Rosen2 Ichap1

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INTERNET CHAPTER ONE
Microeconomics Background
for the Study of Public Finance
He who has choice also has pain.
—German proverb
ertain tools of microeconomics are used throughout the text. They are briefly reviewed
C in this appendix. Readers who have had an introductory course in microeconomics will
likely find this review sufficient to refresh their memories. Those confronting the material for
the first time may want to consult one of the standard introductory texts.1 The subjects cov-
ered are demand and supply, consumer choice, and marginal analysis.
DEMAND AND SUPPLY

The demand and supply model shows how the price and output of a commodity are deter-
mined in a competitive market. We discuss in turn the determinants of demand, supply, and
their interaction.
Demand
Which factors influence people’s decisions to consume certain goods? To make the problem
concrete, let us consider the specific case of coffee. A bit of introspection suggests that the fol-
lowing factors affect the amount of coffee that people want to consume during a given time
period:
1. Price. We expect that as the price goes up, the quantity demanded goes down.
2. Income. Changes in income modify people’s consumption opportunities. It is hard to say
a priori, however, what effect such changes have on consumption of a given good. One
possibility is that as incomes go up, people use some of their additional income to
purchase more coffee. On the other hand, it may be that as incomes increase, people
consume less coffee, perhaps spending their money on cognac instead. We expect that
changes in income affect demand one way or the other, but in some cases it is hard to
predict the direction of the change. If an increase in income increases the demand (other
things being the same), the good is called a normal good. If an increase in income
decreases demand (other things being the same), the good is called an inferior good.
1 See, for example, Samuelson and Nordhaus (1989).

1-2 Internet Chapter 1: Microeconomics Background for the Study of Public Finance
3. Prices of related goods. Suppose the price of tea goes up. If people can substitute cof-
fee for tea, this increase in the price of tea increases the amount of coffee people wish to
consume. Now suppose the price of cream goes up. If people consume coffee and cream
together, this tends to decrease the amount of coffee consumed. Goods like tea and cof-
fee are called substitutes; goods like coffee and cream are called complements.
4. Tastes. The extent to which people “like” a good affects the amount they demand. Not
much coffee is demanded by Mormons because their religion prohibits its consumption.
Often, it is realistic to assume that consumers’ tastes stay the same over time, but this is
not always the case. For example, when some scientists claimed that coffee might cause
birth defects, it presumably changed the tastes of pregnant women for coffee.
We see, then, that a wide variety of things can affect demand. However, it is often useful
to focus on the relationship between the quantity of a commodity demanded and its price.
Suppose that we fix income, the prices of related goods, and tastes. We can imagine varying
the price of coffee and seeing how the quantity demanded changes under the assumption that
the other relevant variables stay at their fixed values. A demand schedule (or demand curve)
is the relation between the market price of a good and the quantity demanded of that good
during a given time period, other things being the same. (Economists often use the Latin for
“other things being the same,” ceteris paribus.)
A hypothetical demand schedule for coffee is represented graphically by curve Dc in
Figure IC1.1. The horizontal axis measures pounds of coffee per year in a particular market,
and the price per pound is measured on the vertical. Thus, for example, if the price is $2.29
per pound, people are willing to consume 750 pounds; when the price is only $1.38, they are
willing to consume 1,225 pounds. The downward slope of the demand schedule reflects the
reasonable assumption that when the price goes up, the quantity demanded goes down.
The demand curve can also be interpreted as an approximate schedule of “willingness to
pay,” because it shows the maximum price that people would pay for a given quantity. For
example, when people purchase 750 pounds per year, they value it at $2.29 per pound. At any
price more than $2.29, they would not willingly consume 750 pounds per year. If for some
reason people were able to obtain 750 pounds at a price less than $2.29, this would in some
sense be a “bargain.”
FIGURE IC1.1
Price per pound of coffee
Hypothetical
Demand Curve for
Coffee
$2.29
$1.38
Dc
750 1,225
Pounds of coffee per year
Internet Chapter 1: Microeconomics Background for the Study of Public Finance 1-3
FIGURE IC1.2

