Overview. Managerial Economics & Business Strategy Baye Chapters 4-5 Edited by DF 10/12. Consumer Behavior

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1 Managerial Economics & usiness Strategy aye hapters 4-5 Edited by DF 1/12 Overview onsumer ehavior ndifference urve nalysis onsumer Preference Ordering onstraints The udget onstraint hanges in ncome hanges in Prices onsumer Optimum V. Generating Demand urves ndividual Demand Market Demand Michael McGraw-Hill/rwin R. aye, Managerial Economics and usiness Strategy, 5e. opyright opyright 26 by The 26 McGraw-Hill by The McGraw-Hill ompanies, nc. nc. ll ll rights reserved. onsumer ehavior onsumer Opportunities The possible goods and services consumer can afford to consume. onsumer Preferences The goods and services consumers actually consume. Given the choice between 2 bundles of goods a consumer either Prefers bundle to bundle :, or U()>U() Prefers bundle to bundle :, or U()<U() s indifferent between the two:, or U()=U() ndifference urve nalysis ndifference urve curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction. Represented by U(,), whose partial derivatives are denoted U, U Marginal Rate of Substitution The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level. MRS = U /U Good Good onsumer Preference Ordering Properties omplete everything can be compared Monotone More is etter Diminishing Marginal Rate of Substitution Transitive omplete Preferences ompleteness Property onsumer is capable of expressing preferences (or indifference) between all possible bundles. ( dont know is NOT an option!) f the only bundles available to a consumer are,, and, then the consumer is indifferent between and (they are on the same indifference curve). will prefer to. will prefer to. Good Good 1

2 More s etter Property More s etter! undles that have at least as much of every good and more of some good are preferred to other bundles. undle is preferred to since contains at least as much of good and strictly more of good. undle is also preferred to since contains at least as much of good and strictly more of good. More generally, all bundles on are preferred to bundles on or. nd all bundles on are preferred to. Good Good Diminishing Marginal Rate of Substitution Marginal Rate of Substitution The amount of good the consumer is willing to give up to maintain the same satisfaction level decreases as more of good is acquired. The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level. To go from consumption bundle to the consumer must give up 5 units of to get one additional unit of. To go from consumption bundle to the consumer must give up units of to get one additional unit of. To go from consumption bundle to D the consumer must give up only 8.33 units of to get one additional unit of. Good D Good onsistent undle Orderings Transitivity Property For the three bundles,, and, the transitivity property implies that if and, then. Transitive preferences along with the more-is-better property imply that indifference curves will not intersect. the consumer will not get caught in a perpetual cycle of indecision. Good Good Opportunity Set The udget onstraint The set of consumption bundles that are affordable. P x + P y M. udget ine The bundles of goods that exhaust a consumers income. P x + P y = M. Market Rate of Substitution The slope of the budget line -P x / P y M/P The Opportunity Set udget ine = M/P (P /P ) M/P hanges in the udget ine hanges in ncome ncreases lead to a parallel, outward shift in the budget line (M 1 > M ). Decreases lead to a parallel, downward shift (M 2 < M ). hanges in Price decreases in the price of good rotates the budget line counter-clockwise (P > P 1 ). n increases rotates the budget line clockwise (not shown). M 1 /P M /P M 2 /P M /P M 2 /P M /P M 1 /P New udget ine for a price decrease. onsumer Optimum The optimal bundle is an affordable bundle that yields the highest level of satisfaction. onsumer equilibrium occurs at a point where MRS = P / P. Equivalently, the slope of the indifference curve equals the budget line. Or else the optimum is at a corner M /P M /P 1 M/P onsumer Equilibrium M/P 2

