1. 1 © 2015 Pearson Education, Inc. Chapter Outline and Learning Objectives 10.1Utility and Consumer Decision Making 10.2Where Demand Comes From 10.3Social Influences on Decision Making 10.4Behavioral Economics: Do People Make Their Choices Rationally? Appendix: Using Indifference Curves and Budget Lines to Understand Consumer Behavior CHAPTER 10 CHAPTER Consumer Choice and Behavioral Economics

2. 2 © 2015 Pearson Education, Inc. Consumer Decision Making In our study of consumers so far, we have looked at what they do, but not why they do what they do. Economics is all about the choices that people make; a better understanding of those choices furthers our understanding of economic behavior. At the same time, we need to know the limits of our understanding. This chapter will examine what we know, and what we can’t explain, about how consumers behave.

3. 3 © 2015 Pearson Education, Inc. Rationality and Its Implications As a starting point, economists assume that consumers are rational: making choices intended to make themselves as well-off as possible. We examine these choices when consumers make their decisions about how much of various items to buy, given their scarce resources (income). Facing this budget constraint, how do people choose? Budget constraint: The limited amount of income available to consumers to spend on goods and services.

4. 4 © 2015 Pearson Education, Inc. Measuring Utility Economists refer to the enjoyment or satisfaction that people obtain from consuming goods and services as utility. Utility cannot be directly measured; but for now, suppose that it could. What would we see? As people consumed more of an item (say, pizza) their total utility would change: The amount by which it would change when consuming an extra unit of a good or service is called the marginal utility. Generally expect to see the first items consumed produce the most marginal utility, so that subsequent items gave diminishing marginal utility. Law of diminishing marginal utility: The principle that consumers experience diminishing additional satisfaction as they consume more of a good or service during a given period of time.

5. 5 © 2015 Pearson Education, Inc. Pizza on Super Bowl Sunday The table shows the total utility you might derive from eating pizza on Super Bowl Sunday. The numbers (utils), represent utility: higher is better. A graph of your utility initially rises quickly, then more slowly. Eventually, it turns downward as you get sick of pizza. Total and marginal utility from eating pizza on Super Bowl Sunday Figure 10.1

6. 6 © 2015 Pearson Education, Inc. Pizza on Super Bowl Sunday—continued The increase in utility from one slice to the next is the marginal utility of a slice of pizza. We can calculate marginal utility for every slice of pizza and then graph the results. The graph of marginal utility is decreasing, showing the Law of Diminishing Marginal Utility. Total and marginal utility from eating pizza on Super Bowl Sunday Figure 10.1

7. 7 © 2015 Pearson Education, Inc. Allocating Your Resources Given unlimited resources, a consumer would consume every good and service up until the maximum total utility. But resources are scarce; consumers have a budget constraint. The concept of utility can help us figure out how much of each item to purchase. Each item you purchase gives some (possibly negative) marginal utility. If you take MU and divide by the price of the item, you get a ratio called “the marginal utility per dollar spent.” This is the rate at which that item allows the consumer to transform money into utility.

8. 8 © 2015 Pearson Education, Inc. Utility from Pizza and Coke Suppose you go to a restaurant where you can obtain “utility” by eating pizza or drinking Coke. The table gives the total and marginal utility derived from each activity. Total utility and marginal utility from eating pizza and drinking Coke Table 10.1 Number of Slices of Pizza Total Utility from Eating Pizza Marginal Utility from the Last Slice Number of Cups of Coke Total Utility from Drinking Coke Marginal Utility from the Last Cup 00—00— 120 1 2361623515 3461034510 45264505 55425533 651−3652−1

9. 9 © 2015 Pearson Education, Inc. Marginal Utility from Pizza and Coke Suppose your budget is $10; pizza costs $2 per slice; Coke costs $1 per cup. “Marginal utility of pizza per dollar” is just marginal utility of pizza divided by the price, $2. Similarly, for Coke, divide MU by $1. Converting marginal utility to marginal utility per dollar Table 10.2 (1) Slices of Pizza (2) Marginal Utility (MU Pizza ) (4) Cups of Coke (5) Marginal Utility (MU Coke ) 12010120 2168215 31053 463455 521533 6−3−1.56−1

