The Consumer’s Optimal Choice

After completing this section, you will be able to

In this second part of Week 2, we bring together the pieces of the consumer model -- the budget
constraint and the indifference map. We will use the completed model to show how a rational
consumer selects an optimal consumption bundle. This particular bundle contains the
quantities of the two goods that maximizes the individual's utility when her income and the
prices of the two goods are fixed. We will also use the model to demonstrate how consumer
choices are affected when the prices faced by the consumer and her income change. The
exercise involving price changes is especially illuminating since it will help you later see how
economists arrive at a demand curve.

Let's study how Rama, who is Celeste’s pen pal and lives in Kolkata, India, decides how to
allocate her daily income of 1,200 rupees (Rs) among two goods that are dietary staples of
eastern India: fish (maach) and rice (bhaat). Assume that the price of a kilogram (kg) of fish is
pf = 300 Rs and that of a kilogram (kg) of rice is p r = 120 Rs.

In Figure 2B.1a below, Rama’s budget line is shown along with three of her indifference curves.
The curves are labeled U1, U2, and U3, with U3 representing the highest utility level among the
three curves. We could draw more indifference curves representing other utility levels, but only
three are drawn in order to keep the diagram uncluttered. The diagram also shows four
consumption bundles labeled A through D. Our task is to determine which of these bundles
Rama will select.
Figure 2B.1a

We can immediately exclude two bundles. Bundle A is above the area bounded by the budget
line. This means that Rama cannot afford this bundle. Bundle D can also be excluded since it
lies inside the area bounded by the budget line. If Rama were to buy bundle D, she would have
unspent income since the cost of the bundle is only 960 Rs. However, lying inside the area
bounded by the budget line is not reason enough to ensure that bundle D should be excluded.
If you recall from our previous section (section 2A), the indifference curves shown here indicate
that for Rama more is better. Visually, you can see that there are consumption bundles along
the budget line that would provide her more utility. Thus, as a rational consumer, she will spend
all the income she has set aside for her daily spending since this has the potential for raising her
level of satisfaction above the level obtained with bundle D. She can clearly afford to buy
bundles that include more of both goods. As a first step towards finding the optimal
consumption bundle, Rama, or any consumer, will select a bundle that lies on the budget line.
Since this is an important finding, let’s state it as a condition:

Condition 1: The utility maximizing consumer will purchase a consumption bundle that
lies on the budget line.

Buying a bundle on the budget line is a good first step, but it is still only a first step. Rama must
still decide among the many bundles that are on the budget line. In what follows, we will
describe two methods that she can use to find the optimal bundle. With this first method, let’s
suppose Rama starts at some arbitrary point along the budget line, say bundle C. But, is this
the optimal consumption bundle? She has three choices: she could stay at C, she could move
leftwards up along the budget line and consume more fish and less rice, or she could move
downwards to the right along the budget line and consume less fish and more rice. To
determine the direction she will move, let’s calculate how her utility would change with each
move. If her utility falls when moving in both directions, then she should stay in place. Bundle
C would then be the optimal consumption bundle. However, If her utility falls when moving
towards a bundle with more fish (the left of C) and rises when moving towards a bundle with
more rice (to the right of C), then she should consume more rice and less fish and move down
and to the right along the budget line. She should continue moving as long as her utility
continues to rise. Turning to Figure 2B.1a, it’s clear that a bundle with more rice and less fish
(to the right of C) would raise her utility. Bundles with more fish and less rice (to the left of C)
would cause utility to fall. In this example, Rama would decide to move downwards and to the
right.

Let’s now suppose that after a series of rightward moves Rama has arrived at consumption
bundle B. If she continues moving rightwards along the budget line, she will experience a fall in
her utility. This tells us that consumption bundle B is the optimal consumption bundle. Indeed,
moving anywhere along the budget line would reduce her utility. We can confirm this by looking
at Figure 2B.1a. Notice that consumption bundle B is on indifference curve U 2, the highest
indifference curve that Rama can reach with her fixed budget and fixed prices.

There is an alternative (and more standard) way to find Rama’s optimal consumption bundle.
This method relies on the information contained in the slope of the budget line and the slope of
indifference curves. Let’s review this information.

Once Rama is on the budget line (satisfies Condition 1), the only way that she can add another
unit of a good (say, rice) to her consumption bundle is to reduce spending on the other good
(fish). After all, being on the budget line means that there is no unspent income. How much
income does she need to free up and what impact will this have on her purchases of fish? One
kg of rice costs 120 Rs, so Rama must reduce spending on fish by this amount. This in turn
would cause the quantity of fish purchased to fall by ⅖ of a fish since one kg of fish costs 300
Rs. This can be computed as follows:

pr/pr = 120 Rs per rice/300 Rs per fish = ⅖ fish per rice

This ratio or trade off is in essence the market price of rice in terms of foregone fish. Note that if
you have a diagram with rice on the horizontal axis, this information is represented by the slope
of the budget line. To see this, consider the graph on the left in Figure 2B.1b.
Figure 2B.1b.

The slope of the entire budget line can be computed quickly as follows.1 The distance down
from the point where the budget line intercepts the y axis to zero is -4 fish. The horizontal
distance across from zero to the point where the budget line intercepts the x axis is +10 rice.
Dividing the distance down (-4 fish) by the distance across (+10 rice) and ignoring the negative
sign, we have 4 fish/10 rice or ⅖ fish per rice.

Now let’s turn to the slope of the indifference curve. Recall that the slope represents the
marginal rate of substitution (MRS) between rice and fish. If fish is on the vertical axis and rice
on the horizontal axis, it indicates the value a consumer places on an extra unit of rice
expressed in units of fish. Let’s suppose Rama is already at point C. In the graph on the right
in Figure 2B.1b, we have calculated the MRS at point C. The value is 1 fish per rice. This
means that Rama is indifferent between receiving 1 extra fish or 1 extra rice. Each makes her
equally as well off. But, if she was asked to give up less than 1 fish for 1 rice, she would be
better off.

Let’s return to the question of how the consumer arrives at the optimal bundle when they are
already on the budget line. In this approach, we compare the slope of the indifference curve to
the slope of the budget line at a particular consumption bundle. This comparison in turn
indicates to her whether she will stay in place or move along the budget line. At point C, the
following relationship holds:

MRS = 1 fish per rice > pr/pf = ⅖ fish per rice

The left-hand side tells us how much value Rama places on an extra unit of rice and the right-
hand side tells us what the market will charge her for that extra unit of rice. Buying an extra unit

1
Recall that the slope is defined as the vertical distance down divided by the horizontal distance
across.
of rice would clearly make her better off, so she will purchase more rice and less fish. The
move will place her on an indifference curve (one of the many not drawn) with higher utility. The
slope of this indifference curve at the new point to the right of C will be smaller indicating that
MRS has fallen and the value of an extra unit of rice is lower.

After this initial move, she will again face the same decision. She will continue to move towards
point B along the budget line as long as MRS exceeds p r/pf, even though the gap between them
is narrowing. She will stop moving when MRS = p r/pf or when the slope of the budget line is
equal to the slope of the indifference curve. At this point, the value she places on an additional
unit of rice is equal to what the market charges her for that unit. It also means that she has
spent her income in such a way that there are no longer any additional opportunities for her to
raise her utility. Visually, Rama is on the highest possible indifference curve that can be
reached with her fixed income and the fixed prices. So, we have a second condition that must
be satisfied by the optimal consumption bundle:

Condition 2: The slope of the indifference curve must equal the slope of the budget
line.

In the next two sections, we explore how Rama’s optimal choices of rice and fish change
following a change in her income and a change in the price of one of the goods.