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Microeconomics for

Managers

Biresh Sahoo, Ph.DProfessor, XIM Bhubaneswar

Lecture 2: Module I: Theory of Consumer Behavior

and Demand Analysis

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Module I:

Theory of Consumer Behavior

Consumers problem

Consumer preferences and utility

Axioms (assumptions) about preferences

Utility curve (indifference curve)

Substitution between goods And most importantly, learningand applyingthese concepts in practice

Topics to be covered:

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Consumers Problem

A consumers economic problem is to allocate hisher

limited funds to competing needs and desires over a

given time period

Chooses a consumption bundle that gives himher

maximum satisfaction

!ecision to consume more of one good is a decision to

consume less of another

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Consumer Preferences

Preferencestell us about a consumers li"es and disli"es#

$hree ways of representing preferences

A consumer is indifferentbetween two alternatives (A and%, say) if she li"es (or disli"es) them e&ually# Symbolically,

A%#

A consumer prefers A to % if u(A) ' u(%)#

A consumer prefers % to A if u(%) ' u(A)#

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Axioms about Preferences

Complete A consumer can ran", in order of hisher preference, all

potentially available alternatives#

$ransitive f (x*,x+) is preferred to (y*,y+) and (y*,y+) is preferred

to (*,+), then (x*,x+) is preferred to (*,+),

-onotonicity f (x*,x+) is a bundle of goods and (y*,y+) is a

bundle of goods with at least as much of both goods and more of

one, then (y*,y+) is preferred to (x*,x+) #

Convexity An average bundle is preferred to extreme bundles#

$hat is, if (x*,x+) . (y*,y+), then for any (/ *), then

(x*0(*1)y*, x+0(*1)y+) is preferred to (x*,x+) (y*,y+)#

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Indifference Curve (IC

Starting with any alternative, an indifference curve

shows all the other alternatives a consumer li"es

e&ually well#

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#ou$ %$ints&

Bread %o'(&

A

)

*

CB

IC

+

16,

-

1.,

2,6

",

12

,

12

1,,

1

Better

than A

)orse

than A

Identifyin Alternatives and

Indifference Curves %ICs&

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Properties of Indifference Curves

$hin

!ownward slopping

2igher the C, the higher the level of satisfaction

3o two Cs can intersect with each other

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Indifference Curves Ruled Out by the

More-is-better Principle

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u,

u1

u,

#ou$ %$ints&

Bread %o'(&Bread %o'(&

#ou$ %$ints&1 2

y1

y2

1 2

y1

y2A

BA

B

C

, ,

Since A % and A C,

therefore % C# 2owever, C % since C contains more of

both goods# $herefore, no two

Cs can intersect#

u1

roof of

Case 2

roof of

Case !

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Indifference Curve (IC) MapCollection of indifference curves that represent the

preferences of an individual

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IC Map

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Substitution et!een "oods

4conomic decisions involve trade1offs

$o determine whether a consumer has made the bestchoice, we need to "now the rate at which she is willing to

ma"e trade1offs (substitute) between different goods

ndifference curves provide that information

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Rate of Substitution

Consider moving along an indifference curve, from one

bundle to another

$his is the same as subtracting units of one good andcompensating the consumer for the loss by adding units of

another good

Slope of the indifference curve shows how much of the

second good is needed to ma"e up for the decrease in the

first good

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Rates of Substitution

5oo" at move from

bundle A to C

Consumer loses *soup6 gains + bread

7illing to substitute

for soup with bread

at + ounces per pint

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$nother !ay of representin# MRS

A %13y1&

,

y2

y1

21 4ood %&

4ood %y&-ovement from A to % involves a

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%hat &eter'ines MRS

Differences in tastes

references for one ood over another affect the slo$e of an

indifference curve

Im$lications for M##tartin $oint on the indifference curve

eo$le li7e variety so most indifference curves et flatter as 8e move

from to$ left to 9ottom riht

Lin7 9et8een slo$e and M# im$lies that M# declines the amount

of ; re

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Indifference Curves and Consu'er Tastes

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MRS alon# an Indifference Curve

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Perfect Substitutes and Co'ple'ents

Some special cases of preferences represent opposites ends of the

substitutability spectrum

$wo products areperfect substitutesif their functions are identical6 a

consumer is willing to swap one for the other at a fixed rate

$wo products areperfect complementsif they are valuable only

when used together in fixed proportions

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Perfect Substitutes

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Perfect Co'ple'ents

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Thank you

for your patience