10. 10 © 2015 Pearson Education, Inc. Rule of Equal Marginal Utility per Dollar Spent Suppose the MU/$ obtained from pizza was greater than that obtained from Coke. Then you should eat more pizza, and drink less Coke, until the ratios of MU are equal. This is where we get the Rule of Equal Marginal Utility per Dollar Spent: consumers seek to equalize the “bang for the buck”. Some combinations satisfying this rule are given below. Equalizing marginal utility per dollar spent Table 10.3 Combinations of Pizza and Coke with Equal Marginal Utilities per Dollar Marginal Utility Per Dollar (MU/P) Total SpendingTotal Utility 1 slice of pizza and 3 cups of Coke10$2 + $3 = $520 + 45 = 65 3 slices of pizza and 4 cups of Coke5$6 + $4 = $1046 + 50 = 96 4 slices of pizza and 5 cups of Coke3$8 + $5 = $1352 + 53 = 105

11. 11 © 2015 Pearson Education, Inc. Optimizing Your Consumption of Pizza and Coke The actual bundle you purchase depends on your budget constraint: If you have $5 to spend, you would purchase 1 slice of pizza and 3 cups of Coke. If you have $10 to spend, you would purchase 3 slices of pizza and 4 cups of Coke. In each case, you seek to exhaust your budget, since spending additional money gives more utility. Equalizing marginal utility per dollar spent Table 10.3 Combinations of Pizza and Coke with Equal Marginal Utilities per Dollar Marginal Utility Per Dollar (MU/P) Total SpendingTotal Utility 1 slice of pizza and 3 cups of Coke10$2 + $3 = $520 + 45 = 65 3 slices of pizza and 4 cups of Coke5$6 + $4 = $1046 + 50 = 96 4 slices of pizza and 5 cups of Coke3$8 + $5 = $1352 + 53 = 105

12. 12 © 2015 Pearson Education, Inc. Conditions for Maximizing Utility This gives us two conditions for maximizing utility: 1.Satisfy the Rule of Equal Marginal Utility per Dollar Spent: 2.Subject to your budget constraint: Spending on pizza + Spending on Coke = Income

13. 13 © 2015 Pearson Education, Inc. What If We “Disobey” the Rule? It should be clear that failing to spend all your money results in less utility—each item you buy increases utility. But what if you buy a combination which doesn’t satisfy the Rule of Equal Marginal Utility per Dollar? For example, you could buy 4 slices of pizza and 2 cups of Coke for $10. From Table 10.1, this would give you 52 + 35 = 87 utils, less than the 96 utils that you get from 3 slices and 4 cups. Marginal utility per dollar from 4 th slice: 3 utils per dollar Marginal utility per dollar from 2 nd cup: 15 utils per dollar Since you get so much more marginal utility per dollar from Coke, you ought to drink more Coke—and indeed, that would increase utility.

14. 14 © 2015 Pearson Education, Inc. What If Prices Change? If the price of pizza changes from $2 to $1.50, then the Rule of Equal Marginal Utility per Dollar Spent will no longer be satisfied. You must adjust your purchasing decision. The price change impacts your optimal consumption bundle in two ways: 1.Because of the lower price, you can afford more than before. It is “like” you have a higher income. This is the Income Effect (I.E.). 2.Because of the lower price, pizza is now relatively cheaper compared to Coke than it was before. This is the Substitution Effect (S.E.).

15. 15 © 2015 Pearson Education, Inc. 1. The Income Effect (I.E.) The Income Effect (I.E.) of a price change refers to the change in the quantity demanded of a good that results from the effect of the change in price on consumer purchasing power, holding all other factors constant. Remember from Chapter 3 that some goods are “normal” (we consume more as our income rises) and some are “inferior” (we consume less as our income rises). If pizza is a normal good, the I.E. from a drop in price causes you to consume more pizza. If pizza is an inferior good, the I.E. from a drop in price causes you to consume less pizza.

16. 16 © 2015 Pearson Education, Inc. 2. The Substitution Effect (S.E.) The Substitution Effect (S.E.) of a price change refers to the change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods, holding constant the effect of the price change on consumer purchasing power. To isolate the S.E., we can think of your income decreasing so you can just afford your previous combination. If you had $10 before, you bought 3 slices of pizza (3 x $2.00) and 4 cups of Coke (4 x $1.00). If pizza cost $1.50, $8.50 would allow you to purchase the same combination of items: 3 x $1.50 + 4 x $1.00.

17. 17 © 2015 Pearson Education, Inc. 2. The Substitution Effect—continued But this would no longer maximize utility, since the Rule of Equal Marginal Utility per Dollar Spent is not satisfied: To restore equality, consumption of pizza should rise (decreasing the marginal utility of pizza), and/or consumption of Coke should fall (increasing the marginal utility of pizza) Consuming more pizza and less Coke is the substitution effect.

