consumer choice and behavioral economics

1 of 49Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.

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The Kindle can download books wirelessly. The Kindle experienced steady sales in

the months following its introduction, and then it

received a huge boost from talk-show host Oprah

Winfrey.

Consumer Choice and Behavioral Economics

CHAPTER 9

Fernando Quijano

Prepared by:


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9.1 Utility and Consumer Decision MakingDefine utility and explain how consumers

choose goods and services to maximize their utility.

9.2 Where Demand Curves Come FromUse the concept of utility to explain the law of

demand.

9.3 Social Influences on Decision MakingExplain how social influences can affect

consumption choices.

9..4 Behavioral Economics: Do People Make Their Choices Rationally?Describe the behavioral economics approach to understanding decision making.

Appendix: Using Indifference Curves and Budget Lines to Understand Consumer BehaviorUse indifference curves and budget lines to understand consumer behavior.

CHAPTER 9Chapter Outline and Learning Objectives

Consumer Choice and Behavioral Economics


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Utility and Consumer Decision Making

The Economic Model of Consumer Behavior in a Nutshell

The economic model of consumer behavior predicts that consumers will choose to buy the combination of goods and services that makes them as well off as possible from among all the combinations that their budgets allow them to buy.

Utility

Utility The enjoyment or satisfaction people receive from consuming goods and services.

Define utility and explain how consumers choose goods and services to maximize their utility.

9.1 LEARNING OBJECTIVE


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Marginal utility (MU) The change in total utility a person receives from consuming one additional unit of a good or service.

Law of diminishing marginal utility The principle that consumers experience diminishing additional satisfaction as they consume more of a good or service during a given period of time.

The Principle of Diminishing Marginal Utility




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FIGURE 9-1Total and Marginal Utility from Eating Pizza on Super Bowl Sunday

The Principle of Diminishing Marginal Utility

The figure shows that for the first 5 slices of pizza, the more you eat, the more your total satisfaction, or utility, increases.If you eat a sixth slice, you start to feel ill from eating too much pizza, and your total utility falls. Each additional slice increases your utility by less than the previous slice, so your marginal utility from each slice is less than the one before. Panel (a) shows your total utility rising as you eat the first 5 slices and falling with the sixth slice. Panel (b) shows your marginal utility falling with each additional slice you eat and becoming negative with the sixth slice. The height of the marginal utility line at any quantity of pizza in panel (b) represents the change in utility as a result of consuming that additional slice. For example, the change in utility as a result of consuming 4 slices instead of 3 is 6 utils, so the height of the marginal utility line in panel (b) for the fourth slice is 6 utils.




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The Rule of Equal Marginal Utility per Dollar Spent

Budget constraint The limited amount of income available to consumers to spend on goods and services.

Table 9-1Total Utility and Marginal Utility from Eating Pizza and Drinking Coke

NUMBER OFSLICES OF

PIZZA

TOTAL UTILITYFROM EATING

PIZZA

MARGINAL UTILITY

FROM THELAST SLICE

NUMBER OF CUPS OF

COKE

TOTAL UTILITYFROM

DRINKING COKE

MARGINAL UTILITYFROM THELAST CUP

0 0 -- 0 0 --1 20 20 1 20 202 36 16 2 35 153 46 10 3 45 104 52 6 4 50 55 54 2 5 53 36 51 3 6 52 1




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(1)SLICES

OF PIZZA

(2)MARGINAL UTILITY

(MUPIZZA)

(3)MARGINAL

UTILITYPER DOLLAR (4)

CUPSOF COKE

(5)MARGINAL UTILITY

(MUCOKE)

(6)MARGINAL

UTILITYPER DOLLAR

1 20 10 1 20 20

2 16 8 2 15 15

3 10 5 3 10 10

4 6 3 4 5 5

5 2 1 5 3 3

6 3 1.5 6 1

-1

Coke

Coke

PMU

Table 9-2Converting Marginal Utility to Marginal Utility per Dollar



Pizza

Pizza

PMU


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COMBINATIONS OF PIZZA AND COKE WITH EQUAL MARGINAL UTILITIES

PER DOLLAR

MARGINAL UTILITYPER DOLLAR

(MARGINAL UTILITY/PRICE) TOTAL SPENDING TOTAL UTILITY

1 slice of pizza and 3 cups of Coke 10 $2 + $3 = $5 20 + 45 = 65

3 slices of pizza and 4 cups of Coke 5 $6 + $4 = $10 46 + 50 = 96

4 slices of pizza and 5 cups of Coke 3 $8 + $5 = $13 52 + 53 = 105

Table 9-3Equalizing Marginal Utility per Dollar Spent


We can summarize the two conditions for maximizing utility:

1.

