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Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
1 of 39
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
2 of 39
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
6/e.
6/e. Perez
PerezSheffrin,
O’Sullivan,
and Tools Sheffrin,
Tools O’Sullivan,
Applications,
Principles,and
Economics: Principles
Consumer Choice Using
Utility Theory
In February 2006,
Apple Computer sold
its billionth song at its
iTunes music store.
PREPARED BY
FERNANDO QUIJANO, YVONN QUIJANO,
AND XIAO XUAN XU
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
APPLYING THE CONCEPTS
1
How does a tax on one good affect the demand for substitute
goods?
New Zealand’s Tax on Light Spirits
2
Why do consumers dislike the bundling of goods?
Online Music Stores and Piracy
How do consumers respond to offsetting changes in taxes?
3
The Substitution Effect of a Gas Tax Decreases Gas
Consumption
4
5
How do consumers respond to free goods?
The Big Difference between $0.20 and FREE!
How does product branding affect consumers’ brain activity?
Neuroscience and the Cola Challenge
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
4 of 39
22.1
TOTAL AND MARGINAL UTILITY
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 22
Consumer Choice
Using Utility Theory
• utility
The satisfaction experienced
from consuming a good.
• util
One unit of utility.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
22.1
TOTAL AND MARGINAL UTILITY
► FIGURE 22.1
Total Utility and Marginal Utility
In Panel A, the total utility or
satisfaction from downloaded
songs increases with the
number of songs, but at a
decreasing rate.
In Panel B, the marginal
utility from songs decreases
as the number of songs
increases.
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22.1
TOTAL AND MARGINAL UTILITY
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 22
Consumer Choice
Using Utility Theory
• marginal utility
The change in total utility from one
additional unit of a good.
• law of diminishing marginal utility
As the consumption of a particular
good increases, marginal utility
decreases.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
22.2
CONSUMER CHOICE
Consumer Constraints: The Budget Line
• budget line
The line connecting the combinations
of two goods that exhaust a
consumer’s budget.
• budget set
The set of affordable combinations of
two goods.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
22.2
CONSUMER CHOICE
Consumer Constraints: The Budget Line
 FIGURE 22.2
Budget Set and Budget Line
The budget set (the shaded
triangle) shows all the
affordable combinations of
books and movies, and the
budget line (with endpoints a
and k) shows the combinations
that exhaust the budget.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
22.2
CONSUMER CHOICE
Making Choices Using the Equimarginal Rule
• equimarginal rule
Pick the combination of two activities
where the marginal benefit per dollar
for the first activity equals the
marginal benefit per dollar for the
second activity.
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22.2
CONSUMER CHOICE
Making Choices Using the Equimarginal Rule
Economics: Principles, Applications, and Tools
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6/e.
C H A P T E R 22
Consumer Choice
Using Utility Theory
EQUIMARGINAL RULE
Pick the combination of two activities where the marginal benefit
per dollar for the first activity equals the marginal benefit per
dollar for the second activity.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
APLICATION
1
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
NEW ZEALAND’S TAX ON LIGHT SPIRITS
APPLYING THE CONCEPTS #1: How does a tax on one
good affect the demand for substitute goods?
How did teenagers in New Zealand respond to a special
tax on their favorite alcoholic beverage? We can use the
equimarginal rule to explore New Zealand’s recent
experiences with taxing alcoholic beverages.
• “Light spirits”—beverages with alcohol content between 14 and 24 percent—
provided the biggest alcoholic bang per buck for teens.
• The government imposed a special tax on light spirits, nearly doubling the price.
• The tax decreased the bang per buck and teens responded by cutting back.
• Producers responded by changing their beverage recipes to avoid the tax.
Moreover, they priced these new “super-light” beverages below the original light
beverage price.
• Given the equimarginal rule, we would expect many teens to switch to super-light
beverages, and that’s exactly what happened.
The simple lesson is that consumers respond to taxes and changes in price.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
APLICATION
2
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
ONLINE MUSIC STORES AND PIRACY
APPLYING THE CONCEPTS #2: Why do consumers
dislike the bundling of goods?
Online music stores provide an alternative to buying bundles of songs on CDs. We
can use the theory of consumer choice to explain the logic behind this recent
development.
 FIGURE 22.3
Internet Music Piracy and iTunes
When music is sold as 15-song
bundles on CDs, the consumer
has three budget points (a, c, and
d) rather than an entire budget
line.
