17 Behavioral Economics and Risk Taking

The happier you are the more money you have.

The answer is no.

Jack Whittaker won a $315 million Powerball prize in 2002.
He is broke, divorced from his wife, has been arrested for drunk driving, and was robbed on two separate occasions while carrying $500,000.
He lost his daughter and granddaughter to drug overdoses.

Money can be used to lift spirits.

More money means more opportunities to strengthen your connections with others and contribute to your community.
It also means you can afford to travel, experience the diverse wonders of nature, and spend more time with family and friends instead of working all the time.
Saving money for a goal can make the experience more rewarding.
We say yes if you are careful about how you spend it and don't get consumed by money.

We use our understanding of income constraints, price, and personal satisfaction to determine which economic choices yield the greatest benefits.

Imagine that on a hot day you stop at a convenience store to get a cold drink.

You decide to get a snack while you're there.

apple pie is on sale and you choose it instead of brownies.

Many people pay thousands of dollars for diamond jewelry.

To better understand the decisions consumers make, economists measure the enjoyment from consumption of a good or attempt to measure the satisfaction that consumers get when they make pur service.

Utility theory seeks to measure satisfaction.

To understand why people buy goods and services, we need to recognize that some products produce more utility than others, and that everyone gets different levels of satisfaction from the same good or service.

This way of modeling decisions has tremendous value.

Predicting what people are likely to purchase is possible when we understand utility.

Do you like a slice of apple pie?

We expect the firm to maximize profits, the laborer to accept the best offer, and the consumer to find the best combination of goods.

A brownie lover may get 25 Utils from her favorite snack, but someone who is less susceptible to the pleasures of chewy, gooey chocolate may rate the same brownie at 10 Utils.
These are approximations of relative utility.
You can't say that you and a friend receive 10 Utils from eating brownies.

It is possible for the level of enjoyment one receives to be consistent.

If you rate a brownie at 25 Utils and a slice of apple pie at 15 Utils, we know that you like brownies more than apple pie.

A balance between economic and personal factors is what most of us think of as utility.

Despite the inherent problem of equating money and satisfaction, researchers are still exploring the connection.

The connection between total utility and marginal utility is explored in the next section.

We can understand why more money doesn't bring more satisfaction.

The "happiness index" was published by the Organisation for Economic Co- operation and Development.

11 topics are essential in the areas of material living conditions and quality of life and have been identified by the Organisation for Economic Co-operation and Development.

The results depend on the relative importance assigned to the different measures.

Their income is only $26,000 per year.

Australians live to an average age of 81, two years longer than the average in developed countries, they have a high degree of civic engagement, and they enjoy a very high life satisfaction rating.

The United States is identified as having the highest income by the Organisation for Economic Co-operation and Development, but it scores lower in work life balance than other top countries.

Mexico has a very low rating because of safety concerns, poor education, and low levels of income.

It is possible to understand how to increase total utility by thinking about choices consumers make.

Consider a person who likes brownies.

After eating five brownies, total utility increases until it reaches 75 Utils.

The dashed line connecting panels a and b shows the relationship between total utility and marginal utility.

The total utility falls after a certain number of brownies are eaten because the marginal utility becomes negative after five brownies are eaten.
The marginal utility is positive in panel b and the total utility is rising in panel a.
To the right of the dashed line, the marginal utility is negative and the total utility is falling.

The marginal utility values from the table are plotted in a way that shows the decline in utility as consumption increases.

The relationship between total utility and marginal utility is obvious when we see the dashed line.

The total utility eventually falls because the marginal utility becomes negative after five brownies are eaten.
The marginal utility is positive in panel b and the total utility is rising in panel a.
To the right of the dashed line, the marginal utility is negative and the total utility is falling.

The consumer is tired of eating brownies when marginal utility is negative.

The brownies are no longer adding to the consumer's utility and he or she will stop eating them.

One of the increases is the declines as consumption concept of diminishing marginal utility.

In rare cases, marginal utility can rise.

Many people choose to run because of the health benefits.

The first mile can be hard as the runner's body warms up.
It is easier to run for a while.
You stop running when the extra miles become more exhausting and less satisfying.
If you force yourself to do more running after you have already pushed your limit, it will yield less utility.

This theory should be confirmed by your own intuition.

