CHAPTER 2 THEORETICAL TOOLS OF PUBLIC FINANCE 35

exceeds the cost of that next movie, then the next step is upward, and you buy
the movie and continue up the optimization mountain. If the benefit is below the
cost, then the next step is downward, and you realize that you need to go back-
ward (buy fewer movies) to get back to the top. Only when the benefit equals the
cost of the next unit do you realize you are at the top of the mountain.

The Effects of Price Changes: Substitution and Income Effects

The key result from the constrained choice analysis is that MUM /MUC
PM /PC : Andrea consumes movies and CDs until the ratio of the marginal
utility of movies to CDs equals the ratio of their prices. An implication of this
result is that when the relative price of a good, such as movies in our example,
rises (i.e., PM /PC rises), then the relative quantity of that good demanded falls.
This is because, for the equality previously described to hold, when PM /PC
rises, then MUM /MUC must also rise. For MUM /MUC to rise, the quantity of
movies relative to CDs must fall (since the marginal utility of any good falls as
the quantity consumed of that good rises).
This point is illustrated graphically in Figure 2-7. We have already shown
that, with an income of $96, and prices of $16 for CDs and $8 for movies,
Andrea chooses 6 movies and 3 CDs at point A, the point at which BC1 and
IC1 are tangent. If the price of movies were to rise to $16, for example, the
budget constraint would become steeper; it rotates inward from BC1 to BC2.

FIGURE 2-7

Quantity of
CDs, QC Substitution and Income
Effects When the price of
movies increases, it has two
effects. First, holding utility con-
stant, there is a substitution
effect, which causes Andrea to
demand fewer movies since they
6
are relatively more expensive
(moving from point A to point B).
B
4.24 Second, holding relative prices
A constant, there is an income
3 effect, which causes
C
IC1 her to demand fewer movies
because she is poorer (moving
IC2 from point B to point C).
BC2 BCg BC1
3 4.24 6 12 Quantity of
movies, QM

Income Substitution
effect effect