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BUS525,MANAGERIAL

ECONOMICS

COURSECONVENER:
DR.TAMGIDAHMED
CHOWDHURY
CHAPTER3:CONSUMER
CHOICE
Topicstodiscuss
ConsumerPreferences

ManagerialEconomics
BudgetConstraints

ConsumerChoice

RevealedPreference

MarginalUtilityandConsumerChoice

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CONSUMER
BEHAVIOR
theoryofconsumerbehavior:Description
ofhowconsumersallocateincomesamong
differentgoodsandservicestomaximizetheir

ManagerialEconomics
wellbeingorutilityorsatisfaction.
Consumerbehaviorisbestunderstoodinthree
distinctsteps:
1.Consumerpreferences(willingnessfactor)
2.Budgetconstraints(abilityfactor)
3.Consumerchoices(demandingforthegoods)

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CONSUMER
PREFERENCES
Fewassumptions
Completeness:Preferencesareassumedtobe
complete.Inotherwords,consumerscancompare

ManagerialEconomics
andrankallpossiblebaskets.Thus,foranytwo
marketbasketsAandB,aconsumerwillpreferAto
B,willpreferBtoA,orwillbeindifferentbetween
thetwo.
Transitivity:Preferencesaretransitive.
Transitivitymeansthatifaconsumerprefers
basketAtobasketBandbasketBtobasketC,then
theconsumeralsoprefersAtoC.
Moreisbetterthanless:Goodsareassumedto
besociallydesirable.Consumerwouldprefera 4
basketwith2Xand2Yoverabasketof4Xand3Y.
CONSUMERPREFERENCES:
MEASURINGUTILITY
Indifferencecurve
(IC):Curve
representingall
combinationsof

ManagerialEconomics
marketbasketsthat
provideaconsumer
withthesamelevelof
satisfaction.

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UTILITYFUNCTION
Formulathatassignsalevelofutilityto
individualmarketbasket.Forexample,

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U(F,C)=F+2Cistheutilityfunction
8unitsfood(F)and3unitsclothing(C)would
provideutility=8+2(3)=14.
6unitfoodsand4unitsclothingwillprovidethe
sameutility.
But4unitsoffoodand4unitsofclothingdonot
yieldthesameutility.

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INDIFFERENCECURVE(IC)
FeaturesorcharacteristicsofIC
1. ICisdownwardslopping(because,withthefixed
income,aconsumerhastoreduceconsumptionofa

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productwhenconsumptionofanotherproductrises)
2. ICisconvextotheorigin(becauseofdiminishing
marginalrateofsubstitution)
3. ICscantintersecteachother(bydoingso,it
violatestransitivityrule)
4. Highertheindifferencecurvemoreisthe
satisfaction(becauseinahigherIC,consumergets
moreproductsthanalowerIC)
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2NDFEATUREOFIC
Marginalrateof
substitution:marginal
rateofsubstitution

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(MRS)Maximum
amountofagoodthata
consumeriswillingto
giveupinordertoobtain
oneadditionalunitof
anothergood.
ICfollowsdiminishing
marginalrateof
substitution 8
EXCEPTIONSOFIC
Substituteproducts:Twogoodsforwhichthe
marginalrateofsubstitutionofonefortheotheris
aconstant.

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perfectcomplementsTwogoodsforwhich
theMRSiszeroorinfinite;theindifference
curvesareshapedasrightangles.

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MATHEMATICALEXAMPLES
SupposethatRahimandKarimspendtheirincomes
ontwogoods,food(F)andclothing(C).Rahims
preferencesarerepresentedbytheutilityfunction
U(F,C)=10FC,whileKarimspreferencesare

ManagerialEconomics
representedbytheutilityfunctionU(F,C)=0.20F 2C2.
Withfoodonthehorizontalaxisandclothingonthe
verticalaxis,identifyonagraphthesetofpointsthat
giveRahimthesamelevelofutilityasthebundle
(10,5).DothesameforKarimonaseparategraph.
Onthesametwographs,identifythesetofbundles
thatgiveRahimandKarimthesamelevelofutilityas
thebundle(15,8).
DoyouthinkRahimandKarimhavethesame
preferencesordifferentpreferences?Explain.
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BUDGETLINE
Itshowsdifferentcombinationsofgoodsandservicesthatan
individualcanbuywithhis/herincome.
Showtheimpactofchangeinincomeonbudgetline

