1. ANTHONY PATRICK O’BRIEN
R. GLENN HUBBARD
ANTHONY PATRICK O’BRIEN
MICROECONOMICS
FIFTH EDITION
GLOBAL EDITION
© Pearson Education Limited 2015

2. Consumer Choice and Behavioral Economics

3. 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.

4. Utility and Consumer Decision Making
10.1
Define utility and explain how consumers choose goods and services to maximize their utility.

5. 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.

6. Measuring Happiness
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.

7. Pizza on Super Bowl Sunday
The table shows the total utility you might derive from eating pizza on Super Bowl Sunday.
The numbers, in utils, represent happiness: higher is better.
A graph of this utility is initially rising quickly, then more slowly; and eventually, it turns downward (as you get sick of pizza).
The table shows that for the first 5 slices of
pizza, the more you eat, the more your total
satisfaction, or utility, increases. If you eat
a sixth slice, you start to feel ill from eating
too much pizza, and your total utility falls.
Each additional slice increases your utility
by less than the previous slice, so your
marginal utility from each slice is less than
the one before. Panel (a) shows your total
utility rising as you eat the first 5 slices and
falling with the sixth slice. Panel (b) shows
your marginal utility falling with each additional
slice you eat and becoming negative
with the sixth slice. The height of the marginal
utility line at any quantity of pizza in
panel (b) represents the change in utility as
a result of consuming that additional slice.
For example, the change in utility as a result
of consuming 4 slices instead of 3 is 6 utils,
so the height of the marginal utility line in
panel (b) for the fourth slice is 6 utils.
Figure 10.1
Total and marginal utility from eating pizza on Super Bowl Sunday

8. 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…
… then graph the results. The graph of marginal utility is decreasing, showing the Law of Diminishing Marginal Utility directly.
Figure 10.1
Total and marginal utility from eating pizza on Super Bowl Sunday

9. 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 purchased gives some (possibly negative) marginal utility; by dividing by the price of the item, we obtain the marginal utility per dollar spent; that is, the rate at which that item allows the consumer to transform money into utility.

10. Utility from Pizza and Coke
Suppose you can now obtain utility by eating pizza and drinking Coke.
The table gives the total and marginal utility derived from each activity.
Number
of Slices
of Pizza
Total Utility
from Eating
Pizza
Marginal
Utility from
the Last Slice
of Cups
of Coke
Total
Utility from Drinking Coke
the Last Cup — 1 20 2 36 16 35 15 3 46 10 45 4 52 6 50 5 54 53 51 −3 −1
Table 10.1
Total utility and marginal utility from eating pizza and drinking Coke

11. Marginal Utility from Pizza and Coke
Suppose that pizza costs $2 per slice, and Coke $1 per cup.
Marginal utility of pizza per dollar is just marginal utility of pizza divided by the price, $2.
Similarly for Coke: divide by $1.
(1)
Slices
of Pizza
(2)
Marginal
Utility
(MUPizza)
(4)
Cups
of Coke
(5)
(MUCoke) 1 20 10 2 16 8 15 3 5 4 6 −3
−1.5 −1
Table 10.2
Converting marginal utility to marginal utility per dollar

12. Rule of Equal Marginal Utility per Dollar Spent
Suppose the marginal utility per dollar obtained from pizza was greater than that obtained from Coke.
Then you should eat more pizza, and drink less Coke.
This implies the Rule of Equal Marginal Utility per Dollar Spent: consumers should seek to equalize the “bang for the buck”.
Some combinations satisfying this rule are given below.
Combinations of Pizza
and Coke with Equal
Marginal Utilities per Dollar
Marginal Utility Per Dollar
(MU/P)
Total
Spending
Total Utility
1 slice of pizza and 3 cups of Coke 10
$2 + $3 = $5
= 65
3 slices of pizza and 4 cups of Coke 5
$6 + $4 = $10
= 96
4 slices of pizza and 5 cups of Coke 3
$8 + $5 = $13
= 105
Table 10.3
Equalizing marginal utility per dollar spent