3 Price hanges and onsumer Equilibrium Substitute Goods n increase (decrease) in the price of good leads to an increase (decrease) in the consumption of good. Examples: oke and Pepsi. Verizon Wireless or T&T. omplementary Goods n increase (decrease) in the price of good leads to a decrease (increase) in the consumption of good. Examples: DVDs and DVD players. omputer PUs and monitors. When the price of good falls and the consumption of rises, then and are complementary goods. (P 1 > P 2 ) omplementary Goods Pretzels () M/P M/P 1 2 M/P 2 eer () ncome hanges and onsumer Equilibrium Normal Goods Normal Goods Good is a normal good if an increase (decrease) in income leads to an increase (decrease) in its consumption. nferior Goods Good is an inferior good if an increase (decrease) in income leads to a decrease (increase) in its consumption. n increase in income increases the consumption of normal goods. (M < M 1 ). M 1 / 1 M / M / 1 M 1 / Decomposing the ncome and Substitution Effects nitially, bundle is consumed. decrease in the price of good expands the consumers opportunity set. The substitution effect (SE) causes the consumer to move from bundle to. higher real income allows the consumer to achieve a higher indifference curve. The movement from bundle to represents the income effect (E). The new equilibrium is achieved at point. SE E ndividual Demand urve n individuals demand curve is derived from each new equilibrium point found on the indifference curve as the price of good is varied. P P 1 1 D 3

4 Market Demand The market demand curve is the horizontal summation of individual demand curves. t indicates the total quantity all consumers would purchase at each price point. ndividual Demand urves 5 4 Market Demand urve buy-one, get-one free pizza deal. lassic Marketing pplication Other goods () D E D 1 D D M F Pizza () onclusion ndifference curve properties reveal information about consumers preferences between bundles of goods. ompleteness. More is better. Diminishing marginal rate of substitution. Transitivity. ndifference curves along with price changes determine individuals demand curves. Market demand is the horizontal summation of individuals demands. Production and ost: Overview Production nalysis Total Product, Marginal Product, verage Product soquants socosts ost Minimization ost nalysis Total ost, Variable ost, Fixed osts ubic ost Function ost Relations Multi-Product ost Functions V. earning urve Production nalysis Production Function = F(,) The maximum amount of output that can be produced with units of capital and units of labor. Short-Run vs. ong-run Decisions Fixed vs. Variable nputs Total Product obb-douglas Production Function Example: = F(,) =.5.5 is fixed at 16 units in short run. Short run production function: = (16).5.5 = 4.5 Output when 1 units of labor are used? = 4 (1).5 = 4(1) = 4 units 4

5 Marginal Productivity Measures Marginal Product of abor: MP = d/d Measures the output produced by the last worker. Slope of the short-run production function (with respect to labor). Marginal Product of apital: MP = d/d Measures the output produced by the last unit of capital. When capital is allowed to vary in the short run, MP is the slope of the production function (with respect to capital). verage Productivity Measures verage Product of abor P = /. Measures the output of an average worker. Example: = F(,) =.5.5 f the inputs are = 16 and = 16, then the average product of labor is P = [(16).5 (16).5 ]/16 = 1. verage Product of apital P = /. Measures the output of an average unit of capital. Example: = F(,) =.5.5 f the inputs are = 16 and = 16, then the average product of labor is P = [(16).5 (16).5 ]/16 = 1. ncreasing, Diminishing and Negative Marginal Returns Guiding the Production Process ncreasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns MP =F(,) P Producing on the production function ligning incentives to induce maximum sustainable worker effort. Employing the right level of inputs When labor or capital vary in the short run, to maximize profit a manager will hire labor until the value of marginal product of labor equals the wage: VMP = w, where VMP = P x MP. capital until the value of marginal product of capital equals the rental rate: VMP = r, where VMP = P x MP. soquant The combinations of inputs (, ) that yield the producer the same level of output. The shape of an isoquant reflects the ease with which a producer can substitute among inputs while maintaining the same level of output. Marginal Rate of Technical Substitution (MRTS) The rate at which two inputs are substituted while maintaining the same output level. MP MRTS = MP 5

6 inear soquants eontief soquants apital and labor are perfect substitutes = a + b MRTS = b/a inear isoquants imply that inputs are substituted at a constant rate, independent of the input levels employed. ncreasing Output apital and labor are perfect complements. apital and labor are used in fixed-proportions. = min {b, c} Since capital and labor are consumed in fixed proportions there is no input substitution along isoquants (hence, no MRTS ) ncreasing Output obb-douglas soquants nputs are not perfectly substitutable. Diminishing marginal rate of technical substitution. s less of one input is used in the production process, increasingly more of the other input must be employed to produce the same output level. = a b MRTS = MP /MP ncreasing Output socost The combinations of inputs that produce a given level of output at the same cost: 1 /r w + r = /r Rearranging, = (1/r) - (w/r) For given input prices, isocosts farther from the origin are /r associated with higher costs. hanges in input prices change the slope of the isocost line. /w New socost ine associated with higher costs ( < 1 ). 1 1 /w New socost ine for a decrease in the wage (price of labor: w > w 1 ). /w /w 1 ost Minimization ost Minimization Marginal product per dollar spent should be equal for all inputs used: MP MP = w r ut, this is just MP MP = w MRTS = r w r Slope of socost = Slope of soquant Point of ost Minimization 6

