Managerial Economics- Basic Consumer Theory

Kritika Mathur

What is Economics and What is Managerial Economics?

• The study of how societies and individuals allocate scarce resources among competing ends

• Managerial Economics is the study of how to direct scarce resources in the way that most efficiently achieves a managerial goal– The focus of managerial economics is to give you

tools to make decisions

Contents• What is Demand?• Discussion on utility and types• Indifference curve analysis• Budget line• Consumer Equilibrium• ICC• PCC• Deriving demand curve• SE,IE,PE

What is Demand?

• Desire to own anything• Ability to pay for it• Willingness to spend on it

Demand is a relationship between two variables, price and quantity demanded, with all other factors that could affect demand being held constant

Demand Schedule

• The demand schedule shows the quantity of goods that a consumer would be willing and able to buy at specific prices

Price Quantity Demanded

10 15

9 18

8 20

Demand Curve

Questions

• Ceteris Paribus-everything else kept constant• Everything else includes everything except

price of the good in question• Can you name a few ???

Price of Related Goods

• Perfect Complements-Eg?

• Perfect Substitutes-Eg?

Income

• Income increases and price doesn’t change –Earlier if I was consuming 10 units of Dairy Milk when the price was 10Rs , when my income increases I may end up consuming 15 units when the price of dairy milk is till 10Rs per unit

Questions

• Can someone show the effect of Income on the demand curve

• Do you think taste and preferences play a role?

Individual Demand Curve to Market Demand Curve

• Horizontal summation of individual demand curves

• Can someone draw this on the board?

Observed something?

Utility

• Utility is nothing but satisfaction derived from the product consumed

• Concept of TU, MU, AU• TU= Overall utility• AU=Average utility• MU = Marginal utility• MU= Any formula that you observe?

UtiltyQuantity Good A

T U M U

0 01 102 193 274 345 406 457 498 52

UtiltyQuantity Good A

T U M U

0 0 -1 10 102 19 93 27 84 34 75 40 66 45 57 49 48 52 3

Cardinal Utility

• This approach was given by Marshall,Manger and Gossen according to these economists utility can be measured.

• Under cardinal utility theory, the util is a unit of measurement like metre or second.– The Law of Diminishing Marginal Utility:the total

utility of a consumer will increase through consumption, but for successive units of the goods consumed, the additional or extra units of utility got - the marginal utility will diminish

Ordinal Utility

• Ordinal utility theory states that while the utility of a particular good or service cannot be measured using a numerical scale

• Pairs of alternative bundles (combinations) of goods can be ordered such that one is considered by an individual to be worse than, equal to, or better than the other

Indifference curve

• On the x axis consumption of wheat and on the y axis consumption of cloth is given

• Draw it• Draw two more Indifference curves(ICs)• On which IC am I better off?• Define it

Indifference Curve

• An indifference curve is a graph showing different bundles of goods between which a consumer is indifferent.

• At each point on the curve, the consumer has no preference for one bundle over another.

• The same level of utility (satisfaction) for the consumer

Indifference Curve

U=5

U>5 (preferred toAny point on U=5)

U<5(any point on U=5 preferred)

Indifferent between any point on U=5Qy

QxO

A Preference Map

U=5

U=6

Qy

Qx

a

b

c

d

O

The Shape of Indifference curves

• Negative slope (more is preferred to less)• Marginal rate of substitution (MRS)• Convex to the origin (diminishing marginal

rate of substitution)• MRS=ΔQy/ΔQx keeping utility constant—slope

of the indifference curve

Indifference Curves

• Perfect Complements – Right shoe and Left shoe

• Perfect Substitutes- Coke and Pepsi

Budget line

• On the x axis again we have consumption of wheat and on the y axis we have consumption of cloth

• A budget line is a line showing the alternative combinations of any two goods that a consumer can afford at given prices for the goods and a given level of income.

Budget line

?? Qx

Qy

??

M = PyQy+PxQx

?? is the slope of the budget lineO

Budget line

M/Px Qx

Qy

M/Py

M = PyQy+PxQx

Px/Py is the slope of the budget lineO

Budget lineM= PyQy+PxQx

PyQy = M- PxQxQy = M/Py – (Px/Py)Qx M/Py is the Y interceptPx/Py is the slope of the budget line

Budget Line

• Draw new budget line when increases from M to 10M

• Draw new budget line when price of x changes from PX to Px/2

• Draw new budget line when price of y changes to 2Py

Consumer Equilibrium 1/3

U=5

Qx

Qy

U=4

U=6

Consumer Equilibrium 2/3

Qx

Qy

O

Consumer Equilibrium 3/3

U=5

Qx

Qy

Qy*

Qx*

Highest indifference curveachievable

U=4 can achieve more

U=6 cant afford

Budget line and indifference curve are tangent.On budget line and highest indifference curvewhere MRS=Px/Py

E*

O

Income Consumption Curve

U=5 could afford

Qx

Qy

Qy*

Qx*

Highest indifference curveachievable

U=4 can achieve more

U=6 can afford now after income has increased

Budget line and indifference curve are tangent.On budget line and highest indifference curvewhere MRS=Px/Py

E*

S*

M/Px 1.5M/Px

1.5M/Py

M/Py

O

Income Consumption Curve

• Locus of points of contact between the indifference curve and the constant-slope(why?) budget line when the budget line shifts outward due to increases in money income

Income Consumption Curve

U=5 could afford

Qx

Qy

Qy*

Qx*

U=4 can achieve more

U=6 can afford now after income has increased

Budget line and indifference curve are tangent.On budget line and highest indifference curvewhere MRS=Px/Py

E*

S*

M/Px 1.5M/Px

1.5M/Py

M/Py

O

ICC

ICC-Inferior goodQy

QxU’

U”

Qx” Qx’

X inferior, Y normalK

E

O M/Px 1.5M/Px

1.5M/Py

M/Py

Change in Price

• Change in the price of X changes the slope of the budget line by changing the X intercept

Qy

QxM/2Px M/Px

M/Py

O

Price Consumption Curve

Qy

QxU’

U”

Qx’ Qx”

Budget linewith M/Px

Budget linewith M/2Px

PCC is locus of points of contact between the indifference curve and the changing (relative

price) budget line, when the budget line rotates

A

B

O

PCC to Demand Curve

Qy

Qx

Qx

Px

U’

U”

Qx’ Qx”

Qx’ Qx”

Budget linewith M/Px

Px

Budget linewith M/2Px

2Px

Demand curve for X

O

O