13. Optimizing Your Consumption of Pizza and Coke
The actual combination to purchase would depend on your budget constraint:
With $5 to spend, you would purchase 1 slice of pizza and 3 cups of Coke.
With $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.
Combinations of Pizza
and Coke with Equal
Marginal Utilities per Dollar
Marginal Utility Per Dollar
(MU/P)
Total
Spending
Total Utility
1 slice of pizza and 3 cups of Coke 10
$2 + $3 = $5
= 65
3 slices of pizza and 4 cups of Coke 5
$6 + $4 = $10
= 96
4 slices of pizza and 5 cups of Coke 3
$8 + $5 = $13
= 105
Table 10.3
Equalizing marginal utility per dollar spent

14. Conditions for Maximizing Utility
This gives us two conditions for maximizing utility:
Satisfy the Rule of Equal Marginal Utility per Dollar Spent:
Exhaust your budget:
Spending on pizza + Spending on Coke = Amount available

15. What If We “Disobey” the Rule?
It should be clear that failing to spend all your money will result in less utility—each item you buy increases our 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 = 87 utils, less than the 96 utils that you get from 3 slices and 4 cups.
Marginal utility per dollar from 4th slice: 3 utils per dollar
Marginal utility per dollar from 2nd 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.

16. 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.
We can think of this adjustment in two ways:
You can afford more than before; this is like having a higher income.
Pizza has become cheaper relative to Coke.
We refer to the effect from 1. as the income effect, and the effect from 2. as the substitution effect.

17. 1. Income Effect
The income effect 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.
We know that some goods are normal (goods that we consume more of as our income rises) and some are inferior (goods that we consume less of as our income rises).
If pizza is a normal good, the income effect of its price decreasing will cause you to consume more pizza.
If pizza is an inferior good, the income effect of its price decreasing will cause you to consume less pizza.

18. 2. Substitution Effect
The substitution effect 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 substitution effect, 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 $ x $1.00.

19. 2. Substitution Effect—continued
But this would no longer maximize utility, since the Rule of Equal Marginal Utility per Dollar Spent is not satisfied:
𝑴𝑼 𝑷𝒊𝒛𝒛𝒂 𝑶𝒍𝒅 𝑷𝒓𝒊𝒄𝒆 𝑷𝒊𝒛𝒛𝒂 = 𝑴𝑼 𝑪𝒐𝒌𝒆 𝑶𝒍𝒅 𝑷𝒓𝒊𝒄𝒆 𝑪𝒐𝒌𝒆 𝟏𝟎 𝟐 = 𝟓 𝟏 𝟏𝟎 𝟏.𝟓𝟎 > 𝟓 𝟏
𝑴𝑼 𝑷𝒊𝒛𝒛𝒂 𝑵𝒆𝒘 𝑷𝒓𝒊𝒄𝒆 𝑷𝒊𝒛𝒛𝒂 > 𝑴𝑼 𝑪𝒐𝒌𝒆 𝑶𝒍𝒅 𝑷𝒓𝒊𝒄𝒆 𝑪𝒐𝒌𝒆
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.

20. New Optimal Consumption
A possible new combination of items is 4 slices of pizza and 4 cups of Coke, costing 4 x $ 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.
Number of Slices
of Pizza
Marginal
Utility from Last Slice
(Mupizza)
Number
of Cups
of Coke
Utility from Last Cup (Mucoke) 1 20
13.33 2 16
10.67 15 3 10
6.67 4 6 5
1.33 −3 — −1
Table 10.5
Adjusting optimal consumption to a lower price of pizza

21. Summarizing the Income and Substitution Effects
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.
Table 10.4
Income effect and substitution effect of a price change

22. Where Demand Curves Come From
10.2
Use the concept of utility to explain the law of demand.

23. 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:
A consumer responds optimally to a fall in the price of a product by consuming
more of that product. In panel (a), the price of pizza falls from $2 per slice
to $1.50, and the optimal quantity of slices consumed rises from 3 to 4. When we
graph this result in panel (b), we have the consumer’s demand curve.
Figure 10.2
Deriving the demand curve for pizza

24. Deriving the Market Demand Curve for Pizza
Each individual has a demand curve for pizza.
By adding the individual demand at each price, we obtain the market demand for pizza.
The table shows that the total quantity demanded in a market is the sum of the
quantities demanded by each buyer. We can find the market demand curve by
adding horizontally the individual demand curves in panels (a), (b), and (c). For
instance, at a price of $1.50, your quantity demanded is 4 slices, David’s is 6 slices,
and Lori’s is 5 slices. Therefore, panel (d) shows that a price of $1.50 and a quantity
demanded of 15 is a point on the market demand curve.
Figure 10.3
Deriving the market demand curve from individual demand curves