Effect of an
Increase in the
Price of Tea on
the Demand for
Coffee
D′c
Dc
As already stressed, the demand curve is drawn on the assumption that all other variables
that might affect quantity demanded do not change. What happens if one of them does?
Suppose, for example, that the price of tea increases, and as a consequence, people want to
buy more coffee. In Figure IC1.2, schedule Dc from Figure IC1.1 (before the increase) is
reproduced. As a consequence of the increase in the price of tea, at each price of coffee peo-
ple are willing to purchase more coffee than they did previously. In effect, then, an increase
in the price of tea shifts each point on Dc to the right. The collection of new points is D′c.
Because D′c shows how much people are willing to consume at each price (ceteris paribus), it
is by definition the demand curve.
More generally, a change in any variable that influences the demand for a good—except
its own price—shifts the demand curve.2 (A change in a good’s own price induces a move-
ment along the demand curve.)
Supply
Now consider the factors that determine the quantity of a commodity that firms supply to
the market. We will continue using coffee as our example.
1. Price. In many cases, it is reasonable to assume that the higher the price per pound of
coffee, the greater the quantity profit-maximizing firms are willing to supply.
2. Price of inputs. Coffee producers employ inputs to produce coffee—labour, land, and
fertilizer. If their input costs go up, the amount of coffee that they can profitably supply
at any given price goes down.
3. Conditions of production. The most important factor here is the state of technology. If
there is a technological improvement in coffee production, the supply increases. Other
variables also affect production conditions. For agricultural goods, weather is
important. Several years ago, for example, flooding in Latin America seriously reduced
the coffee crop.
As with the demand curve, it is useful to focus attention on the relationship between the
quantity of a commodity supplied and its price, holding the other variables at fixed levels. The
2 There is no need, incidentally, for D′c to be parallel to Dc. In general, this will not be the case.
Sc
FIGURE IC1.3

Hypothetical
Supply Curve for
Coffee
S′c Sc
FIGURE IC1.4
Effect of an
Increase in the
Wages of Coffee
Pickers on the
Supply of Coffee
supply schedule is the relation between market prices and the amount of a good that pro-
ducers are willing to supply during a given time period, ceteris paribus.
A supply schedule for coffee is depicted as Sc in Figure IC1.3. Its upward slope reflects
the assumption that the higher the price, the greater the quantity supplied, ceteris paribus.
When any variable that influences supply (other than the commodity’s own price)
changes, the supply schedule shifts. Suppose, for example, that the wage rate for coffee-bean
pickers increases. This increase reduces the amount of coffee that firms are willing to supply
at any given price. The supply curve therefore shifts to the left. As depicted in Figure IC1.4,
the new supply curve is S′c. More generally, when any variable other than the commodity’s
own price changes, the supply curve shifts. (A change in the commodity’s price induces a
movement along the supply curve.)
Equilibrium
The demand and supply curves provide answers to a set of hypothetical questions: If the price
of coffee is $2 per pound, how much are consumers willing to purchase? If the price is $1.75
per pound, how much are firms willing to supply? Neither schedule by itself tells us the
actual price and quantity. But taken together, the schedules determine price and quantity.
Sc
FIGURE IC1.5

Equilibrium in the
Coffee Market P1
Pe
P2
Dc
Q 1D Q 2S Q e Q 2D Q 1S
In Figure IC1.5 we superimpose demand schedule Dc from Figure IC1.1 on supply

schedule Sc from Figure IC1.3. We want to find the price and output at which there is an
equilibrium—a situation that tends to be maintained unless there is an underlying change
in the system. Suppose the price is P1 dollars per pound. At this price, the quantity
demanded is Q1D and the quantity supplied is Q1S. Price P1 cannot be maintained, because
firms want to supply more coffee than consumers are willing to purchase. This excess
supply tends to push the price down, as suggested by the arrows.
Now consider price P2. At this price, the quantity of coffee demanded, Q2D, exceeds the
quantity supplied, Q2S. Because there is excess demand for coffee, we expect the price to rise.
Similar reasoning suggests that any price at which the quantity supplied and quantity
demanded are unequal cannot be an equilibrium. In Figure IC1.5, quantity demanded
equals quantity supplied at price Pe. The associated output level is Qe pounds per year.
Unless something else in the system changes, this price and output combination continues
year after year. It is an equilibrium.
Suppose something else does change: For example, the weather turns bad, ruining a
considerable portion of the coffee crop. In Figure IC1.6, Dc and Sc are reproduced from
S′c Sc
FIGURE IC1.6
Effect of Bad
Weather on the
Coffee Market
P ′e
Pe
Dc
Q′e Qe
Figure IC1.5, and as before, the equilibrium price and output are Pe and Qe, respectively.
As a consequence of the weather change, the supply curve shifts to the left, say to S′c. Given
the new supply curve, Pe is no longer the equilibrium price. Rather, equilibrium is found
at the intersection of Dc and S′c, at price P′e and output Q′e . Note that, as one might expect,
the crop disaster leads to a higher price and smaller output—P′e > Pe and Q′e < Qe. More
generally, a change in any variable that affects supply or demand creates a new equilibrium
combination of price and quantity.
Supply and Demand for Inputs

