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We have arrived at the point where we bring together our indifference curve and budget line to determine the consumer’s optimal choice.
Below, we have merged the indifference curve and the budget line into one graph. The indifference curve touches the budget line at one point. This point of contact is described as being tangent–a term you might remember from geometry, for the point where two lines pass through the same point. The optimal combination of chicken meals and vegetarian meals per week is at this point of tangency where the indifference curve touches the budget line.
At the single point of tangency between the indifference curve (representing a consumer’s preferences) and budget line (representing the constraints imposed by the price of goods and services and consumer income), the slopes of both lines are equal, meaning the opportunity costs of the two goods are equal. The marginal rate of substitution (the slope of the indifference curve) is equal to the marginal rate of transformation (the slope of the budget line). At this point, the consumer is said to be optimizing consumption.
The optimal choice is the point at which the consumer is doing the best they can do given personal preferences and the constraints of product prices and consumer income. In the graph above, the optimal combination occurs where 
and 
come together. The consumer chooses 6 chicken and 2 vegetarian meals per week, maximizing total satisfaction at 100 for .
Suppose product prices do not change, but the budget increases to $200 as represented by budget line 
. What happens to the consumer’s optimal choice? In the graph, locate the budget line and the indifference curve 
. At this new point, the consumer chooses more chicken meals (7 instead of 6) and more vegetarian meals (3 instead of 2). The consumer has reached a higher level of total satisfaction on (150 instead of 100). Things are definitely looking up!
Let’s revisit an example we explored in the lesson that introduced the budget line. Recall the scenario in which Kate sets aside $100 a month to have lunch at either the local Mexican restaurant or the local Italian restaurant and that all meals are priced at $10. The budget line identified all possible combinations of meals Kate can afford if she spends all $100 on going out to lunch. It also represented the effect of Kate’s budget constraint by showing the maximum consumption possible of 2 meals that Kate can afford, given the prices of the 2 meals, when all her income is spent.
Let’s re-examine Kate’s choices. What if Kate were no longer constrained by her income? Suppose she got a promotion at work and now earns more income. That increase in income will allow her to spend more on lunches out. She sets aside $200 a month! We will invoke ceteris paribus, ruling out any other factors changing.
Let’s work through the numbers first. Prices for the meals have not changed. With double the budget Kate can now afford either:
If we graph her budget, the 20 Mexican meals or 20 Italian meals are the two endpoints. Drawing a line to connect these two points creates a budget line. You will see that whenever there is an increase in income, the budget line simply shifts rightward, parallel to the original line.
Not surprisingly, there is still more we can learn when budget lines shift. In the lesson about elasticity, you learned how to classify goods as either normal goods or inferior goods based on a change in income. Using budget lines we can examine these concepts graphically.
In the graph below, income increased and the budget line shifted outward. Notice the two dots, one red and the other blue. Before the budget line shifted, the consumer purchased 4 Mexican meals and 8 Italian meals. After the change in income, the consumer purchased 16 Mexican meals and only 4 Italian meals. Given the increased number of Mexican meals from 4 to 16 with a budget increase, we classify the Mexican meals as a normal good for this consumer. And the reduction from 8 to 4 Italian meals with a budget increase implies that for this consumer Italian meals are an inferior good.
If the consumer buys an increased quantity of one good when consumer income increases, then the good is classified as a normal good. If the consumer buys a smaller quantity of a good as consumer income rises, then the good is classified as an inferior good.
Let’s reconsider Kate’s choices in light of changes in the price of the meals. Simply defined, prices are the cost of goods or services to the consumer. How will Kate’s choices change when prices change?
Suppose the Italian restaurant decides to end its luncheon special, and now it is going to cost Kate $20 to get lunch there. This will certainly impact her budget constraint, and ultimately, her final choice as well. Notice that Kate's budget itself is not changing; she still has a budget of $100. It is only the price of Italian meals that increased.
Below is the graph with the original budget constraint, Kate was able to afford 10 and 10 of each type of meal ( line) with her $100. Now, however, there is a new budget line ().
Notice that nothing changed with the Mexican restaurant meals—they are still priced at $10 per meal and with a $100 budget, Kate can still afford 10 meals. However, the maximum number of Italian meals is only 5, half as many as before.
At the endpoints, the new budget line shows that Kate can now afford either:
).
The effect on the budget line is a pivot. It did not shift parallel with the original budget line (), because the income constraint did not change.
A change in income would have shifted the entire budget line parallel to the original line, but that did not happen. The change in the price of meals was related to the Italian restaurant. So only the quantity of Italian restaurant meals was affected.
Next, let’s consider how the price change of the Italian meal causes both the substitution and income effects.
With the price increase for Italian meals, Kate can now afford:
Now that Italian meals have become more expensive, Kate is dining at the Mexican restaurant more than the Italian restaurant. Like most shoppers respond to higher prices, Kate has substituted away from the more expensive $20 Italian meal to the relatively less expensive $10 Mexican meal. She is still dining in both restaurants but buying 5 fewer Italian meals than before the price increase. This is what we call the substitution effect. The substitution effect refers to the change in demand for a good when price rises, and shoppers choose less expensive substitute goods or services, if available. A relative price increase reduces the quantity demanded for the higher-priced product.
Next, to understand the income effect of a price increase, let’s go back to the graph and examine the budget line ().
Suppose that when the price of Italian meals went up to $20 a meal and the new budget line pivoted inward, that it also shifted. With her budget of $100, Kate not only bought fewer Italian meals, but she also purchased fewer Mexican meals. This is what we call the income effect. The income effect states that changes in the prices of products affect the buying power of our income and affecting demand for all goods or services. Price increases make us poorer so we reduce our overall purchases—both Mexican and Italian meals.
IN CONTEXT
Suppose you decide that chili is on your menu for dinner. But you are out of hamburger and make a quick trip to the store. At the meat counter, you see your favorite brand of 90% lean ground beef for $5 per pound. The 85% lean ground beef is priced at $2.00 less per pound. What do you do? Do you buy the more expensive ground beef? Maybe not. Most shoppers at this point would dismiss the more expensive ground beef and substitute it for the lower priced 85% lean ground beef. If this is your reaction, then you have just demonstrated the substitution effect of a price rise on one product.
Now, let’s consider the effect of rising prices on the stuff you typically buy when your income doesn’t change. You’re still making that chili. You wander over to the canned foods aisle. A quick scan tells you that ground beef is not the only product with higher prices. Cans of kidney beans, black beans, and stewed tomatoes are now priced higher. Not much higher but enough to notice. Are you sensing that even though your income hasn’t changed it might be more difficult to make your budget stretch across all these higher priced items? If this is your reaction, then you are experiencing the income effect. When prices rise, it makes us poorer because we have to spend more on things we used to spend less on. When the prices of groceries increases you will walk out of the store with fewer bags of groceries than before the price increases.
When product prices rise, consumers often substitute away from a higher-priced good to a similar lower-priced substitute product. Also, a higher price for one good can lead to more or less demand for the other good if the goods are related (complements or substitutes).
Source: THIS TUTORIAL HAS BEEN ADAPTED FROM OPENSTAX “PRINCIPLES OF ECONOMICS 2E”. ACCESS FOR FREE AT https://openstax.org/books/principles-economics-2e/pages/1-introduction. LICENSE: CC ATTRIBUTION 4.0 INTERNATIONAL.
