106 PART 2 • Producers, Consumers, and Competitive Markets

4. Indifference curves, which represent all combinations approach uses the ordinal properties of utility (that
of goods and services that give the same level of sat- is, it allows for the ranking of alternatives). The util-
isfaction, are downward-sloping and cannot intersect ity function approach obtains a utility function by
one another. attaching a number to each market basket; if basket
5. Consumer preferences can be completely described by A is preferred to basket B, A generates more utility
a set of indifference curves known as an indifference than B.
map. An indifference map provides an ordinal ranking 12. When risky choices are analyzed or when comparisons
of all choices that the consumer might make. must be made among individuals, the cardinal proper-
6. The marginal rate of substitution (MRS) of F for C is ties of the utility function can be important. Usually
the maximum amount of C that a person is willing the utility function will show diminishing marginal
to give up to obtain 1 additional unit of F. The MRS utility: As more and more of a good is consumed, the
diminishes as we move down along an indifference consumer obtains smaller and smaller increments of
curve. When there is a diminishing MRS, indifference utility.
curves are convex. 13. When the utility function approach is used and both
7. Budget lines represent all combinations of goods for goods are consumed, utility maximization occurs
which consumers expend all their income. Budget when the ratio of the marginal utilities of the two
lines shift outward in response to an increase in con- goods (which is the marginal rate of substitution) is
sumer income. When the price of one good (on the equal to the ratio of the prices.
horizontal axis) changes while income and the price of 14. In times of war and other crises, governments some-
the other good do not, budget lines pivot and rotate times ration food, gasoline, and other products, rather
about a fixed point (on the vertical axis). than allow prices to increase to competitive levels.
8. Consumers maximize satisfaction subject to budget Some consider nonprice rationing to be more equitable
constraints. When a consumer maximizes satisfaction than relying on uncontested market forces.
by consuming some of each of two goods, the marginal 15. An ideal cost-of-living index measures the cost of buy-
rate of substitution is equal to the ratio of the prices of ing, at current prices, a bundle of goods that generates
the two goods being purchased. the same level of utility as was provided by the bundle
9. Maximization is sometimes achieved at a corner solu- of goods consumed at base-year prices. The Laspeyres
tion in which one good is not consumed. In such cases, price index, however, represents the cost of buying
the marginal rate of substitution need not equal the the bundle of goods chosen in the base year at current
ratio of the prices. prices relative to the cost of buying the same bundle at
10. The theory of revealed preference shows how the base-year prices. The CPI, even with chain weighting,
choices that individuals make when prices and income overstates the ideal cost-of-living index. By contrast,
vary can be used to determine their preferences. When the Paasche index measures the cost at current-year
an individual chooses basket A even though he or she prices of buying a bundle of goods chosen in the cur-
could afford B, we know that A is preferred to B. rent year divided by the cost of buying the same bun-
11. The theory of the consumer can be presented by dle at base-year prices. It thus understates the ideal
two different approaches. The indifference curve cost-of-living index.

QUESTIONS FOR REVIEW

1. What are the four basic assumptions about individual 5. What happens to the marginal rate of substitution as
preferences? Explain the significance or meaning of you move along a convex indifference curve? A linear
each. indifference curve?
2. Can a set of indifference curves be upward sloping? If 6. Explain why an MRS between two goods must equal
so, what would this tell you about the two goods? the ratio of the price of the goods for the consumer to
3. Explain why two indifference curves cannot intersect. achieve maximum satisfaction.
4. Jon is always willing to trade one can of Coke for 7. Describe the indifference curves associated with two
one can of Sprite, or one can of Sprite for one can of goods that are perfect substitutes. What if they are per-
Coke. fect complements?
a. What can you say about Jon’s marginal rate of sub- 8. What is the difference between ordinal utility and
stitution? cardinal utility? Explain why the assumption of car-
b. Draw a set of indifference curves for Jon. dinal utility is not needed in order to rank consumer
c. Draw two budget lines with different slopes and choices.
illustrate the satisfaction-maximizing choice. What 9. Upon merging with the West German economy,
conclusion can you draw? East German consumers indicated a preference for
 CHAPTER 3 • Consumer Behavior 107

Mercedes-Benz automobiles over Volkswagens. would like. Can you tell if the consumer is better off
However, when they converted their savings into or worse off?
deutsche marks, they flocked to Volkswagen dealer- 11. Describe the equal marginal principle. Explain why
ships. How can you explain this apparent paradox? this principle may not hold if increasing marginal util-
10. Draw a budget line and then draw an indifference ity is associated with the consumption of one or both
curve to illustrate the satisfaction-maximizing choice goods.
associated with two products. Use your graph to 12. The price of computers has fallen substantially over
answer the following questions. the past two decades. Use this drop in price to explain
a. Suppose that one of the products is rationed. why the Consumer Price Index is likely to overstate
Explain why the consumer is likely to be worse off. substantially the cost-of-living index for individuals
b. Suppose that the price of one of the products is who use computers intensively.
fixed at a level below the current price. As a result, 13. Explain why the Paasche index will generally under-
the consumer is not able to purchase as much as she state the ideal cost-of-living index.