If songs are sold individually, the
consumer has a complete budget
line and can legally reach his or
her ideal combination of 6 songs
and 48 arcade games (point b).
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C H A P T E R 22
Consumer Choice
Using Utility Theory
22.3
THE INDIVIDUAL DEMAND CURVE
An individual demand curve shows the relationship between the price of a product
and the quantity demanded by a rational consumer. In other words, the demand
curve shows, for each price, the utility-maximizing quantity for the consumer.
 FIGURE 22.4
The Individual Demand Curve
When the price of a movie
is $3, Maxine maximizes
utility at point i, with four
movies.
If the price drops to $2,
she maximizes utility at
point j, with seven movies.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
22.3
THE INDIVIDUAL DEMAND CURVE
The Income and Substitution Effects of a Price Change
• substitution effect
The change in quantity consumed
that is caused by a change in the
relative price of the good, with real
income held constant.
• income effect
The change in quantity consumed
that is caused by a change in real
income, with relative prices held
constant.
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22.3
THE INDIVIDUAL DEMAND CURVE
The Income and Substitution Effects of a Price Change
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 22
Consumer Choice
Using Utility Theory
Points on the Demand Curve
In general, each point on a demand curve shows the utilitymaximizing choice for a particular price.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
APLICATION
3
Economics: Principles, Applications, and Tools
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6/e.
THE SUBSTITUTION EFFECT OF A GAS TAX DECREASES
GAS CONSUMPTION
APPLYING THE CONCEPTS #3: How do consumers respond
to offsetting changes in taxes?
If the government raises the gasoline tax and cuts income taxes, will gasoline consumption
decrease?
• Initial price of gas = $4 per gallon
• Price of another good = $1 per unit
• When the consumer maximizes utility, gas consumption is 1,000 gallons per year and
the marginal utility of gas = 12 utils. The marginal utility of the other good = 3 utils. This
yields the equimarginal principle:
12 utils 3 utils

$4
$1
Then, a tax of $2 is imposed on gasoline. The price of gas after tax = $4 + $2 = $6, and the
equimarginal principle is affected as follows:
12 utils 3 utils

$6
$1
The citizen will cut back on gasoline and spend more on the other good. The decrease in
gas consumption is the substitution effect in action.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
22.4
CONSUMER PUZZLES—FREE GOODS
AND BRANDING
Economics: Principles, Applications, and Tools
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APLICATION
4
THE BIG DIFFERENCE BETWEEN $0.20 AND FREE!
APPLYING THE CONCEPTS #4: How do consumers
respond to free goods?
A few years ago Amazon.com introduced free shipping
for U.S. orders over $25. A consumer who bought a
single book for less than $25 would pay about $4 in shipping, but if adding a
second book to the order brought the book total to at least $25, shipping was free.
The free-shipping offer decreased the effective price of any book that pushed the
book order over $25, and sales increased dramatically.
In France, the company offered cheap—but not free—shipping for orders over
$25. Crossing the $25 threshold cut the shipping charge to only 1 franc, about
$0.20. In contrast with the U.S. experience, book sales increased by a relatively
small amount.
The Amazon experiences in the United States and France illustrate a puzzle in
consumer behavior. Cutting the shipping charge from $4 to zero had a huge
effect, but cutting the charge to $0.20 didn’t have much of an effect. Consumers
are highly responsive to freebies, and many firms incorporate free goods and
services into their marketing.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
APLICATION
5
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
NEUROSCIENCE AND THE COLA CHALLENGE
APPLYING THE CONCEPTS #5: How does product
branding affect consumers’ brain activity?
In the “Pepsi Challenge” advertisements, randomly chosen consumers tasted
Pepsi and Coke, and a majority preferred Pepsi. In an advertising campaign
running at the same time, Coca-Cola proclaimed that a majority of consumers
who tasted both products actually preferred Coke. Can both companies be
correct?
There was a subtle difference between the two taste tests. Pepsi used blind
tasting, while Coca-Cola used nonblind tasting. When consumers don’t know
what brand they are drinking, Pepsi has the edge. In other words, branding
makes a difference. Neuroscientists ran the cola challenge while monitoring the
brain activity of the tasters. When the participants knew which brand they were
drinking, the portion of the brain involved in higher order functions—working
memory, associations, higher-order cognitions, and ideas—was stimulated, and
the activation was much greater with Coke than with Pepsi. In other words,
branding affects brain activity and consumer preference.
