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  • ♪ [music] ♪

  • [Joana] The way we make choices about what to buy

  • depends on how our dreams, our wants, meet reality.

  • We've covered thinking on the margin,

  • budget constraints, and indifference curves.

  • Now let's bring this all together

  • to model how you decide what to purchase.

  • Remember, your budget constraint represents

  • how the market values goods

  • and what you can afford, given your income.

  • Your indifference curves represent how you value goods

  • based on your personal preferences.

  • We all wish we could have more of everything.

  • We would love to be way out here

  • where we can consume as much as we want.

  • But the reality is that we have limited resources

  • and the prices of things force us to make tradeoffs.

  • We want to get the best bang for our buck

  • and that means finding that optimal combination of goods

  • that brings together how the market values goods

  • and our preferences.

  • That's what this graph,

  • illustrating your indifference curves

  • and budget constraint, lets us better understand.

  • When you make a decision,

  • you are effectively trying to be the happiest that you can,

  • given the constraints that you face.

  • You are, without knowing, solving

  • a "constrained optimization" problem, where you are choosing

  • the combination of goods that maximize your utility

  • given the prices of goods and your income.

  • Let's go back to our pizza and coffee example.

  • You have a budget of $50. Pizza costs $10.

  • And each cup of coffee costs $5.

  • Now, let's assume your indifference map

  • looks like this.

  • Making the best choice you can afford means

  • you will spend your entire budget

  • on the combination of pizzas and cups of coffee

  • that make you the happiest.

  • This means that your optimal consumption combination

  • is on your budget line.

  • Making the best choice you can afford also means

  • that you will try to reach the indifference curve

  • that represents the highest degree of satisfaction or utility.

  • Because pizza and coffee are good things --

  • things that make you happy --

  • this will occur on the indifference curve

  • that is the farthest away from the origin.

  • Why?

  • Because the more pizza and coffee you have,

  • the happier you are.

  • What keeps you from reaching this indifference curve?

  • If you thought prices and income, you are right!

  • Your budget constraint determines what you can afford.

  • So your optimal consumption combination will be

  • where your budget constraint is tangent

  • to the highest indifference curve.

  • To see why, let's go back to thinking about

  • why you try to reach the indifference curve

  • that is the farthest away from the origin.

  • The best way to go about it is to look at a point

  • where the budget line intersects one of your indifference curves.

  • This particular combination of pizza and coffee --

  • it's affordable, because it's on your budget line.

  • However, you are not the happiest you could be, now are you?

  • Given your preferences,

  • it's clear that you would be happier

  • if you could buy this combination.

  • It has more pizza,

  • and just as many cups of coffee.

  • But, hey, it's beyond your budget.

  • But now look at this.

  • You are indifferent between this combination

  • and this combination.

  • Both are on the same indifference curve,

  • and that means they provide you with the same utility.

  • So, if you are trying to get the most utility you can,

  • given what you can afford,

  • you will never choose a combination of goods

  • that intersects your budget constraint.

  • You will choose one that is tangent to it.

  • The point of tangency between the budget constraint

  • and the indifference curve also means

  • that at your optimal consumption combination,

  • the market's relative price of the goods equals

  • your willingness to substitute between them --

  • and that's your marginal rate of substitution.

  • Another way to see this is to recognize

  • that at your best choice,

  • the marginal utility per dollar of both goods is the same.

  • Let's go back to thinking at the margin.

  • At this point, would it make you happier

  • to spend more money on pizza and less on coffee?

  • Here, the marginal rate of substitution is 4,

  • and that means you are willing to forego four cups of coffee

  • to get one additional pizza.

  • But pizza is only twice as expensive as coffee.

  • So this is great news for you.

  • The market is asking you to forego fewer cups of coffee

  • than you are willing to.

  • So you get that extra pizza.

  • Another way to think about this is to realize that at this point,

  • your marginal utility per dollar of pizza is greater

  • than your marginal utility per dollar from cups of coffee.

  • Remember, as you get more pizzas,

  • and are left with fewer cups of coffee,

  • your marginal utility from pizzas is decreasing,

  • and your marginal utility from cups of coffee is increasing.

  • You will stop getting additional pizzas

  • when your marginal utility per dollar

  • from both goods is equal.

  • Of course, very few of us calculate marginal utility

  • or think of constrained optimization

  • when we choose what to buy.

  • But these concepts can help you understand your world

  • and guide you how to make better decisions in the future.

  • [Narrator] You're on your way to mastering economics.

  • Make sure this video sticks

  • by taking a few quick practice questions.

  • Or, if you're ready for more microeconomics,

  • click for the next video.

  • Still here?

  • Check out Marginal Revolution University's other popular videos.

  • ♪ [music] ♪

♪ [music] ♪

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B1 US indifference marginal utility budget pizza combination

Consumer Optimization

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    Amy.Lin posted on 2017/10/01
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