Supply and demand can be used not only to investigate the markets for consumption goods
but also the markets for inputs into the production process. (Inputs are sometimes referred
to as factors of production.) For example, we could label the horizontal axis in Figure IC1.5
“number of hours worked per year” and the vertical axis “wage rate per hour.” Then the
schedules would represent the supply and demand for labour, and the market would deter-
mine wages and employment. Similarly, supply and demand analysis can be applied to the
markets for capital and for land.
Measuring the Shapes of Supply and Demand Curves

Clearly, the market price and output for a given item depend substantially on the shapes of
its demand and supply curves. Conventionally, the shape of the demand curve is measured
by the price elasticity of demand: the absolute value of the percentage change in quantity
demanded divided by the percentage change in price.3 If a 10 percent increase in price leads
to a 2 percent decrease in quantity demanded, the price elasticity of demand is 0.2. An
important special case is when the quantity demanded does not change at all with a price
increase. Then the demand curve is vertical and elasticity is zero. At the other extreme, when
the demand curve is horizontal, then even a small change in price leads to a huge change in
quantity demanded. By convention, this is referred to as an infinitely elastic demand curve.
Similarly, the price elasticity of supply is defined as the percentage change in quantity
supplied divided by the percentage change in price.
THEORY OF CHOICE
The fundamental problem of economics is that resources available to people are limited rel-
ative to their wants. The theory of choice shows how people make sensible decisions in the
presence of such scarcity. In this section we develop a graphical representation of consumer
tastes and show how these tastes can best be gratified in the presence of a limited budget.
Tastes
We assume that an individual derives satisfaction from the consumption of commodities.4
Economists use the slightly archaic word utility as a synonym for satisfaction. Consider
Oscar who consumes only two commodities, marshmallows and donuts. (Using mathemat-
ical methods, all the results for the two-good case can be shown to apply to situations in
which there are many commodities.) Assume further that for all feasible quantities of marsh-
mallows and donuts, Oscar is never satiated—more consumption of either commodity
3 The elasticity need not be constant all along the demand curve.
4 In this context, the notion of commodities should be interpreted very broadly. It includes not only items such as
food, cars, and compact disk players, but also less tangible things like leisure time, clean air, and so forth.
FIGURE IC1.7
Marshmallows per day

These bundles are
Ranking preferred to bundle a
Alternative
Bundles
•b
h a
7 • • •f
g • These bundles are less
desirable than bundle a
5 Donuts per day
always produces some increase in his utility. Economists believe that under most circum-
stances, this assumption is pretty realistic.
In Figure IC1.7, the horizontal axis measures the number of donuts consumed each
day, and the vertical axis shows daily marshmallow consumption. Thus, each point in the
quadrant represents some bundle of marshmallows and donuts. For example, point a rep-
resents a bundle with seven marshmallows and five donuts.
Because Oscar’s utility depends only on his consumption of marshmallows and
donuts, we can also associate with each point in the quadrant a certain level of utility. For
example, if seven marshmallows and five donuts create 100 “utils” of happiness, then point
a is associated with 100 “utils.”
Some commodity bundles create more utility than point a, and others less. Consider
point b in Figure IC1.7, which has both more marshmallows and donuts than point a. Since
satiation is ruled out, b must yield higher utility than a. Bundle f has more donuts than a
and no fewer marshmallows, and is also preferred to a. Indeed, any point to the northeast
of a is preferred to a.
The same reasoning suggests that bundle a is preferred to bundle g, because the latter
has fewer marshmallows and donuts than the former. Point h is also less desirable than a,
because although it has the same number of marshmallows as a, it has fewer donuts. Point
a is preferred to any point southwest of it.
We have identified some bundles that yield more utility than a, and some that yield less.
Can we find some bundles that produce just the same amount of utility as point a?
Presumably there are such bundles, but we need more information about the individual to
find out which they are. Consider Figure IC1.8, where point a from Figure IC1.7 is repro-
duced. Imagine that we pose the following question to Oscar: “You are now consuming seven
marshmallows and five donuts. If I take away one of your donuts, how many marshmallows
do I need to give you to make you just as satisfied as you were initially?” Suppose that after
thinking a while, Oscar (honestly) answers that he would require two more marshmallows.
Then by definition, the bundle consisting of four donuts and nine marshmallows yields the
same amount of utility as a. This bundle is denoted i in Figure IC1.8.
We could find another bundle of equal utility by asking: “Starting again at point a, sup-
pose I take away one marshmallow. How many more donuts must I give you to keep you as
well off as you originally were?” Assume the answer is two donuts. Then the bundle with six
FIGURE IC1.8