18. 18 © 2015 Pearson Education, Inc. New Optimal Consumption A possible new combination of items is 4 slices of pizza and 4 cups of Coke, costing 4 x $1.50 + 4 x $1.00 = $10.00. The marginal utility per dollar is not quite equal, but it is as close as we can get without allowing fractional goods. Adjusting optimal consumption to a lower price of pizza Table 10.5 Number of Slices of Pizza Marginal Utility from Last Slice (Mu pizza ) Number of Cups of Coke Marginal Utility from Last Cup (Mu coke ) 12013.33120 21610.67215 3106.67310 464455 521.33533 6−3−3—6−1−1—

19. 19 © 2015 Pearson Education, Inc. Summarizing the Income and Substitution Effects Income effect and substitution effect of a price change Table 10.4 When price... consumer purchasing power... The income effect causes quantity demanded to... The substitution effect causes the opportunity cost of consuming a good to... decreases,increases.increase, if a normal good, and decrease, if an inferior good. decrease when the price decreases, which causes the quantity of the good demanded to increase. increases,decreases.decrease, if a normal good, and increase, if an inferior good. increase when the price increases, which causes the quantity of the good demanded to decrease.

20. 20 © 2015 Pearson Education, Inc. Deriving Your Demand Curve for Pizza We can use our two observations of consumer behavior (with pizza prices of $2.00 and $1.50) to trace out your demand curve for pizza: Deriving the demand curve for pizza Figure 10.2

21. 21 © 2015 Pearson Education, Inc. Deriving the Market Demand Curve for Pizza Each person has his or her own demand curve for pizza. By adding up each individual demand at each price, we obtain the market demand for pizza. Deriving the market demand curve from individual demand curves Figure 10.3

22. 22 © 2015 Pearson Education, Inc. Making the Connection Could a Demand Curve Slope Upward? For a demand curve to be upward sloping, the good has to be an inferior good making up a very large portion of consumers’ budgets. Also, the I.E. would have to be stronger than the S.E. A 2006 experiment revealed that in poor regions in China, decreases in the price of rice led to some very poor people consuming less rice. Economists call a good with an upward-sloping demand curve a “Giffen good”.

23. 23 © 2015 Pearson Education, Inc. Why Would Social Influences Matter for Consumption? In most standard economic models, people are assumed to make choices independently of others. Such models sometimes incorrectly predict consumer behavior, by ignoring the social aspects of decision-making. “The utility from drugs, crime, going bowling… depends on whether friends and neighbors take drugs, commit crime, go bowling…” Gary Becker and Kevin Murphy in Social Economics: Market Behavior in a Social Environment

24. 24 © 2015 Pearson Education, Inc. Examples of Social Influences on Demand Celebrity endorsements Firms use celebrity endorsements regularly. They work. Consumers might believe: “The celebrity knows more about the product than I do”; or “By buying this product, I will become more like the celebrity.” Network externalities Network externalities are situations in which the usefulness of a product increases with the number of consumers who use it. Examples: Facebook; Blu-ray discs; AT&T cell phone service Network externalities might result in market failure, if enough people become locked into inferior products. Example: QWERTY keyboards are designed to be slower to use than alternatives, but almost all keyboards are QWERTY now.

25. 25 © 2015 Pearson Education, Inc. Examples of Social Influences on Demand—cont. Fairness People like to be treated fairly, and prefer to treat each other fairly even if it is bad for them financially. Example: People tend to tip their servers, even if they never plan to go back to the restaurant. Businesses learn from this, and attempt to appear fair even when it will cost them profits. Example: The NFL sells tickets to the Super Bowl at $850-$1250 (2013 prices); but these tickets get resold for much more. Surveys reveal that NFL fans would consider it unfair if the NFL raised ticket prices; instead, fans believe the current system of randomly distributing tickets to applicants is fairer. The NFL forgoes potential profit to avoid alienating fans.

26. 26 © 2015 Pearson Education, Inc. Testing Fairness in the Laboratory Ultimatum game Pairs are given $100. Person A proposes a split of the money, say $75 for him, and $25 for person B. If B accepts, each get the money. If B rejects, neither gets any. “Optimal” play: B should accept any split, hence A should offer B very little. Actual play: Non-even splits are often rejected; and people anticipate this, tending to offer 50/50 splits. Dictator game Same game, except B cannot reject. “Optimal” play: give B nothing! Actual play: 50/50 splits are still common!

