Ch 4.

The Theory of
Individual Behavior

Consumer Behavior
Assume

2 goods exist in the

economy.

Assume

a consumer is able to
order his or her preferences for
alternative bundles or
combinations of goods from best
to worst.
2

Consumer Behavior
A

>B
the consumer prefers bundle A to
bundle B.

B
the consumers view the two
bundles as equally satisfying. He
or she indifferent between
bundles A and B.
3

Consumer Behavior
The

preference ordering is
assumed to satisfy four basic
properties:
1. Completeness.
2. More is better.
3. Diminishing marginal rate of
substitution.
4. Transitivity.
4

Consumer Behavior
Completeness:

- for any two bundles, say A and

B,
either A > B, B > A, A B.

Consumer Behavior
More

is better:
- for any two bundles, say A and
B,
either A > B, B > A, A B.
Figure 4-1 Page 120.

Consumer Behavior
Diminishing

marginal rate of
substitution:
- As a consumer obtains more of
good
X, the rate at which he or she is
willing to substitute good X for
good
Y decreases.
7

Consumer Behavior
Transitivity:

- For any three bundles, A, B, and

C,
if A > B and B > C, then A > C.
Similarly A B, and B C, then
A-C

The Budget Constraint

Budget

set:
The bundles of goods a
consumer can
afford.
Px X + Py Y equals or less M
The budget set.
9

The Budget Constraint

Budget

line:
The bundles of goods that
exhaust a
consumers income.
Px X + Py Y = M
The budget line.
10

Changes In Income
Changes

in income shrink or
expand opportunities.
Figure 4-5 Page 126.

11

Changes In Prices
Figure

4-6 Page 127.

12

Consumer Equilibrium
The

objective of the consumer is to

choose the consumption bundle that
maximizes his or her utility, or
satisfaction.

Consumer

equilibrium:
The affordable bundle that yields the
greatest satisfaction to the consumer.
Figure 4-8 Page 128.
13

Consumer Equilibrium
Consumer

equilibrium:
MRS = (Px / Py)
MRS = marginal rate of
substitution
Px = price of good X
Py = price of good Y

14

Comparative Statics

(Price Changes and Consumer Behavior)

A

change in the price of a good

will lead to a change in the
equilibrium consumption bundle.

Figure 4-9 Page 130.

Change in consumer equilibrium
due to a decrease in the price of
good X (Note: that good Y is a
substitute for good X).
15

Comparative Statics

(Price Changes and Consumer Behavior)

Figure 4-10 Page 131.

When the price of good X falls,
the consumption of
complementary good Y rises.

16

Comparative Statics

(Income Changes and Consumer

Behavior)

Figure 4-11 Page 132.

An increase in income increases
the consumption of normal goods.
Figure 4-12 Page 133.
An increase in income decreases
the equilibrium consumption of
good X (an inferior good).
17

Conceptual and
Computational Questions
1.

A consumer has $400 to spend on

goods X and Y. The market prices of these two
goods are Px = $10 and Py = $40.
1.a. Illustrate the consumers opportunity set in a
carefully labeled diagram.
1.b. Show how the consumers opportunity set
changes if income increases by $400. How
does the $400 increases in income alter the
market rate of substitution between goods X
and Y?

18

Conceptual and
Computational Questions
2.

A consumer must divide $250 between the

consumption of product X and product Y. The
relevant market prices are Px=$5 and Py=$10.
2.a. Write the equation for the consumers
budget line.
2.b. Illustrate the consumers opportunity set in
a
carefully labeled diagram.
2.c. Show how the consumers opportunity set
changes when the price of good X
increases
to $10?
19

Conceptual and
Computational Questions
3.

A consumer is in equilibrium at point A in the

accompanying figure (Figure at page 148). The
price of good X is $5.
3.a. What is the price of good Y?
3.b. What is the consumers income?
3.c. At point A, how many units of good X does
the consumer purchase?
3.d. Suppose the budget line changes so that the
consumer achieves a new equilibrium at
point B. What change in the economic
environment led to this new equilibrium? Is
the consumer better off or worse off as a
result of the price change?
20