Chapter 3: Consumer Behavior

PART II
PRODUCERS, CONSUMERS, AND COMPETITIVE MARKETS
CHAPTER 3
CONSUMER BEHAVIOR
REVIEW QUESTIONS
1. What does transitivity of preferences mean?
Transitivity of preferences implies that if someone prefers A to B and prefers B to C,
then he or she prefers A to C.
2. Suppose that a set of indiference curves was not negatively sloped. What could you say
about the desirability of the two goods?
One major assumption of preference theory is that more is preferred to less. Thus, we
can expect that consumers will experience a lower level of satisfaction if we take some
of a good away from them. From this, we necessarily derive negatively sloped
indiference curves. However, if one good is undesirable, then less of the undesirable
good leaves the consumer better of, e.g., less toxic waste is preferred to more toxic
waste. When one good is undesirable, the indiference curves showing the trade-of
between that good and a desired good have positive slopes. In Figure 3.2 below, the
indiference curve U
2
is preferred to the indiference curve U
1
.
Good Y
Toxic Waste
Preferred
Position
U
2
U
1
Figure 3.2
3. Explain why two indiference curves cannot intersect.
The explanation is most easily achieved with the aid of a graph such as Figure 3.3,
which shows two indiference curves intersecting at point A. We know from the
defnition of an indiference curve that a consumer has the same level of utility along
any given curve. In this case, the consumer is indiferent between bundles A and B
because they both lie on indiference curve U
1
. Similarly, the consumer is indiferent
between bundles A and C because they both lie on indiference curve U
2
. By the
transitivity of preferences this consumer should also be indiferent between C and B.
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Chapter 3: Consumer Behavior
However, we see from the graph that C lies above B, so C must be preferred to B. Thus,
the fact that indiference curves cannot intersect is proven.
Good Y
Good X
A
C
B
U
1
U
2
Figure 3.3
4. Draw a set of indiference curves for which the marginal rate of substitution is constant.
Draw two budget lines with diferent slopes; show what the satisfaction-maximizing choice
will be in each case. What conclusions can you draw?
In Figure 3.4, Good X and Good Y are perfect substitutes and, thus, the indiference
curves are straight lines, U
1
and U
2
, each with a slope of -1. For goods that are perfect
substitutes, the consumer will always prefer to purchase the cheaper of the two goods
to obtain maximum utility. For example, if Good Y is cheaper than Good X, the
consumer would face the budget constraint L
2
and would maximize utility at point A.
On the other hand, if Good X were cheaper than Good Y, the consumer would face the
budget constraint L
1
and would maximize utility at point B. If Good X and Good Y
have the same price, the budget constraint would coincide with the indiference curve,
and the consumer would be indiferent between any point on the curve. To see this,
recall that the slope of the budget line is

P
x
P
y
.
More generallly, the slope of a linear
indiference curve is the constant rate at which the consumer is willing to trade the two
goods. If the slope of the budget line and the indiference curve are the same, then the
consumer is indiferent between any point on the budget line. When the slopes are
diferent, the consumer will choose one of the corners, depending on the respective
slopes.
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Chapter 3: Consumer Behavior
Good Y
Good X
A
B
U
1
U
2 L
1
L
2
Figure 3.4
5. Explain why a persons marginal rate of substitution between two goods must equal the
ratio of the price of the goods for the consumer to achieve maximum satisfaction.
The MRS describes the rate at which the consumer is willing to trade one good for
another to maintain the same level of satisfaction. The ratio of prices describes the
trade-of that the market is willing to make between the same two goods. The tangency
of the indiference curve with the budget line represents the point at which the trade-
ofs are equal and consumer satisfaction is maximized. If the MRS between two goods
is not equal to the ratio of prices, then the consumer could trade one good for another at
market prices to obtain higher levels of satisfaction. This trading continues until the
highest level of satisfaction is achieved.
6. Explain why consumers are likely to be worse of when a product that they consume is
rationed.
If the maximum quantity of a good is fxed by decree and desired quantities are not
available for purchase, then there is no guarantee that the highest level of satisfaction
can be achieved. The consumer will not be able to give up the consumption of other
goods in order to obtain more of the rationed good. Only if the amount rationed is
greater than the desired level of consumption can the consumer still maximize
satisfaction without constraint. (Note: rationing may imply a higher level of social
welfare because of equity or fairness considerations across consumers.)
