Chapter3:ConsumerBehavior

PARTII
PRODUCERS,CONSUMERS,ANDCOMPETITIVEMARKETS
CHAPTER3
CONSUMERBEHAVIOR
QUESTIONSFORREVIEW

1. What are the four basic assumptions about individual preferences? Explain the
significanceormeaningofeach.
(1)Preferencesarecomplete:thismeansthattheconsumerisabletocompareand
rankallpossiblebaskets;(2)Preferencesaretransitive:thismeansthatpreferences
areconsistent,inthatifbundleAispreferredtobundleBandbundleBispreferred
tobundleC,thenweshouldbeabletoconcludethatbundleAispreferredtobundle
C;(3)Moreispreferredtoless:thismeansthatallgoodsaredesirable,andthatthe
consumerwillalwaysprefertohavemoreofagood;(4)Diminishingmarginalrate
ofsubstitution:thismeansthatindifferencecurvesareconvex,andthattheslopeof
theindifferencecurveincreases(becomeslessnegative)aswemovedownalongthe
curve.Asaconsumermovesdownalongherindifferencecurvesheiswillingtogive
upfewerunitsofthegoodontheverticalaxisinexchangeforonemoreunitofthe
good on the horizontal axis. This assumption also means that balanced market
basketsarepreferredtobasketsthathavealotofonegoodandverylittleofthe
othergood.

2. Canasetofindifferencecurvesbeupwardsloping? Ifso,whatwouldthistellyou
aboutthetwogoods?
Asetofindifferencecurvescanbeupwardslopingifweviolateassumptionnumber
three;moreispreferredtoless.Whenasetofindifferencecurvesisupwardsloping,
itmeansoneofthegoodsisabadinthattheconsumerpreferslessofthegood
rather than more of the good. The positive slope means that the consumer will
acceptmoreofthebadgoodonlyifshealsoreceivesmoreoftheothergoodinreturn.
Aswemoveupalongtheindifferencecurvetheconsumerhasmoreofthegoodshe
likes,andalsomoreofthegoodshedoesnotlike.

3.Explainwhytwoindifferencecurvescannotintersect.
TheexplanationismosteasilyachievedwiththeaidofagraphsuchasFigure3.3,
which shows two indifference curves intersecting at point A. We know from the
definitionofanindifferencecurvethataconsumerhasthesamelevelofutilityalong
anygivencurve.Inthiscase,theconsumerisindifferentbetweenbundles AandB
becausetheybothlieonindifferencecurveU1.Similarly,theconsumerisindifferent
between bundles A and C because they both lie on indifference curve U2. By the
transitivityofpreferencesthisconsumershouldalsobeindifferentbetweenCandB.
However,weseefromthegraphthat C liesabove B, so C mustbepreferredto B.
Thus,thefactthatindifferencecurvescannotintersectisproven.

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 Chapter3:ConsumerBehavior

GoodY

C
U2

B
U1
GoodX

Figure3.3

4.Jonisalwayswillingtotradeonecanofcokeforonecanofsprite,oronecanofsprite
foronecanofcoke.
a. WhatcanyousayaboutJonsmarginalrateofsubstitution?
Jonsmarginalrateofsubstitutioncanbedefinedasthenumberofcansofcokehe
wouldbewillingtogiveupinexchangeforacanofsprite.Sinceheisalwayswilling
totradeoneforone,hisMRSisequalto1.

b. DrawasetofindifferencecurvesforJon.
Since Jon is always willing to trade one can of coke for one can of sprite, his
indifferencecurvesarelinearwithaslopeof1.

c. Draw two budget lines with different slopes and illustrate the satisfaction
maximizingchoice.Whatconclusioncanyoudraw?
Jons indifference curves are linear with a slope of 1. Jons budget line is also
linear,andwillhaveaslopethatreflectstheratioofthetwoprices.IfJonsbudget
lineissteeperthanhisindifferencecurvesthenhewillchoosetoconsumeonlythe
goodontheverticalaxis.IfJonsbudgetlineisflatterthanhisindifferencecurves
then he will choose to consumer only the good on the horizontal axis. Jon will
alwayschooseacornersolution,unlesshisbudgetlinehasthesameslopeashis
indifferencecurves. InthiscaseanycombinationofSpriteandCokethatusesup
hisentireincomewithmaximizehissatisfaction.

5. What happens to the marginal rate of substitution as you move along a convex
indifferencecurve?Alinearindifferencecurve?
TheMRSmeasureshowmuchofagoodyouarewillingtogiveupinexchangefor
one more unit of the other good, keeping utility constant. The MRS diminishes
alongaconvexindifferencecurveinthatasyoumovedownalongtheindifference

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 Chapter3:ConsumerBehavior
curve,youarewillingtogiveuplessandlessoftheonegoodinexchangeforthe
other.TheMRSisalsotheslopeoftheindifferencecurve,whichincreases(becomes
lessnegative)asyoumovedownalongtheindifferencecurve.TheMRSisconstant
alongalinearindifferencecurve,sinceinthiscasetheslopedoesnotchange.The
consumer is always willing to trade the same number of units of one good in
exchangefortheother.