Increasing marginal utility would allow you to enjoy what you are doing more and never want to stop.
Because economists don't observe this behavior among rational consumers, we can be confident that diminishing marginal utility has a lot to do with running.

The best television show runs its course.

The same humor or drama that once made the show interesting is no longer relevant.

Tell your friend to mix it up and do something different.

On the first day, there is a lot of excitement.

You run to rides, don't to amusement parks mind waiting in line, and experience the thrill for the first time.

The lower price entices you to return after the second day.

Some games and concerts are more anticipated by the public than other games and concerts.

The promise of unlimited food is not enough for the average diner.

Negative marginal utility is caused by eating more.
Reducing utility will limit how much customers eat.

The diminishing marginal utility of minutes on cell phone plans is what cell phone companies rely on.

Cell phone companies know that consumers won't stay on their phones forever.

A person doesn't want a second copy of the same paper.

Most people don't steal additional copies from vending machines because the second paper is worthless.

The eating contest is hard to watch.

A lot of people are uneasy about eating so many hot dogs.

A number of interesting real- world situations can be explained by diminishing marginal utility.

It helps you understand the concept of diminishing marginal utility.

It is difficult to say that it is easier to say that it is easier to say that it is easier to say that it is easier to say that it is easier to say that it is easier to say that it is easier to say that it is easier to say that it is easier to Each of us will make thousands of purchases over the course of the year.

We try to spend in a way that allows us to meet both our short run and long run needs, and our budgets are generally not unlimited.
We start with two goods and then look at the findings across a consumer's entire income or budget.

Imagine a world with only two things: pizza and Pepsi.

This example will show us how much it costs to buy pizza instead of Pepsi.

Each pizza slice costs $2 and the can of soda is $1.

We need a rule for making decisions before we can answer that question.

To reach your consumer optimum, you must allocate your available money by choosing goods that give you the most utility per dollar spent.
If you get the biggest bang for your buck, you will be better off.
The marginal utility relationship helps quantify the decision.
If you want to get more for your money, then you should buy Pepsi instead of pizza.

We get the marginal utility per dollar spent if we divide it by the price.

A road map to consumer satisfaction can be found by comparing the marginal utility per dollar spent on pizza and Pepsi.

The marginal utility for each slice of pizza is shown in column 5.

The marginal utility per dollar spent for pizza is listed in column 6 while the mar ginal utility is listed in column 3.

It's time to make your first spending decision, which is whether to drink a soda or eat a slice of pizza.
The marginal utility per dollar spent for the first slice of pizza is higher than the marginal utility for the first can of soda.

After eating the first slice of pizza, you can either have a second slice or have the first can of soda.

This time you pay $1 for a drink.

There is a choice between having a second slice of pizza and having a second can of soda.

Because both choices yield the same amount of utility per dollar spent and you have enough money to afford both, we'll assume you would purchase both at the same time.
You have $4 left after your purchase costs $3.

You can choose between the third slice of pizza at 6 Utils per dollar spent or the third can of Pepsi at 7 Utils per dollar spent.

You buyPepsi because it's the better value.
You can choose between the third slice of pizza at 6 Utils per dollar spent or the fourth can of Pepsi at 6 Utils per dollar spent.
You have $3 left and the items are of equal utility, so you buy both.

A total utility of 9 + 8 + 7 + 6 is calculated by looking at column 2 in Table 16.2.

Three slices of pizza yielded a total utility of 20 + 16 + 12.
Adding the two together gives a total of 78 satisfaction benefits.
This is the most expensive utility you can afford.
Table 16.3 reports the maximum utility for every affordable combination of pizza and soda.

The combination of pizza and Pepsi is highlighted in orange.

The result we found was the marginal utilities per dollar spent.

This process results in the highest total utility according to Table 16.3

The Better Life Index tries to measure 11 factors of material well-being in 34 countries.

The goal of the index is to give member governments a snapshot of how their citizens are living, thus providing a road map for future policy priorities.

Average household income is one of the factors that can be objectively measured.

"life satisfaction" is measured from survey responses.
There are results in three countries.

Each measurement has one to three indicators.

"Jobs" is measured through the unemployment rate, job security, and personal earnings.

There are five glaring challenges to the well-being of Mexico's citizens.

Some factors are more important than others.

