9Good Good 0Budget line: 5 1 0 4 2 3 4 Market rate of substitution : ConstraintsIncome Changes Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-10Good Good 0�1�� �1�� �0�� �0�� � ↑ Constraints�2�� �2�� � ↓Price ChangesCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-11Good Good 0New budget line��� ��0> ��1 Initial budget lineConstraints���0 ���1The 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?–What is rate at which the market trades goods X and Y?• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-12ConstraintsThe Budget Constraint in Action•Answers:–Maximum X is: units.–Maximum Y is: units. –Market rate of substitution: .• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-13ConstraintsConsumer 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 rate at which these goods are traded in the market (market rate of substitution). • Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-14Consumer EquilibriumConsumer Equilibrium in ActionCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-15Good Good 0Consumer equilibriumABCIIIIIIConsumer EquilibriumDConsumer Equilibrium in Action•Consider the following consumer market information:–.–.•Does this information constitute a consumer equilibrium? –No!•Propose a solution to bring the consumer to an equilibrium point.–Trade consumption of X for more Y. –Total utility can increase.• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-16Consumer EquilibriumComparative Statics•Price and income changes impact 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.•This section explores how price and income changes impact consumer equilibrium.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.4-17Comparative StaticsPrice Changes and Consumer Equilibrium•Price increases (decreases) reduce (expand) 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.•complements when an increase (decrease) in the price of X leads to a decrease