EXERCISES
1. In this chapter, consumer preferences for various com- 5. Suppose that Bridget and Erin spend their incomes on
modities did not change during the analysis. In some two goods, food (F) and clothing (C). Bridget’s prefer-
situations, however, preferences do change as con- ences are represented by the utility function U(F,C) ⫽
sumption occurs. Discuss why and how preferences 10FC, while Erin’s preferences are represented by the
might change over time with consumption of these utility function U(F,C) ⫽ .20F2C2.
two commodities: a. With food on the horizontal axis and clothing
a. cigarettes. on the vertical axis, identify on a graph the set of
b. dinner for the first time at a restaurant with a points that give Bridget the same level of utility as
special cuisine. the bundle (10, 5). Do the same for Erin on a sepa-
2. Draw indifference curves that represent the follow- rate graph.
ing individuals’ preferences for hamburgers and soft b. On the same two graphs, identify the set of bundles
drinks. Indicate the direction in which the individuals’ that give Bridget and Erin the same level of utility
satisfaction (or utility) is increasing. as the bundle (15, 8).
a. Joe has convex indifference curves and dislikes c. Do you think Bridget and Erin have the same pref-
both hamburgers and soft drinks. erences or different preferences? Explain.
b. Jane loves hamburgers and dislikes soft drinks. If 6. Suppose that Jones and Smith have each decided to
she is served a soft drink, she will pour it down the allocate $1000 per year to an entertainment budget
drain rather than drink it. in the form of hockey games or rock concerts. They
c. Bob loves hamburgers and dislikes soft drinks. If he both like hockey games and rock concerts and will
is served a soft drink, he will drink it to be polite. choose to consume positive quantities of both goods.
d. Molly loves hamburgers and soft drinks, but insists However, they differ substantially in their preferences
on consuming exactly one soft drink for every two for these two forms of entertainment. Jones prefers
hamburgers that she eats. hockey games to rock concerts, while Smith prefers
e. Bill likes hamburgers, but neither likes nor dislikes rock concerts to hockey games.
soft drinks. a. Draw a set of indifference curves for Jones and a
f. Mary always gets twice as much satisfaction from an second set for Smith.
extra hamburger as she does from an extra soft drink. b. Using the concept of marginal rate of substitution,
3. If Jane is currently willing to trade 4 movie tickets for explain why the two sets of curves are different
1 basketball ticket, then she must like basketball better from each other.
than movies. True or false? Explain. 7. The price of DVDs (D) is $20 and the price of CDs (C)
4. Janelle and Brian each plan to spend $20,000 on the is $10. Philip has a budget of $100 to spend on the two
styling and gas mileage features of a new car. They goods. Suppose that he has already bought one DVD
can each choose all styling, all gas mileage, or some and one CD. In addition, there are 3 more DVDs and 5
combination of the two. Janelle does not care at all more CDs that he would really like to buy.
about styling and wants the best gas mileage possi- a. Given the above prices and income, draw his
ble. Brian likes both equally and wants to spend an budget line on a graph with CDs on the horizontal
equal amount on each. Using indifference curves and axis.
budget lines, illustrate the choice that each person will b. Considering what he has already purchased and
make. what he still wants to purchase, identify the three
 108 PART 2 • Producers, Consumers, and Competitive Markets

