Managerial Economics
eighth edition
Thomas Maurice
Chapter 5
Theory of Consumer Behavior
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Utility
Benefits consumers obtain from goods & services they consume is utility A utility function shows an individuals perception of the utility level attained from consuming each conceivable bundle of goods
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Theory of Consumer Behavior
Assume consumers have complete information about availability, prices, & utility levels of all goods & services All bundles of goods can be ranked based on their ability to provide utility for any pair of bundles A & B:
Prefer bundle A to bundle B Prefer bundle B to bundle A Indifferent between the two bundles
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Indifference Curves
Locus of points representing different bundles of goods, each of which yields the same level of total utility Negatively sloped & convex Marginal rate of substitution (MRS)
Absolute value of the slope of the indifference curve Diminishes along the indifference curve as X increases & Y decreases
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Typical Indifference Curve
(Figure 5.1)
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Indifference Map
(Figure 5.3)
Quantity of Y
IV III II I
Quantity of X
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Marginal Utility
Addition to total utility attributable to the addition of one unit of a good to the current rate of consumption, holding constant the amounts of all other goods consumed
MU U X
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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 Ratio of the marginal utilities of the goods
Y MU X MRS X MUY
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Consumers Budget Line
Shows all possible commodity bundles that can be purchased at given prices with a fixed money income
M PX X PY Y
or
M PX Y X PY PY
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Typical Budget Line
M P Y
(Figure 5.5)
A
M PX X P P Y Y
Quantity of Y
Quantity of X 10
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M PX
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Shifting Budget Lines (Figure 5.6)
120 R
Quantity of Y
Quantity of Y
100 80
A F
100
N 240
C 125
B 200
D 250
160 200
Quantity of X
Quantity of X
Panel A Changes in money income
Panel B Changes in price of X
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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
Y MU X PX MRS X MUY PY
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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 MUY PX PY
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Constrained Utility Maximization
(Figure 5.7)
50 45
Quantity of pizzas
40
B
R
D
E IV III
30
20 15 10
10 20 30 40 50 60
II T I
70
80
90
100
Quantity of burgers
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Individual Consumer Demand
An individuals 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 demandquantity demanded varies inversely with price
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Market Demand
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
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Derivation of Market Demand
(Table 5.1)
Quantity demanded Price Consumer 1 Consumer 2 Consumer 3 Market demand
$6
3 5 8 10 12 13
0 1 3 5 7 10
0 0 1 4
3 6 12 19 25 31
5
4
3
2 1
6
8
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Derivation of Market Demand
Figure (5.9)
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Substitution & Income Effects
When price changes, total change in quantity demanded is composed of two parts
Substitution effect Income effect
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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 Change in consumption of a good resulting strictly from a change in purchasing power
Income effect
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Income & Substitution Effects: A Decrease in Px (Figure 5.11)
Total effect of = Substitution Income + price effect effect decrease 9 = 5 + 4 Total effect of = Substitution Income + price effect effect decrease 3 = 5 + (-2)
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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
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