Daniel l. Rubinfeld

92 Part 2 Producers, Consumers, and Competitive Markets
Lr",,, .. Y,,. :3 Consumer Behavior 93
Spending
on Other 20,000
Goods (5)
lS,OOO -
questions lie in the economic theory of consumer behavior. In this section, we
describe the theoretical underpilU1ings of cost indexes such as the CPT, using an
example that describes the hypothetical price changes that students and their
parents might face.
cost-at-living index Ratio of
the present cost of a typical
bundle of consumer goods
and sen'ices compared with
the cost during a base period.
15,000
E
o 2,000 5,000
B
Gasoline (gallons per year)
When a good is rationed, less is available than consumers would like to buy.
Consumers may be worse off. Without gasoline ratiorling, up to 20,000 gallo~s of
gasoline are available for consumption (at point B). The cnsumer choos~s po~t ~
on indifference curve U 2
, consuming 5,000 gallons of gasoline. However, WIth a limit
of 2,000 gallons of gasoline tmder rationing (at point E), the consumer moves to D on
Let's look at two sisters, Rachel and Sarah, whose preferences are identical.
When Sarah began her college education in 1990, her parents gave her a "discretionary"
budget of $500 per quarter. Sarah could spend the money on food,
which was available at a price of $2.00 per pound, and on books, 'which were
available at a price of $20 each. Sarah bought 100 pounds of food (at a cost of
$200) and 15 books (at a cost of $300). Ten years later, in 2000 '.vhen Rachel (who
had worked during the interim) is about to start college, her parents promise her
a budget that is equivalent in buying power to that of her older sister.
Unfortunately, prices in the college town have increased, with food now $2.20
per pound and books $100 each. By how much should the discretionary budget
be increased to make Rachel as well off in 2000 as her sister Sarah was in 1990
Table 3.3 summarizes the relevant data and Figure 3.21 provides the answer.
The initial budget constraint facing Sarah in 1990 is given by line Ij in Figure
3.21; her utility-maximizing combination of food and books is at point A on
indifference curve U j . We can check that the cost of achieving this level of utility
is $500, as stated in the table:
5500 100 lbs. of food X 52000/lb. + 15 books x $20/book
With rationing, hmvever, our consumer can purchase only 2,000 gallons of
gasoline. Thus, she now faces budget line ADE, a line that ~s no loner a
straight line because purchases above 2,000 gallons are not posslbl.e: The figure
shows that her choice to consume at D involves a lower level of uhhty, U j , than
\,>'ould be achieved without rationing, U 2 , because she is consuming less gasoline
and more of other than she would otherwise prefer.
As Figure 3 .21 shovvs, for Rachel to achieve the same level of utility as Sarah
while facing the new higher prices, she requires a budget sufficient to purchase
the food-book consumption bundle given by point B on line 12 (and tangent to
indifference curve U j ), where she chooses 300 lbs. of food and 6 books. Note that
in doing so, Rachel has taken into account the fact that the price of books has
increased relative to food. Therefore she has substituted toward food and away
from books.
The cost to Rachel of attaining the same level of utility as Sarah is given by
*3J'J
$1,260 = 300 lbs. of food X $2.20/lb. + 6 books X ~D100/book
In §1.1, we introduce the
Consumer Price Index as a
measure of the cost of a "typical"
consumer's entire market
basket. As such, changes
in the CPT also measure the
rate of inflation.
The Social Security system has been the subject of heated debate for som~ time
now. Under the present system, a retired person receives an annual benefit that
is imtially determined at the time of retirement and is based on his or her work
history. The benefit then increases from year to year at a rate equal to the rate of
increa'se of the Consumer Price Index (CPI). The CPI is calculated each year by the
us Bureau of Labor Statistics as the ratio of the present cost of a typical blllldle of CO/1-
sUlller goods alld services ill colllparisoll to the cost dllrillg a base period. Does the CPI
accurately reflect the cost of living for retirees Is it appropriate to use the CPI
as we no~v do-as a cost-of-living index for other government programs, for
private umon pensions, and for private wage agreements The answers to these
1990 (SARAH) 2000 (RACHEL)
Price of books $20/book $100/book
Number of books 15 6
Price of food $2.00/lbo $2.20/lb.
Pounds of food 100 300
Expenditure $500 $1,260