6.ExplainwhyanMRSbetweentwogoodsmustequaltheratioofthepriceofthegoods
fortheconsumertoachievemaximumsatisfaction.
TheMRSdescribestherateatwhichtheconsumeriswillingtotradeonegoodfor
anothertomaintainthesamelevelofsatisfaction. Theratioofpricesdescribesthe
tradeoff that the market is willing to make between the same two goods. The
tangencyoftheindifferencecurvewiththebudgetlinerepresentsthepointatwhich
thetradeoffsareequalandconsumersatisfactionismaximized.IftheMRSbetween
twogoodsisnotequaltotheratioofprices,thentheconsumercouldtradeonegood
foranotheratmarketpricestoobtainhigherlevelsofsatisfaction.Forexample,ifthe
slopeofthebudgetline(theratiooftheprices)is4thentheconsumercantrade4
unitsofgood2foroneunitofgood1.IftheMRSatthecurrentbundleis6,thenthe
consumeriswillingtotrade6unitsofgood2foroneunitofgood1. Sincethetwo
slopesarenotequaltheconsumerisnotmaximizinghersatisfaction.Theconsumeris
willingtotrade6butonlyhastotrade4,sosheshouldmakethetrade.Thistrading
continuesuntilthehighestlevelofsatisfactionisachieved.Astradesaremade,the
MRSwillchangeandbecomeequaltothepriceratio.
7. Describe the indifference curves associated with two goods that are perfect
substitutes.Whatiftheyareperfectcomplements?
Two goods are perfect substitutes if the MRS of one for another is a constant
number.GiventheMRSisaconstantnumber,theslopeoftheindifferencecurves
willbeconstant,andtheindifferencecurvesarethereforelinear. Iftwogoodsare
perfect complements, the indifference curves are Lshaped. In this case the
consumerwantstoconsumethetwogoodsinafixedproportion,sayoneunitofgood
1forevery1unitofgood2.Ifshehasmoreofonegoodbutnotmoreoftheother
thenshedoesnotgetanyextrasatisfaction.

8.Whatisthedifferencebetweenordinalutilityandcardinalutility?Explainwhythe
assumptionofcardinalutilityisnotneededinordertorankconsumerchoices.
Ordinalutilityimpliesanorderingamongalternativeswithoutregardforintensityof
preference. Forexample,iftheconsumersfirstchoiceispreferredtotheirsecond
choice,thenutilityfromthefirstchoicewillbehigherthanutilityfromthesecond
choice. Howmuchhigherisnotimportant.Anordinalutilityfunctiongeneratesa
rankingofbundlesandnomeaningisgiventotheutilitynumberitself. Cardinal
utilityimpliesthattheintensityofpreferencesmaybequantified,andthattheutility
numberitselfhasmeaning.Anordinalrankingisallthatisneededtorankconsumer
choices.ItisnotnecessarytoknowhowintenselyaconsumerprefersbasketAover
basketB;itisenoughtoknowthatAispreferredtoB.
9. UponmergingwiththeWestGermaneconomy,EastGermanconsumersindicateda
preference for MercedesBenz automobiles over Volkswagens. However, when they
converted their savings intodeutsche marks, they flocked toVolkswagen dealerships.
Howcanyouexplainthisapparentparadox?

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 Chapter3:ConsumerBehavior
Threeassumptionsarerequired toaddress thisquestion: 1)thataMercedes costs
more than a Volkswagen; 2) that the East German consumers utility function
comprisestwogoods,automobilesandallothergoodsevaluatedindeutschemarks;
and 3) that East Germans have incomes. Based on these assumptions, we can
surmisethatwhileEastGermanconsumersmaypreferaMercedestoaVolkswagen,
theyeithercannotaffordaMercedesortheypreferabundleofothergoodsplusa
VolkswagentoaMercedesalone.WhilethemarginalutilityofconsumingaMercedes
exceedsthemarginalutilityofconsumingaVolkswagen,theconsumerwillconsider
marginalutilityperdollarforeachgood.Thismeansthemarginalutilityperdollar
musthavebeenhigherfortheVolkswagensinceconsumersflockedtotheVolkswagen
dealershipsandnottheMercedesdealerships.
10.Drawabudgetlineandthendrawanindifferencecurvetoillustratethesatisfaction
maximizing choice associated with two products. Use your graph to answer the
followingquestions.
a. Supposethatoneoftheproductsisrationed.Explainwhytheconsumerislikely
tobeworseoff.
When goods are not rationed, the consumer is able to choose the satisfaction
maximizingbundlewheretheslopeofthebudgetlineisequaltotheslopeofthe
indifference curve, or theprice ratioisequal to theMRS. This ispoint A in the
graphbelow.Ifgood1isnowrationedtheconsumerwillnotbeabletoattainthe
utilitymaximizingpoint. Heorshewillhavetoconsumemoreoftheothergood
instead.ThisispointBbelow.

U2

U1

good1

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 Chapter3:ConsumerBehavior
b. Supposenowthatthepriceofoneoftheproductsisfixedatalevelbelowthe
currentprice. Asaresult,theconsumerisnotabletopurchaseasmuchasshe
wouldlikeoftheproduct.Canyoutelliftheconsumerisbetterofforworseoff?
Whenthepriceofthegoodisfixedatalevelbelowthecurrent(equilibrium)price,
therewillbeashortageofthegoodandthegoodwillhavetobeeffectivelyrationed.
Asinthequestionabove,theconsumerisworseoffbecausesheisnotabletoattain
herutilitymaximizingpoint.

