Page 837 - Krugmans Economics for AP Text Book_Neat

The flattening of indifference curves as you slide down them to the right—which re-
The principle of diminishing marginal
flects the same logic as the principle of diminishing marginal utility—is known as the
rate of substitution states that the more
principle of diminishing marginal rate of substitution. It says that an individual of good R a person consumes in proportion
who consumes only a little bit of good A and a lot of good B will be willing to trade off to good M, the less M he or she is willing Section 14 Appendix
a lot of good B in return for one more unit of good A, and an individual who already to substitute for another unit of R.
consumes a lot of good A and not much of good B will be less willing to make that Two goods, R and M, are ordinary goods
trade-off. in a consumer’s utility function when (1) the
We can illustrate this point by referring back to Figure 80.5. At point V, a bundle consumer requires additional units of R to
with a high proportion of restaurant meals to rooms, Ingrid is willing to forgo 10 compensate for fewer units of M, and vice
restaurant meals in return for 1 room. But at point Y, a bundle with a low proportion versa; and (2) the consumer experiences a
of restaurant meals to rooms, she is willing to forgo only 2 restaurant meals in return diminishing marginal rate of substitution
for 1 room. when substituting one good for another.
From this example we can see that, in Ingrid’s utility function, rooms and restau-
rant meals possess the two additional properties that characterize ordinary goods. In-
grid requires additional rooms to compensate her for the loss of a meal, and vice versa;
so her indifference curves for these two goods slope downward. And her indifference
curves are convex: the slope of her indifference curve—the negative of the marginal rate
of substitution—becomes flatter as we move down it. In fact, an indifference curve is
convex only when it has a diminishing marginal rate of substitution—these two condi-
tions are equivalent.
With this information, we can define ordinary goods, which account for the great
majority of goods in any consumer’s utility function. A pair of goods are ordinary goods
in a consumer’s utility function if they possess two properties: the consumer requires
more of one good to compensate for less of the other, and the consumer experiences a
diminishing marginal rate of substitution when substituting one good for the other.
Next we will see how to determine Ingrid’s optimal consumption bundle using in-
difference curves.

The Tangency Condition
Now let’s put some of Ingrid’s indifference curves on the same diagram as her budget
line to illustrate an alternative way of representing her optimal consumption choice.
Figure 80.6 shows Ingrid’s budget line, BL, when her income is $2,400 per month,

figure 80.6

The Optimal Consumption Quantity of
restaurant
Bundle Optimal
meals
The budget line, BL, shows Ingrid’s possible con- consumption
80 bundle
sumption bundles, given an income of $2,400 per
month, when rooms cost $150 per month and 70 B
restaurant meals cost $30 each. I 1 , I 2 , and I 3 are
indifference curves. Consumption bundles such 60
as B and C are not optimal because Ingrid can
50
move to a higher indifference curve. The optimal I 3
consumption bundle is A, where the budget line 40 A
is just tangent to the highest possible indiffer-
ence curve. 30 I 2

20
C
10 I 1
BL
0 2 4 6 8 10 12 14 16
Quantity of rooms

module 80 Appendix 795