ABSTRACT
First, we need to step back and reect further on what is happening behind the demand and supply curves. The indifference curve analysis of Chapter 2 emphasised that price determines the rate at which an individual can trade off the good in question with other goods he also values. At the point at which the budget constraint is tangential to the indifference curve, the individual’s marginal rate of substitution of one good for another (the slope of the indifference curve) is equal to the price ratio (the slope of the budget constraint). Price then captures the value of the last unit of the good purchased (the marginal value) to the individual, in terms of whatever alternative good is considered. (When all choices have been made, the value of the last cent spent must be equal for each good purchased – assuming that an independent decision can be made over each cent.) Money therefore represents all other goods the individual values and knowledge of how demand changes as price changes tells us about how much individuals making up a market value each individual good at the margin.