7 Optimal nput Substitution ost nalysis firm initially produces by employing the combination of inputs represented by point at a cost of. Suppose w falls to w 1. The isocost curve rotates counterclockwise; which represents the same cost level prior to the wage change. To produce the same level of output,, the firm will produce on a lower isocost line ( 1 ) at a point. The slope of the new isocost line represents the lower wage relative to the rental rate of capital. 1 1 /w 1 /w 1 /w 1 Types of osts Fixed costs (F) Variable costs (V) Total costs (T) Sunk costs Total and Variable osts (): Minimum total cost of producing alternative levels of output: () = V() + F V(): osts that vary with output. F: osts that do not vary with output. () = V + F V() F Fixed and Sunk osts F: osts that do not change as output changes. Sunk ost: cost that is forever lost after it has been paid. voidable F is the rest. () = V + F V() F Some Definitions Fixed ost verage Total ost T = V + F T = ()/ verage Variable ost V = V()/ verage Fixed ost F = F/ M T V MR F T V (T-V) = F = (F/ ) = F Fixed ost M T V Marginal ost M = Δ/Δ F 7

8 Variable ost Total ost V = [V( )/ ] = V( ) M T V T = [( )/ ] = ( ) M T V T V Variable ost Total ost ubic ost Function () = f + a + b 2 + c 3 Marginal ost? Memorize: M() = a + 2b + 3c 2 alculus: d/d = a + 2b + 3c 2 n Example Total ost: () = Variable cost function: V() = + 2 Variable cost of producing 2 units: V(2) = 2 + (2) 2 = 6 Fixed costs: F = 1 Marginal cost function: M() = Marginal cost of producing 2 units: M(2) = 1 + 2(2) = 5 Economies of Scale R Multi-Product ost Function ( 1, 2 ): ost of jointly producing two outputs. General function form: Economies of Scale Diseconomies of Scale ( 2 2 ) = f + a + b +, c

9 Economies of Scope ( 1, ) + (, 2 ) > ( 1, 2 ). t is cheaper to produce the two outputs jointly instead of separately. Example: t is cheaper for ig reek umber to produce 2x4s and sawdust mulch jointly than separately. ost omplementarity The marginal cost of producing good 1 declines as more of good two is produced: ΔM 1 ( 1, 2 ) /Δ 2 <. Example: ow hides and steaks. uadratic Multi-Product ost Function ( 1, 2 ) = f + a ( 1 ) 2 + ( 2 ) 2 M 1 ( 1, 2 ) = a M 2 ( 1, 2 ) = a ost complementarity: a < Economies of scope: f > a 1 2 ( 1,) + (, 2 ) = f + ( 1 ) 2 + f + ( 2 ) 2 ( 1, 2 ) = f + a ( 1 ) 2 + ( 2 ) 2 f > a 1 2 : Joint production is cheaper Numerical Example: ( 1, 2 ) = ( 1 ) 2 + ( 2 ) 2 ost omplementarity? es, since a = -2 < M 1 ( 1, 2 ) = Economies of Scope? es, since 9 > earning urve ost declines with accumulated output = Σs, s= to t. dea: efficiency improves with experience due to individual learning and better team coordination. Original examples: aircraft and ship building in WW Recent examples: microprocessors, fuel cells ln M = a b ln is usual functional form The incremental cost decreases b% when accumulated output increases 1% onclusion To maximize profits (minimize costs) managers must use inputs such that the value of marginal of each input reflects price the firm must pay to employ the input. The optimal mix of inputs is achieved when the MRTS = (w/r). ost functions are the foundation for helping to determine profit-maximizing behavior in future chapters. 9