25. Could a Demand Curve Slope Upward?
For a demand curve to be upward sloping, the good would have to be an inferior good making up a very large portion of consumers’ budgets with a greater income effect than substitution effect.
A 2006 economic experiment revealed that for poor regions in China, decreases in the price of rice led to some very poor people consuming less rice.
A good with an upward-sloping demand curve is known as a Giffen good.

26. Social Influences on Decision Making
10.3
Explain how social influences can affect consumption choices.

27. 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

28. 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.

29. 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.

30. 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!

31. 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.

32. 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.

33. Behavioral Economics: Do People Make Their Choices Rationally?
10.4
Describe the behavioral economics approach to understanding decision making.

34. 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:
Taking into account monetary costs but ignoring nonmonetary opportunity costs
Failing to ignore sunk costs
Being unrealistic about their own future behavior

35. 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:
If you had not won the lottery, would you have been willing to pay $3000 for the ticket?
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.

36. 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.

37. 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.

38. 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?

39. 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.

40. 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:
Unrealistic assumptions are necessary to simplify complex decision making problems, in order to focus on the most important factors.
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.

41. 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

42. 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.

43. 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”.

44. Appendix: Using Indifference Curves and Budget Lines to Understand Consumer Behavior
Use indifference curves and budget lines to understand consumer behavior.

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

46. Building an Indifference Curve
Consumption Bundle B
Consumption Bundle F
3 slices of pizza and 4 cans of Coke
5 slices of pizza and 2 cans of Coke
Suppose Dave is indeed indifferent between B and F, and suppose we could find all of the bundles that Dave liked exactly as much.
Perhaps bundle E: 2 slices of pizza and 8 cans of Coke would make Dave just as happy.
The curve marked I3 is an indifference curve for Dave: a curve showing the combinations of consumption bundles that give the consumer the same utility.
Every possible combination of pizza and
Coke will have an indifference curve passing
through it, although in the graph we show
just four of Dave’s indifference curves. Dave
is indifferent among all the consumption
bundles that are on the same indifference
curve. So, he is indifferent among bundles E,
B, and F because they all lie on indifference
curve I3. Moving to the upper right in the
graph increases the quantities of both goods
available for Dave to consume. Therefore, the
further to the upper right the indifference
curve is, the greater the utility Dave receives.
Figure 10A.1
Plotting Dave’s preferences for pizza and Coke

47. Comparing Utility
Lower indifference curves represent lower levels of utility; higher indifference curves represent higher levels of utility.
Bundle A is on I1, a lower indifference curve; and 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 a higher indifference curve, and is clearly better than B (more pizza and Coke).
Figure 10A.1
Plotting Dave’s preferences for pizza and Coke

48. The Slope of an Indifference Curve
Along an indifference curve, the slope tells us the rate at which the consumer is willing to trade off one product for another, while keeping the consumer’s utility constant. The rate is known as the Marginal Rate of Substitution (MRS).
From E to B, Dave is willing to trade 4 cans of Coke for 1 slice of pizza; the MRS is 4 between E and B.
From B to F, Dave is willing to trade 2 cans of Coke for 2 slices of pizza; the MRS is 1 between B and F.
It is typical for the MRS to decrease, producing this convex shape for indifference curves.
Figure 10A.1
Plotting Dave’s preferences for pizza and Coke

49. Can Indifference Curves Ever Cross?
Bundles X and Z are on the same indifference curve, so Dave is indifferent between them.
Similarly for bundles X and Y.
We generally assume that preferences are transitive, so that if a consumer is indifferent between X and Z, and 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.
Because bundle X and bundle Z are both on
indifference curve I1, Dave must be indifferent
between them. Similarly, because bundle
X and bundle Y are on indifference curve I2,
Dave must be indifferent between them. The
assumption of transitivity means that Dave
should also be indifferent between bundle
Z and bundle Y. We know he won’t be however,
because bundle Y contains more pizza
and more Coke than bundle Z. So, Dave
will definitely prefer bundle Y to bundle Z,
which violates the assumption of transitivity.
Therefore, none of Dave’s indifference
curves can cross.
Figure 10A.2
Indifference curves cannot cross

