Managerial Economics Session 4

Managerial Economics
Session 4
Dr Prema Basargekar

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 2
Outline
 Consumer preferences
 Indifference Curve analysis
 Consumer Budget Constraints.
 Consumer Equilibrium
 Price, Income & Substitution Effects
 Individual demand curve
 Types of demand
 Individual & Market demand
 Linear demand curve

Introduction and Objectives
 Consumers make a trade off due to
limitations of resources.
 Consumer behaviour is a study of
understanding these trade offs and finding
out how the consumers make the economic
decisions.
 It affects the pricing and production
decisions of any organization.

Introduction and objectives cont..
 Utility is tied with consumption.
 Utility is a want satisfying capacity of a product
 Non-satiation principle – consumers always
prefer more to less.
 Preferences are complete.- can be ranked &
compared with each other.
 Ordinal utility – can be ranked but cannot be
measured
 Cardinal utility – can be measured
 Scarcer the good the greater is its substitution
value

An Indifference Curve
I2
3
4
5
10
8
Videorentalsperweek
a
b
c
d
1 2 3 4 5 10
Pizzas per week
0
An indifference curve (I) shows all
combinations of two goods that
provide a particular consumer with
the same total utility.
Indifference curve:
• negative slope
• convex to origin

Indifference Curves
 Indifference curves represent all the market baskets
that provide a given consumer the same amount of
utility or satisfaction
 Assumptions:
 The consumer is indifferent to different combinations
of two goods.
 The scarcer a good the greater is its substitution
value.
 The consumer aims to maximise his total satisfaction
and has got complete market information.
 Utility is not measurable but the consumer can only
specify his preference for a particular combination of
two goods.

Indifference combination of ‘X’ and ‘Y’
goods
Combination Units of ‘X’ Units of ‘Y’
1 3 21
2 4 15
3 5 11
4 6 8
5 7 6

Indifference curve
 An indifference
curve of a consumer
represents a
particular level of
satisfaction for the
consumer.
 A consumer may
infact specify a large
number of such
curves each
representing
different level of

Properties of IC
 Basic Characteristics
 Higher indifference curves are better.
 Indifference curves do not intersect.
 Indifference curves slope downward.
 Indifference curves are convex to origin.- bend
inwards

The Diminishing Marginal Rate of
Substitution
 The rate at which the consumer will substitute one product for
the other is called as MRS
 MRS = - ∆Y/∆ X
 MRS always decreases as the stock of X increases & that of
Y increases.
 X & Y are not perfect substitute to each other. Hence when
the quantity of X increases, it becomes more and more
difficult for the consumer to sacrifice more & more units of Y
for one unit of X.
 If the consumer is required to sacrifice additional units of Y,
he/she will demand more units of X to maintain the same
level of satisfaction.
 Hence, indifference curves are convex to the origin.

The Diminishing MRS between X & Y
Combinatio
n
Commodit
y Y
Commodit
y X
Change in
Y
- ∆Y
Change in X
∆ X
MRS
- ∆Y/∆ X
A 25 5
B 15 7 -10 2 -5
C 10 12 -5 5 -1
D 6 20 -4 8 -0.5
E 4 30 -2 10 -0.2

Indifference Curves Do Not Intersect
Videorentalsperweek
Pizzas per week0
I’
I
i
k
j
If indifference curves crossed (i)
every point on I and every point on
I’ would have to reflect the same
level of utility as i.
Indifference curves cannot intersect
k: more pizzas and videos
than j; higher utility than j

Budget Constraints
 A budget constraint represents all combinations of
product that can be purchased for a fixed amount.
 Total budget = Spending on goods =Spending on
services
 B = PyY +PxX
 Eg – Y = Rs. 250 & X = Rs 100
 B = 250Y + 100X
 Basic Characteristics
 Show affordable combinations of X and Y.
 Slope of –PX/PY reflects relative prices.

The Consumer’s Budget Constraint
Qty
X
Price X Spending
X
Qty Y Price Y Spending
Y
Total
spending
4.0 250 1000.0 0.00 100 0.00 1000
3.5 250 875.0 1.25 100 125.0 1000
3.0 250 750.0 2.50 100 250.0 1000
2.5 250 625.0 3.75 100 375.0 1000
2.0 250 500.0 5.00 100 500.0 1000
1.5 250 375.0 6.25 100 625.0 1000
1.0 250 250.0 7.50 100 750.0 1000
0.5 250 125.0 8.75 100 875.0 1000
0.0 250 0.0 10.00 100 1000.0 1000

Indifference Curves and Utility
Maximization
 The budget line
– Combinations of goods
– Able to buy
– Consumption possibilities frontier
 Slope of budget line:
v
p
p
v
p
p
pI
pI
=−=
/
/