11. Based on hispreferences, Bill iswillingtotrade 4movie ticketsfor1ticket toa

basketballgame.Ifmovieticketscost$8eachandatickettothebasketballgamecosts
$40,shouldBillmakethetrade?Whyorwhynot?
NoBillshouldnotmakethetrade.Ifhegivesupthe4movieticketsthenhewill
save$8perticketforatotalof$32. However,thisisnotenoughforabasketball
ticket.Hewouldinfacthavetogiveup5movieticketsifhewantedtobuyanother
basketballticket.Noticealso,thatthemarginalutilityperdollarishigherformovie
tickets so Bill will be better off if he consumes more movie tickets and fewer
basketballtickets.TofigurethisoutrecallthatwhatBilliswillingtododefineshis
MRS.HisMRSis4sothismeansthatthemarginalutilityofabasketballgameis4
andthemarginalutilityofamovieis1:
MU ball 4
MRS 4 .
MU movie 1
Nowthemarginalutilityperdollarcanbecomputed:
MUball 4 1

Pball 40 10
MUmovie 1
.
Pmovie 8

12. Describetheequalmarginalprinciple. Explainwhythisprinciplemaynotholdif

increasingmarginalutilityisassociatedwiththeconsumptionofoneorbothgoods.
Theequalmarginalprinciplestatesthattheratioofthemarginalutilitytopricemust
be equal across all goods to obtain maximum satisfaction. In other words, utility
maximizationisachievedwhenthebudgetisallocatedsothatthemarginalutilityper
dollarofexpenditureisthesameforeachgood.Ifthemarginalutilityperdollarisnot
equalthenutilitycanbeincreasedbyallocatingmoredollarstothegoodwiththe
highermarginalutilityperdollar.Theconsumerwillobtainmorebangforthebuck
iftheyreallocatetheirdollars.
Ifmarginalutilityisincreasing,theconsumermaximizessatisfactionbyconsuming
everlargeramountsofthegood.Thus,theconsumerwouldspendallincomeonone
good, assuming a constant price, resulting in a corner solution. With a corner
solution,theequalmarginalprinciplecannothold.

13.Thepriceofcomputershasfallensubstantiallyoverthepasttwodecades.Usethis
drop in price to explain why the Consumer Price Index is likely to overstate
substantiallythecostoflivingindexforindividualswhousecomputersintensively.
Theconsumerpriceindexmeasuresthecostofatypicalbasketofgoodspurchasedby
theconsumerinthecurrentyearrelativetothecostofthebasketinthebaseyear.
Eachgoodinthebasketisassignedaweight,whichreflectstheimportanceofthe

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 Chapter3:ConsumerBehavior
goodtotheconsumer,andtheweightsarekeptfixedfromyeartoyear.Theproblem
withfixingtheweightsisthatconsumerswillshifttheirpurchasesfromyeartoyear
togivemoreweighttogoodswhosepriceshavefallen,andlessweighttogoodswhose
priceshaverisen.TheCPIwillthereforegivetoomuchweighttogoodswhoseprices
haverisen,andtoolittleweighttogoodswhosepriceshavefallen.Fortheindividual
who uses computers intensively, the fixed weight for computers inthe basket will
understatetheimportanceofthisgood,andwillhenceunderstatetheeffectofthefall
inthepriceofcomputers.TheCPIwilloverstatetheriseinthecostoflivingforthis
typeofindividual.
14. Explain why the Paasche index will generally understate the ideal costofliving
index.
ThePaascheindexmeasuresthecurrentcostofthecurrentbundleofgoodsrelative
to the base year cost of the current bundle of goods. The Paasche index will
understatetheidealcostoflivingbecauseitassumestheindividualwillbuythe
currentyearbundleinthebaseperiod.Inreality,atbaseyearpricestheconsumer
wouldhavebeenabletoattainthesamelevelofutilityatalowercostbyaltering
theirconsumptionbundle.Sincethebaseyearcostisoverstated,thedenominator
willbelargerandtheindexwillbelower,orunderstated.

EXERCISES

1.Inthischapter,consumerpreferencesforvariouscommoditiesdidnotchangeduring
the analysis. Yet in some situations, preferences do change as consumption occurs.
Discusswhyandhowpreferencesmightchangeovertimewithconsumptionofthesetwo
commodities:
a. cigarettes
The assumption that preferences do not change is a reasonable one if choices are
independentacrosstime.Itdoesnothold,however,whenhabitformingoraddictive
behaviorisinvolved,asinthecaseofcigarettes:theconsumptionofcigarettesinone
periodinfluencestheirconsumptioninthenextperiod.
b. dinnerforthefirsttimeatarestaurantwithaspecialcuisine
Thisexampleisparalleltoexamplesofadventureseeking. Forsome,anewdining
experiencecreatesenthusiasmtoseekoutmoreexcitinganddifferentcuisinesand
dishes. Forothers,theydevelopafondnessforregularityandconsistencyorfearof
thenewandunknown.Ineitherofthesecases,choiceschangeasconsumptionoccurs.
2. Draw indifference curves that represent the following individuals preferences for
hamburgersandsoftdrinks.Indicatethedirectioninwhichtheindividualssatisfaction
(orutility)isincreasing.
a. Joehasconvexpreferencesanddislikesbothhamburgersandsoftdrinks.
SinceJoedislikesbothgoods,hissetofindifferencecurveswillbebowedinwards
towards the origin instead of outwards, as in the normal case where more is
preferredtoless.Givenhedislikesbothgoods,hissatisfactionisincreasinginthe
directionoftheorigin.Convexityofpreferencesimplieshisindifferencecurveswill
havethenormalshapeinthattheyarebowedtowardsthedirectionofincreasing
satisfaction.Convexityalsoimpliesthatgivenanytwobundlesbetweenwhichthe
consumerisindifferent,theaverageofthetwobundleswillbeinthepreferredset,
orwillleavehimatleastaswelloff.
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 Chapter3:ConsumerBehavior

hamburger

softdrink
b. Janeloveshamburgersanddislikessoftdrinks.Ifsheisservedasoftdrink,she
willpouritdownthedrainratherthandrinkit.
SinceJanecanfreelydisposeofthesoftdrinkifitisgiventoher,sheconsidersitto
beaneutralgood. Thismeansshedoesnotcareaboutsoftdrinksonewayorthe
other.Withhamburgersontheverticalaxis,herindifferencecurvesarehorizontal
lines.Hersatisfactionincreasesintheupwarddirection.
hamburger

softdrink

c. Bobloveshamburgersanddislikessoftdrinks.Ifheisservedasoftdrink,hewill
drinkittobepolite.
SinceBobwilldrinkthesoftdrinkinordertobepolite,itcanbethoughtofasa
bad. When served another soft drink, he will require more hamburgers atthe
sametimeinordertokeephissatisfactionconstant.Moresoftdrinkswithoutmore
hamburgerswillworsenhisutility. Morehamburgersandfewersoftdrinks will
increasehisutility.
hamburger

softdrink

d. Mollyloveshamburgersandsoftdrinks,butinsistsonconsumingexactlyonesoft
drinkforeverytwohamburgersthatsheeats.