27. 27 © 2015 Pearson Education, Inc. Testing Fairness in the Laboratory—conclusions The results from these laboratory games suggest that people strongly value fairness. However it may be the perception of fairness that people value: Subjects might be concerned about the experimenter or other subjects thinking they were selfish, if they kept a large proportion for themselves. When subjects are asked to perform tasks to earn the money, they are more likely to keep as much as they believe they earned. Conclusion: Care needs to be taken in interpreting artificial laboratory experiments.

28. 28 © 2015 Pearson Education, Inc. Making the Connection What’s Up with “Fuel Surcharges”? As oil prices rose in 2008, many firms introduced “fuel surcharges” to make their cost-related price increases appear fair to consumers. In 2011, demand for air travel was starting to rise. This would suggest prices would also rise. But decreases in the price of oil allowed supply to expand. The unnecessary “fuel surcharges” remained, as companies would not want to explain why prices didn’t fall when the “fuel surcharges” were removed.

29. 29 © 2015 Pearson Education, Inc. Behavioral Economics In recent years, some economists have started studying situations in which people make choices that do not appear to be economically rational. This field of study is known as behavioral economics. Three common mistakes made by consumers are: 1.Taking into account monetary costs but ignoring nonmonetary opportunity costs 2.Failing to ignore sunk costs 3.Being unrealistic about their own future behavior

30. 30 © 2015 Pearson Education, Inc. 1. Ignoring Nonmonetary Opportunity Costs People often treat monetary and non-monetary costs differently, even though they are both opportunity costs. Example: People who won the NFL lottery for Super Bowl tickets were asked the following two questions: 1.If you had not won the lottery, would you have been willing to pay $3000 for the ticket? 2.If, after winning the lottery, someone had offered you $3000 for your ticket, would you have sold it? Traditional economists believe that if you answer “no” to the first question, you should answer “yes” to the second; both questions rely on whether you value the ticket at $3000 or more.

31. 31 © 2015 Pearson Education, Inc. Super Bowl Ticket Question Results People did not answer those questions similarly; far from it: 94% said they would not have bought the ticket for $3000; but 92% said they would not sell the ticket for $3000 either! Behavioral economists refer to this difference to the endowment effect: the tendency of people to be unwilling to sell a good they already own even if they are offered a price that is greater than the price they would be willing to pay to buy the good if they didn’t already own it. In simpler terms, people don’t like losing what they have; they consider losing an object to hurt them more than gaining a similar object would help them.

32. 32 © 2015 Pearson Education, Inc. 2. Failing to Ignore Sunk Costs A sunk cost is a cost that has already been paid, and cannot be recovered. Once you have paid money and can’t get it back, you should ignore that money in any future decisions you make. But people often allow past costs to influence future decisions. Example: NFL teams persist with first-round-pick quarterbacks much longer than later-round picks with similar performance, because they have “paid” more for the first-rounder. Admitting mistakes and moving on is crucial, but people often find that difficult to do.

33. 33 © 2015 Pearson Education, Inc. Making the Connection A blogger Who Understands Sunk Costs In 2000, Arnold Kim began blogging about Apple products. By 2008, Kim’s site had become very successfully, and he was earning more than $100,000 per year from paid advertising. Sounds good, right? The “problem” was, Kim was a medical doctor who had invested over $200,000 in his education. What should Kim do? He believed he would ultimately make more as a blogger than as a doctor, but committing to blogging full-time would mean “wasting” his education. Kim realized his education costs were sunk—unrecoverable regardless of what career choice he made. So he went with what he wanted to do: blogging full time. Could you have made the same choice?

34. 34 © 2015 Pearson Education, Inc. 3. Being Unrealistic about Future Behavior People often make decisions that are inconsistent with their long-run intentions. Example: In 2010, 69% of smokers reported wanting to quit, and 52% actually attempted to quit. But despite their intentions, few actually quit; they found it hard to control their future behavior. Have you ever intended to quit a bad behavior or start a new good behavior, and failed? You likely believed that you would be able to carry through with your intentions.

35. 35 © 2015 Pearson Education, Inc. Is Our Theory Useless? Our theory of utility maximization suggests we should compare the marginal utility per dollar spent on every item we buy. But when you go grocery shopping, buying dozens of items, would you really do this? Likely, no. Does this invalidate our theory? Traditional economists often answer “no”, because: 1.Unrealistic assumptions are necessary to simplify complex decision making problems, in order to focus on the most important factors. 2.Models are best judged by the success of their predictions, rather than the accuracy of their assumptions. Indeed, models like our standard one are quite successful in predicting many types of consumer behavior.