Table 16.3 shows diminishing marginal utility.

If you only use pizza orPepsi, you will have a lower total utility: 60 Utils with pizza and 45 Utils withPepsi.
The preferred outcome of four Pepsis and three pizza slices corresponds to a modest amount of each good; this outcome avoids the utility reduction associated with excessive consumption of either good.

You maximize your total utility if you think about the margin of which good provides the highest marginal utility.

Most people don't think this way.
Consumers make marginal choices all the time.
Consumer choice is an instinct to seek the most satisfaction.
Generalizing the two- good example is what we will do next.

The idea of measuring utility makes sense and helps us solve simple problems.

When you travel without a gps device, you make choices about which route to take to save time.
One route will be better than the other if you turn left or right at the stop sign.
marginal thinking is what economists focus on.

Life is more complex than the model suggests.

You can choose among many goods when you have $10 to spend.

Because you buy many items at all kinds of prices over the course of a year, you have to juggle hundreds or thousands of purchases so that you enjoy roughly the same utility per dollar spent.
Consumer optimum compares the utility gained with the price paid for every item a consumer buys.

The ratio of the marginal utility per dollar spent on every item, from good A to good Z, is equal if a consumer's income or budget is balanced.

The relationship between changes in price sooner is explored in the next section.

You reached an optimum when you bought four Pepsis and three slices of pizza.

The prices of a slice of pizza and a can of soda were the same as before.

If the price of a slice of pizza drops to $1.50, then that's a good thing.

Lower prices increase the marginal utility per dollar spent and cause consumers to buy more of a good.

The marginal utility per dollar spent is lowered by higher prices.
The law of demand has been restated.

The law of demand states that when the price goes up, the quantity goes down, and when the price goes down, the quantity goes up.

It makes sense to connect the prices that consumers pay, the quantity that they buy, and the marginal utility that they receive if we think of consumer desire for a particular product as demand.

There are two effects of a lower price.

To separate these two effects, we need to go back to our previous example.

It is more affordable to buy a slice of pizza at a lower price.
If there is a change in the price, the consumer can afford six slices and still have money left over.

When the price of a slice of pizza is less than $2, your optimum is three slices.

50 cents per slice is the savings if the price of a slice of pizza is lowered to $1.50.

You can buy another slice if you purchase three slices.
The fourth slice of pizza yields an additional 8 Utils, according to column 5 in Table 16.2.

You could use the $1.50 you saved on pizza to buy a fifth can of soda and still have 50 cents left over.

Pizza has become less expensive, which may cause you to substitute it for something else.

There is a substitution effect at work.
You have more purchasing power when you save money on pizza.
The income effect is real.

When prices change enough to have a measurable effect on the purchasing power of the consumer, the real- income effect matters.

Suppose a 10% price reduction in peanut butter cups occurs.

How much money is saved is the key to answering this question.

A 10% reduction in the price of candy bars would be less than 10 cents.

Some consumers will switch to peanut butter cups because of the lower price.
The real- income effect is insignificant.
The consumer saved less than 10 cents.
The money saved could be used to purchase other goods, but very few goods cost so little, and the enhanced purchasing power is effectively zero.
The answer to the question is that there will be a small substitution effect and no real income effect.

The cost of your favorite Starbucks creation is usually $5.

Imagine how it would taste if you spent over $50 on extra shots, add- ins, and flavors.
The law of diminishing marginal utility says that more units of the same good will bring more marginal utility.
When you consider what $50 could buy instead of coffee, the effects are substantial.
$50 is enough to buy a week's worth of groceries.
It's hard to imagine that a single Starbucks drink would provide more utility than a week's worth of food.

The diamond- water paradoxes were first described by Adam Smith in 1776 and explain why water, which is essential to life, is inexpensive and diamonds, which do not sustain life, are expensive.

Many people of Smith's era found inexpensive, while diamonds do not sustain life.
Consumer choice theory can be used to answer expensive.

The diamond- water paradoxes compares the amount of marginal utility a person receives from a small quantity of something rare with the amount of marginal utility received from consuming a small amount of additional water after already consuming a large amount.

The law of demand captures marginal utility by the price of a good.

When the price of diamonds increases, the quantity demands decline.
In graphical terms, the consumer surplus is the area under the demand curve and above the price, or the gains from trade that a consumer enjoys.
Consumers will enjoy less surplus if the price of diamonds increases.