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 Chapter3:ConsumerBehavior
Molly wants to consume the two goods in a fixed proportion so her indifference
curves are Lshaped. For any given amount of one good, she gets no extra
satisfaction from having more of the other good. She will only increase her
satisfactionifshehasmoreofbothgoods.
hamburger

softdrink

e. Billlikeshamburgers,butneitherlikesnordislikessoftdrinks.
LikeJane,Billconsiderssoftdrinkstobeaneutralgood. Sincehedoesnotcare
aboutsoftdrinksonewayortheotherwecanassumethatnomatterhowmanyhe
has,hisutilitywillbethesame. Hislevelofsatisfactiondependsentirelyonhow
manyhamburgershehas.
hamburger

softdrink

f. Maryalwaysgetstwiceasmuchsatisfactionfromanextrahamburgerasshedoes
fromanextrasoftdrink.
HowmuchextrasatisfactionMarygainsfromanextrahamburgerorsoftdrinktells
ussomethingaboutthemarginalutilitiesofthetwogoods,oraboutherMRS.Ifshe
alwaysreceivestwicethesatisfactionfromanextrahamburgerthenhermarginal
utility from consuming an extra hamburger is twice her marginal utility from
consuminganextrasoftdrink.HerMRS,withhamburgersontheverticalaxis,is
1/2.Herindifferencecurvesarestraightlineswithaslopeof1/2.
hamburger

softdrink

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 Chapter3:ConsumerBehavior

3. IfJaneiscurrentlywillingtotrade4movieticketsfor1basketballticketthenshe
mustlikebasketballbetterthanmovies.Trueorfalse?Explain.
Thisstatementisnotnecessarily true. Ifsheisalwayswillingtotrade4movie
ticketsfor1basketballticketthenyesshelikesbasketballbetterbecauseshewill
alwaysgainthesamesatisfactionfrom4movieticketsasshedoesfrom1basketball
ticket.However,itcouldbethatshehasconvexpreferences(diminishingmarginal
rateofsubstitution)andisatabundlewhereshehasalotofmovieticketsrelative
tobasketballtickets.Thiswouldmakeherwillingtogiveupmoremovieticketsto
getanotherbasketballticket. Itwouldnotmeanthoughthatshelikedbasketball
better.Herwillingnesstogiveupagoodwouldinthiscasedependonthequantity
ofeachgoodinhercurrentbasket.
4.JanelleandBrianeachplantospend$20,000onthestylingandgasmileagefeatures
ofanewcar.Theycaneachchooseallstyling,allgasmileage,orsomecombinationof
the two. Janelle does not care at all about styling and wants the best gas mileage
possible. Brian likes both equally and wants to spend an equal amount on the two
features. Using indifference curves and budget lines, illustrate the choice that each
personwillmake.
Assume styling ison the vertical axis and gasmileage ison the horizontal axis.
Janellehasindifferencecurvesthatarevertical.Ifthestylingisthereshewilltake
it,butsheotherwisedoesnotcareaboutit.Asherindifferencecurvesmoveoverto
the right, she gains more gas mileage and more satisfaction. She will spend all
$20,000ongasmileage. BrianhasindifferencecurvesthatareLshaped. Hewill
notspendmoreononefeaturethanontheotherfeature.Hewillspend$10,000on
stylingand$10,000ongasmileage.

5.SupposethatBridgetandErinspendtheirincomeontwogoods,food(F)andclothing
(C). Bridgetspreferencesarerepresentedbytheutilityfunction U(F,C) 10FC ,while
Erinspreferencesarerepresentedbytheutilityfunction U(F,C) .20F 2 C 2 .

a. On agraph, with food on thehorizontal axis and clothing on thevertical axis,

identifythesetofpointsthatgiveBridgetthesamelevelofutilityasthebundle
(10,5).DothesameforErinonaseparategraph.
Bridgetreceivesautilityof10*10*5=500fromthisbundle.Theindifferencecurveis
representedbytheequation10FC=500orFC=50.Somebundlesonthisindifference
curve are (5,10), (10,5), (25,2), and (2,25). Erin receives a utility of .
2*10*10*5*5=500fromthebundle(10,5). Herindifferencecurveisrepresentedby
the equation 500 .2F 2 C 2 , or 50=FC. This is the same indifference curve as
Bridget.Bothindifferencecurveshavethenormal,convexshape.

b. Onthesametwographs,identifythesetofbundlesthatgiveBridgetandErinthe
samelevelofutilityasthebundle(15,8).
Foreachperson,pluginF=15andC=8intotheirrespectiveutilityfunctions. For
Bridget, thisgivesherautilityof1200,soherindifferencecurveisgivenbythe

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 Chapter3:ConsumerBehavior
equation 10FC=1200, or FC=120. Some bundles on this indifference curve are
(12,10),(10,12),(3,40),and(40,3).ForErin,thisbundlegivesherautilityof2880,
soherindifferencecurveisgivenbytheequation 2880 .2F 2 C 2 ,orFC=120.This
isthesameindifferencecurveasBridget.
c. Do you think Bridget and Erin have the same preferences or different
preferences?Explain.
Theyhavethesamepreferencesbecauseforanygivenbundletheyhavethesame
levelofutility.Thismeansthattheywillrankallbundlesinthesameorder.Note
however,thatitisnotnecessarythattheyreceivethesamelevelofutilitytohave
thesamesetofpreferences. Allthatisnecessaryisthattheyrankthebundlesin
thesameorder.