2. Spending on pizza + Spending on Coke = Amount available to be spent

Pizza

Pizza PMU

Coke

Coke

PMU




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Solved Problem 9-1Finding the Optimal Level of Consumption

NUMBER OFICE CREAM

CONES

TOTAL UTILITY FROM

ICE CREAM CONES

MARGINAL UTILITY

FROM LAST CONE

NUMBER OFCANS OF LIME FIZZ

TOTAL UTILITY FROM

CANS OF LIME FIZZ

MARGINAL UTILITY FROM

LAST CAN

0 0 -- 0 0 --

1 30 30 1 40 40

2 55 25 2 75 35

3 75 20 3 101 26

4 90 15 4 119 18

5 100 10 5 134 15

6 105 5 6 141 7




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Solved Problem 9-1Finding the Optimal Level of Consumption (continued)

ICE CREAM CONES CANS OF LIME FIZZ

QUANTITY MU MU1 30 15 40 40

2 25 12.5 35 35

3 20 10 26 26

4 15 7.5 18 18

5 10 5 15 15

6 5 2.5 7 7

YOUR TURN: For more practice, do related problems 1.7 and 1.8 at the end of this chapter.



PMU

PMU


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What if the Rule of Equal Marginal Utility per Dollar Does Not Hold?

Don’t Let This Happen to YOU!Equalize Marginal Utilities per Dollar

The idea of getting the maximum utility by equalizing the ratio of marginal utility to price for the goods you are buying can be difficult to grasp.



YOUR TURN: Test your understanding by doing elated problem 1.10 at the end of this chapter.


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Income effect The change in the quantity demanded of a good that results from the effect of a change in price on consumer purchasing power, holding all other factors constant.

Substitution effect The change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods, holding constant the effect of the price change on consumer purchasing power.

The Income Effect and Substitution Effect of a Price Change




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INCOME EFFECT

SUBSTITUTION EFFECT

PRICE DECREASE

Increases the consumer‘s purchasing power, which . . .

causes the quantity demanded to increase, if a normal good.

causes the quantity demanded to decrease, if an inferior good,

Lowers the opportunitycost of consuming the good, which causes the quantity of the good demanded to increase.

PRICE INCREASE

Decreases the consumer's purchasing power, which . . .

causes the quantity demanded to decrease, if a normal good.

causes the quantity demanded to increase, if an inferior good,

Raises the opportunity cost of consuming the good, which causes the quantity of the good demanded to decrease.

Table 9-4Income Effect and Substitution Effect of a Price Change





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NUMBEROF

SLICESOF PIZZA

MARGINAL UTILITY

FROM LAST SLICE

(MUPIZZA)

MARGINAL UTILITY PER

DOLLARNUMBER OF

CUPSOF COKE

MARGINAL UTILITY

FROM LAST CUP

(MUCOKE)

MARGINAL UTILITY PER

DOLLAR

1 20 13.33 1 20 20

2 16 10.67 2 15 15

3 10 6.67 3 10 10

4 6 4 4 5 5

5 2 1.33 5 3 3

6 3 – 6 1 –

Table 9-5Adjusting Optimal Consumption

to a Lower Price of Pizza




Coke

Coke

PMU

Pizza

Pizza

PMU


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Where Demand Curves Come From

FIGURE 9-2Deriving the Demand Curve for PizzaA consumer responds optimally to a fall in the price of a product by consuming more of that product. In panel (a), the price of pizza falls from $2 per slice to $1.50, and the optimal quantity of slices consumed rises from 3 to 4.When we graph this result in panel (b),we have the consumer’s demand curve.

Use the concept of utility to explain the law of demand.



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Where Demand Curves Come FromFIGURE 9-3Deriving the Market Demand Curve from Individual Demand Curves

Use the concept of utility to explain the law of demand.


The table shows that the total quantity demanded in a market is the sum of the quantities demanded by each buyer. We can find the market demand curve by adding horizontally the individual demand curves in parts (a), (b), and (c). For instance, at a price of $1.50, your quantity demanded is 4 slices, David’s quantity demanded is 6 slices, and Lori’s quantity demanded is 5 slices. Therefore, part (d) shows a price of $1.50, and a quantity demanded of 15 is a point on the market demand curve.


