THE CONSUMER’S OPTIMAL CHOICES

Consider once again our Pepsi and pizza example. The consumer would like to end up with the best possible combination of Pepsi and pizza-that is, the combination on the highest possible indifference curve. But the consumer must also end up on or below his budget constraint, which measures the total resources available to aim. Figure 6 shows the consumer’s budget constraint and three of his many indifference curves. The highest
indifference curve that the consumer can reach (/2 in the figure) is the one that just barely touches the budget constraint. The point at which this indifference curve and the budget constraint touch is called the optimum. The consumer would prefer point A, but he cannot afford that point because it lies above his budget constraint. The consumer can afford point B, but that point is on a lower indifference curve and, therefore, provides the consumer less satisfaction. The optimum represents the best combination of consumption of Pepsi and pizza available to the consumer.

figure 6  The Consumer’s Optimum

The consumer chooses the point on his budget constraint that lies on the highest indifference curve. At this point, called the optimum, the marginal rate of substitution equals the relative price of the two goods. Here the highest indifference curve the consumer can reach is 12, The consumer prefers point A, which lies on indifference curve 13, but the consumer cannot afford this bundle of Pepsi and pizza. By contrast. point B is
affordable. but because it lies on a lower indifference curve. the consumer does not prefer it

THE CONSUMER'S OPTIMAL CHOICES

THE CONSUMER’S OPTIMAL CHOICES

Notice that, at the optimum, the slope of the indifference curve equals the slope of the budge constraint. We say that the indifference curve is tangent to the budget constraint. The slope of the indifference curve is the marginal rate of substitution between Pepsi and pizza, and the slope of the budge constraint is the relative price of Pepsi and pizza. Thus, the consumer chooses consumption of the goods so that the marginal rate of substitution equals the relative price. In Chapter 7, we saw how market prices reflect the marginal value that consumers place on goods. That analysis of consumer choice shows the same result in another way. In making his consumption choices, the consumer takes as given the relative price of the two goods and then chooses an optimum at which his marginal rate of substitution equals this relative price. The relative price is the rate at which the market is willing to trade one good for the other, whereas the marginal rate of substitution is the rate at which the consumer is willing to trade one good for the other. At the consumer’s optimum, the consumer’s valuation of the two goods (as measured by the marginal rate of substitution) equals the market’s valuation (as meat tired by the relative price) result of this consumer optimization, market prices of different  goods reflect the value that consumers place on those goods.

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