ManagerialEconomics
Slopeofthebudgetlineisthe
priceratiooftwogoodsunder
consideration

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SLOPEOFTHEBUDGETLINE
LineAG(whichpasses
throughpointsB,D,
andE)showsthe

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budgetassociated
withanincomeof$80,
apriceoffoodofPF=
$1perunit,anda
priceofclothingofPC
=$2perunit.
Theslopeofthe
budgetline(measured
betweenpointsBand
D)isPF/PC=
12
10/20=1/2.
CHANGEINBUDGETLINEWITHACHANGEINPRICE

PriceChangesA
changeinthe
priceofonegood(with
incomeunchanged)
causesthebudgetline

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torotateaboutone
intercept.
Whenthepriceoffood
fallsfrom$1.00to
$0.50,thebudgetline
rotatesoutwardfrom
L1toL2.
However,whenthe
priceincreases
from$1.00to$2.00,
thelinerotates
inwardfromL1toL3.
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MATHEMATICALEXAMPLE

Samirabuysfivenewcollegetextbooksduringhis
firstyearatschoolatacostof$80each.Used
bookscostonly$50each.Whenthebookstore

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announcesthattherewillbea10percent
increaseinthepriceofnewbooksanda5percent
increaseinthepriceofusedbooks,Samiras
fatheroffershim$40extra.
A)WhathappenstoSamirasbudgetline?
Illustratethechangewithnewbooksonthe
verticalaxis.
B)IsSamiraworseorbetteroffafterthe
pricechange?Explain. 14
CONSUMERCHOICE:FINDINGBEST
POINT
Consumers
satisfactionwillbe
maximumatapoint

ManagerialEconomics
whereICandbudget
linearetangentto
eachother.
Utilityismaximized
atthepointwhere
MRS=priceratioof
twogoods
AtpointB,MRS=
(10/10)=1whichis
notequaltoprice 15
ratio.
OTHEREQUILIBRIUMS

Showtheoptimumpointincaseofsubstitute
productsandincaseofcomplementproducts

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Showthechangeinequilibriumifincome
increases
Showthechangeinequilibriumifpriceofa
productincreases

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diminishingmarginalutilityPrinciplethatas
moreofagoodisconsumed,theconsumptionof
additionalamountswillyieldsmalleradditionstoutility.
Theadditionalconsumptionoffoodwillgiveatotal
increaseinutilityofMUF.F.Ontheotherhandbecause
ofmoreFconsumption,Cconsumptionwilldeclineand

ManagerialEconomics
thustotalreductionwouldbeMUC.C.
Thesetwowillbebalancedthus:
0=MUF(F)+MUC(C)
Rearranging,(C/F)=MUF/MUC
MRS=MUF/MUC
PF/PC=MUF/MUC
Principlethatutilityismaximizedwhenthe
consumerhasequalizedthemarginalutilityperdollarof
expenditureacrossallgoods. 17
GASOLINERATIONING
Whenagoodisrationed,less
isavailablethanconsumers
wouldliketobuy.Consumers

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maybeworseoff.Without
gasolinerationing,upto
20,000gallonsofgasolineare
availableforconsumption(at
pointB).
Theconsumerchoosespoint
ConindifferencecurveU2,
consuming5000gallonsof
gasoline.
However,withalimitof2000
gallonsofgasolineunder
rationing(atpointE),the
consumermovestoDonthe
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lowerindifferencecurveU1.
MATHEMATICALEXAMPLE
Soniahasamonthlyincomeof$200thatshe
allocatesamongtwogoods:meatand
potatoes.Supposemeatcosts$4perpound

ManagerialEconomics
andpotatoes$2perpound.Drawher
budgetconstraint.
Supposealsothatherutilityfunctionis
givenbytheequationU(M,P)=0.20M2P2.
Whatcombinationofmeatandpotatoes
shouldshebuytomaximizeherutility?

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