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budget set
Economics: Principles, Applications, and Tools
budget line
O’Sullivan, Sheffrin, Perez
C H A P T E R 22
Consumer Choice
Using Utility Theory
equimarginal rule
income effect
KEY TERMS
law of diminishing marginal utility
marginal utility
substitution effect
util
utility
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C H A P T E R 22
Consumer Choice
Using Utility Theory
CONSUMER CHOICE WITH INDIFFERENCE CURVES
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
A P P E N D I X TO
CHAPTER 22
APPLYING THE CONCEPTS
1
To determine whether a consumer is making the best
choice, what single question can you ask?
What’s Your MRS?
2
Why do consumers dislike the bundling of goods?
Online Music and Piracy
3
How do consumers respond to free goods?
The Big Difference between $0.20 and FREE!
4
How do consumers respond to offsetting changes in
taxes?
The Substitution Effect of a Gas Tax Decreases Gas
Consumption
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
21 of 39
C H A P T E R 22
Consumer Choice
Using Utility Theory
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
A P P E N D I X TO
CHAPTER 22
CONSUMER CHOICE WITH INDIFFERENCE CURVES
22A.1
CONSUMER CONSTRAINTS AND
PREFERENCES
Consumer Constraints: The Budget Set and Budget Line
• budget line
The line connecting all the
combinations of two goods that
exhaust a consumer’s budget.
• budget set
A set of points that includes all the
combinations of two goods that a
consumer can afford, given the
consumer’s income and the prices
of the goods.
• price ratio
The price of the good on the
horizontal axis divided by the price
of the good on the vertical axis.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
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A P P E N D I X TO
CHAPTER 22
CONSUMER CHOICE WITH INDIFFERENCE CURVES
22A.1
CONSUMER CONSTRAINTS AND
PREFERENCES
Consumer Constraints: The Budget Set and Budget Line
 FIGURE 22A.1
Budget Set and Budget Line
The budget set (the shaded triangle)
shows all the affordable combinations
of books and movies, and the budget
line (with endpoints a and k) shows the
combinations that exhaust the budget.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
Economics: Principles, Applications, and Tools
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A P P E N D I X TO
CHAPTER 22
CONSUMER CHOICE WITH INDIFFERENCE CURVES
22A.1
CONSUMER CONSTRAINTS AND
PREFERENCES
Consumer Preferences: Indifference Curves
• utility
The satisfaction experienced from
consuming a good.
• indifference curve
A curve showing the different
combinations of two goods that
generate the same level of utility or
satisfaction.
• marginal rate of substitution (MRS)
The rate at which a consumer is
willing to trade or substitute one good
for another.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
Economics: Principles, Applications, and Tools
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A P P E N D I X TO
CHAPTER 22
CONSUMER CHOICE WITH INDIFFERENCE CURVES
22A.1
CONSUMER CONSTRAINTS AND
PREFERENCES
 FIGURE 22A.2
Indifference Curve and the
Marginal Rate of Substitution
The indifference curve shows the different
combinations of movies and books that generate the
same utility level.
The slope is the marginal rate of substitution (MRS)
between the two goods.
The MRS is eight books per movie between points b
and i, but only one book per movie between points m
and n.
The indifference curve passing through points
b, i, m, and n separates the combinations of
books and movies into three groups:
1 Superior combinations.
2 Inferior combinations.
3 Equivalent combinations.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
Economics: Principles, Applications, and Tools
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A P P E N D I X TO
CHAPTER 22
CONSUMER CHOICE WITH INDIFFERENCE CURVES
22A.1
CONSUMER CONSTRAINTS AND
PREFERENCES
• indifference curve map
A set of indifference curves,
each with a different utility level.
 FIGURE 22A.3
Indifference Curve Map
An indifference curve map shows a set of
indifference curves, with utility increasing
as we move northeasterly to higher
indifference curves (from I1 to I2 to I3).
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C H A P T E R 22
Consumer Choice
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A P P E N D I X TO
CHAPTER 22
CONSUMER CHOICE WITH INDIFFERENCE CURVES
22A.2
MAXIMIZING UTILITY
The Tangency Condition
 FIGURE 22A.4
Maximizing Utility: MRS Equals the
Price Ratio
To maximize utility, the consumer finds the
combination of books and movies where
an indifference curve is tangent to the
budget line.