Figure 16.2 shows the market for water and the market for diamonds.

The consumer surplus is highlighted in blue and the triangular area is highlighted with dots.
The blue area of total utility for water is larger than the dotted area of total utility for dia monds because water is essential for life.
Water creates more utility than diamonds do.
In most places in the United States, water is plentiful, so people take additional units of it for granted.
If someone offered you a gallon of water right now, you would probably not take it.

It is not surprising that water would yield less marginal utility than diamonds.

The price of water would surpass the price of diamonds if it were as rare as dia monds.

We should consider how we use water.

The marginal utility of water is high because each of those uses has high value.
We use it to fill our fish tanks.
The marginal utility of water for those uses is much lower.
Water is used in both essential and non-essential ways because its price is low, so low- value uses, like filling fish tanks, yield enough utility to justify the cost.
The price of water is low because it is abundant.
Diamonds are rare and their price is high.
Diamonds are given as gifts for extremely special occasions due to the fact that a consumer must get a great deal of marginal utility from the purchase of a diamond to justify the expense.

People don't realize that demand and supply are equally important in determining the value of a good.

The demand for water is larger than the demand for diamonds.

The blue area, which is the consumer surplus for water, is larger than the dotted area, which is the consumer surplus for diamonds, because water is essential for life.

Diamonds are rare and the price is high.

They are parallel to the water paradoxes.

The key is the business model.

McDonald's is a lot like water ing food at low prices, a combination that encourages in the diamond- water paradoxes.

It's easy to find consumers to eat more than they would if the price of Mcdonald's was the same anywhere.
70 million customers a day are served by the diminishing chain.

Even though the marginal utility of an indi very little additional utility is low, it is not uncommon for vidual bite to be high.

Consumers discard excess at scale restaurants.

Consider fine dining.

The customers they serve are small.
Smaller portions are served by the total utility.
A five- course upscale restaurant is low compared with a meal that is meant to be enjoyed, but the marginal utility of an individual outweighs the price.
It's quite high for someone to be willing to pay for a meal at an upscale restaurant.

The answer is no.

Increasing income makes it easier for people to buy more goods, but diminishing marginal utility makes it harder for them to be satisfied.
People are more satisfied when they have more money.
Quality of life and money are not directly related.
Sometimes more money leads to more utility and other times it leads to more problems.

Price is a key factor in determining utility.

Consumers face a budget and want to maximize their utility, the prices they pay determine their marginal utility per dollar spent.
We can understand individuals' consumption patterns by comparing the marginal utility per dollar spent.
Diminishing marginal utility helps to describe consumer choice.
Consumers don't purchase their favorite products exclusively because marginal utility goes down.
They diversified their choices in order to get more utility.
There are two different effects on real income and a separate substitution effect that determines the composition of the bundle of goods that are purchased.

In the next chapter, we want to know how many people use consumer choice theory to make their decisions.

Behavioral economics argues that decision makers are not entirely rational about their choices.

In the appendix that follows, we refine consumer theory by removing indifference curves.

The appendix will give you a glimpse into how economists model consumer choice.

Economists model consumer satisfaction by examining utility, which is a measure of the level of satisfaction that a consumer enjoys from the consumption of goods and services.

The amount of good or service that a person will consume is limited by this property.

Consumers can find goods and services that maximize the level of satisfaction from a given income or budget by looking at the nation of goods and services.

When a consumer maximizes the utility from his or her income or budget, the marginal utility per dollar spent on every item is equal to that of every other item purchased.

Consumer behavior can be affected by price changes.

The marginal utility per dollar spent will go up if the price goes down.
The product that has become less expensive will be replaced by another product.
The substitution effect is what this is.
The real- income effect is when the lower price causes an increase in purchasing power.

Water is inexpensive because it is essential to life, while diamonds are expensive because they do not sustain life.

The paradoxes of Adam Smith's era were puzzling to many people.
The price of water is low because its supply is plentiful, and the price of diamonds is high because their supply is small.
The price of water would be more expensive than the price of diamonds.

Finding your soul mate can make you both want to work to support your lifestyle more than anything else.

We give economic advice about love and marriage, which is time and energy well spent.

