R. GLENN
HUBBARD
ANTHONY PATRICK
O’BRIEN
MICROECONOMICS
FIFTH EDITION
GLOBAL EDITION
© Pearson Education Limited 2015
CHAPTER
CHAPTER
10
Consumer Choice and
Behavioral Economics
Chapter Outline and
Learning Objectives
10.1 Utility and Consumer
Decision Making
10.2 Where Demand Comes
From
10.3 Social Influences on
Decision Making
10.4 Behavioral Economics: Do
People Make Their Choices
Rationally?
Appendix: Using
Indifference Curves and
Budget Lines to Understand
Consumer Behavior
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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.
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Utility and Consumer Decision Making
10.1 LEARNING OBJECTIVE
Define utility and explain how consumers choose goods and services to
maximize their utility.
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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.
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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.
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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).
Figure 10.1
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Total and marginal
utility from eating pizza
on Super Bowl Sunday
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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
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Total and marginal
utility from eating pizza
on Super Bowl Sunday
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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.
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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
Number
of Cups
of Coke
0
0
—
0
0
—
1
20
20
1
20
20
2
36
16
2
35
15
3
46
10
3
45
10
4
52
6
4
50
5
5
54
2
5
53
3
6
51
−3
6
52
−1
Table 10.1
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Total
Marginal
Utility from
Utility from
Drinking Coke the Last Cup
Total utility and marginal utility from
eating pizza and drinking Coke 10 of 59
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)
Marginal
Utility
(MUCoke)
1
20
10
1
20
20
2
16
8
2
15
15
3
10
5
3
10
10
4
6
3
4
5
5
5
2
1
5
3
3
6
−3
−1.5
6
−1
−1
Table 10.2
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Converting marginal utility to
marginal utility per dollar
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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
20 + 45 = 65
3 slices of pizza and 4 cups of Coke
5
$6 + $4 = $10
46 + 50 = 96
4 slices of pizza and 5 cups of Coke
3
$8 + $5 = $13
52 + 53 = 105
Table 10.3
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Equalizing marginal utility per dollar
spent
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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
20 + 45 = 65
3 slices of pizza and 4 cups of Coke
5
$6 + $4 = $10
46 + 50 = 96
4 slices of pizza and 5 cups of Coke
3
$8 + $5 = $13
52 + 53 = 105
Table 10.3
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Equalizing marginal utility per dollar
spent
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Conditions for Maximizing Utility
This gives us two conditions for maximizing utility:
1. Satisfy the Rule of Equal Marginal Utility per Dollar Spent:
MU Pizza MU Coke

PPizza
PCoke
2. Exhaust your budget:
Spending on pizza + Spending on Coke = Amount available
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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 52 + 35 = 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.
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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:
1. You can afford more than before; this is like having a higher
income.
2. 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.
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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.
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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 $1.50 + 4 x $1.00.
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2. Substitution Effect—continued
But this would no longer maximize utility, since the Rule of Equal
Marginal Utility per Dollar Spent is not satisfied:
𝑴𝑼𝑷𝒊𝒛𝒛𝒂
𝑶𝒍𝒅 𝑷𝒓𝒊𝒄𝒆𝑷𝒊𝒛𝒛𝒂
𝟏𝟎
𝟐
𝟏𝟎
𝟏. 𝟓𝟎
𝑴𝑼𝑷𝒊𝒛𝒛𝒂
𝑵𝒆𝒘 𝑷𝒓𝒊𝒄𝒆𝑷𝒊𝒛𝒛𝒂
𝑴𝑼𝑪𝒐𝒌𝒆
=
𝑶𝒍𝒅 𝑷𝒓𝒊𝒄𝒆𝑪𝒐𝒌𝒆
𝟓
=
𝟏
𝟓
>
𝟏
𝑴𝑼𝑪𝒐𝒌𝒆
>
𝑶𝒍𝒅 𝑷𝒓𝒊𝒄𝒆𝑪𝒐𝒌𝒆
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.
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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.
Number
of Slices
of Pizza
Marginal
Utility from
Last Slice
(Mupizza)
1
20
13.33
1
20
20
2
16
10.67
2
15
15
3
10
6.67
3
10
10
4
6
4
4
5
5
5
2
1.33
5
3
3
6
−3
—
6
−1
—
Number
of Cups
of Coke
Table 10.5
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Marginal
Utility from
Last Cup
(Mucoke)
Adjusting optimal consumption
to a lower price of pizza
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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
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Income effect and
substitution effect of a
price change
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Where Demand Curves Come From
10.2 LEARNING OBJECTIVE
Use the concept of utility to explain the law of demand.
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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:
Figure 10.2
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Deriving the demand
curve for pizza
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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.
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Figure 10.3
Deriving the market demand
curve from individual demand
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curves
Making
the
Connection
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.
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Social Influences on Decision Making
10.3 LEARNING OBJECTIVE
Explain how social influences can affect consumption choices.
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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
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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.
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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.
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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!
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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.
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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.
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Behavioral Economics: Do People Make Their Choices
Rationally?
10.4 LEARNING OBJECTIVE
Describe the behavioral economics approach to understanding decision making.
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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
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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.
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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.
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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.
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Making
the
A blogger Who Understands Sunk Costs
Connection
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?
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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.
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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.
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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
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Making
the
J.C. Penney Meets Behavioral Economics
Connection
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.
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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”.
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Appendix: Using Indifference Curves and Budget Lines
to Understand Consumer Behavior
LEARNING OBJECTIVE
Use indifference curves and budget lines to understand consumer behavior.
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Two Competing Consumption Bundles
Consumption Bundle B
3 slices of pizza and 4 cans of Coke
Consumption Bundle F
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.
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Building an Indifference Curve
Consumption Bundle B
3 slices of pizza and 4 cans of Coke
Consumption Bundle F
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.
Figure 10A.1
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Plotting Dave’s preferences for
pizza and Coke
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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
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Plotting Dave’s preferences for
pizza and Coke
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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.
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Figure 10A.1
Plotting Dave’s preferences for
pizza and Coke
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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.
Figure 10A.2
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Indifference curves
cannot cross
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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…
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.
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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.
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Figure 10A.4
Finding optimal consumption
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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.
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Figure 10A.5
How a price decrease affects
the budget constraint
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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).
Figure 10A.6
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How a price change
affects optimal
consumption
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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.
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.
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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.
Figure 10A.8
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How a change in income
affects the budget constraint
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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.
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Figure 10A.9
How a change in income
affects optimal consumption
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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
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Figure 10A.10 At the optimum point, the
slopes of the indifference
curve and budget constraint
are the same
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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:
 (Change in the quantity of Coke  MU Coke )  (Change in the quantity of pizza  MU Pizza)
Rearranging terms gives:
 Change in the quantity of Coke MU Pizza

Change in the quantity of pizza
MU Coke
And this first term is slope of the indifference curve, so it is equal to
the MRS:
MU Pizza
 Change in the quantity of Coke
 MRS 
Change in the quantity of pizza
MU Coke
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The Rule of Equal Marginal Utility per Dollar Spent
Combining the results from the previous two slides, we have:
PPizza
MU Pizza
 MRS 
PCoke
MU Coke
Dropping the MRS term from the middle, we can rewrite this as:
MU Coke MU Pizza

PCoke
PPizza
This means we have derived the Rule of Equal Marginal Utility per
Dollar Spent.
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