7. Upon merging with West Germanys economy, East German consumers indicated a
preference for Mercedes-Benz automobiles over Volkswagen automobiles. However, when
they converted their savings into deutsche marks, they focked to Volkswagen dealerships.
How can you explain this apparent paradox?
Three assumptions are required to address this question: 1) that a Mercedes costs more
than a Volkswagen; 2) that the East German consumers utility function comprises two
goods, automobiles and all other goods evaluated in deutsche marks; and 3) that East
Germans have incomes. Based on these assumptions, we can surmise that while once-
East German consumers may prefer a Mercedes to a Volkswagen, they either cannot
aford a Mercedes or they prefer a bundle of other goods plus a Volkswagen to a
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Chapter 3: Consumer Behavior
Mercedes alone. While the marginal utility of consuming a Mercedes exceeds the
marginal utility of consuming a Volkswagon, the consumer will consider marginal
utility per dollar for each good. This means the marginal utility per dollar must have
been higher for the Volkswagon since consumers focked to the Volkswagon dealerships
and not the Mercedes dealerships.
8. Describe the equal marginal principle. Explain why this principle may not hold if
increasing marginal utility is associated with the consumption of one or both goods.
The equal marginal principle states that the ratio of the marginal utility to price must
be equal across all goods to obtain maximum satisfaction. This explanation follows
from the same logic examined in Review Question 5. Utility maximization is achieved
when the budget is allocated so that the marginal utility per dollar of expenditure is
the same for each good. If marginal utility is increasing, the consumer maximizes
satisfaction by consuming ever larger amounts of the good. Thus, the consumer would
spend all income on one good, assuming a constant price, resulting in a corner solution.
With a corner solution, the equal marginal principle cannot hold.
9. What is the diference between ordinal utility and cardinal utility? Explain why the
assumption of cardinal utility is not needed in order to rank consumer choices.
Ordinal utility implies an ordering among alternatives without regard for intensity of
preference. For example, the consumers frst choice is preferred to their second choice.
Cardinal utility implies that the intensity of preferences may be quantifed. An ordinal
ranking is all that is needed to rank consumer choices. It is not necessary to know how
intensely a consumer prefers basket A over basket B; it is enough to know that A is
preferred to B.
10. The price of computers has fallen substantially over the past two decades. Use this
drop in price to explain why the Consumer Price Index is likely to substantially
understate the cost-of-living index for individuals who use computers intensively.
The consumer price index measures the changes in the weighted average of the prices
of the bundle of goods purchased by consumers. The weights equal the share of
consumer's expenditures on all of the goods in the bundle. A base year is chosen, and
the weights for that year are used to compute the CPI in that and subsequent years.
When the price of a good falls substantially then a consumer will substitute towards
that good, altering the share of that consumer's income spent on each good. By using
the base year's weights the CPI does not take into account that large price changes
alter these expenditure shares, and so gives an inaccurate measure of changes in the
cost of living.
For example, assume Fred spends 10% of his income on computers in 1970, and that
Fred's expenditure shares in 1970 were used as the weights to calculate Fred's CPI in
subsequent years. If Fred's demand for computers was inelastic, then reductions in the
price of computers (relative to other goods) would reduce the share of his income spent
on computers. After 1970 a CPI that used Fred's 1970 expenditure shares as weights
would give a 10% weight to the falling price of computers, even though Fred spent less
that 10% of his income on computers. As long as the prices of other goods rose, or fell
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Chapter 3: Consumer Behavior
less than 10%, then the CPI gives too little weight to the changes in the prices of other
goods, and understates the changes in Fred's cost of living.