36. 36 © 2015 Pearson Education, Inc. The Behavioral Economics of Shopping Behavioral economists say that it does matter that consumers do not usually make “optimal” consumption choices. They believe modeling how people actually make decisions is important. Some important “irrational” consumption behaviors include: Rules of Thumb Making general rules that often, but not always, produce optimal results This can save on decision-making time Anchoring “Irrelevant” information can often influence behavior. Example: posting “limit 10 items per customer” will often induce people to buy 10 items, even they would have bought fewer without the sign

37. 37 © 2015 Pearson Education, Inc. Making the Connection J.C. Penney Meets Behavioral Economics When Ron Johnson became CEO of J.C. Penney, he instituted a new pricing strategy of “everyday low prices”, instead of artificially high “regular” prices, and normal “sale” prices. It turns out that consumers buy much more when told an item is on sale, even if the sale price is the same as the “everyday low price”. This is an example of “anchoring”; the “regular” price acts as an anchor, making people believe they are getting a good deal. Johnson thought people were smart enough to see through this common department store ploy. But he was wrong, and he paid for his mistake with his job when he was fired after only 17 months.

38. 38 © 2015 Pearson Education, Inc. Common Misconceptions to Avoid Economists do not assume people maximize utility; but they commonly assume people behave as if they maximized utility. To maximize utility, do not seek to equalize the utility gained from each unit of a good, but instead from each dollar spent on each good. Take care interpreting economic experiments; the lessons sometimes don’t carry over to the “real world”.

39. LEARNING OBJECTIVE 39 © 2015 Pearson Education, Inc. Appendix: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Use indifference curves and budget lines to understand consumer behavior.

40. 40 © 2015 Pearson Education, Inc. Two Competing Consumption Bundles Suppose Dave is faced with the choice of the above two weekly “consumption bundles”. It seems reasonable to assume that either: Dave prefers bundle A to bundle B Dave prefers bundle B to bundle A Dave is indifferent between bundles A and B; that is, Dave would be equally happy with either A or B. In the first situation, we would say Dave gets higher utility from A than from B. In the third, we say that the utility from A and B is the same. Consumption Bundle A Consumption Bundle B 3 slices of pizza and 4 cans of Coke 5 slices of pizza and 2 cans of Coke

41. 41 © 2015 Pearson Education, Inc. Building an Indifference Curve Suppose Dave is indeed indifferent between two bundles, call them B and F. Also, suppose we could find all of the bundles that Dave likes exactly the same. Maybe there is also a bundle E (2 slices of pizza and 8 cans of Coke) that makes Dave just as happy. The curve marked IC 3 is an indifference curve for Dave. An I.C. shows all the combinations of consumption bundles that give the consumer the same utility. Plotting Dave’s preferences for pizza and Coke Figure 10A.1 Consumption Bundle B Consumption Bundle F 3 slices of pizza and 4 cans of Coke 5 slices of pizza and 2 cans of Coke

42. 42 © 2015 Pearson Education, Inc. Comparing Utility Lower indifference curves represent lower levels of utility; higher indifference curves represent higher levels of utility. Bundle A is on IC 1, a lower indifference curve. It is clearly worse than E, B, or F, since it has less pizza and Coke than any of those bundles. Bundle C is on the highest indifference curve, and is clearly better than bundle B (more pizza and Coke). Plotting Dave’s preferences for pizza and Coke Figure 10A.1

43. 43 © 2015 Pearson Education, Inc. The Slope of an Indifference Curve The slope of an indifference curve tells us the rate at which the consumer is willing to trade off one product for another, while keeping the consumer’s utility constant. This is called the Marginal Rate of Substitution (MRS). From E to B, Dave is willing to trade 4 cans of Coke for 1 slice of pizza. So the slope (= MRS) is 4. But from B to F, Dave is willing to trade 2 cans of Coke for 2 slices of pizza. So the MRS changes and now equals 1. It is typical for the MRS to decrease, producing this convex shape for indifference curves. Plotting Dave’s preferences for pizza and Coke Figure 10A.1

44. 44 © 2015 Pearson Education, Inc. Can Indifference Curves Ever Cross? Bundles X and Z are on the same indifference curve (IC 1 ), so Dave is indifferent between them. Similarly for bundles X and Y on IC 2. We generally assume that preferences are transitive, so that if a consumer is indifferent between X and Z, and between X and Y, then he must also be indifferent between Y and Z. But Dave will prefer Y to Z, since Y has more pizza and Coke. Since transitivity is such a sensible assumption, we conclude that indifference curves will never cross. Indifference curves cannot cross Figure 10A.2