The one who is willing to enter into a binding contract market doesn't use money, so all you need to do is find some made in a market.

It uses barter.

You find a person who feels the same way about you.

When partners have different skills and characteristics, partnerships work best.

One person is in charge of finances, the other is in charge of the yard.
A couple can make gains from trade by using their comparative advantage in the production of household services.

There is a strong relationship between consumption complementarities.

You've found someone special when you do things together.
Taking walks, having a common passion for animals, and belonging to the same religious organization are some of the activities that can be done together.
A beneficial partnership is more than just getting more done.
It's about having more fun because each partner enjoys life more when the other is around.

Think of a business contract between two people about how they will organize their lives together when you think of marriage.

Do you suppose this couple has found a contract with their consumer?

Both indicate that you liked it.

If you offer 50% off on the first pizza but don't offer it again, you have a budget of $8 and cookies and pizza.

Explain that the pretzels cost $1 each.
The pricing strategy of the consumer taurant.

The optimum price for cashews is $6 per sumer if the price of cookies goes up.

For $2 per slice, fill in the missing information in the table at the pizzeria.

If you and your friends want to go on a vacation, you can either go to Cabo San Lucas or Mexico for spring break.

The answer was $1,000 to each destination.

Most people don't wear ties, but you expect to see a difference in pain relief.

Real prices are high, that's the key to answering this question.

Underwear is similar to water in that the data are expressed in total Utils.

The first taco has 10 Utils.

It does not mean that ties are more valuable than the second taco.

There are less extras to society.
People get more marginal Utils from the second taco than they do from the first taco because they get the "Perfect" tie instead of the "Perfect" underwear.

In their daily lives, demand is only half of the curse.

The other half of the equation is supply.
Ties are more pain relief than underwear.
The lives of those who cursed in their daily ties were not spared from the pain of price.
Ties are a fashion statement.
When ties are a luxury good, this result is not surprising.
There is a law of diminishing marginal utility.

There is a small overall market for diamonds.

The simple supply and demand model can't capture everything.

The tool of indifference curve analysis was used to explore the question.
The purpose of this appendix is to get you thinking about the connections between price changes and consumption decisions.

When consumers make decisions, economists use differences curves to describe the trade offs.

The simplest way to think about indifference curves is to imagine a topographical map with each level of personal line representing a specific elevation.

When you look at a map.

This book is a two-dimensional space that we use to illustrate the most utility, which is the only limitation of this combination of two goods analysis.

The maximization point is where total utility is the highest.

Remember that you had $10 to spend and only two items to purchase: pizza at $2 per slice and a can of soda for $1.

If you maximize the marginal utility per dollar spent, you'll be able to get four Pepsis and three slices of pizza.

We'll start with another question to answer the question we just posed.

This may seem odd, but think about your own consumption habits.

We all stop eating and drinking at some point.

The lines of equal satisfaction are represented by the indifference curve.

The indifference curve is shown in Figure 16A.1 as circles around the point of maximum satisfaction.
The closer the indifference curve is to the maximization point, the higher the consumer's level of satisfaction.

The difference curves can be seen as approaching the maximization point from all directions.

Some paths are better than others.
Only one path makes sense.
Pizza orPepsi are either bad or good in quadrants II, III, and IV because they make the consumer feel too full or sick.

The maximization point shows where a consumer gets the most use.

If you want to maximize utility, you need to attain more of both pizza and Pepsi because they are both good.
Pizza andPepsi are either bad or good in quadrants II, III, and IV because they make the consumer feel too full or sick.
The most affordable path to the highest utility is quadrant I because the consumer has to pay to get pizza andPepsi, and at least one of the items is reducing the consumer's utility.

People aren't likely to choose an option that makes them feel too full or sick, so Quadrants II, III, and IV are highlighted in orange.

quadrant I is the preferred path to the highest utility.
Increasing the amount of pizza andPepsi will produce more utility.

We need to account for a person's budget and cost in real life.

If you have that amount of money to spend on pizza, you can choose how much you want the consumer to pay for 10 cans of Pepsi.

You could afford it.

In Chapter 16 we saw a number of different combinations of pizza and Pepsi.

There are many affordable combinations of the two goods.