EXERCISES
1. In this chapter, consumer preferences for various commodities did not change during
the analysis. Yet in some situations, preferences do change as consumption occurs. Discuss
why and how preferences might change over time with consumption of these two
commodities:
a. cigarettes
The assumption that preferences do not change is a reasonable one if choices are
independent across time. It does not hold, however, when habit-forming or addictive
behavior is involved, as in the case of cigarettes: the consumption of cigarettes in one
period infuences their consumption in the next period.
b. dinner for the frst time at a restaurant with a special cuisine
While there may not be anything physically addictive in dining at new and diferent
restaurants, one can become better informed about a particular restaurant. One may
enjoy choosing more new and diferent restaurants, or one may be tired of choosing
another new and diferent place to eat. In either of these cases, choices change as
consumption occurs.
2. Draw the indiference curves for the following individuals preferences for two goods:
hamburgers and beer.
a. Al likes beer but hates hamburgers. He always prefers more beer no matter how
many hamburgers he has.
For Al, hamburgers are a bad. His indiference curves slope upward and to the right
rather than downward and to the left. For Al, U
1
is preferred to U
2
and U
2
is preferred
to U
3
. See fgure 3.2a. If you instead assumed that hamburgers were a neutral good,
then the indiference curves would be vertical and utility is increasing to the right as
more beer is consumed.
b. Betty is indiferent between bundles of either three beers or two hamburgers. Her
preferences do not change as she consumes any more of either food.
Since Betty is indiferent between three beers and two burgers, an indiference curve
connects these two points. Bettys indiference curves are a series of parallel lines with
slope of

2
3
. See fgure 3.2b.
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Chapter 3: Consumer Behavior
Hamburgers
Beer
U
3
U
2
U
1
Figure 3.2.a
Hamburgers
Beer
U
1
U
2
U
3
1
2
3
4
5
6
7
8
9
3 6 9
Figure 3.2.b
c. Chris eats one hamburger and washes it down with one beer. He will not consume
an additional unit of one item without an additional unit of the other.
For Chris, hamburgers and beer are perfect complements, i.e., he always wants to
consume the goods in fxed proportions to each other. The indiference curves are L-
shaped, with corners on a 45-degree line out of the origin. See fgure 3.2c.
d. Doreen loves beer but is allergic to beef. Every time she eats a hamburger she
breaks out in hives.
For Doreen, hamburgers are not considered a good but rather a bad, and thus her
preferred position is not upwards and to the right, but rather downward and to the
right. For Doreen, U
1
is preferred to U
2
and U
2
is preferred to U
3
. See fgure 3.2d.
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Chapter 3: Consumer Behavior
Hamburgers
Beer
U
1
U
2
U
3
1
2
3
1 2 3
Figure 3.2.c
Hamburgers
Beer
U
1
U
2
U
3
Figure 3.2.d
3. The price of tapes is $10 and the price of CDs is $15. Philip has a budget of $100 and has
already purchased 3 tapes. He thus has $70 more to spend on additional tapes and CDs.
Draw his budget line. If his remaining expenditure is made on 1 tape and 4 CDs, show
Philips consumption choice on the budget line.
Given Philips remaining income of $70, he can aford 7 tapes if he spends the entire
amount on tapes, and he can aford 4.7 CDs if he spends the entire amount on CDs.
According to fgure 3.3, his budget line therefore intersects the vertical axis at a
quantity of 7 tapes and the horizontal axis at a quantity of 4.7 CDs. Since he faces
constant prices, the budget line has a constant slope and is a straight line.
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Chapter 3: Consumer Behavior
4.7
7
CDs
Tapes
4
1
Figure 3.3
4. Debra usually buys a soft drink when she goes to a movie theater, where she has a
choice of three sizes: the 8 ounce drink costs $1.50, the 12 ounce drink, $2.00, and the 16
ounce drink, $2.25. Describe the budget constraint that Debra faces when deciding how
many ounces of the drink to purchase. (Assume that Debra can costlessly dispose of any
of the soft drink that she does not want.
First notice that as the size of the drink increases, the price eper ounce decreases.
When she buys the 8 ounce soft drink she pays
$1.50
8 oz
= $0.19 per oz. When she
buys the 12 ounce size she pays $0.17 per ounce, and when she buys the 16 ounce
size, she pays $0.14 per ounce. Given that there are three diferent prices per ounce
of soft drink, the budget line will have two kinks in it, as illustrated in fgure 3.4.