6. Suppose that Jones and Smith have each decided to allocate $1,000 per year to an
entertainment budget in the form of hockey games or rock concerts. They both like
hockeygamesandrockconcertsandwillchoosetoconsumepositivequantitiesofboth
goods. However, they differ substantially in their preferences for these two forms of
entertainment. Jonesprefershockeygamestorockconcerts,whileSmithprefersrock
concertstohockeygames.
a. DrawasetofindifferencecurvesforJonesandasecondsetforSmith.
Given they each like both goods and they will each choose to consume positive
quantitiesofbothgoods,wecanassumetheirindifferencecurveshavethenormal
convexshape.HoweversinceJoneshasanoverallpreferenceforhockeyandSmith
hasanoverallpreferenceforrockconcerts,theirtwosetsofindifferencecurveswill
havedifferentslopes.Supposethatweplacerockconcertsontheverticalaxisand
hockey games on the horizontal axis, Jones will have a larger MRS than Smith.
Jonesiswillingtogiveupmorerockconcertsinexchangeforahockeygamesincehe
prefershockeygames.TheindifferencecurvesforJoneswillbesteeper.
b. Using the concept of marginal rate of substitution, explain why the two sets of
curvesaredifferentfromeachother.
Atanycombinationofhockeygamesandrockconcerts,Jonesiswillingtogiveup
morerockconcertsforanadditionalhockeygame,whereas,Smithiswillingtogiveup
fewerrockconcertsforanadditionalhockeygame. SincetheMRSisameasureof
how many of one good (rock concerts) an individual is willing to give up for an
additionalunitoftheothergood(hockeygames),thentheMRS,andhencetheslopeof
theindifferencecurves,willbedifferentforthetwoindividuals.
7. ThepriceofDVDs(D)is$20andthepriceofCDs(C)is$10. Philiphasabudgetof
$100tospendonthetwogoods.SupposethathehasalreadyboughtoneDVDandone
CD.Inadditionthereare3moreDVDsand5moreCDsthathewouldreallyliketobuy.
a. Giventheabovepricesandincome,drawhisbudgetlineonagraphwithCDson
thehorizontalaxis.
Hisbudgetlineis PD D PC C I ,or20D+10C=100.Ifhespendshisentireincome
onDVDshecouldaffordtobuy5.IfhespendshisentireincomeonCDshecould
affordtobuy10.

b. Consideringwhathehasalreadypurchased,andwhathestillwantstopurchase,
identifythethreedifferentbundlesofCDsandDVDsthathecouldchoose.
Assumethathecannotpurchasefractionalunitsforthispartofthequestion.

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 Chapter3:ConsumerBehavior
Givenhehasalreadypurchasedoneofeach,foratotalof$30,hehas$70left.Since
hewants3moreDVDshecanbuythesefor$60andspendhisremaining$10on1
CD.Thisisthefirstbundlebelow.Hecouldalsochoosetobuyonly2DVDsfor$40
andspendtheremaining$30on3CDs.Hecanchoosethefollowingbundles:
PurchasedQuantities TotalQuantities
D
C D
C
3 1 2 6
2 3 3 4
1 5 4 2

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 Chapter3:ConsumerBehavior
8.Annehasajobthatrequireshertotravelthreeoutofeveryfourweeks.Shehasan
annualtravelbudgetandcaneithertravelbytrainorbyplane.Theairlineshetypically
flieswithhasafrequenttravelerprogramthatreducesthecostofherticketsdepending
onthenumberofmilesshehasflowninagivenyear.Whenshereaches25,000milesthe
airlinewillreducethepriceofherticketsby25%fortheremainderoftheyear.When
shereached50,000miles,theairlinewillreducethepriceofherticketsby50%forthe
remainderoftheyear. GraphAnnesbudgetline,withtrainmilesontheverticalaxis
andplanemilesonthehorizontalaxis.
Thetypicalbudgetlineislinear(withaconstantslope)becausethepricesofthetwo
goodsdonotchangeastheconsumerbuysmoreorlessofaparticulargood.Inthis
case, the price of airline miles will change depending on how many miles she
purchases. Asthepricechanges,theslopeofthebudgetlinewillchange. Since
therearethreeprices,therewillbethreeslopes,ortwokinks,tothebudgetline.
Sincethepricefallsasshefliesmoremiles,thebudgetlinewillbecomeflatterwith
everypricechange.Seethegraphintheproblembelow.

9. Debrausuallybuysasoftdrinkwhenshegoestoamovietheater,whereshehasa
choiceofthreesizes:the8ouncedrinkcosts$1.50,the12ouncedrink,$2.00,andthe16
ouncedrink,$2.25.DescribethebudgetconstraintthatDebrafaceswhendecidinghow
manyouncesofthedrinktopurchase.(AssumethatDebracancostlesslydisposeofany
ofthesoftdrinkthatshedoesnotwant.
Firstnoticethatasthesizeofthedrinkincreases,thepriceperouncedecreases.
$1.50
Whenshebuysthe8ouncesoftdrinkshepays $0.19peroz. Whenshe
8oz
buysthe12ouncesizeshepays$0.17perounce,andwhenshebuysthe16ounce
size,shepays$0.14perounce.Giventhattherearethreedifferentpricesperounce
ofsoftdrink,thebudgetlinewillhavetwokinksinit,asillustratedbelow.Notice
thatateachkink,theslopeofthebudgetlinegetsflatter(duetothedecreasingcost
perouncerelativetotheothergoodontheverticalaxis).

