CHAPTER 2 THEORETICAL TOOLS OF PUBLIC FINANCE 33

to see two movies. In essence, he is trading the CD for two movies, even though
in reality he accomplishes the trade using money rather than the goods them-
selves. When a persons budget is fixed, if he buys one thing he is, by definition,
reducing the money he has to spend on other things. Indirectly, this purchase
has the same effect as a direct good-for-good trade.

Putting It All Together: Constrained Choice

Armed with the notions of utility functions and budget constraints, we can
now ask: What is the utility-maximizing bundle that consumers can afford?
That is, what bundle of goods makes consumers best off, given their limited
resources?
The answer to this question is shown in Figure 2-6. This figure puts to-
gether the indifference curves corresponding to the utility function U
Q
C
QM shown in Figure 2-4 with the budget constraint shown in Figure
2-5. In this framework, we can rephrase our question: What is the highest indif-
ference curve that an individual can reach given a budget constraint? The answer is the
indifference curve, IC2, that is tangent to the budget constraint: this is the far-
thest-out indifference curve that is attainable, given Andreas income and mar-
ket prices. In this example, Andrea makes herself as well off as possible by
choosing to consume 6 movies and 3 CDs (point A). That combination
of goods maximizes Andreas utility, given her available resources and market
prices.

FIGURE 2-6

Quantity of
CDs, QC Budget Constrained Optimization
constraint, Given a utility function of
BC1 U QC
QM , an income of
6 $96, and prices of CDs and
movies of $16 and $8, respec-
tively, Andreas optimal choice is
3 CDs and 6 movies (point A ).
B
This represents the highest
indifference curve she can reach,
A given her resources and market
3 IC3 prices. She can also afford
IC2 points such as B and C, but they
leave her on a lower indifference
IC1
C curve ( IC1 instead of IC2 ).

6 12 Quantity of
movies, QM