Ounces of
Soft Drink
8 12 16
Figure 3.4
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Chapter 3: Consumer Behavior
5. Suppose Bill views butter and margarine as perfectly substitutable for each other.
a. Draw a set of indiference curves that describes Bills preferences for butter and
margarine.
Butter
Margarine
U
1
U
2
U
3
10
5
15
20
5 10 15 20
Figure 3.5.a
b. Are these indiference curves convex? Why?
Convexity implies that a line segment connecting any two points on a curve lies above
the curve, i.e., the curve is bowed inward. Because the consumer considers butter
and margarine to be perfect substitutes, there is no diminishing marginal utility, and
the resultant indiference curves are straight lines. Straight-line indiference curves
are not strictly convex.
c. If butter costs $2 per package, while margarine costs only $1, and Bill has a $20
budget to spend for the month, which butter-margarine market basket will he
choose? Can you show this graphically?
Let Bills income be represented by Y, the price of butter by P
B
, the quantity of butter
by B, the price of margarine by P
M
, and the quantity of margarine by M. Then the
general form of the budget constraint is: Y = P
B
B + P
M
M.
Substituting for the given values of Y, P
B
, and P
M
, we obtain the specifc representation
of Bills budget constraint: 20 = 2B + 1M, or B = 10 - 0.5M.
Because Bill is indiferent between butter and margarine, and the price of butter is
greater than the price of margarine, Bill will only buy margarine. This is a corner
solution, because the optimal choice occurs on an axis. In Figure 3.5.c Bills utility
maximizing bundle is point A.
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Chapter 3: Consumer Behavior
Butter
Margarine
U
1
U
2
U
3
10
5
15
20
5 10 15 20
L
1
A
Figure 3.5.c
6. Suppose that Jones and Smith have decided to allocate $1,000 per year on liquid
refreshments in the form of alcoholic or nonalcoholic drinks. Jones and Smith difer
substantially in their preferences for these two forms of refreshment. Jones prefers
alcoholic to nonalcoholic drinks, while Smith prefers the nonalcoholic option.
a. Draw a set of indiference curves for Jones and a second set for Smith.
Alcoholic
Nonalcoholic
J
1
J
2
S
1
S
2
Figure 3.6.a
b. Discuss why the two sets of curves are diferent from each other using the concept of
marginal rate of substitution.
At any combination of alcoholic, A, and nonalcoholic, N, drinks, Jones is willing to give
up a lot of N for an additional unit of A; whereas, Smith is willing to give up a lot of A
for an additional unit of N. Because Jones needs more N to compensate him for giving
up some A, he has a lower marginal rate of substitution of alcoholic for nonalcoholic
beverages than Smith. With alcoholic beverages on the vertical axis, Jones
indiference curves are less steep than Smiths at any point on the graph.
c. If both Smith and Jones pay the same prices for their refreshments, will their
marginal rates of substitution of alcoholic for nonalcoholic drinks be the same or
diferent? Explain.
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Chapter 3: Consumer Behavior
In order to maximize utility, the consumer must consume quantities such that the
MRS between any two commodities is equal to the ratio of prices. If Smith and Jones
are rational consumers, their MRS must be equal because they face the same market
prices. But because they have diferent preferences, they will consume diferent
amounts of the two goods, alcoholic and nonalcoholic. At those diferent levels,
however, their MRS are equal.
7. Consumers in Georgia pay twice as much for avocados as they do for peaches. However,
avocados and peaches are equally priced in California. If consumers in both states
maximize utility, will the marginal rage of substitution of peaches for avocados be the same
for consumers in both states? If not, which will be higher?
The marginal rate of substitution of peaches for avocados is the amount of avocados
that a person is willing to give up to obtain one additional peach. When consumers
maximize utility, they set their marginal rate of substitution equal to the price ratio,
which in this case is
P
peach
P
avocado
.
In Georgia,
P
avocado
= 2P
peach , which means that when
consumers are maximizing utility,
MRS =
P
peach
P
avocado
=
1
2
.
In California,
P
avocado
= P
peach,
which means that when consumers are maximizing utility,
MRS =
P
peach
P
avocado
=
1
1
.
The
marginal rate of substitution is therefore not the same in both states, and will be
higher in California.
