taxation and redistribution

– 𝑃,m/P,C

> 𝑀𝑅?

you get more utility buying fewer cakes and

more movies.

Substitution effect

Holding utility constant, a relative rise in

the price of a good will always cause an individual to choose

less of that good.

Income effect

A rise in the price of a good will typically cause

an individual to choose less of all goods because her income

can purchase less than before.

Social efficiency

Social efficiency represents the net gains to society from all

trades that are made in a market, and it consists of the sum of

two components: consumer and producer surplus. Also called

total social surplus.

• Consumer surplus: The benefit that consumers derive from

consuming a good, above and beyond the price they paid for

the good.

• Producer surplus: The benefit that producers derive from

selling a good, above and beyond the cost of producing that

good.

Social surplus

Social surplus for this market in equilibrium is the sum of the

shaded areas A + B + C + D + E

Explain why a consumer’s optimal choice is the point at which her budget constraint is

tangent to an indifference curve.

Consumers optimize their choice when they are on the highest possible indifference curve given

their budget constraint. Suppose a consumer’s choice is feasible (on the budget constraint) but not

at a tangency, as at point A in the accompanying figure. Under these circumstances, the budget

constraint must pass through the indifference curve where it intersects the chosen point. There

must then be at least a segment of the budget constraint that lies above (up and to the right of)

the indifference curve associated with that choice. Any choice on that segment would yield higher

utility. Only when no part of the budget constraint lies above the indifference curve associated with

a consumer’s choice are no feasible improvements in utility possible. The single tangency point (C

in the figure) is the only point at which this occurs.

You have $100 to spend on food and clothing. The price of food is $4 and the price

of clothing is $10.

First we determine the maximum amounts of food and clothing we can obtain if we buy only one

good. These values represent our intercept points.