At the utility-maximizing combination
(point e), the marginal rate of substitution
(the consumer’s own trade-off, shown by
the slope of the indifference curve) equals
the price ratio (the market trade-off,
shown by the slope of the budget line).
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C H A P T E R 22
Consumer Choice
Using Utility Theory
22A.2
MAXIMIZING UTILITY
The Utility-Maximizing Rule: MRS = Price Ratio
• utility-maximizing rule
Pick the combination that makes the
marginal rate of substitution equal to
the price ratio.
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
A P P E N D I X TO
CHAPTER 22
CONSUMER CHOICE WITH INDIFFERENCE CURVES
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C H A P T E R 22
Consumer Choice
Using Utility Theory
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A P P E N D I X TO
CHAPTER 22
APLICATION
1
WHAT’S YOUR MRS?
APPLYING THE CONCEPTS #1: To determine
whether a consumer is making the best choice,
what single question can you ask?
We can use the utility-maximizing rule to determine whether consumers are doing the
best they can. Suppose a firm has a fixed budget of $200 to spend on punch and
cookies for its holiday party.
• The price of punch is $2 per cup and the price of cookies is $1 per cookie; both
goods will, of course, be provided free of charge to workers at the party.
• The firm’s objective is to maximize the utility of the typical employee, and your job
is to determine whether the company spent this year’s party budget wisely.
• Assume that all employees have identical tastes for cookies and punch, so data
from a single person will apply to every employee. You can ask the typical
employee a single question. What’s your question?
“How many cookies would you be willing to trade for one cup of punch?
If the answer is “two cookies per cup of punch,” the MRS equals the price ratio, and
the firm did the best it could. On the other hand, if the answer is “five cookies per cup
of punch,” the MRS exceeds the price ratio, and the firm could have generated higher
utility with its $200 by providing more punch and fewer cookies.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
Economics: Principles, Applications, and Tools
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6/e.
A P P E N D I X TO
CHAPTER 22
APLICATION
2
ONLINE MUSIC AND PIRACY
APPLYING THE CONCEPTS #2: Why do
consumers dislike the bundling of goods?
 FIGURE 22A.5
Internet Music Piracy and iTunes
When music is sold as 15-song bundles
on CDs, the consumer has three budget
points (a, c, and d) rather than an entire
budget line.
If songs are sold individually, the
consumer has a full budget line and can
legally reach his or her ideal combination
of 6 songs and 48 arcade games (point
b).
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
APLICATION
3
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
A P P E N D I X TO
C H A P T E R 2 2 THE BIG DIFFERENCE BETWEEN $0.20 AND FREE!
APPLYING THE CONCEPTS #3: How do consumers
respond to free goods?
A few years ago Amazon.com introduced free shipping for U.S. orders
over $25. A consumer who bought a single book for less than $25 would
pay about $4 in shipping, but if adding a second book to the order brought
the book total to at least $25, shipping was free. The free-shipping offer
decreased the effective price of any book that pushed the book order over
$25, and sales increased dramatically.
In France, the company offered cheap—but not free—shipping for orders
over $25. Crossing the $25 threshold cut the shipping charge to only 1
franc, about $0.20. In contrast with the U.S. experience, book sales
increased by a relatively small amount.
The Amazon experiences in the United States and France illustrates a
puzzle in consumer behavior. Cutting the shipping charge from $4 to zero
had a huge effect, but cutting the charge to $0.20 didn’t have much of an
effect. Consumers are highly responsive to freebies, and many firms
incorporate free goods and services into their marketing.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
31 of 39
C H A P T E R 22
Consumer Choice
Using Utility Theory
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
A P P E N D I X TO
CHAPTER 22
CONSUMER CHOICE WITH INDIFFERENCE CURVES
22A.3
DRAWING THE INDIVIDUAL
DEMAND CURVE
The Negatively Sloped Demand Curve
With so many curves floating around, it is worth reviewing their
roles in consumer decision making:
• The budget line shows the affordable combinations of two
goods, representing the consumer’s constraints.
• An indifference curve shows the different combinations of two
goods that generate the same utility level, representing the
consumer’s preferences.