different bundles of CDs and DVDs that he could the gas-mileage index rises by one unit, the price of the
choose. For this part of the question, assume that he car increases by $2500.
cannot purchase fractional units. a. Illustrate the various combinations of style (S) and
8. Anne has a job that requires her to travel three out of gas mileage (G) that Brenda could select with her
every four weeks. She has an annual travel budget and $25,000 budget. Place gas mileage on the horizontal
can travel either by train or by plane. The airline on axis.
which she typically flies has a frequent-traveler pro- b. Suppose Brenda’s preferences are such that she
gram that reduces the cost of her tickets according to always receives three times as much satisfaction
the number of miles she has flown in a given year. from an extra unit of styling as she does from gas
When she reaches 25,000 miles, the airline will reduce mileage. What type of car will Brenda choose?
the price of her tickets by 25 percent for the remainder c. Suppose that Brenda’s marginal rate of substitu-
of the year. When she reaches 50,000 miles, the airline tion (of gas mileage for styling) is equal to S/(4G).
will reduce the price by 50 percent for the remainder of What value of each index would she like to have in
the year. Graph Anne’s budget line, with train miles on her car?
the vertical axis and plane miles on the horizontal axis. d. Suppose that Brenda’s marginal rate of substitu-
9. Debra usually buys a soft drink when she goes to a tion (of gas mileage for styling) is equal to (3S)/G.
movie theater, where she has a choice of three sizes: What value of each index would she like to have in
the 8-ounce drink costs $1.50, the 12-ounce drink $2.00, her car?
and the 16-ounce drink $2.25. Describe the budget 14. Connie has a monthly income of $200 that she allocates
constraint that Debra faces when deciding how many between two goods: meat and potatoes.
ounces of the drink to purchase. (Assume that Debra a. Suppose meat costs $4 per pound and potatoes $2
can costlessly dispose of any of the soft drink that she per pound. Draw her budget constraint.
does not want.) b. Suppose also that her utility function is given by
10. Antonio buys five new college textbooks during his the equation U(M, P) ⫽ 2M ⫹ P. What combination
first year at school at a cost of $80 each. Used books of meat and potatoes should she buy to maximize
cost only $50 each. When the bookstore announces her utility? (Hint: Meat and potatoes are perfect
that there will be a 10 percent increase in the price of substitutes.)
new books and a 5 percent increase in the price of used c. Connie’s supermarket has a special promotion. If
books, Antonio’s father offers him $40 extra. she buys 20 pounds of potatoes (at $2 per pound),
a. What happens to Antonio’s budget line? Illustrate she gets the next 10 pounds for free. This offer
the change with new books on the vertical axis. applies only to the first 20 pounds she buys. All
b. Is Antonio worse or better off after the price change? potatoes in excess of the first 20 pounds (excluding
Explain. bonus potatoes) are still $2 per pound. Draw her
11. Consumers in Georgia pay twice as much for avoca- budget constraint.
dos as they do for peaches. However, avocados and d. An outbreak of potato rot raises the price of pota-
peaches are the same price in California. If consumers toes to $4 per pound. The supermarket ends its
in both states maximize utility, will the marginal rate promotion. What does her budget constraint look
of substitution of peaches for avocados be the same for like now? What combination of meat and potatoes
consumers in both states? If not, which will be higher? maximizes her utility?
12. Ben allocates his lunch budget between two goods, 15. Jane receives utility from days spent traveling on vaca-
pizza and burritos. tion domestically (D) and days spent traveling on
a. Illustrate Ben’s optimal bundle on a graph with vacation in a foreign country (F), as given by the utility
pizza on the horizontal axis. function U(D,F) ⫽ 10DF. In addition, the price of a day
b. Suppose now that pizza is taxed, causing the price spent traveling domestically is $100, the price of a day
to increase by 20 percent. Illustrate Ben’s new opti- spent traveling in a foreign country is $400, and Jane’s
mal bundle. annual travel budget is $4000.
c. Suppose instead that pizza is rationed at a quan- a. Illustrate the indifference curve associated with a
tity less than Ben’s desired quantity. Illustrate Ben’s utility of 800 and the indifference curve associated
new optimal bundle. with a utility of 1200.
13. Brenda wants to buy a new car and has a budget of b. Graph Jane’s budget line on the same graph.
$25,000. She has just found a magazine that assigns c. Can Jane afford any of the bundles that give her a
each car an index for styling and an index for gas mile- utility of 800? What about a utility of 1200?
age. Each index runs from 1 to 10, with 10 representing *d. Find Jane’s utility-maximizing choice of days spent
either the most styling or the best gas mileage. While traveling domestically and days spent in a foreign
looking at the list of cars, Brenda observes that on aver- country.
age, as the style index increases by one unit, the price 16. Julio receives utility from consuming food (F) and cloth-
of the car increases by $5000. She also observes that as ing (C) as given by the utility function U(F,C) ⫽ FC.
 CHAPTER 3 • Consumer Behavior 109

In addition, the price of food is $2 per unit, the price 17. The utility that Meredith receives by consuming food
of clothing is $10 per unit, and Julio’s weekly income F and clothing C is given by U(F,C) ⫽ FC. Suppose that
is $50. Meredith’s income in 1990 is $1200 and that the prices
a. What is Julio’s marginal rate of substitution of food of food and clothing are $1 per unit for each. By 2000,
for clothing when utility is maximized? Explain. however, the price of food has increased to $2 and
b. Suppose instead that Julio is consuming a bundle the price of clothing to $3. Let 100 represent the cost
with more food and less clothing than his utility of living index for 1990. Calculate the ideal and the
maximizing bundle. Would his marginal rate of Laspeyres cost-of-living index for Meredith for 2000.
substitution of food for clothing be greater than or (Hint: Meredith will spend equal amounts on food and
less than your answer in part a? Explain. clothing with these preferences.)
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