8. Anne is a frequent fyer whose fares are reduced (through coupon giveaways) by 25
percent after she fies 25,000 miles a year, and then by 50 percent after she fies 50,000 miles.
Can you graph the budget line that Anne faces in making her fight plans for the year?
In Figure 3.8, we plot miles fown, M, against all other goods, G, in dollars. The budget
constraint is:
Y = P
M
M + P
G
G, or
G =
Y
P
G
M
P
M
P
G

.
The slope of the budget line is

P
P
M
G
. In this case, the price of miles fown changes as
the number of miles fown changes, so the budget curve is kinked at 25,000 and at
50,000 miles. If we assume P
M
is $1 per mile for less than or equal to 25,000 miles,
then P
M
= $0.75 for 25,000 < M 50,000, and P
M
= $0.50 for M > 50,000. Also, assume
that P
G
= $1.00. The slope of the budget line from A to B is -1, the slope of the budget
line from B to C is -0.75, and the slope of the budget line from C to D is -0.5.
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Chapter 3: Consumer Behavior
All Other
Goods
Miles
25 50
Slope = -1
Slope = -0.75
Slope = -0.50
5
10
15
20
25
30
35
40
45
50
55
B
A
C
Figure 3.8
9. Antonio buys 8 new college textbooks during his frst year at school at a cost of $50 each.
Used books cost only $30 each. When the bookstore announces that there will be a 20
percent price increase in new texts and a 10 percent increase in used texts for the next
year, Antonios father ofers him $80 extra. Is Antonio better of or worse of after the price
change?
It follows from the axiom of revealed preferences that, since Antonio chose to purchase
only new textbooks when both new and used textbooks were available, it must be the
case that Antonio does not consider used textbooks substitutes for new textbooks at the
old prices.With the increase in price, however, to $60 for new textbooks and $33 for
used texts, the relative price of new texts to used texts increases from
50
30
167 = . to
60
33
182 = . . Antonio may react to the relative price increase in one of two ways:
(1) If new and used texts are not substitutes for Antonio (L-shaped indiference curves),
then Antonio will be just as well of when the price of new texts rises and his father
gives him $80 (= (60 - 50)8).
(2) If he chooses to buy a few used texts in response to the relative price increase (given
the extra $80), he will move to a higher indiference curve and will therefore be better
of. See Figures 3.9.a and 3.9.b.
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Chapter 3: Consumer Behavior
New Texts
All Other Goods
(Including Used Texts)
U
1
L
1
L
2 L
1
refects the price
increase for texts and
the extra $80.00
Figure 3.9.a
New Texts
All Other Goods
(Including Used Texts)
U
1
L
1
L
2
U
2
B
A
Figure 3.9.b
10. Suppose that Samantha and Jason both spend $24 per week on video and movie
entertainment. When the prices of videos and movies are both $4, they both rent 3 videos
and buy 3 movie tickets. Following a video price war and an increased cost of movie
tickets, the video price falls to $2 and the movie ticket increases to $6. Samantha now rents
6 videos and buys 2 movie tickets; Jason, however, buys 1 movie ticket and rents 9 videos.
a. Is Samantha better of or worse of after the price change?
Samanthas original point of utility maximization may be represented by point A on U
1
in Figure 3.10.a. With the new prices, Samantha could still aford to choose bundle A:
$24 = $2(3 videos) + $6 (3 movies). The fact that she chose bundle B reveals she has
obtained a higher level of utility, U
2
. See Figure 3.10.a.
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Chapter 3: Consumer Behavior
Videos
Movies
3
6
9
12
3 6 9
B
A
12
U
1
U
2
L
2
L
1
Figure 3.10.a
b. Is Jason better of or worse of?
Similarly, Jason must also be better of.
11. Connie Consumer has a monthly income of $200 which she allocates among two goods:
meat and potatoes.
a. Suppose meat costs $4 per pound and potatoes cost $2 per pound. Draw her budget
constraint.Let M = meat and P = potatoes. Connies budget constraint is $200 = 4M +
2P, or M = 50 - 0.5P. As shown in Figure 3.11.a, with M on the vertical axis, the vertical
intercept is 50.The horizontal intercept maybe found by setting M = 0 and solving for P.