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 Chapter3:ConsumerBehavior

8 12 16 Ouncesof
SoftDrink

10.Antoniobuys5newcollegetextbooksduringhisfirstyearatschoolatacostof$80
each.Usedbookscostonly$50each.Whenthebookstoreannouncesthattherewillbea
10% increase intheprice ofnew books and a5%increasein thepriceofused books,
Antoniosfatheroffershim$40extra.
a. WhathappenstoAntoniosbudgetline?Illustratethechangewithnewbookson
theverticalaxis.
Inthefirstyearhespends$80eachon5newbooksforatotalof$400.Forthesame
amount of money he could have bought 8 used textbooks. His budget line is
therefore80*New+50*Used=400.Afterthepricechange,newbookscost$88,used
bookscost$52.5,andhehasanincomeof$440. Ifhespendsallofhisincomeon
newbooks,hecanstillaffordtobuy5newbooks,butcannowaffordtobuy8.4used
booksifhebuysonlyusedbooks.Thenewbudgetlineis88*New+52.5*Used=440.
Thebudgetlinehaschangeditsslopeandbecomeflatterifweplaceusedbookson
thehorizontalaxis.
b. IsAntonioworseorbetteroffafterthepricechange?Explain.
Thefirstyearhebought5booksatacostof$80eachforatotalof$400.Thenew
priceofbooksis$88andthecostof5newbooksisnow$440.The$40extraincome
willcoverthepriceincrease. Antonioisdefinitelynotworseoffsincehecanstill
affordthesamenumberofnewbooks.Hemayinfactbebetteroffifhedecidesto
switchtousedbooks.
11. Consumers in Georgia pay twice as much for avocados as they do for peaches.
However,avocadosandpeachesareequallypricedinCalifornia. Ifconsumersinboth
statesmaximizeutility,willthemarginalrateofsubstitutionofpeachesforavocadosbe
thesameforconsumersinbothstates?Ifnot,whichwillbehigher?
Themarginalrateofsubstitutionofpeachesforavocadosistheamountofavocados
thatapersoniswillingtogiveuptoobtainoneadditionalpeach. Whenconsumers
maximizeutility,theysettheirmarginalrateofsubstitutionequaltothepriceratio,

35
 Chapter3:ConsumerBehavior
Ppeach
whichinthiscaseis . InGeorgia, Pavocado 2Ppeach ,whichmeansthatwhen
Pavocado
Ppeach 1
consumersaremaximizingutility, MRS . InCalifornia, Pavocado Ppeach
Pavocado 2
Ppeach 1
,whichmeansthatwhenconsumersaremaximizingutility, MRS . The
Pavocado 1
marginal rateofsubstitutionisthereforenot thesameinbothstates, andwillbe
higherinCalifornia.

12.Benallocateshislunchbudgetbetweentwogoods,pizzaandburritos.
a. IllustrateBensoptimalbundleonagraphwithpizzaonthehorizontalaxis.
Thisisthestandardgraph,whereBensbudgetlineislinearandheconsumesatthe
pointwherehisindifferencecurveistangenttohisbudgetline.Thisplaceshimon
thehighestpossibleindifferencecurve.
b. Supposenowthatpizzaistaxed,causingthepricetoincreaseby20%.Illustrate
Bensnewoptimalbundle.
When the price of pizza increases, the budget line will pivot inwards. This will
shrinkthesizeofBensbudgetsetandhewillnolongerbeabletoaffordhisold
bundle. Hisnewoptimalbundleiswheretheindifferencecurveistangenttohis
newbudgetlineandthisindifferencecurveisbelowhisoriginalindifferencecurve.

c. SupposeinsteadthatpizzaisrationedataquantitylessthanBensdesired
quantity.IllustrateBensnewoptimalbundle.
RationingthequantityofpizzathatcanbepurchasedwillresultinBennotbeing
abletochoosehisoptimalbundle. Hewillhavetochooseabundleonthebudget
linethatisabovehisoriginalbundle. Thisnewbundlewillhavealowerlevelof
utility.
burrito
rationedbundle

originalbundle

pizza

13. Brendawantstobuyanewcarandhasabudgetof$25,000. Shehasjustfounda

magazinethatassignseachcaranindexforstylingandanindexforgasmileage.Each
index runs from 110, with 10 representing either the most styling or the best gas
mileage.Whilelookingatthelistofcars,Brendaobservesthatonaverage,asthestyle

36
 Chapter3:ConsumerBehavior
indexrisesbyoneunit,thepriceofthecarincreasesby$5,000.Shealsoobservesthatas
thegasmileageindexrisesbyoneunit,thepriceofthecarincreasesby$2,500.
a. Illustratethevariouscombinationsofstyle(S)andgasmileage(G)thatBrenda
couldselectwithher$25,000budget.Placegasmileageonthehorizontalaxis.
Forevery $5,000shespends onstyletheindex risesbyonesothemostshecan
achieveisacarwithastyleindexof5.Forevery$2,500shespendsongasmileage,
theindexrisesbyonesothemostshecanachieveisacarwithagasmileageindex
of10.Theslopeofherbudgetlineis1/2.
b. Suppose Brendas preferences are such that she always receives three times as
much satisfaction from an extra unit of styling as she does from gas mileage.
WhattypeofcarwillBrendachoose?
IfBrenda alwaysreceivesthreetimesasmuchsatisfactionfromanextra unitof
stylingasshedoesfromanextraunitofgasmileagethensheiswillingtotradeone
unitofstylingforthreeunitsofgasmileage,andstillmaintainthesamelevelof
satisfaction. This is her MRS or the slope of her indifference curves, which is
constant.SincetheMRSis1/3andtheslopeofherbudgetlineis1/2,Brendawill
chooseallstyling.Youcanalsocomputethemarginalutilityperdollarforstyling
andgasmileageandnotethatstylingwillbehigher. Inthegraphbelow,shewill
moveuptothehighestpossibleindifferencecurvewhereshechoosesallstylingand
nogasmileage.
styling

