Examining production isoquants: All input combinations are equal

80 Part II: Considering Which Side You’re On in the Decision-Making Process

Knowing the marginal rate of substitution

The marginal rate of substitution measures the change in the quantity of the good on the vertical axis of the diagram that is necessary per one unit change of the good on the horizontal axis of the diagram in order for the consumer to receive the same amount of total utility. Wow, that’s a mouthful, even for an economist. In the case of the apple and orange example, it’s the change in the quantity of apples consumed necessary given a one unit change in oranges for the same level of total utility. This is simply the slope of the indifference curve.

Now this is what you really have to remember: The slope of the indifference curve equals the marginal utility of the good on the horizontal axis divided by the marginal utility of the good on the vertical axis.

Consuming within limits

Now, add the budget constraint to the diagram. Remember, you can only purchase combinations of goods on the budget constraint.

In the earlier section “Doing the Best You Can Given Consumer Constraints,” I give an equation for my budget constraint in purchasing apples and oranges

Adding this budget constraint to the indifference curve map graphed in Figure 5-2 generates the diagram in Figure 5-3.

Money can buy you happiness

There’s an old saying, “Money can’t buy you happiness.” I won’t get into the philosophical aspects of the saying, but as an economist, I can say money does buy satisfaction because money is used to purchase the goods that satisfy my wants and desires. On the other hand, I don’t get any satisfaction from the money itself. I want to buy stuff — bicycles, vacations, good food, and lots of other stuff. I get satisfaction from the stuff I buy with money, not the money. As a result, although you can purchase combinations of goods inside the budget constraint, you don’t want to do that. You get satisfaction from consuming goods — not from money. If I gave you a one dollar bill and told you that you could never spend it, would you be any happier? Probably not. You want money in order to spend it — to buy as much stuff as possible. You save in order to buy more stuff in the future, not because you want money.

Chapter 5: Consumer Behavior: A Market for Anything?

81

Figure 5-3:

Optimal combination of apples and oranges.

Deciding what makes you happiest

Consumers want to get as much happiness as possible.

Higher indifference curves represent more happiness, so consumers want to get to the highest indifference curve possible given the budget constraint. In Figure 5-3, this combination is illustrated at point A — 4 apples and 6 oranges. Although the figure includes higher indifference curves, you can’t reach those combinations of apples and oranges given the budget constraint.

Now for some magic. At the point where you’re happiest given your budget constraint, the indifference curve and budget constraint are tangent with one another. This means the slopes of these two curves are equal. Therefore

Or, if you rearrange that equation

The preceding equation is an application of what economists call the equimarginal principle. By equating — “equi” — the marginal utilities per dollar spent (marginal) for all goods, you receive the maximum satisfaction or utility given your budget constraint.