U0
Derivation of an
Indifference Curve
9 i
a
7
j
6
U0
4 5 7 Donuts per day
marshmallows and seven donuts, denoted j in Figure IC1.8, must also yield the same
amount of utility as bundle a.
We could go on like this indefinitely—start at point a, take away various amounts of
one commodity, find out the amount of the other commodity required for compensation,
and record the results on Figure IC1.8. The outcome is curve U0U0, which shows all points
that yield the same amount of utility. U0U0 is referred to as an indifference curve, because
it shows all consumption bundles among which the individual is indifferent.
By definition, the slope of a curve is the change in the value of the variable measured
on the vertical axis divided by the change in the variable measured on the horizontal—the
“rise over the run.” The slope of an indifference curve has an important economic inter-
pretation. It shows the rate at which the individual is willing to trade one good for another.
For example, in Figure IC1.9, around point i, the slope of the indifference curve is m/n. But
by definition of an indifference curve, n is just the amount of donuts that Oscar is willing
to substitute for sacrificing m marshmallows. For this reason, the absolute value of the
slope of the indifference curve is often referred to as the marginal rate of substitution of
donuts for marshmallows.5 This is abbreviated MRSdm.
As drawn in Figure IC1.9, the marginal rate of substitution declines as we move down
along the indifference curve. For example, around point ii, MRSdm is p/q, which is clearly
smaller than m/n. This makes intuitive sense. Around point i, Oscar has a lot of marsh-
mallows relative to donuts and is therefore willing to give up quite a few marshmallows in
return for an additional donut—hence a higher MRSdm. On the other hand, around point
ii, Oscar has a lot of donuts relative to marshmallows, so he is unwilling to sacrifice a lot of
marshmallows in return for yet another donut. The decline of MRSdm as we move down
along the indifference curve is called a diminishing marginal rate of substitution.
Recall that our construction of indifference curve U0U0 was based on bundle a as a
starting point. But point a was chosen arbitrarily, and we could just as well have started at
any other point in the quadrant. In Figure IC1.10, if we start with point b and proceed in
the same way, we generate indifference curve U1U1. Or starting at point k we generate
5 As noted later, marginal means additional or incremental. The indifference curve’s slope shows the marginal rate of
substitution because it indicates the rate at which the individual would be willing to substitute marshmallows for an
additional donut.
U0
FIGURE IC1.9

An Indifference
Curve with a
Diminishing m •i
Marginal Rate of n
Substitution
ii
p •
q U0
Donuts per day

FIGURE IC1.10
U2
U0 U1
An Indifference
Map
k
•
b
•
a •
U2
U1
Increasing utility U0
Donuts per day
indifference curve U2U2. Note that any point on U2U2 represents a higher level of utility
than any point on U1U1, which in turn is preferred to any point on U0U0. If Oscar is inter-
ested in maximizing his utility, he tries to reach the highest indifference curve that he can.
The entire collection of indifference curves is referred to as the indifference map. The
indifference map tells us everything there is to know about the individual’s preferences.
Budget Constraint
Basic setup. Suppose that marshmallows (M) cost 3 cents apiece, donuts (D) cost 6 cents,
and Oscar’s weekly income is 60 cents. What options does Oscar have? Whatever amounts he
purchases must satisfy the equation
3 × M + 6 × D = 60. (IC1.1)
In words, expenditures on marshmallows (3 × M) plus expenditures on donuts (6 × D) must

equal income (60).6 Thus, for example, if M = 10, then to satisfy Equation (IC1.1), D must
equal 5 (3 × 10 + 6 × 5 = 60). Alternatively, if M = 8, then D must equal 6 (3 × 8 + 6 × 6 = 60).
6 If Oscar is a utility maximizer, he will not throw away any of his income.
FIGURE IC1.11