gasmileage

c. SupposethatBrendasmarginalrateofsubstitution (ofgasmileageforstyling)
S
wasequalto .Whatvalueofeachindexwouldsheliketohaveinhercar?
4G
Tofindtheoptimalvalueofeachindex,setMRSequaltothepriceratioof1/2and
crossmultiplytogetS=2G.Nowsubstituteintothebudget5000S+2500G=25000to
getG=2andS=4.
d. SupposethatBrendasmarginalrateofsubstitution (ofgasmileageforstyling)
3S
wasequalto .Whatvalueofeachindexwouldsheliketohaveinhercar?
G
TofindtheoptimalvalueofeachindexsetMRSequaltothepriceratioof1/2and
crossmultiplytogetG=6S.Nowsubstituteintothebudget5000S+2500G=25000to
getG=7.5andS=1.25.

14.Conniehasamonthlyincomeof$200,whichsheallocatesbetweentwogoods:meat
andpotatoes.

37
 Chapter3:ConsumerBehavior
a. Supposemeatcosts$4perpoundandpotatoescost$2perpound.Drawherbudget
constraint.

LetM=meatandP=potatoes.Conniesbudgetconstraintis

$200=4M+2P,or

M=500.5P.

Asshowninthefigurebelow,withMontheverticalaxis,theverticalinterceptis50.
ThehorizontalinterceptmaybefoundbysettingM=0andsolvingforP.
Meat

100

75

BudgetConstraint
50 andUtilityFunction

25
U=100

Potatoes
25 50 75 100 125

b. Supposealsothatherutilityfunctionisgivenbytheequationu(M,P)=2M+P.
Whatcombination ofmeat andpotatoesshould shebuytomaximizeherutility?
(Hint:Meatandpotatoesareperfectsubstitutes.)
Whenthetwogoodsareperfectsubstitutes,theindifferencecurvesarelinear.Tofind
theslopeoftheindifferencecurve,choosealevelofutilityandfindtheequationfora
representative indifference curve. Suppose u=50, then 2M+P=50, or M=250.5P.
Therefore, Connies budget line and her indifference curves have the same slope.
Conniesutilityisequalto100whenshebuys50poundsofmeatandnopotatoesorno
meatand100poundsofpotatoes.TheindifferencecurveforU=100coincideswith
her budget constraint. Any combination of meat and potatoes along this line will
provideherwithmaximumutility.
c. Conniessupermarkethasaspecialpromotion. Ifshebuys20poundsofpotatoes
(at$2perpound),shegetsthenext10poundsforfree.Thisofferappliesonlytothe
first20poundsshebuys. Allpotatoesinexcessofthefirst20pounds(excluding
bonuspotatoes)arestill$2perpound.Drawherbudgetconstraint.
Assumethatpotatoesareonthehorizontalaxis. Conniesbudgetconstrainthasa
slopeof1/2untilConniehaspurchasedtwentypoundsofpotatoes,isthenflatfrom
20to30poundsofpotatoes,sincethetennextpoundsofpotatoesarefree,andthen
hasaslopeof1/2untilitinterceptsthepotatoaxisat110.
d. An outbreak of potato rot raises the price of potatoes to $4 per pound. The
supermarketendsitspromotion.Whatdoesherbudgetconstraintlooklikenow?
Whatcombinationofmeatandpotatoesmaximizesherutility?

38
 Chapter3:ConsumerBehavior
Withthepriceofpotatoesat$4,Conniemay buyeither 50pounds ofmeator50
pounds of potatoes, or some combination in between. See Figure 3.14.d. She
maximizesutilityatU=100atpointAwhensheconsumes50poundsofmeatandno
potatoes.Thisisacornersolution.
Meat

100

75

A BudgetConstraint
50

IndifferenceCurveforU=100
25

Potatoes
25 50 75 100 125

Figure3.14.d

15.Janereceivesutilityfromdaysspenttravelingonvacationdomestically(D)anddays
spent traveling on vacation in a foreign country (F), as given by the utility function
U(D,F) 10DF .Inaddition,thepriceofadayspenttravelingdomesticallyis$100,the
price of a day spent traveling in a foreign country is $400, and Janes annual travel
budgetis$4,000.
a. Illustrate the indifference curve associated with a utility of 800 and the
indifferencecurveassociatedwithautilityof1200.
Theindifferencecurvewithautilityof800hastheequation10DF=800,orDF=80.
ChoosecombinationsofDandFwhoseproductis80tofindafewbundles. The
indifferencecurvewithautilityof1200hastheequation10DF=1200,orDF=120.
ChoosecombinationsofDandFwhoseproductis120tofindafewbundles.
b. GraphJanesbudgetlineonthesamegraph.
IfJanespendsallofherbudgetondomestictravelshecanafford40days. Ifshe
spendsallofherbudgetonforeigntravelshecanafford10days.

c. CanJaneaffordanyofthebundlesthatgiveherautilityof800? Whatabouta
utilityof1200?
Yesshecanaffordsomeofthebundlesthatgiveherautilityof800aspartofthis
indifferencecurveliesbelowthebudgetline.Shecannotaffordanyofthebundles
thatgiveherautilityof1200asthiswholeindifferencecurveliesabovethebudget
line.
d. FindJanesutilitymaximizingchoiceofdaysspenttravelingdomesticallyand
daysspentinaforeigncountry.
39
 Chapter3:ConsumerBehavior
Theoptimalbundleiswheretheslopeoftheindifferencecurveisequaltotheslope
ofthebudgetline,andJaneisspendingherentireincome.Theslopeofthebudget
lineis
PD 1
.
PF 4
Theslopeoftheindifferencecurveis
MU D 10F F
MRS .
MU F 10D D
Settingthetwoequalweget:
F 1

D 4
4F D.
Wenowhavetwoequationsandtwounknowns:
4F D
100D 400F 4000.
SolvingtheabovetwoequationsgivesD=20andF=5.Utilityis1000.
Thisbundleisonanindifferencecurvebetweenthetwoyouhadpreviouslydrawn.