First, let's take the pairs along the budget line.
If you spend $10 on a can of soda, the coordinates are 10,0, which represents 10 cans of soda and 0 slices of pizza.
The coordinates are (0,5) if you spend your entire budget on pizza.

We can see the many combinations that would exhaust $10 by connecting these two points with a line.

If you have a budget, your goal is to pick the combination that maximizes your satisfaction.
One way to maximize utility is to spend $10 on four cans of Pepsi and three slices of pizza, which is the point of utility maximization we discovered in the chapter.

Spending the leftover money in your budget will increase your satisfaction.

The combination is a failure to maximize utility.
The point is on the other side of the budget constraint line.
This is a combination of items that you can't afford.
The budget constraint is a limiting set of choices or a constraint imposed by scarcity.

indifference curves are examined in greater detail in the next section.

We can join the budget constraint to better describe how consumers make choices once we understand the properties of indifference curves.

It is important to keep in mind the assumptions about indifference curves.

Our model is logically consistent because of the properties described in this section.

The lower indifference curves are preferred to the higher ones within that quadrant.

No rational consumer would ever operate in these regions because of quadrants II through IV.

The indifference curve shows the trade off between two goods.

The slope of the indifference curve in the figure is reflected in the MRS.
Points A and B are willing to trade one good for another along the same indifference curve, so the consumer finds the combinations.

The consumer needs to get two slices of pizza between points A and B to make up for the loss of a can.

The figure shows that the consumer chooses only two cans of soda and three slices of pizza.

The marginal rate of substitution is -2.

The indifference curve between points C and D shows that the consumer is indifferent between the combinations.

The MRS is -4 because the consumer is willing to give up four cans of soda to get one more slice of pizza.
The consumer has a lot of pizza, but very littlePepsi.

The consumer has two cans.

The consumer starts with two slices of pizza, which is more valuable than points C and D. When giving up another good that is in short supply, it takes more of the plentiful good to keep the consumer indifferent.

The property of indifference curves is that they can't be thick.

If they were thick, it would be possible to draw two points inside an indifference curve where one of the two points was preferred to the other.

Both points B and C are preferred to point A.

Because point B has one more slice of pizza than point A, and point C has two more cans of soda than point A.
The consumer cannot be indifferent between these three points because they add to the consumer's utility.

By their nature, difference curves cannot intersect.

Let's look at a hypothetical case to understand why.
We know that points A and B bring the consumer the same utility because they are located along the light orange curve.
The same utility can be found at points A and C, which are located along the darker orange curve.

The utility at point A is equal to the utility at point B and the utility at point C is equal to the utility at point C.

There are two points, point B and point C. Point C is preferred to point B because (2,4) dominates (1,3).

indifference curves cannot intersect without violating the assumption that consumers are rational utility maximizers.

indifference curves are bowed inward toward the origin and cannot be thick.

The utility at point A is equal to the utility at point C.

Point A is located at (2,4) and point B is located at (1,3).

The indifference curves are usually convex and inward toward the origin.

These are found on either side of the curve.

You can't taste any difference between the two bottled water brands.

If you were indifferent between drinking goods, you would get a straight- one additional bottle of Aquafina or one additional bottle of Evian.

The two goods are straight, parallel lines with a marginal rate of substitution, or slope, everywhere along the curve.

It is important to note that the slope of the indifference curve of perfect substitute can be any constant rate.

Shoes are an example.

We like the indifference curve.

The slope is -1 everywhere along the lines and curves.

Both shoes are able to walk comfortably.

The reason shoes are not sold individually is explained here.
indifference curves are right angles because an extra left or right shoe has no marginal value to the consumer.
Left and right shoes are needed.
The person has one left and one right shoe at the point where this curve forms.
The points are also on IC1.
Since the individual has only one pair of usable shoes, the points are connected since an extra left or right shoe does not add utility.

In combinations other than1:1, perfect complement can also occur.

An ordinary chair has four legs for each seat.

The indifference curve is still a right angle, but additional chair legs do not enhance the consumer's utility unless they come in groups of four.

The indifference curves and the budget constraint are shown in the figure.

The consumer moves closer to the optimum as the indifference curves move higher.
The consumer will run out of money eventually.
The budget constraint represents the set of possible choices.
IC3 is the highest indifference curve that can be attained within the set of possible choices.

The point is the preferred choice among the possible decisions.