A Budget Line
5
10
Videorentalsperweek
5 10
Pizzas per week
0
Slope = -pp / pv = -$20/$10 = -2
Slope = -2: the price of 1 pizza is 2 videos.
Budget line: all combinations of pizza and videos that
can be purchased at fixed prices with a given income.
If is Pv = $ 10 and Pp = $ 20 & the total budget is $ 100

Utility Maximization
I1
I2
I3
e
5
10
Videorentalsperweek
4
5 10
Pizzas per week
0 3
A consumer’s utility is maximized at
point e, where indifference curve I2 is
tangent to the budget line.
a

Budget line and consumer equilibrium
 The budget line or price line
depicts the different
combination of two goods
which the consumer can
buy by spending all his
income.
 The consumer equilibrium
comes when budget line
touches indifferent line
tangentially meaning that
the slopes are equal. It
means marginal rate of
substitution is equal to the
ratio of prices ‘X’ and ‘Y.’.

Consumer Equilibrium
 Combination of goods that maximizes utility for a given
set of prices and a given level of income
 Represented graphically by the point of tangency
between an indifference curve and the budget line
 MUX/MUY = PX/PY
 MUX/PX = MUY/PY

Derivation of Consumer Demand
Curve
 Given consumer income and price of commodity “Y”, we
can derive the consumer’s demand curve for commodity
“X”.
 Eg when M = $ 6, given the Py = $1, with reduction in Px
from $ 2 to $ 1 to $ 0.67 , the budget line becomes
tangent to higher levels of indifference curves such as
from U1 to U2 to U3.
 It depicts the relationship between price and demand for
the product.

Effect of a Drop in the Price of Pizza
DI”I
e
5
10
Videorentalsperweek
4
e”
5
Pizzas per week
0 3 4 6.67
e
$8
Priceperpizza
6
e”
Pizzas per week
0 3 4
(a) (b)
A reduction in the price of pizza
rotates the budget line rightward.
The consumer is back in equilibrium
at point e” along the new budget line.
A drop in price of pizza increases
quantity demanded.

Income and Substitution Effects of a
Price Change
 The increase in the demand for a commodity
presents the combined effect of the substitution
and income effects.
 Indifference curve analysis can be used to
separate the substitution effect from the income
effect.
 The substitution effect shows that when the price
of X falls, the consumer will substitute X for Y.
 The income effect shows that when Px falls, the
individual’s real income increases and so he/she
purchases more of X.
 It can be seen by drawing a hypothetical budget
line which is parallel to the budget line.

Substitution and Income Effects of a Drop in the Price of
Pizza
I
I*
e
e*
5
10
Videorentalsperweek
4
C
e’
5 10
Pizzas per week
0 3 F4
Income
effect
Substitution
effect
A reduction in the price of pizza moves the
consumer from e to e*.
Substitution effect: e to e’; consumer’s reaction
to a change in relative prices along the
original indifference curve.
Income effect: e’ to e*; moves the
consumer to a higher indifference
curve at the new relative price ratio.

Income & Substitution Effect
 Price effect = Substitution effect + Income
effect
 The substitution effect works only in one
direction. If one of the two commodities
becomes relatively cheaper, more of it and the
less of other would be purchased.
 Income effect can work in both the directions.
 In reality substitution effect is larger than
income effect.

Suppose you have $14 to spend on apples and cookies. The price of one
apple is $2 and the price of one cookie is $4. Using the information below
determine the utility-maximizing combination of apples and cookies.
Qty of Apples TU of Apples Qty of Cookies TU of Cookies
1 10 1 10
2 15 2 18
3 19 3 24
4 22 4 28
5 20 5 30

Review
 1. Manisha is allocating her budget between
goods A & B. If she has used up the budget on
a combination for which MUA/ PA > MUB/PB,
she can increase her utility by
 A. More A & less B
 B. More B & less A
 C. More A without changing the consumption
of B
 D. Less B without changing the consumption
of A

Numerical: If you have a budget of $24 per week
to allocate for Goods A, B & C
QA MU A QB MUB QC MUC
1 50 1 75 1 25
2 40 2 60 2 20
3 30 3 40 3 15
4 20 4 30 4 10
5 15 5 20 5 7.5
a. If PA = $2, PB = $3, PC = $ 1. How much each of these
should be purchased?
b. If the PA rises to $4 while other prices remaining the same,
how much each should be purchased?
c. If the budget cuts down to $12, then how much of each you
should purchase?

Concepts Learnt
 Law of Diminishing Marginal Utility
 Law of Equi-Marginal Utility
 Indifference Curve
 Properties of Indifference Curve
 Budget Line
 Consumer Equilibrium
 Income and Substitution Effects
 Deriving Demand Curve

Managerial Economics Session 4

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