Microeconomics for Managers

Biresh Sahoo, Ph.D

Professor, XIM Bhubaneswar Lecture 2: Module I: Theory of Consumer Behavior and Demand Analysis

Module I: Theory of Consumer Behavior Topics to be covered:

Consumers problem Consumer preferences and utility Axioms (assumptions) about preferences Utility curve (indifference curve) Substitution between goods And most importantly, learning and applying these concepts in practice

Consumers Problem
A consumers economic problem is to allocate his her

limited funds to competing needs and desires over a given time period
Chooses a consumption bundle that gives him her

maximum satisfaction
!ecision to consume more of one good is a decision to

consume less of another

Consumer Preferences
Preferences tell us about a consumers li"es and disli"es# $hree ways of representing preferences A consumer is indifferent between two alternatives (A and

%, say) if she li"es (or disli"es) them e&ually# Symbolically, A%#

A consumer prefers A to % if u(A) ' u(%)# A consumer prefers % to A if u(%) ' u(A)#

Axioms about Preferences

Complete( A consumer can ran", in order of his her preference, all

potentially available alternatives#

$ransitive( )f (x*,x+) is preferred to (y*,y+) and (y*,y+) is preferred

to (,*,,+), then (x*,x+) is preferred to (,*,,+),

-onotonicity( )f (x*,x+) is a bundle of goods and (y*,y+) is a

bundle of goods with at least as much of both goods and more of one, then (y*,y+) is preferred to (x*,x+) #
Convexity( An average bundle is preferred to extreme bundles#

$hat is, if (x*,x+) . (y*,y+), then for any (/ *), then (x*0(*1)y*, x+0(*1)y+) is preferred to (x*,x+) (y*,y+)#

Indifference Curve (IC

Starting with any alternative, an indifference curve

shows all the other alternatives a consumer li"es e&ually well#

Bread %o'(&

Identifyin/ Alternatives and Indifference Curves %ICs&

Better than A
A B

1., 16, 12 1,, , ", )orse than A

C IC

12

2,

#ou$ %$ints&

Properties of Indifference Curves

$hin !ownward slopping 2igher the )C, the higher the level of satisfaction 3o two )Cs can intersect with each other

Indifference Curves Ruled Out by the More-is-better Principle

Bread %o'(&

2roof of Case 2

Bread %o'(&

2roof of Case !

A
y2 y1

C B u1 u,

y2 y1

B A u1 u,
11 12

11

12

#ou$ %$ints&

#ou$ %$ints&

Since A % and A C, therefore % C# 2owever, C % since C contains more of both goods# $herefore, no two )Cs can intersect#

Indifference Curve (IC) Map

Collection of indifference curves that represent the

preferences of an individual

IC Map

Substitution et!een "oods

4conomic decisions involve trade1offs $o determine whether a consumer has made the best

choice, we need to "now the rate at which she is willing to ma"e trade1offs (substitute) between different goods
)ndifference curves provide that information

Rate of Substitution
Consider moving along an indifference curve, from one

bundle to another
$his is the same as subtracting units of one good and

compensating the consumer for the loss by adding units of another good
Slope of the indifference curve shows how much of the

second good is needed to ma"e up for the decrease in the first good

Rates of Substitution
5oo" at move from

bundle A to C
Consumer loses *

soup6 gains + bread

7illing to substitute

for soup with bread at + ounces per pint

Mar#inal Rate of Substitution (MRS)

$he marginal rate of substitution for 8 with 9, -:S89, is

the rate at which a consumer must ad;ust 9 to maintain the same level of well1being when 8 changes by a tiny amount, from a given starting point

MRS XY = Y X
$ells us how much 9 a consumer needs to compensate for

losing a little bit of 8 $ells us how much 9 to ta"e away to compensate for gaining a little bit of 8

$nother !ay of representin# MRS

-ovement from A to % involves a <loss in utility in terms of y, i#e#, 1y-Uy = (y+1y*)-Uy and <gain in utility in terms of x, i#e#, x-Ux = (x+1x*)-Ux6 and the sum of these <loss and <gain adds up to ,ero, i#e#, 1y-Uy 0 x-Ux = /
4ood %y&

y1

A %113y1&

5y
y2 , 11

B %123y2& u,
12

>y -U x -:S = 1 = >x -U y

4ood %1&

%hat &eter'ines MRS(

Differences in tastes
2references for one /ood over another affect the slo$e of an

indifference curve
Im$lications for M6#

#tartin/ $oint on the indifference curve

2eo$le li7e variety so most indifference curves /et flatter as 8e move

from to$ left to 9ottom ri/ht

Lin7 9et8een slo$e and M6# im$lies that M6# declines: the amount

of ; re<uired to com$ensate for a /iven chan/e in = decreases

Indifference Curves and Consu'er Tastes

MRS alon# an Indifference Curve

Perfect Substitutes and Co'ple'ents

Some special cases of preferences represent opposites ends of the

substitutability spectrum
$wo products are perfect substitutes if their functions are identical6 a

consumer is willing to swap one for the other at a fixed rate

$wo products are perfect complements if they are valuable only

when used together in fixed proportions

Perfect Substitutes

Perfect Co'ple'ents

Thank you
for your patience