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Social Influences on Decision Making

The Effects of Celebrity Endorsements

In many cases, it is not just the number of people who use a product that makes it desirable but the types of people who use it.

If consumers believe that media stars or professional athletes use a product, demand for the product will often increase.

Sociologists and anthropologists have argued that social factors such as culture, customs, and religion are very important in explaining the choices consumers make.

Economists have traditionally seen such factors as being relatively unimportant, if they take them into consideration at all.

Recently, however, some economists have begun to study how social factors influence consumer choice.

Explain how social influences can affect consumption choices.



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Are There Any Upward-SlopingDemand Curves in the Real World?

Makingthe

Connection

For a demand curve to be upward sloping, the good would have to be an inferior good and the income effect would have to be larger than the substitution effect.

Goods with upward-sloping demand curves, referred to as Giffen goods, are difficult to find.



Rice is a Giffen good in poor parts of China.

YOUR TURN: Test your understanding by doing related problem 2.7 at the end of this chapter.


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Why Do Firms Pay Tiger Woodsto Endorse Their Products?

Makingthe

Connection

The average weekend golfer might believe that if Tiger endorses Nike golf balls, maybe Nike balls are better than other golf balls.

But it seems more likely that people buy products associated with Tiger Woods or other celebrities because using these products makes them feel closer to the celebrity endorser or because it makes them appear to be fashionable.



Tiger Woods earns much more from product endorsements than from playing golf.

YOUR TURN: Test your understanding by doing related problem 3.9 at the end of this chapter.


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Network Externalities

Network externality A situation in which the usefulness of a product increases with the number of consumers who use it.

Does Fairness Matter?

A Test of Fairness in the Economic Laboratory: The Ultimatum Game Experiment

Economists have used experiments to increase their understanding of the role that fairness plays in consumer decision making.




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Does Fairness Matter?

Business Implications of Fairness

FIGURE 9-4The Market for Tickets to The Producers



The St. James Theater could have raised prices for the Broadway musical The Producers to $125 per ticket and still sold all of the 1,644 tickets available. Instead, the theater kept the price of tickets at $75, even though the result was a shortage of more than 400 seats. Is it possible that this strategy maximized profits?


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Professor Krueger Goes to the Super Bowl

Makingthe

Connection

Should the NFL raise the price of Super Bowl tickets?



Krueger concluded that whatever the NFL might gain in the short run from raising ticket prices, it would more than lose in the long run by alienating football fans.

YOUR TURN: Test your understanding by doing related problems 3.11 and 3.12 at the end of this chapter.


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Behavioral Economics: Do People Make Their Choices Rationally?

Behavioral economics The study of situations in which people make choices that do not appear to be economically rational.

• They take into account monetary costs but ignore nonmonetary opportunity costs.

• They fail to ignore sunk costs.

• They are unrealistic about their future behavior.

Consumers commonly commit the following three mistakes when making decisions:

Describe the behavioral economics approach to understanding decision making.



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Behavioral Economics: Do People Make Their Choices Rationally?Ignoring Nonmonetary Opportunity Costs

Opportunity cost The highest-valued alternative that must be given up to engage in an activity.

Endowment effect The tendency of people to be unwilling to sell a good they already own even if they are offered a price that is greater than the price they would be willing to pay to buy the good if they didn’t already own it.




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A Blogger Who Understandsthe Importance ofIgnoring Sunk Costs

Makingthe

Connection

Would you give up being a surgeon to start your own blog?



YOUR TURN: Test your understanding by doing related problems 4.7, 4.8, and 4.9 at the end of this chapter.

Knowing that it is rational to ignore sunk costs can be important in making key decisions in life.


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Behavioral Economics: Do People Make Their Choices Rationally?Failing to Ignore Sunk Costs

Sunk cost A cost that has already been paid and cannot be recovered.

Being Unrealistic about Future Behavior

If you are unrealistic about your future behavior, you underestimate the costs of choices that you make today.




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Why Don’t Students Study More?Making

theConnection

If the payoff to studying is so high, why don’t students study more?



Many students study less than they would if they were more realistic about their future behavior.

YOUR TURN: Test your understanding by doing related problems 4.10 and 4.11 at the end of this chapter.


