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Chapter 4The Theory of Individual BehaviorCopyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Chapter OutlineConsumer behaviorConstraintsBudget constraintChanges in incomeChanges in pricesConsumer equilibriumComparative staticsPrice changes and consumer behaviorIncome changes and consumer behaviorIncome and substitution effectsApplications of indifference curve analysisChoices by consumersChoices by workers and managersRelationship between indifference curves and demand curvesIndividual demandMarket demand4-2Chapter Overview2IntroductionChapter 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.4-3Chapter Overview3Consumer BehaviorConsumer opportunitiesSet of possible goods and services consumers can afford to consume.Consumer preferencesDetermine which set goods and services will be consumed.4-4Consumer Behavior4Properties of Consumer Preferences4-5Consumer Behavior5ConstraintsWhile 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. 4-6Constraints6The Budget Constraint4-7Constraints7The Budget Constraint In Action4-80SlopeBundle GBundle HConstraints8The Market Rate of Substitution4-90Constraints9Income Changes 4-100Constraints10Price Changes4-110New budget lineInitial budget lineConstraints11The Budget Constraint in Action4-12Constraints12The Budget Constraint in Action4-13Constraints13Consumer Equilibrium4-14Consumer Equilibrium14Consumer Equilibrium in Action4-150Consumer equilibriumABCIIIIIIConsumer EquilibriumD15Consumer Equilibrium in Action4-16Consumer Equilibrium16Comparative StaticsPrice and income changes impact a consumers 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.

4-17Comparative Statics17Price Changes and Consumer EquilibriumPrice increases (decreases) reduce (expand) a consumers 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 (increase) in the consumption of Y.

4-18Comparative Statics18Price Changes and Consumer Equilibrium in Action4-190Point A: Initial consumer equilibriumABPoint B: New consumer equilibrium IIIComparative Statics19Income Changes and Consumer EquilibriumIncome increases (decreases) expands (reduces) a consumers 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.

4-20Comparative Statics20Income Changes and Consumer Equilibrium in Action4-210ABIIIPoint A: Initial consumer equilibriumPoint B: New consumer equilibrium Comparative Statics21Substitutions and Income EffectsMoving from one equilibrium to another when the price of one good changes can be broken down into two effects: Substitution effectIncome effect4-22Comparative Statics22Substitution and Income Effects in Action4-230Point A: Initial consumer equilibriumCABSubstitution effectIncome effectComparative StaticsIGHFJPoint C: new consumer equilibrium23Consumer Choice with a Gift Certificate4-24Good X0Point A: Initial consumer equilibriumAIIICBGood YApplications of Indifference Curves24Labor-Leisure Choice Model4-250EILeisure(hours per day)Income(per day)16 hours of leisure8 hours of workWorker equilibriumApplications of Indifference CurvesIIIII25Labor-Leisure Budget Set in Action4-26Applications of Indifference Curves26Indifference and Demand Curves The indifference curves and consumers reactions to changes in prices and income are the basis of the demand functions in chapters 2 and 3. 4-27The Relationship Between Indifference Curve Analysis and Demand Curves27From Indifference Curves to Individual Demand 4-280ABIIIDemandThe Relationship Between Indifference Curve Analysis and Demand Curves284-290ADemandmktBABA+BDemandBDemandAFrom Individual to Market DemandThe Relationship Between Indifference Curve Analysis and Demand CurvesConclusionIndifference curve properties reveal information about consumers preferences between bundles of goods.CompletenessMore is betterDiminishing rate of substitutionTransitivityIndifference curves along with price changes determine individuals demand curves.Market demand is the horizontal summation of individuals demands.

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