Meat
Potatoes
U = 100
50
25
75
100
25 50 75 100 125
Budget Constraint
and Utility Function
Figure 3.11.a
b. Suppose also that her utility function is given by the equation u(M, P) = 2M + P.
What combination of meat and potatoes should she buy to maximize her utility?
(Hint: Meat and potatoes are perfect substitutes.)
Connies utility is equal to 100 when she buys 50 pounds of meat and no potatoes or no
meat and 100 pounds of potatoes. The indiference curve for U = 100 coincides with her
budget constraint. Any combination of meat and potatoes along this line will provide
her with maximum utility.
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Chapter 3: Consumer Behavior
c. Connies supermarket has a special promotion. If she buys 20 pounds of potatoes (at
$2 per pound), she gets the next 10 pounds for free. This ofer applies only to the
frst 20 pounds she buys. All potatoes in excess of the frst 20 pounds (excluding
bonus potatoes) are still $2 per pound. Draw her budget constraint.
Figure 3.11.c represents Connies budget constraint when the supermarket runs its
special promotion on potatoes. Notice that her budget constraint has a slope of -2 until
Connie has purchased twenty pounds of potatoes, is then fat, since the ten next pounds
of potatoes are free, and then has a slope of -2 until it intercepts the potato axis at 110.
Meat
Potatoes
50
25
75
100
2040 110
Slope = -2
Slope = -2
Slope = 0
Figure 3.11.c
d. An outbreak of potato rot raises the price of potatoes to $4 per pound. The
supermarket ends its promotion. What does her budget constraint look like now?
What combination of meat and potatoes maximizes her utility?
With the price of potatoes at $4, Connie may buy either 50 pounds of meat or 50
pounds of potatoes, or some combination in between. See Figure 3.11.d. She
maximizes utility at U = 100 at point A when she consumes 50 pounds of meat and no
potatoes. This is a corner solution.
Meat
Potatoes
Indiference Curve for U = 100
50
25
75
100
25 50 75 100 125
Budget Constraint
A
Figure 3.11.d
12. The utility that Jane receives by consuming food F and clothing C is given by:
u(F,C) = FC.
36
Chapter 3: Consumer Behavior
a. Draw the indiference curve associated with a utility level of 12 and the indiference
curve associated with a utility level of 24. Are the indiference curves convex?
To fnd the baskets of food, F, and clothing, C, which yield satisfactions of 12 and 24
solve the equations C
F
=
12
and C
F
=
24
.
U = 12 U = 24
Food Clothing Food Clothing
1.0 12.0 1.0 24.0
1.5 8.0 2.0 12.0
2.0 6.0 3.0 8.0
3.0 4.0 4.0 6.0
4.0 3.0 6.0 4.0
6.0 2.0 8.0 3.0
8.0 1.5 12.0 2.0
12.0 1.0 24.0 1.0
The indiference curves are convex.
b. Suppose that food costs $1 a unit, clothing costs $3 a unit, and Jane has $12 to spend
on food and clothing. Graph the budget line that she faces.
The budget constraint is:
Y = P
F
F + P
C
C, or 12 = 1F + 3C, or C = 4
1
3

F.
See Figure 3.12.a.
Clothing
Food
4
2
6
8
2 4 6 8 10 12
U = 12
U = 24
Figure 3.12.a
c. What is the utility-maximizing choice of food and clothing? (Hint: Solve the problem
graphically.)
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Chapter 3: Consumer Behavior
The highest level of satisfaction occurs where the budget line is tangent to the highest
indiference curve. In Figure 3.12.a this is at the point F = 6 and C = 2. To check this
answer, note that it exhausts Janes income, 12 = 6P
F
+ 2P
C
. Also, this bundle yields a
satisfaction of 12, as (6)(2) = 12. See Figure 3.12.a.
d. What is the marginal rate of substitution of food for clothing when utility is
maximized?
At the utility-maximizing level of consumption, the slope of the indiference curve is
equal to the slope of the budget constraint. Since the MRS is equal to the negative
slope of the indiference curve, the MRS in this problem is equal to one-third. Thus,
Jane would be willing to give up one-third of a unit of clothing for one unit of food.
e. Suppose that Jane buys 3 units of food and 3 units of clothing with her $12 budget.