• The demand curve shows how much of a single product a
consumer is willing to buy at a particular price. To get the
demand curve, we use both the budget line and indifference
curves.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
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A P P E N D I X TO
CHAPTER 22
CONSUMER CHOICE WITH INDIFFERENCE CURVES
22A.3
DRAWING THE INDIVIDUAL
DEMAND CURVE
The Negatively Sloped Demand Curve
 FIGURE 22A.6
Drawing the Demand Curve
A decrease in the price of movies tilts
the budget line outward.
In Panel A, the indifference curve is
tangent to the new budget line at point
t, with a larger quantity of movies (7
instead of 4).
In Panel B, when the price of movies is
$3, the consumer maximizes utility with
4 movies. A decrease in price to $2
increases the utility-maximizing
number of movies to 7, illustrating the
law of demand.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
Economics: Principles, Applications, and Tools
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A P P E N D I X TO
CHAPTER 22
CONSUMER CHOICE WITH INDIFFERENCE CURVES
22A.3
DRAWING THE INDIVIDUAL
DEMAND CURVE
The Income and Substitution Effects of a Price Change
• substitution effect
The change in quantity consumed
that is caused by a change in the
relative price of the good, with real
income held constant.
• income effect
The change in quantity consumed
that is caused by a change in real
income, with relative prices held
constant.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
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A P P E N D I X TO
CHAPTER 22
CONSUMER CHOICE WITH INDIFFERENCE CURVES
22A.3
DRAWING THE INDIVIDUAL
DEMAND CURVE
The Income and Substitution Effects of a Price Change
Let’s take a closer look at a consumer’s response to a change in
price. We will break down Maxine’s response to a decrease in
price into two effects:
• Substitution effect. A decrease in the price of movies
decreases the price of movies relative to the price of other
goods, such as books. As movies become less costly relative
to books, Maxine substitutes movies for books.
• Income effect. A decrease in the price of movies increases
Maxine’s real income (the purchasing power of her nominal
income), and she will buy more of all normal goods. If watching
movies is a normal good, she will watch more movies.
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C H A P T E R 22
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A P P E N D I X TO
CHAPTER 22
CONSUMER CHOICE WITH INDIFFERENCE CURVES
22A.3
DRAWING THE INDIVIDUAL
DEMAND CURVE
The Income and Substitution Effects of a Price Change
 FIGURE 22A.7
The Substitution Effect of a
Decrease in Price
To observe the substitution effect,
shown by the move from point e to
point s, we offset the decrease in price
of movies (from $3 to $2) by
decreasing the consumer’s income to
$26, thereby making the original choice
(point e) just affordable. At the original
choice, the MRS (three books per
movie) exceeds the new price ratio
(two books per movie), so the
consumer can do better.
Moving from point e to point s, utility
increases and the quantity of movies
increases from four to six.
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C H A P T E R 22
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A P P E N D I X TO
CHAPTER 22
CONSUMER CHOICE WITH INDIFFERENCE CURVES
22A.3
DRAWING THE INDIVIDUAL
DEMAND CURVE
The Income and Substitution Effects of a Price Change
 FIGURE 22A.8
The Income Effect of a Decrease in
Price
To observe the income effect, shown
by the move from point s to point t, we
restore the consumer’s original
nominal income of $30 (up from the
$26 used to reveal the substitution
effect) while keeping a price of $2 per
movie.
The budget line shifts outward, and the
consumer maximizes utility at point t,
so the quantity of movies increases
from six to seven.
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C H A P T E R 22
Consumer Choice
Using Utility Theory
APLICATION
4
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
THE SUBSTITUTION EFFECT OF A GAS TAX DECREASES GAS
CONSUMPTION
APPLYING THE CONCEPTS #4: How do consumers respond to
offsetting changes in taxes?
 FIGURE 22A.9
Increasing the Gas Tax and
Decreasing the Income Tax
If a $2 gasoline tax is combined with a
$2,000 decrease in the income tax, a
person who initially buys 1,000 gallons
(point a) can still afford the initial
choice.
But the increase in the relative price of
gasoline means that the initial point no
longer maximizes utility.
At point a, the MRS is less than the
new price ratio, and the substitution
effect moves the consumer from point
a to point b, reducing gasoline
consumption from 1,000 to 700
gallons.
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KEY TERMS
Economics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 22
Consumer Choice
Using Utility Theory
budget line
marginal rate of substitution (MRS)
budget set
price ratio
income effect
substitution effect
indifference curve
utility
indifference curve map
utility-maximizing rule
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39 of 39