Managerial Economics & Business Strategy Chapter 4 Theory of Individual Behavior
Price Changes and Consumer Equilibrium • Substitute Goods n An increase (decrease) in the price of good X leads to an increase (decrease) in the consumption of good Y. • Examples: – Coke and Pepsi. – Verizon Wireless or T-Mobile. • Complementary Goods n An increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y. • Examples: – DVD and DVD players. – Computer CPUs and monitors.
When the price of good X falls and the consumption of Y falls, then X and Y are substitute goods. (PX 1 < PX 2) Substitute Goods Pretzels (Y) M/PY 1 A Y 1 B Y 2 I 0 X 1 M/PX 1 II X 2 M/PX 2 Beer (X)
Complementary Goods When the price of Pretzels (Y) good X falls and the consumption of Y rises, then X and Y M/PY 1 are complementary goods. (PX 1 > PX 2) B Y 2 II A Y 1 I 0 X 1 M/PX 1 X 2 M/PX 2 Beer (X)
Income Changes and Consumer Equilibrium • Normal Goods n Increase (decrease) in income leads to an increase (decrease) in its consumption. • Inferior Goods n Increase (decrease) in income leads to a decrease (increase) in its consumption.
Normal Goods An increase in income increases the consumption of normal goods. Y M 1/Y (M 0 < M 1). B Y 1 M 0/Y II A Y 0 I 0 X 0 M 0/X X 1 M 1/X X
Inferior Goods An increase in income decreases the consumption of inferior goods. Y M 1/Y Y 1 B (M 0 > M 1). II M 0/Y A Y 0 I 0 X 1 X 0 M 0/X M 1/X X
When price of a good decreases • Two things happen n Relative price of the good decreases • Buy more of the cheaper good • Substitution Effect n Real income or purchasing power increases • If buy same bundle of goods bought previously have money left over • Income Effect
To graphically break up the effects • Price decrease causes a rotation on the BC n New optimal bundle • Look at what would we have bought with this new income level (new BC) at our old Utility level n n Take money away from consumer to keep original Utility level Price has changed though so cannot keep the slope of the original BC
The Result is Three Points • Old optimal bundle to new optimal bundle is the TOTAL EFFECT • Old optimal bundle to new tangency on original IC is SUBSTITUTION EFFECT n Same indifference curve • New tangency on original IC to new optimal bundle is INCOME EFFECT n Same budget constraint
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