Would her marginal rate of substitution of food for clothing be greater or less than
1/3? Explain.
If Jane buys 3 units of food for $1.00 per unit and 3 units of clothing for $3.00 per unit,
she would spend all her income. However, she would obtain a level of satisfaction of
only 9, which represents a sub-optimal choice. At this point, the MRS is greater than
one-third, and thus, at the prices she faces, she would welcome the opportunity to give
up clothing to get more food. She is willing to trade clothing for food until her MRS is
equal to the ratio of prices. See Figure 3.12.e.
Clothing
Food
4
2
6
8
2 4 6 8 10 12
U = 12
U = 9
3
3
Figure 3.12.e
13. The utility that Meredith receives by consuming food F and clothing C is given by
u(F,C) = FC. Suppose that Merediths income in 1990 is $1,200 and the prices of food and
clothing are $1 per unit for each. However, by 1995 the price of food has increased to $2
and the price of clothing to $3. Let 100 represent the cost of living index for 1990.
Calculate the ideal and the Laspeyres cost-of-living index for Meredith for 1995. (Hint:
Meredith will spend equal amounts on food and clothing with these preferences.)
Laspeyres Index
38
Chapter 3: Consumer Behavior
The Laspeyres index represents how much more Meredith would have to spend in 1995
versus 1990 if she consumed the same amounts of food and clothing in 1995 as she did in
1990. That is, the Laspeyres index for 1995 (L) is given by:
L = 100 (Y)/Y
where Y represents the amount Meredith would spend at 1995 prices consuming the same
amount of food and clothing as in 1990: Y

= P
F
F + P
C
C = 2F + 3C, where F and C represent
the amounts of food and clothing consumed in 1990.
We thus need to calculate F and C, which make up the bundle of food and clothing which
maximizes Merediths utility given 1990 prices and her income in 1990. Use the hint to
simplify the problem: Since she spends equal amounts on both goods, P
F
F = P
C
C. Or, you can
derive this same equation mathematically: With this utility function, MU
C
=

U/C = F, and
MU
F
= U/F = C. To maximize utility, Meredith chooses a consumption bundle such that
MU
F
/MU
C
= P
F
/P
C
, which again yields P
F
F = P
C
C.
From the budget constraint, we also know that: P
F
F +P
C
C = Y.
Combining these two equations and substituting the values for the 1990 prices and income
yields the system of equations: C = F and C + F = 1,200.
Solving these two equations, we fnd that: C = 600 and F = 600.
Therefore, the Laspeyres cost-of-living index is:
L = 100(2F + 3C)/Y = 100[(2)(600) + (3)(600)]/1200 = 250.
Ideal Index
The ideal index represents how much more Meredith would have to spend in 1995 versus
1990 if she consumed amounts of food and clothing in 1995 which would give her the same
amount of utility as she had in 1990. That is, the ideal index for 1995 (I) is given by:
I = 100(Y'')/Y, where Y'' = P'
F
F + P'
C
C' = 2F' + 3C'
where F' and C' are the amount of food and clothing which give Meredith the same utility as
she had in 1990. F' and C' must also be such that Meredith spends the least amount of money
at 1995 prices to attain the 1990 utility level.The bundle (F',C') will be on the same
indiference curve as (F,C) and the indiference curve at this point will be tangent to a budget
line with slope -(P'
F
/P'
C
), where P'
F
and P'
C
are the prices of food and clothing in 1995. Since
Meredith spends equal amounts on the two goods, we know that 2F' = 3C'. Since this bundle
lies on the same indiference curve as the bundle F = 600, C = 600, we also know that F'C' =
(600)(600).
Solving for F' yields: F'[(2/3)F'] = 360,000 or F' = [( / ) , )] 3 2 360 000 = 734.8.
From this, we obtain C' = (2/3)F' = (2/3)734.8 = 489.9.
We can now calculate the ideal index:
I = 100(2F' + 3C')/Y = 100[2(734.8) + (3)(489.9)]/1200 = 244.9.
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