Module 4A

THEORY OF INDIVIDUAL BEHAVIOR

1
Unit Learning Outcomes
1. Explain four basic properties of a consumer’s preference ordering and
their ramifications for a consumer’s indifference;
2. Illustrate how changes in prices and income impact an individual’s
opportunities;
3. illustrate a consumer’s equilibrium choice and how it changes in
response to changes in prices and income.
4. Separate the impact of a price change into substitution and income
effects.
5. Show how to derive an individual’s demand curve from indifference
curve analysis and market demand from a group of individuals’
demands.
• Consumer?
Is an individual who purchases
goods and services from firms for
the purpose of consumption;
As a manager of a firm, you are
interested not only in who
consumes the good but in who
purchases it.
 Consumer Behavior

Consumer Behavior

• Consumer opportunities
• Set of possible goods and services
consumers can afford to consume.
• Consumer preferences
• Determine which set of goods and
services will be consumed.

4-4
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 Consumer Behavior

4 - Basic Properties of Consumer Preferences

• 
Property 1. Completeness:
• For any two bundles of goods either:
•.
•.
•.
The consumer is capable of expressing a preference for, or
indifference among all bundles. If preference were not
complete there might cases where a consumer would claim not
to know whether he or she preferred bundle A to bundle B, or
preferred bundle B to A or was indifferent between the two
bundles.

4-5
 Consumer Behavior

Properties of Consumer Preferences

•• Property
  2- More is better
If bundle has at least as much of every good as
bundle and more of some good, bundle is preferred
to bundle .
Indifference curve
- shows the combination of goods X and Y that
gives the consumer the same level of satisfaction.
Marginal Rate of Substitution
- the MRS between 2 goods is the rate in which a
consumer is willing to substitute one for the other
and still maintain the same level of satisfaction.
Ex: the consumer is indifferent between bundles A
and B. moving from A to B, the consumer gains 1
unit of X and to remain on the same IC, the
consumer gives up 2 units of good Y. Thus, in
moving from point A to B the MRS between goods X
and Y is 2.
 Consumer Behavior

Properties of Consumer Preferences

Property 3 Diminishing marginal rate of

substitution

As a consumer obtains more of good X, the

the amount of good Y the consumer is
willing to give up to obtain another unit of
good X decreases.

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 Consumer Behavior

Properties of Consumer Preferences

•• Property
  4- Transitivity: For any three bundles,Y
, , and , either:
• If and , then .
• If and , then .

The assumption of transitive preferences,

together with the more-is-better assumption,
implies that indifference curves do not
intersect one another.
It also eliminates the possibility that the
consumer is caught in a perpetual cycle in
which he or she never makes a choice. X

4-8
 Constraints

Constraints
The Budget constraint
• Restriction set by prices and income that limits bundles of
goods affordable to consumers.
• Restricts consumer behavior by forcing the consumer to
select a bundle of goods that is affordable.
• Php500.00 -----------------cashier

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4-9
 Constraints

Constraints
The Budget constraint

•   • Budget set:

• Budget line:

Where:
M - consumer’s income
Px - price of good x
Py – price of good y

4-10
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• If we multiply both sides of the budget line by 1/Py, we get:

Px X + Y = M/Py
Py
Solving for Y yields: Y = M/Py – Px X
Py
Y is a linear function of X with a vertical intercept of M/Py and a slope
of –Px/Py.
 Constraints

The Budget Constraint In Action

 Good

 𝑀
𝑃𝑌
Slope

Bundle H
𝑃
  𝑋   Budget set:

𝑃   Budget line:
  𝑌

Bundle G

0  𝑀   Good
𝑃𝑋

4-12
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• If the consumer spent his/ her entire income on good Y,
expenditures on Y would exactly equals income:
Py Y = M

Consequently, the maximum quantity of good Y is affordable is:

Y = M/Py
 Constraints

 Good
The Market Rate of Substitution
Given: 5
 
- is the rate at which one good maybe traded for another in the market
M = Php10.00
Px = 1.00
Py = 2.00  Market rate of substitution :

M/Py = 10/2 =
4
 
5 units of good Y
  Budget line:
M/PX = 10/1 =
10 units of good X 3
 

Slope:
-Px/Py = -1/2

0 2
  4
  10
    Good

4-14
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 Constraints

The Budget Constraint in Action

•  Consider the following budget line:

1. What is the maximum amount of X that can be consumed?

Maximum X is: units
2. What is the maximum amount of Y that can be consumed?
Maximum Y is: units

3. What is the rate at which the market trades goods X and Y?

• Market rate of substitution:

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 Constraints

Changes in Income Shrink or Expand Opportunities

 Good
1
𝑀
 
𝑃𝑌

0
𝑀
 
𝑃𝑌

𝑀
 
2 increase 𝑀
  ↑
𝑃𝑌 𝑀
  ↓

decrease

2
0
𝑀
  𝑀 0
𝑀 1
      Good
𝑃𝑌 𝑃𝑌 𝑃𝑌
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4-16
 Constraints

Changes in Prices
 Good
A Decrease in the Price of Good X

 𝑀
𝑃𝑌 What is the effect of the
changes in the price of
good X to the BL

New budget line

Initial budget
line
0 1
𝑃
  𝑋 > 𝑃𝑋

0  𝑀  𝑀   Good
𝑃𝑋
0
𝑃𝑋1

4-17
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 Consumer Equilibrium

•  Consumer equilibrium
• Shows the consumption bundle that is affordable and yields
the greatest satisfaction to the consumer.
• Consumption bundle where the rate a consumer choses
(marginal rate of substitution) to trade between goods X and
Y equals the rate at which these goods are traded in the
market (market rate of substitution).

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 Consumer Equilibrium

•  Consumer equilibrium
• Consumption bundle that is affordable and yields the
greatest satisfaction to the consumer.
• Consumption bundle where the rate a consumer selects
(marginal rate of substitution) to trade between goods X
and Y equals the rate at which these goods are traded in
the market (market rate of substitution).

4-19
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 Consumer Equilibrium

Consumer Equilibrium
 Good

Note that from bundle A to D

D, bundle C represents the
consumers equilibrium A
choice. The term equilibrium B Consumer equilibrium
refers to the fact that the
consumer has no incentive to
change to a different C
affordable bundle once this
point is reached

III

II

0   Good

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4-20
 Comparative Statics

Price Changes and Consumer Behavior

• Price and income changes impact a consumer’s budget

set and level of satisfaction that can be achieved.
• This implies that price and income changes will lead to
consumer equilibrium changes.

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 Comparative Statics

Price Changes and Equilibrium

• Price increases (decreases) reduce (expand) a
consumer’s 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.

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 Comparative Statics

Price Changes and Equilibrium in Action

 Good

 𝑀 Point A: Initial consumer equilibrium

𝑃𝑌   Price of good X decreases:
Point B: New consumer equilibrium
  Since when :
Conclude that goods and are
A substitutes
𝑌  0 B
𝑌  1

II
I

𝑋
  0  𝑀 𝑋  𝑀   Good
0   1
0 1
𝑃𝑋 𝑃𝑋

4-23
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 Comparative Statics

Income Changes and Consumer Behavior

• Income increases (decreases) reduce (expand) a

consumer’s 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.

4-24
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 Comparative Statics

Income Changes and Consumption

 Good

𝑀 1 Point A: Initial consumer equilibrium

 
𝑃𝑌   Price of income increases:
Point B: New consumer equilibrium

𝑀 0  Since more of both goods are consumed

  when : Conclude that goods
𝑃𝑌 B and are normal goods.

A
II

0 1
0
𝑀
  𝑀
    Good
𝑃𝑋 𝑃𝑋
4-25
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