50. 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…
Dave’s budget constraint shows the combinations
of slices of pizza and cans of Coke
he can buy with $10. The price of Coke is
$1 per can, so if he spends all of his $10 on
Coke, he can buy 10 cans (bundle G). The
price of pizza is $2 per slice, so if he spends
all of his $10 on pizza, he can buy 5 slices
(bundle L). As he moves down his budget
constraint from bundle G, he gives up 2 cans
of Coke for every slice of pizza he buys. Any
consumption bundles along the line or inside
the line are affordable. Any bundles that
lie outside the line are unaffordable.
Figure 10A.3
Dave’s budget constraint
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.

51. Finding the Optimal Consumption Bundle
Dave would like to reach the highest indifference curve that he can.
He cannot reach I4; no bundle on I4 is within his budget constraint.
The highest indifference curve he can reach is I3; 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.
Dave would like to be on the highest possible
indifference curve, but he cannot reach
indifference curves such as I4 that are outside
his budget constraint. Dave’s optimal
combination of slices of pizza and cans of
Coke is at point B, where his budget constraint
just touches—or is tangent to—the
highest indifference curve he can reach. At
point B, he buys 3 slices of pizza and 4 cans
of Coke.
Figure 10A.4
Finding optimal consumption

52. 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 $ per slice, Dave can buy 10 slices of pizza per week; he can still afford 10 cans of Coke per week.
A fall in the price of pizza from $2 per slice
to $1 per slice increases the maximum number
of slices Dave can buy with $10 from 5
to 10. The budget constraint rotates outward
from point A to point B to show the effect of
the price decrease.
The budget constraint rotates out along the pizza-axis to reflect this increase in purchasing power.
Figure 10A.5
How a price decrease affects the budget constraint

53. 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).
In panel (a), a fall in the price of pizza results
in Dave’s consuming less Coke and
more pizza.
1. A fall in the price of pizza rotates the
budget constraint outward because Dave
can now buy more pizza with his $10.
2. In the new optimum on indifference
curve I2, Dave changes the quantities he
consumes of both goods. His consumption
of Coke falls from 4 cans to 3 cans.
3. In the new optimum, Dave’s consumption
of pizza increases from 3 slices to
7 slices.
In panel (b), Dave responds optimally to the
fall in the price of pizza from $2 per slice to
$1 per slice, by increasing the quantity of
slices he consumes from 3 slices to 7 slices.
When we graph this result, we have Dave’s
demand curve for pizza.
Figure 10A.6
How a price change affects optimal consumption

54. 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 I1; this is the substitution effect.
Following a decline in the price of pizza,
Dave’s optimal consumption of pizza increases
from 3 slices per week (point A) to
7 slices per week (point C). We can think
of this movement from point A to point C
as taking place in two steps: The movement
from point A to point B along indifference
curve I1 represents the substitution effect,
and the movement from point B to point C
represents the income effect. Dave increases
his consumption of pizza from 3 slices per
week to 5 slices per week because of the substitution
effect of a fall in the price of pizza
and from 5 slices per week to 7 slices per
week because of the income effect.
Figure 10A.7
Income and substitution effects of a price change
An increase in purchasing power, causing a movement from B to C; this is the income effect.

55. 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.
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.
Figure 10A.8
How a change in income affects the budget constraint

56. 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.
An increase in income leads Dave to consume
more Coke and more pizza.
1. An increase in income shifts Dave’s budget
constraint outward because he can
now buy more of both goods.
2. In the new optimum on indifference
curve I2, Dave changes the quantities he
consumes of both goods. His consumption
of Coke increases from 4 to 6 cans.
3. In the new optimum, Dave’s consumption
of pizza increases from 3 to 7 slices.
Figure 10A.9
How a change in income affects optimal consumption

57. 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 = PPizza/PCoke
At the point of optimal consumption, the
marginal rate of substitution is equal to the
ratio of the price of the product on the horizontal
axis to the price of the product on the
vertical axis.
Figure 10A.10
At the optimum point, the slopes of the indifference curve and budget constraint are the same

58. 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:

59. 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.