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Solved Problem 9-4How Do You Get People toSave More of Their Income?

Use your understanding of consumer decision making to show how a savings plan may work.



YOUR TURN: For more practice, do related problems 4.12 and 4.13 at the end of this chapter.


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The Power of Oprah’s Kindle Endorsement

>>AN INSIDE LOOK

When successful, a celebrity endorsement can shift the demand curve for a product to the right, from D1 to D2.


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Behavioral economics

Budget constraint

Endowment effect

Income effect

Law of diminishing marginal utilityMarginal utility (MU)

Network externality

Opportunity cost

Substitution effect

Sunk cost

Utility

KEY TERMS


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Appendix

CONSUMPTION BUNDLE A CONSUMPTION BUNDLE B

2 slices of pizza and 1 can of Coke 1 slice of pizza and 2 cans of Coke

We assume that the consumer will always be able to decide which of the following is true:

• The consumer prefers bundle A to bundle B.

• The consumer prefers bundle B to bundle A.

• The consumer is indifferent between bundle A and bundle B; that is, the consumer receivesequal utility from the two bundles.

Using Indifference Curves and Budget Lines toUnderstand Consumer BehaviorConsumer Preferences

Use indifference curves and budget lines to understand consumer behavior.

LEARNING OBJECTIVE


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Appendix

Indifference Curves

Indifference curve A curve that shows the combinations of consumption bundles that give the consumer the same utility.

Consumer Preferences


LEARNING OBJECTIVE


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Appendix

FIGURE 9A-1Plotting Dave’s Preferencesfor Pizza and Coke


Every possible combination of pizza and Coke will have an indifference curve passing through it, although in the graph we show just four of Dave’s indifference curves. Dave is indifferent among all the consumption bundles that are on the same indifference curve. So, he is indifferent among bundles E,B, and F because they all lie on indifference curve I3. Moving to the upper right in the graph increases the quantities of both goods available for Dave to consume. Therefore, the further to the upper right the indifference curve is, the greater the utility Dave receives.


LEARNING OBJECTIVE


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Appendix

Marginal rate of substitution (MRS) The rate at which a consumer would be willing to trade off one good for another.

The Slope of an Indifference Curve



LEARNING OBJECTIVE


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Appendix

Can Indifference Curves Ever Cross?Consumer Preferences

FIGURE 9A-2Indifference CurvesCannot CrossBecause bundle X and bundle Z are both on indifference curve I1, Dave must be indifferent between them. Similarly, because bundle X and bundle Y are on indifference curve I2, Dave must be indifferent between them. The assumption of transitivity means that Dave should also be indifferent between bundle Z and bundle Y. We know that this is not true, however, because bundle Y contains more pizza and more Coke than bundle Z. So Dave will definitely prefer bundle Y to bundle Z, which violates the assumption of transitivity. Therefore, none of Dave’s indifference curves can cross.


LEARNING OBJECTIVE


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Appendix

FIGURE 9A-3Dave’s Budget Constraint

The Budget Constraint

Dave’s budget constraint shows the combinations of slices of pizza and cans of Coke he can buy with $10. The price of Coke is $1 per can, so if he spends all of his $10 on Coke, he can buy 10 cans (bundle G).The price of pizza is $2 per slice, so if he spends all of his $10 on pizza, he can buy 5 slices (bundle L).As he moves down his budget constraint from bundle G, he gives up 2 cans of Coke for every slice of pizza he buys. Any consumption bundles along the line or inside the line are affordable. Any bundles that lie outside the line are unaffordable.


LEARNING OBJECTIVE


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Appendix

FIGURE 9A-4Finding Optimal Consumption

Choosing the Optimal Consumption of Pizza and Coke

Dave would like to be on the highest possible indifference curve, but he cannot reach indifference curves such as I4 that are outside his budget constraint. Dave’s optimal combination of slices of pizza and cans of Coke comes at point B, where his budget constraint just touches—or is tangent to—the highest indifference curve he can reach. At point B, he buys 3 slices of pizza and 4 cans of Coke.


LEARNING OBJECTIVE


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Dell Determines the OptimalMix of Products

Makingthe

Connection

Consumers in panel (a) of the figure prefer screen size to processor speed.

Consumers in panel (b) prefer processor speed to screen size.

YOUR TURN: Test your understanding by doing related problem 9A.8 at the end of this chapter.


