[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

ALL OTHER GOODS ($)
300
200
100
B
F i
F
Budget constraint with
price of CD = $30
F d
A
Budget constraint with
price of CD = $15
Budget constraint with
price of CD = $10
Indifference
curves
rate of substitution is 20, Fran is willing to give up 20 candy bars to get
1 more CD, but only has to give up 15; it clearly pays her to buy more
CDs and fewer candy bars. If her marginal rate of substitution is 10, she
is willing to give up 1 CD for just 10 candy bars; but if she gives up 1 CD,
she can get 15 candy bars. She will be better off buying more candy bars
and fewer CDs. Thus, if the marginal rate of substitution exceeds the relative
price, Fran is better off if she buys more CDs; if it is less, she is
better off if she buys fewer CDs. When the marginal rate of substitution
equals the relative price, it does not pay for her to either increase
or decrease her purchases.
C i
C
C d
0
30
6 10 11 15
F i
20 30
B
USING INDIFFERENCE CURVES TO
DERIVE DEMAND CURVES
PRICE OF CDs ($)
20
15
10
0
Figure 5.14
F
6 11 15
F d
Demand curve
CDs
DERIVING DEMAND CURVES FROM
SHIFTING BUDGET CONSTRAINTS
In panel A, the budget constraint rotates down to the
left as the price of CDs increases, leading Fran to change
consumption from F to F i . The budget constraint rotates
to the right when the price of CDs decreases, and Fran
moves from F to F d . Panel B shows the corresponding
demand curve for CDs, illustrating how the rising prices
lead to a decline in the quantity consumed.
Indifference curves and budget constraints can be used to derive the
demand curve, and thus to show what happens when prices increase.
The analysis consists of two steps.
First, we identify what happens to the budget constraint as, say, the
price of CDs increases. We did this earlier in Figure 5.6, but now we
can add indifference curves to the analysis. In the budget constraint
drawn in Figure 5.14A, we find CDs on the horizontal axis and all other
goods on the vertical axis. If Fran buys no CDs, she has $300 to spend
on all other goods. At a CD price of $15, she can buy up to 20 CDs, producing
the budget line running from point B to C. As the price of CDs
increases, the budget constraint rotates in and becomes steeper. If
she buys no CDs, she still has $300 to spend on other goods. But if
she buys only CDs, the number of CDs she can buy falls as their price
rises. If the price of CDs falls, the budget constraint rotates out and
becomes flatter.
For each budget constraint, we find the point of tangency between the
indifference curve and the budget constraint, here labeled F i , F, and F d .
This shows the point chosen along each budget constraint. Looking at the
horizontal axis, we see, at each price, the quantity of CDs purchased. Panel
B then plots these quantities for each price. At the price of $15, Fran chooses
11 CDs; at a price of $30, she chooses to buy only 6.
SUBSTITUTION AND INCOME EFFECTS
Indifference curves also permit a precise definition of the substitution and income
effects. Figure 5.15 plots some of Jeremy’s indifference curves between CDs and
candy bars. Jeremy’s original budget constraint is line BC and his indifference curve
is I 0 ; the point of tangency, the point he chooses, is point E 0 . Suppose the price of
128 ∂ CHAPTER 5 THE CONSUMPTION DECISION