L
Budget Constraint
Feasible bundles
r Infeasible bundles
10
s
8
O
5 6 N Donuts per day
Let us represent Equation (IC1.1) graphically. The usual way is to graph a number of
points that satisfy the equation. This is straightforward once we recall from basic algebra
that (IC1.1) is just the equation of a straight line. Given two points on the line, the rest of
the line is determined by connecting them. In Figure IC1.11, point r represents 10 marsh-
mallows and 5 donuts, and point s represents 8 marshmallows and 6 donuts. Therefore, the
line associated with Equation (IC1.1) is LN, which passes through these points. By con-
struction, any combination of marshmallows and donuts that lies along LN satisfies
Equation (IC1.1). Line LN is known as the budget constraint or the budget line. Any
point on or below LN (the shaded area) is feasible because it involves an expenditure less
than or equal to income. Any point above LN is impossible because it involves an expen-
diture greater than income.
Two aspects of line LN are worth noting. First, the horizontal and vertical intercepts of
the line have economic interpretations. By definition, the vertical intercept is the point
associated with D = 0. At this point, Oscar spends all his 60 cents on marshmallows, buy-
ing 20 (= 60 ÷ 3) of them. Hence, distance OL is 20. Similarly, at point N, Oscar consumes
zero marshmallows, but can afford a binge consisting of 10 (= 60 ÷ 6) donuts. Distance ON
is therefore 10. In short, the vertical and horizontal intercepts represent bundles in which
Oscar consumes only one of the commodities.
The slope also has an economic interpretation. To calculate the slope, recall that the
“rise” (OL) is 20 and the “run” (ON) is 10, so the slope (in absolute value) is 2. Note that 2
is the ratio of the price of donuts (6 cents) to the price of marshmallows (3 cents). This is
no accident. The absolute value of the slope of the budget line indicates the rate at which
the market permits an individual to substitute marshmallows for donuts. Because the price
of donuts is twice the price of marshmallows, Oscar can trade two marshmallows for each
donut.
To generalize this discussion, suppose that the price per marshmallow is Pm, the price per
donut is Pd, and income is I. Then in analogy to Equation (IC1.1), the budget constraint is
PmM + PdD = I. (IC1.2)
If M is measured on the vertical axis and D on the horizontal, the vertical intercept is I/Pm and
the horizontal intercept is I/Pd. The slope of the budget constraint, in absolute value, is Pd/Pm.
A common mistake is to assume that because M is measured on the vertical axis, the absolute
value of the slope of the budget constraint is Pm/Pd. To see that this is wrong just divide the
rise (I/Pm) by the run (I/Pd): (I/Pm) ÷ (I/Pd) = Pd/Pm. Intuitively, Pd must be in the numera-
tor because its ratio to Pm shows the rate at which the market permits one to trade M for D.
Changes in prices and income. The budget line shows Oscar’s consumption opportunities
given his current income and the prevailing prices. What if any of these change? Return to
the case where Pm = 3, Pd = 6, and I = 60. The associated budget line, 3M + 6D = 60, is drawn
as LN in Figure IC1.12. Now suppose that Oscar’s income falls to 30. Substituting into
Equation (IC1.2), the new budget line is described by 3M + 6D = 30. To graph this equation,
note that the vertical intercept is 10 and the horizontal intercept is 5. Denoting these two
points in Figure IC1.12 as R and S, respectively, and recalling that two points determine a line,
we find that the new budget constraint is RS. The slope of RS in absolute value is 2, just like
that of LN. This is because the relative prices of donuts and marshmallows have not changed.
When income changes but relative prices do not, a parallel shift in the budget line is induced.
If income decreases, the constraint shifts in; if income increases, it shifts out.
Return again to the original constraint, 3M + 6D = 60, which is reproduced in Figure
IC1.13 as LN. Suppose that the price of D increases to 12, but everything else stays the same.
FIGURE IC1.12
Effect on the 20 L
Budget Constraint
Original budget
of a Decrease in constraint
Income
10 R
Budget constraint
after income falls
S N
O
5 10 Donuts per day
FIGURE IC1.13
Effect on the 20 L
Budget Constraint
Original budget
of a Change in
constraint
Relative Prices
Budget constraint
after Pd increases
T N
O
5 10 Donuts per day
Then by Equation (IC1.2), the relevant budget constraint is 3M + 12D = 60. To graph this
new constraint, we begin by noting that it has a vertical intercept of 20, which is the same
as that of LN. Because the price of M has stayed the same, if Oscar spends all his money
only on M, then he can buy just as much as he did before. The horizontal intercept, how-
ever, is changed. It is now at five donuts (= 60 ÷ 12), a point denoted T in Figure IC1.13.
The new budget constraint is then LT. The slope of LT in absolute value is 4 (= 20 ÷ 5),
reflecting the fact that the market now allows each individual to trade four marshmallows
per donut.
More generally, when the price of one commodity changes and other things stay the
same, the budget line pivots along the axis of the good whose price changes. If the price goes
up, the line pivots in; if the price goes down, the line pivots out.
Equilibrium
The indifference map shows what Oscar wants to do; the budget constraint shows what he
can do. To find out what Oscar actually does, they must be put together.
In Figure IC1.14, we superimpose the indifference map from Figure IC1.10 onto
budget line LN from Figure IC1.11. The problem is to find the combination of M and D
that maximizes Oscar’s utility subject to the constraint that he cannot spend more than his
income.
Consider first bundle i on U2U2. This bundle is ruled out, because it is above LN. Oscar
might like to be on indifference curve U2U2, but he simply cannot afford it. Next consider
point ii, which is certainly feasible, because it lies below the budget constraint. But it can-
not be optimal, because Oscar is not spending his whole income. In effect, at bundle ii, he
just throws away money that could have been spent on more marshmallows and/or donuts.
What about point iii? It is feasible, and Oscar is not throwing away any income. Yet he
can still do better in the sense of putting himself on a higher indifference curve. Consider
point E1, where Oscar consumes D1 donuts and M1 marshmallows. Because it lies on LN,
it is feasible. Moreover, it is more desirable than bundle iii, because E1 lies on U1U1, which
is above U0U0. Indeed, no point on LN touches an indifference curve that is higher than
U1U1. Therefore, the bundle consisting of M1 and D1 maximizes Oscar’s utility subject to
budget constraint LN. E1 is an equilibrium because unless something else in the system
changes, Oscar will continue to consume M1 marshmallows and D1 donuts day after day.
FIGURE IC1.14
U0 U1 U2
Utility L
Maximization
Subject to a
Budget Constraint i
E1
M1 •
ii •
U2
iii • U1
U0
N
O
D1 Donuts per day
Note that at the equilibrium, indifference curve U1U1 just barely touches the budget
line. Intuitively, this is because Oscar is trying to achieve the very highest indifference
curve he can while still keeping on LN. In more technical language, line LN is tangent to
curve U1U1 at point E1. This means that at point E1 the slope of U1U1 is equal to the slope
of LN.
This observation suggests an equation to characterize the point of utility maximiza-
tion. Recall that by definition, the slope of the indifference curve (in absolute value) is the
marginal rate of substitution of donuts for marshmallows, MRSdm. The slope of the budget
line (in absolute value) is Pd /Pm. But we just showed that at equilibrium, the two slopes are
equal, or
MRSdm = Pd /Pm. (IC1.3)
Equation (IC1.3) is a necessary condition for utility maximization.7 That is, if the
consumption bundle is not consistent with Equation (IC1.3), then Oscar could do better by
reallocating his income between the two commodities. Intuitively, MRSdm is the rate at which
Oscar is willing to trade M for D, while Pd/Pm is the rate at which the market allows Oscar to
trade M for D. At equilibrium, these two rates must be equal.
Now let us suppose that the price of marshmallows falls by some amount. Figure
IC1.15 reproduces the equilibrium point E1 from Figure IC1.14. As we showed earlier,
when a price changes (ceteris paribus) the budget line pivots along the axis of the good
whose price has changed. Because Pm falls, the budget line LN pivots around N to a point
that is higher on the vertical axis. The new budget line is VN. Given that Oscar now faces
budget line VN, E1 is no longer an equilibrium. The fall in Pm creates new opportunities
for Oscar, and utility maximization requires that he take advantage of them. Specifically,
subject to budget line VN, Oscar maximizes utility at point E2, where he consumes M2
marshmallows and D2 donuts.
At the new equilibrium, the amounts of both D and M increase relative to the amounts
consumed at the old equilibrium (D2 > D1 and M2 > M1). In effect, the price decrease in
FIGURE IC1.15 V
Effect on
Equilibrium of a
Change in Relative L
U1 U
4
Prices
M2 E2
M1
E1 U4
U1
N
O
D1 D2 Donuts per day
7 The equation holds only if some of each commodity is consumed. If the consumption of some commodity is zero,
then Equation (IC1.3) need not be satisfied.