LEARNING OBJECTIVE


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Appendix

FIGURE 9A-5How a Price Decrease Affects the Budget Constraint

Choosing the Optimal Consumption of Pizza and CokeDeriving the Demand Curve

A fall in the price of pizza from $2 per slice to $1 per slice increases the maximum number of slices Dave can buy with $10 from 5 to 10. The budget constraint rotates outward from point A to point B to show this.


LEARNING OBJECTIVE


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Appendix

FIGURE 9A-6How a Price Change Affects Optimal Consumption

Choosing the Optimal Consumption of Pizza and CokeDeriving the Demand Curve

In panel (a), a fall in the price of pizza results in Dave’s consuming less Coke and more pizza.1. A fall in the price of pizza rotates the budget constraint outward because Dave can now buy more pizza with his $10.2. In the new optimum on indifference curve I2, Dave changes the quantities he consumes of both goods. His consumption of Coke falls from 4 cans to 3 cans. 3. In the new optimum, Dave’s consumption of pizza increases from 3 slices to 7 slices.In panel (b) Dave responds optimally to the fall in the price of pizza from $2 per slice to $1, by increasing the quantity of slices he consumes from 3 slices to 7 slices. When we graph this result, we have Dave’s demand curve for pizza.


LEARNING OBJECTIVE


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Appendix

Solved Problem 9A-1When Does a Price Change Make a Consumer Better Off?

Because Dave can now reach a higher indifference curve, we can conclude that he is better off as a result of the price change.

YOUR TURN: For more practice, do related problem 9A.10 at the end of this chapter.


LEARNING OBJECTIVE


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Appendix

FIGURE 9A-7Income and Substitution Effects of a Price Change

Choosing the Optimal Consumption of Pizza and CokeThe Income Effect and the Substitution Effect of a Price Change

Following a decline in the price of pizza, Dave’s optimal consumption of pizza increases from 3 slices (point A) per week to 7 slices per week (point C). We can think of this movement from point A to point C as taking place in two steps: The movement from point A to point B along indifference curve I1 represents the substitution effect, and the movement from point B to point C represents the income effect. Dave increases his consumption of pizza from 3 slices per week to 5 slices per week because of the substitution effect of a fall in the price of pizza and from 5 slices per week to 7 slices per week because of the income effect.


LEARNING OBJECTIVE


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Appendix

FIGURE 9A-8How a Change in Income Affects the Budget Constraint

Choosing the Optimal Consumption of Pizza and CokeHow a Change in Income Affects Optimal Consumption

When the income Dave has to spend on pizza and Coke increases from $10 to $20, his budget constraint shifts outward. With $10, Dave could buy a maximum of 5 slices of pizza or 10 cans of Coke. With $20,he can buy a maximum of 10 slices of pizza or 20 cans of Coke.


LEARNING OBJECTIVE


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Appendix

FIGURE 9A-9How a Change in Income Affects Optimal Consumption

Choosing the Optimal Consumption of Pizza and CokeHow a Change in Income Affects Optimal Consumption

An increase in income leads Dave to consume more Coke and more pizza.1. An increase in income shifts Dave’s budget constraint outward because he can now buy more of both goods.2. In the new optimum on indifference curve I2, Dave changes the quantities he consumes of both goods. His consumption of Coke increases from 4 cans to 6 cans.3. In the new optimum, Dave’s consumption of pizza increases from 3 slices to 7 slices.


LEARNING OBJECTIVE


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Appendix

FIGURE 9A-10At the Optimum Point, the Slopes of the Indifference Curve and Budget Constraint Are the Same

The Slope of the Indifference Curve, the Slope of the Budget Line, and the Rule of Equal Marginal Utility per Dollar Spent

At the point of optimal consumption, the marginal rate of substitution is equal to the ratio of the price of the product on the horizontal axis to the price of the product on the vertical axis.


LEARNING OBJECTIVE


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Appendix

) x pizza ofquanity in the (Change ) x Coke ofquanity in the (Change PizzaCoke MUMU

The Slope of the Indifference Curve, the Slope of the Budget Line, and the Rule of Equal Marginal Utility per Dollar Spent

The Rule of Equal Marginal Utility per Dollar Spent Revisited

From the equality above, we derive the optimal point of consumption:


LEARNING OBJECTIVE

Coke

Coke

Pizza

Pizza

PMU

PMU


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Indifference curve

Marginal rate of substitution (MRS)

KEY TERMS

consumer choice and behavioral economics

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