16.Julioreceivesutilityfromconsumingfood(F)andclothing(C)asgivenbytheutility
function U(F,C) FC .Inaddition,thepriceoffoodis$2perunit,thepriceofclothing
is$10perunit,andJuliosweeklyincomeis$50.
a. WhatisJuliosmarginalrateofsubstitutionoffoodforclothingwhenutilityis
maximized?Explain.
Utility is maximized when MRS (food for clothing) equals P C/PF, the price ratio.
Giventhatclothingisonthehorizontalaxisandfoodisontheverticalaxis,thenthe
priceratioistheslopeofthebudgetline,whichispriceofclothingdividedbythe
priceoffoodor5.
b. Suppose instead that Julio is consuming a bundle with more food and less
clothing than his utility maximizing bundle. Would his marginal rate of
substitutionoffoodforclothingbegreaterthanorlessthanyouranswerinpart
a?Explain.
In absolute value terms, the slope of his indifference curve at this nonoptimal
bundleisgreaterthantheslopeofhisbudgetline.Heiswillingtogiveupmorefood
than he has to at market prices to obtain one more unit of clothing. He will
thereforefinditoptimaltogiveupsomefoodinexchangeforclothing.
food
currentbundle

optimalbundle

clothing

17. TheutilitythatMeredithreceivesbyconsumingfoodFandclothingCisgivenby
u(F,C)=FC.SupposethatMeredithsincomein1990is$1,200andthepricesoffoodand
40
 Chapter3:ConsumerBehavior
clothingare$1perunitforeach.However,by1995thepriceoffoodhasincreasedto$2
and the price of clothing to $3. Let 100 represent the cost of living index for 1990.
CalculatetheidealandtheLaspeyrescostoflivingindexforMeredithfor1995. (Hint:
Meredithwillspendequalamountsonfoodandclothingwiththesepreferences.)
First,weneedtocalculateFandC,whichmakeupthebundleoffoodandclothingwhich
maximizesMeredithsutilitygiven1990pricesandherincomein1990. Usethehintto
simplifytheproblem:Sinceshespendsequalamountsonbothgoods,P FF=PCC.Or,you
canderivethissameequationmathematically:Withthisutilityfunction,MU C=U/C=F,
andMUF=U/F=C.Tomaximizeutility,Meredithchoosesaconsumptionbundlesuch
thatMUF/MUC=PF/PC,whichagainyieldsP FF=PCC.
Fromthebudgetconstraint,wealsoknowthat:
PFF+PCC=Y.
Combiningthesetwoequationsandsubstitutingthevaluesforthe1990pricesandincome
yieldsthesystemofequations:
C=FandC+F=1,200.
Solvingthesetwoequations,wefindthat:
C=600andF=600.
LaspeyresIndex
The Laspeyres index represents how much more Meredith would have to spend in 1995
versus1990ifsheconsumedthesameamountsoffoodandclothingin1995asshedidin
1990.Thatis,theLaspeyresindexfor1995(L)isgivenby:
L=100(Y)/Y
whereYrepresentstheamountMeredithwouldspendat1995pricesconsumingthesame
amountoffoodandclothingasin1990.In1995,600clothingand600foodwouldcost($3)
(600)+($2)(600)=$3000.
Therefore,theLaspeyrescostoflivingindexis:
L=100($3000/$1200)=250.
IdealIndex
TheidealindexrepresentshowmuchMeredithwouldhavetospendonfoodandclothingin
1995togetthesameamountofutilityasshehadin1990.Thatis,theidealindexfor1995
(I)isgivenby:
I=100(Y'')/Y,whereY''=P'FF'+P'CC'=2F'+3C'
whereF'andC'aretheamountoffoodandclothingthatgiveMerediththesameutilityas
shehadin1990.F'andC'mustalsobesuchthatMeredithspends theleastamountof
moneyat1995pricestoattainthe1990utilitylevel.

Thebundle(F',C')willbeonthesameindifferencecurveas(F,C)soF'C'=FC=360,000in
utility.IfMeredithsincomeisadjustedin1995sothatthebundle(F',C')ismaximizingher
utilitygivenherincome, then theindifference curve atthispointwillbetangent tothe
budgetlinewithslope(P' F/P'C),whereP'FandP'Carethepricesoffoodandclothingin1995.
UsingMUF'/MUC'=PF'/PC'weknowthat2F'=3C'.
Wenowhavetwoequations:F'C'=360,000and2F'=3C'.
SolvingforF'yields:
41
 Chapter3:ConsumerBehavior
F'[(2/3)F']=360,000orF'= [(3 / 2 )360,000 )] =734.8.

Fromthis,weobtainC':
C'=(2/3)F'=(2/3)734.8=489.9.
In 1995, the bundle of 734.8 food and 489.9 clothing would cost $2939.60 and Meredith
wouldstillget360,000inutility.
Wecannowcalculatetheidealindex:
I=100($2939.60/$1200)=244.9.

42