FIGURE IC1.16 V
Change in Relative
Prices with No
Effect on Donut L
Consumption
M2 E2
M1
E1
O
D2 = D1 N Donuts per day
marshmallows allows Oscar to purchase more marshmallows and still have money left to
purchase more donuts. While this is common, it need not always be the case. The change
depends on the tastes of the particular individual. Suppose that Bert faces exactly the same
prices as Oscar and also has the same income. Bert’s indifference map and budget con-
straints are depicted in Figure IC1.16. For Bert, donut consumption is totally unchanged
by the decrease in the price of marshmallows. On the other hand, Ernie’s preferences,
depicted in Figure IC1.17, are such that a fall in Pm leaves the amount of marshmallows the
same, and only the amount of donuts increases. Thus, without information about the indi-
vidual’s indifference map, we cannot predict just how he or she will respond to a change in
relative prices.
More generally, a change in prices and/or income changes the position of the budget
constraint. The individual then reoptimizes—finds the point that maximizes utility subject
to the new budget constraint. This usually involves the selection of a new commodity bun-
dle, but without information on the individual’s tastes, one cannot know for sure exactly
what the new bundle looks like. We do know, however, that as long as the individual is a
utility maximizer, the new bundle satisfies the condition that the price ratio equal the mar-
ginal rate of substitution.
FIGURE IC1.17
V
Change in Relative
Prices with No
Effect on
L
Marshmallow
Consumption
E1 E2
M1=M 2
O
D1 D2 N Donuts per day
Derivation of Demand Curves

There is a simple connection between the theory of consumer choice and individual demand
curves. Recall from Figure IC1.15 that at the original price of marshmallows—call it Pm1—
Oscar consumed M1 marshmallows. When the price fell to Pm2, Oscar increased his marsh-
mallow consumption to M2. This pair of points may be plotted as in Figure IC1.18.
Repeating this experiment for various prices of marshmallows, we find the quantity of
marshmallows demanded at each price, holding fixed money income, the price of donuts,
and tastes. By definition, this is the demand curve for marshmallows, shown as Dm in
Figure IC1.18. Thus, we see how the demand curve is derived from the underlying indif-
ference map.
Substitution and Income Effects

