Managerial Economics & Overview

I. Consumer Behavior
Business Strategy Indifference Curve Analysis
Consumer Preference Ordering
Chapter 4

II. Constraints
The Theory of Individual The Budget Constraint
Behavior Changes in Income
Changes in Prices
III. Consumer Equilibrium
IV. Indifference Curve Analysis & Demand Curves
Individual Demand
Market Demand
Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Indifference Curve Analysis

Indifference Curve Analysis
Indifference Curve Good Y
A curve that defines the

combinations of 2 or more goods III. Assume two goods, X and Y and a utility
that give a consumer the same II. function for an individual of the form
level of satisfaction.
I.
U(X,Y) = Square Root of X*Square Root
Marginal Rate of
of Y which can be written:
Substitution
The rate at which a consumer is U(X,Y) = X1/2 Y1/2
willing to substitute one good for
another and stay at the same Example of Indifference Curve:
satisfaction level.
10 = X1/2 Y1/2
Good X

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Indifference Curve Analysis Indifference Curve Analysis

X Y U Notice from our table that to give up one unit
1 100 10 of X when the consumer only has 2, the
2 50 10 consumer would require 50 additional units
of Y to keep the same level of satisfaction
4 25 10
(move from the point (2,50) to (1,100)). If
10 10 10 the consumer started with 100 units of X,
25 4 10 then she only need 1/50 of a unit of Y to
50 2 10 give up one of X and keep utility the same.
100 1 10 (Declining marginal rate of substitution.)

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

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 Indifference Curve Analysis
Marginal Utility partial derivative of the The marginal rate of substitution is just the
utility function with respect to one of the ratio of MUX to MUY or Y/X with our
commodities e.g. U/ X or U/ Y. particular utility function. So in the
In our case: continuous case, if the consumer has 1 of X,
MUX = 1/2 X-1/2 Y1/2 she will give up 100 of Y to get another of
X (steep slope to the indifference curve) but
MUY = 1/2 X1/2 Y-1/2 if she has of 100 of X will only give up 1 of
Note marginal utility is > 0 for X and Y. Y for another of X (flat slope).

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

The Budget Constraint Changes in the Budget Line

Y
Opportunity Set Y The Opportunity Set
Changes in Income
The set of consumption bundles
Increases lead to a parallel,
that are affordable. outward shift in the budget
PxX + PyY M. line.
Budget Line
Decreases lead to a parallel,
Budget Line

downward shift.
The bundles of goods that exhaust a X
consumers income. Px Y
Changes in Price New Budget Line for
PxX + PyY = M. Py A decreases in the price of a price decrease.
Market Rate of Substitution good X rotates the budget
X line counter-clockwise.
The slope of the budget line An increases rotates the
-Px / Py budget line clockwise.
X
Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Individual Demand Curve

Consumer Equilibrium Y
An individuals
Y
The equilibrium demand curve is
consumption bundle is Consumer derived from each new II
Equilibrium
the affordable bundle equilibrium point I
that yields the highest found on the $ X
level of satisfaction. indifference curve as
III. the price of good X is P0
varied. P1
II. D
I. X0 X1 X

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

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 Complementary Goods Normal Goods
Pretzels (Y) Y
An increase in
When the price of
income increases
good X falls, the
the consumption of
consumption of
normal goods.
complementary
good Y rises.

B B
Y2
A II A II
Y1
I
I

0 X1 X2 0 X
Beer (X)

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Consumer Equilibrium Consumer Equilibrium

So if we use our the consumer equilibrium Putting this equilibrium relationship into the
point and the standard budget constraint budget line we have:
then: PxX + PY(PX /PY *X)= M or
MRS = PX /PY so using our value PxX + PxX = M or
Y/X = PX /PY (without the negative
2 PxX = M or X = M/ 2Px so you
signs) or
spend half of your income on X.
Y = (PX /PY)*X.

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Market Demand
Consumer Equilibrium
The market demand curve is the horizontal
summation of individual demand curves.
This is the demand function for good X.
It indicates the total quantity all consumers would
Given only 2 goods, you spend the other
purchase at each price point.
half of your income on Y. So Y = M/ 2PY .
$ Individual Demand $ Market Demand Curve
Note both demand curves slope downward, Curves
50
price elasticity is 1 everywhere, both are 40
normal goods and are unrelated (neither
substitutes nor complements). D1 D2 DM
1 2 Q 1 2 3 Q

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

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 A Classic Marketing
Application
Other
goods
(Y)

A
A buy-one,
C E
get-one free
D
pizza deal. II
I

0 0.5 1 2 B F Pizza
(X)

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002