45. 45 © 2015 Pearson Education, Inc. The Budget Constraint A consumer’s budget constraint is the amount of income he or she has available to spend on goods and services. If Dave has $10, and pizza costs $2 per slice and Coke costs $1 per can… The slope of the budget constraint is the (negative of the) ratio of prices; it represents the rate at which Dave is allowed to trade Coke for pizza: 2 cans of Coke per 1 slice of pizza. Dave’s budget constraintFigure 10A.3

46. 46 © 2015 Pearson Education, Inc. Finding the Optimal Consumption Bundle Dave would like to reach the highest indifference curve that he can. He cannot reach I 4 ; no bundle on I 4 is within his budget constraint. The highest indifference curve he can reach is I 3 ; bundle B is Dave’s best choice, given his budget constraint. Notice that at this point, the indifference curve is just tangent to the budget line. To maximize utility, a consumer needs to be on the highest indifference curve, given his budget constraint. Finding optimal consumptionFigure 10A.4

47. 47 © 2015 Pearson Education, Inc. How a Price Decrease Affects the Budget Constraint When the price of pizza falls, Dave can buy more pizza than before. If pizza falls to $1.00 per slice, Dave can buy 10 slices of pizza per week; he can still afford 10 cans of Coke per week. The budget constraint rotates out along the pizza-axis to reflect this increase in purchasing power. How a price decrease affects the budget constraint Figure 10A.5

48. 48 © 2015 Pearson Education, Inc. Deriving the Demand Curve for Pizza As the price of pizza falls and the budget constraint rotates out, Dave’s optimal bundle will change. When pizza cost $2.00 per slice, Dave bought 3 slices. Now that pizza costs $1.00 per slice, Dave buys 7 slices. These are two points on Dave’s demand curve for pizza (when he has $10 to spend, and Coke costs $1.00 per can). How a price change affects optimal consumption Figure 10A.6

49. 49 © 2015 Pearson Education, Inc. Income and Substitution Effects of Price Changes When the price of pizza falls, Dave changes his consumption from A to C. We can think of this as two separate effects: A change in relative price keeping utility constant, causing a movement along indifference curve I 1; this is the substitution effect. An increase in purchasing power, causing a movement from B to C; this is the income effect. Income and substitution effects of a price change Figure 10A.7

50. 50 © 2015 Pearson Education, Inc. Change in Income: Effect on Budget Constraint When the income Dave has to spend on pizza and Coke increases from $10 to $20, his budget constraint shifts outward. With $10, Dave could buy a maximum of 5 slices of pizza or 10 cans of Coke. With $20, he can buy a maximum of 10 slices of pizza or 20 cans of Coke. How a change in income affects the budget constraint Figure 10A.8

51. 51 © 2015 Pearson Education, Inc. Change in Income: Effect on Optimal Consumption An increase in income leads Dave to consume more Coke… … and more pizza. For Dave, both Coke and pizza are normal goods. A different consumer might have different preferences, and an increase in income might decrease the demand for Coke, for example; in this case, Coke would be an inferior good. How a change in income affects optimal consumption Figure 10A.9

52. 52 © 2015 Pearson Education, Inc. At Optimality, MRS = Ratio of Prices At the point of optimal consumption, the indifference curve is just tangent to the budget line; their slopes are equal. The slope of the indifference curve is the (negative of the) marginal rate of substitution. The slope of the budget line is the (negative of the) ratio of the price of the horizontal axis good to the price of the vertical axis good. So at the optimum, MRS = P Pizza /P Coke At the optimum point, the slopes of the indifference curve and budget constraint are the same Figure 10A.10

53. 53 © 2015 Pearson Education, Inc. Relating MRS and Marginal Utility Suppose Dave is indifferent between two bundles, A and B. A has more Coke than B, so B must have more pizza than A. As Dave moves from A to B, the loss (in utility) from consuming less coke must be just offset by the gain (in utility) from consuming more pizza. We can write: Rearranging terms gives: And this first term is slope of the indifference curve, so it is equal to the MRS:

54. 54 © 2015 Pearson Education, Inc. The Rule of Equal Marginal Utility per Dollar Spent Combining the results from the previous two slides, we have: Dropping the MRS term from the middle, we can rewrite this as: This means we have derived the Rule of Equal Marginal Utility per Dollar Spent.