Figure IC1.19 depicts the situation of Grover, who initially faces budget constraint WN, and
maximizes utility at point E1 on indifference curve i, where he consumes D1 donuts. Suppose
now that the price of donuts increases. Grover’s budget constraint pivots from WN to WZ,
and at the new equilibrium, point E2 on indifference curve ii, he consumes D2 donuts.
Price per marshmallow (Pm )
FIGURE IC1.18
Demand Curve for
Marshmallows
Derived from an
Indifference Map
P m1
P m2
Dm
O
M1 M2
FIGURE IC1.19
W
Substitution and
Income Effects of
a Price Change
X
M2 E2
M1 E1
Ec
Mc i
ii
Z Y N
O
D2 Dc D1 Donuts per day
Substitution Income
effect effect
Just for hypothetical purposes, suppose that at the new equilibrium E2, the price of
donuts falls back to its initial level, but that simultaneously, Grover’s income is adjusted so
that he is kept on indifference curve ii. If this hypothetical adjustment were made, what
budget constraint would Grover face? Suppose we call this budget constraint XY. We know
that XY must satisfy two conditions:
• Because Grover is kept on indifference curve ii, XY must be tangent to indifference
curve ii.
• The slope (in absolute value) must be equal to the ratio of the original price of donuts
to the price of marshmallows. This is because of the stipulation that the price of donuts
is at its original value. Recall, however, that the slope of WN is the ratio of the original
price of donuts to the price of marshmallows. Hence, XY must have the same slope as
WN; that is, it must be parallel to WN.
In Figure IC1.19, XY is drawn to satisfy these two conditions—the line is parallel to WN and
is tangent to indifference curve ii. If Grover were confronted with constraint XY, he would
maximize utility at point Ec, where his consumption of donuts is Dc.
Why should this hypothetical budget line be of any interest? Because drawing line XY
helps us break down the effect of the change in the price of donuts into two components,
the first from E1 to Ec, and the second from Ec to E2.
1. The movement from E1 to Ec is generated by the parallel shift of WN down to XY. But
recall from Figure IC1.12 that such parallel movements are associated with changes in
income, holding relative prices constant. Hence, the movement from E1 to Ec is in effect
due to a change in income, and is called the income effect of the price change.
2. The movement from Ec to E2 is a consequence purely of the change in the relative price
of donuts to marshmallows. This movement shows that Grover substitutes marshmal-
lows for donuts when donuts become more expensive. Hence, the movement from Ec to
E2 is called the substitution effect. Since the movement from Ec to E2 involves compen-
sating income (in the sense of changing income to stay on the same indifference curve),
the movement from Ec to E2 is sometimes called the compensated response to a change
in price. If we wish to keep utility at the level represented by indifference curve ii, we
measure the substitution effect by moving along ii. If, alternatively, we had wanted to
keep utility at the level enjoyed along indifference curve i, we could have measured the
substitution effect along indifference curve i instead. In any case, the compensated
response to a price change shows how the price change affects quantity demanded when
income is simultaneously altered so that the level of utility is unchanged.
Intuitively, when the price of donuts increases two things happen:
• The increase in price reduces the individual’s real income—his or her ability to afford
commodities. When income goes down, the quantity purchased generally changes, even
without any change in relative prices. This is the income effect.
• The increase in the price of donuts makes donuts less attractive relative to marshmal-
lows, inducing the substitution effect.
Any change in prices can be broken down into an income effect and a substitution effect.
We could repeat the exercise depicted in Figure IC1.19 for any change in the price of
marshmallows. Suppose that for each price, we find the compensated quantity of donuts
demanded and make a plot with price on the vertical axis and donuts on the horizontal. This
plot is called the compensated demand curve for donuts. Note that the ordinary demand
curve discussed at the beginning of this appendix shows how quantity demanded varies with
price, holding I fixed, where I is income measured in dollars. In contrast, the compensated
demand curve shows how quantity demanded varies with price, holding the level of utility
fixed.
MARGINAL ANALYSIS IN ECONOMICS

