[Joana] The way we make choices about what to buy

depends on how our dreams, our wants, meet reality.

We've covered thinking on the margin,

budget constraints, and indifference curves.

Now let's bring this all together

to model how you decide what to purchase.

Remember, your budget constraint represents

how the market values goods

and what you can afford, given your income.

Your indifference curves represent how you value goods

based on your personal preferences.

We all wish we could have more of everything.

We would love to be way out here

where we can consume as much as we want.

But the reality is that we have limited resources

and the prices of things force us to make tradeoffs.

We want to get the best bang for our buck

and that means finding that optimal combination of goods

that brings together how the market values goods

and our preferences.

That's what this graph,

illustrating your indifference curves

and budget constraint, lets us better understand.

When you make a decision,

you are effectively trying to be the happiest that you can,

given the constraints that you face.

You are, without knowing, solving

a "constrained optimization" problem, where you are choosing

the combination of goods that maximize your utility

given the prices of goods and your income.

Let's go back to our pizza and coffee example.

You have a budget of $50. Pizza costs $10.

And each cup of coffee costs $5.

Now, let's assume your indifference map

looks like this.

Making the best choice you can afford means

you will spend your entire budget

on the combination of pizzas and cups of coffee

that make you the happiest.

This means that your optimal consumption combination

is on your budget line.

Making the best choice you can afford also means

that you will try to reach the indifference curve

that represents the highest degree of satisfaction or utility.

Because pizza and coffee are good things --

things that make you happy --

this will occur on the indifference curve

that is the farthest away from the origin.

Why?

Because the more pizza and coffee you have,

the happier you are.

What keeps you from reaching this indifference curve?

If you thought prices and income, you are right!

Your budget constraint determines what you can afford.

So your optimal consumption combination will be

where your budget constraint is tangent

to the highest indifference curve.

To see why, let's go back to thinking about

why you try to reach the indifference curve

that is the farthest away from the origin.

The best way to go about it is to look at a point

where the budget line intersects one of your indifference curves.

This particular combination of pizza and coffee --

it's affordable, because it's on your budget line.

However, you are not the happiest you could be, now are you?

Given your preferences,

it's clear that you would be happier

if you could buy this combination.

It has more pizza,

and just as many cups of coffee.

But, hey, it's beyond your budget.

But now look at this.

You are indifferent between this combination

and this combination.

Both are on the same indifference curve,

and that means they provide you with the same utility.

So, if you are trying to get the most utility you can,

given what you can afford,

you will never choose a combination of goods

that intersects your budget constraint.

You will choose one that is tangent to it.

The point of tangency between the budget constraint

and the indifference curve also means

that at your optimal consumption combination,

the market's relative price of the goods equals

your willingness to substitute between them --

and that's your marginal rate of substitution.

Another way to see this is to recognize

that at your best choice,

the marginal utility per dollar of both goods is the same.

Let's go back to thinking at the margin.

At this point, would it make you happier

to spend more money on pizza and less on coffee?

Here, the marginal rate of substitution is 4,

and that means you are willing to forego four cups of coffee

to get one additional pizza.

But pizza is only twice as expensive as coffee.

So this is great news for you.

The market is asking you to forego fewer cups of coffee

than you are willing to.

So you get that extra pizza.

Another way to think about this is to realize that at this point,

your marginal utility per dollar of pizza is greater

than your marginal utility per dollar from cups of coffee.

Remember, as you get more pizzas,

and are left with fewer cups of coffee,

your marginal utility from pizzas is decreasing,

and your marginal utility from cups of coffee is increasing.

You will stop getting additional pizzas

when your marginal utility per dollar

from both goods is equal.

Of course, very few of us calculate marginal utility

or think of constrained optimization

when we choose what to buy.

But these concepts can help you understand your world

and guide you how to make better decisions in the future.

[Narrator] You're on your way to mastering economics.

Make sure this video sticks

by taking a few quick practice questions.

Or, if you're ready for more microeconomics,

click for the next video.

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