The combination (2,4) falls on a less preferable indifference curve.

The consumer is closer to the maximization point when the indifference curves are higher.

The consumer's optimum level of satisfaction can be found in the tangency of the budget constraint with the highest indifference curve.

indifference curve analysis can show how price changes affect consumption choices.

Understanding when the substitution effect is likely to dominate the real- income effect is part of the analysis.

When the price of Pepsi increases from $1 to $2 per can, it is a financial burden that lowers your real purchasing power.

There are cases in which a change in the price ofPepsi wouldn't matter.
A typical American household has a median annual income of $50,000.
A local Toyota car dealer is offering 10% off new cars and a nearby grocery store is selling Pepsi at a 10% discount.
The substitution effect will lead to more people buying Toyotas and less people buying Coca- Cola.
The real- income effects will be different.
Saving 10% on the price of a new car could save you thousands of dollars.
Saving 10% on a bottle ofPepsi will save you only a couple of dimes.
In the case of the new car, there is a substantial real- income effect, while the amount you save on the soda is almost immaterial.

Changes in prices can have different effects.

Under a substitution effect, a change in price will cause the consumer to switch to a cheaper item.

Suppose the price of pizza goes up to $2 per can.

Your marginal utility is reduced by the price increase.
If you use the remaining money to purchase more pizza, you would probably buy fewer Pepsis.
The less expensive pizza would be replaced by the more expensivePepsi.

This isn't the only effect at work.

The purchasing power of your money will be affected by the change in the product price.
A change in purchasing power has an effect on income.
Your $10 won't go as far as it used to.
You can't afford to buy 10 cans at $2 per can, the most you can buy is 5.
The combination is no longer affordable because of this.

You can't afford to buy 10 cans at $2 a can, the most you can buy is 5.

A rise in the price ofPepsi causes you to purchase lessPepsi and results in a lower level of satisfaction at IC2 than your previous point on IC3 did, which is no longer possible.

The substitution effect and real income effect can work against each other.

The substitution effect and the real- income effect are separate in this section.

We can see how each effect impacts the consumer's choice by breaking down the movement from IC3 to IC2.

The new budget constraint will be parallel to BC1 but unrelated to IC2.

The substitution effect is different from the real income effect.
The point of tangency between BCreal income and IC2 is lower because of the slope of the new budget constraint.
Because the slopes of BCreal income and BC1 are equal, we can think of the movement from 4 to A as a function of the real- income effect alone.

We have kept the budget constraint constant.

The only difference between BC1 and BCreal income is the amount of money the consumer can spend, so keeping the slope constant reflects the fact that the consumer has less money to spend.
The substitution effect alone causes the subsequent movement along IC2 from point A to point 3.
BC2 becomes steeper as a result of this outcome.

Separating the substitution effect from the real income effect allows us to see how each effect affects the consumer's choice.

The budget constraint to shift to BCreal income is caused by the real- income effect, and the loss of purchasing power lowers the consumption of both pizza and Pepsi, as noted by the green arrows.
The blue arrows show that the substitution effect increases the consumption of pizza.

The real- income effect shows that the impact of a loss of purchasing power lowers consumption of both pizza and Pepsi.

The substitution effect increases the consumption of pizza.
This outcome is highlighted by the blue arrows in the figure.

You reallocate your consumption to pizza because it is now more expensive.

While your consumption of pizza remains constant, your consumption ofPepsi falls dramatically.

The substitution effect and real- income effect move in opposite directions with respect to the good whose price has not changed, so the result is ambiguous for that good.

40% of your budget was spent on Pepsi before the price increase, as you were spending $4 out of your $10 budget.

A doubling of the price ofPepsi causes a big effect on your income.

This isn't always the case.

If the price of a candy bar were to double, the typical household wouldn't notice.
The substitution effect tends to dominate in that case.

indifference curve analysis is used by economists to gain insight into consumer behavior.

Utility theory is used in this analysis to extend the basic understanding of supply and demand analysis.
We can impose a budget constraint to describe the bundle of goods that maximizes utility because indifference curves are lines of equal utility.
We can show the effect of price changes and budget constraints on consumer decisions.

Kate has a small amount of money.

A cup of espresso costs $4 and a fish sandwich costs $5.

The figure to the right is the IC1 bowling.