In economics, the word marginal usually means additional or incremental. Suppose, for
example, the annual total benefit per citizen of a 50-kilometre road is $42, and the annual
total benefit of a 51-kilometre road is $43.50. Then the marginal benefit of the 51st kilome-
tre is $1.50 ($43.50 – $42.00). Similarly, if the annual total cost per person of maintaining a
50-kilometre road is $38, and the total cost of a 51-kilometre road is $40, then the marginal
cost of the 51st kilometre is $2.
Economists focus a lot of attention on marginal quantities because they usually convey
the information required for rational decision making. Suppose that the government is try-
ing to decide whether to construct the 51st kilometre. The key question is whether the mar-
ginal benefit is at least as great as the marginal cost. In our example, the marginal cost is $2
while the marginal benefit is only $1.50. Does it make sense to spend $2 to create $1.50 worth
of benefits? The answer is no, and the extra kilometre should not be built. Note that basing
the decision on total benefits and costs would have led to the wrong answer. The total cost
per person of the 51-kilometre road ($40) is less than the total benefit ($43.50). Still, it is not
sensible to build the 51st kilometre. An activity should be pursued only if its marginal ben-
efit is at least as large as its marginal cost.8
Another example of marginal analysis: Farmer McGregor has two fields. The first is
planted in wheat and the second in corn. McGregor has seven tons of fertilizer to distrib-
ute between the two fields and wants to allocate the fertilizer so that his total profits are as
high as possible. The relationship between the amount of fertilizer and total profitability
for each crop is depicted in Table IC1.1. Thus, for example, if six tons of fertilizer were
devoted to wheat and one ton to corn, total profits would be $503 (= $178 + $325).
To find the optimal allocation of fertilizer between the fields, it is useful to compute
the marginal contribution to profits made by each ton of fertilizer. The first ton in the
wheat field increases profits from $0 to $100, so the marginal contribution is $100. The
TABLE IC1.1 Total Profit
Tons of Fertilizer Wheat Corn

0 $ 0 $ 0
1 100 325
2 150 385
3 170 415
4 175 435
5 177 441
6 178 444
8 If the marginal cost of an action just equals its marginal benefit, one is indifferent between taking the action and
not taking it.
TABLE IC1.2 Marginal Profit
Tons of Fertilizer Wheat Corn

1 $100 $325
2 50 60
3 20 30
4 5 20
5 2 6
6 1 3
second ton increases profits from $100 to $150, so its marginal contribution is $50. The
complete set of computations for both crops is recorded in Table IC1.2.
Suppose that McGregor puts two tons of fertilizer on the wheat field and five tons on
the corn field. Is this a profit-maximizing allocation? To answer this question, we must
determine whether any other allocation would lead to higher total profits. Suppose that one
ton of fertilizer were removed from the corn field and devoted instead to wheat. As a con-
sequence of removing the fertilizer from the corn field, profits from corn would go down
by $6. But at the same time, profits from the wheat field would increase by $20 (the mar-
ginal profit associated with the third ton of fertilizer in the wheat field). Farmer McGregor
would therefore be $14 richer on balance. Clearly, it is not sensible for McGregor to put two
tons of fertilizer on the wheat field and five tons on the corn, because he can do better (by
$14) with three tons devoted to wheat and four to corn.
Is this latter allocation optimal? To answer, note that at this allocation, the marginal
profit of fertilizer in each field is equal to $20. When the marginal profitability of fertilizer
is the same in each field, there is no way that fertilizer can be reallocated between fields to
increase total profit. In other words, total profits are maximized when the marginal profit
in each field is the same. Readers who are skeptical of this result should try to find an allo-
cation of the seven tons of fertilizer such that the total profit is higher than the $605 ($170
+ $435) associated with the allocation at which the marginal profits are equal.
In general, if resources are being distributed across several activities, maximization of
total returns requires that marginal returns in each activity be equal.9
9 More precisely, this result requires that the marginal returns be diminishing, as they are in Table IC1.2. In most
applications, this is a reasonable assumption.

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1-1

INTERNET CHAPTER ONE

DEMAND AND SUPPLY

1 See, for example, Samuelson and Nordhaus (1989).

Price per pound of coffee

Pounds of coffee per year

Price per pound of coffee

Pounds of coffee per year

Pounds of coffee per year

Price per pound of coffee

In Figure IC1.5 we superimpose demand schedule Dc from Figure IC1.1 on supply

Supply and Demand for Inputs

Measuring the Shapes of Supply and Demand Curves

Marshmallows per day

5 Donuts per day

Marshmallows per day

4 5 7 Donuts per day

Marshmallows per day

Donuts per day

Marshmallows per day

Donuts per day

In words, expenditures on marshmallows (3 × M) plus expenditures on donuts (6 × D) must

Marshmallows per day

PmM + PdD = I. (IC1.2)

MRSdm = Pd /Pm. (IC1.3)

Marshmallows per day

Derivation of Demand Curves

Substitution and Income Effects

MARGINAL ANALYSIS IN ECONOMICS

TABLE IC1.1 Total Profit

Tons of Fertilizer Wheat Corn

TABLE IC1.2 Marginal Profit

Tons of Fertilizer Wheat Corn

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