Consumer Choice

1
Chapter 7

• Consumer Choice
• Utility is the satisfaction a consumer obtains
  from a product.
• Economists assume that people act so as to
  maximize utility.
• In studying consumer choice, economists assume
  tastes and
• preferences are given and can be used to
  describe the process of
• decision making
• Recall QD is a function of (P, Income, Price of
  related goods, tastes/preferences, expectations,
  of sellers, etc)

2
Decision Making

• People compare the perceived costs and benefits
  of
• alternatives and select those that they believe
  give them
• the greatest relative benefits, i.e. Cost-Benefit
  Analysis in
• decision-making
• Utility is a measure of the satisfaction received
  from
• possessing or consuming goods and services.
• Tastes and preferences are fixed and given, and
  play a large role in decision making.
• Consumers make choices that give them the
  greatest utilitythey maximize utility.

3
Marginal Utility

• Marginal utility the extra utility derived from
  consuming one more unit of a good or service.
• Principle of diminishing marginal utility the
  more of a good that one obtains in a specific
  period of time, the less the additional utility
  derived from an additional unit of the good.
• Disutility dissatisfaction, example for most
  people, work has a disutility to it

4
Total and Marginal Utility
Slope MUListening?TU/?Listening Hours
5
Diminishing Marginal Utility

• Utility diminishes over timethe shorter the time
  period, the more quickly marginal utility
  diminishes.
• Consumers are not identicalthe rate at which
  marginal utility diminishes depends on individual
  tastes and preferences, and so differs across
  consumers.

6
Red Lobsters All You Can Eat?

• All You Can Eat assume that you will stop
  eating when your marginal utility falls to zero,
  MU0 (i.e. not too many people are gluttons).
• Red Lobster charged customers 20 for an
  all-you-can-eat crab dinner, but it wasn't
  enough.
• Most peoples marginal utility rate is about 2.25
  pounds of crab.
• Contest Eating group of 5 ate 18 pounds of crab.
• Another had 30 refills of crab legs.
• As the wholesale prices of crab rose to 5/lb and
  higher,
• the consumption rate made the promotion
  unprofitable for
• Red Lobster.

7
Consumer Choice

• Each consumer allocates a specific budget to
  expenditure (Budget Constraint), and then
  allocates the expenditure to maximize utility
  (makes choices of goods/services that satisfy the
  Budget Constraint).
• If two goods offer the same marginal utility, the
  consumer will be indifferent between the two.

8
Consumer Equilibrium

• Equi-marginal principle To maximize utility,
  consumers allocate their incomes among goods so
  as to equate the marginal utilities per dollar
  (MU/P) of the expenditure on the last unit of
  each good purchased.
• This is also referred to as the consumer
  equilibrium.

C. With such choices, the consumer has no reason
to alter her/his basket unless (a) prices
change, (b) income changes or (c ) both change D.
If both income and prices change proportionately,
there is no change in consumer equilibrium either.
9
Application

• Question Mr. Rational has 27 that he plans to
  spend purchasing 5 units of good X (priced at 3
  per unit) and 6 units of good Y (priced at 2 per
  unit). The marginal utility of the fifth unit of
  X is 30, and the marginal utility of the sixth
  unit of Y is 30. If Mr. Rational is a utility
  maximizer, he should
• not buy anything.
• buy more of X and less of Y.
• buy less of X and more of Y.
• buy X and Y in the quantities indicated.
• do none of these because, from the information
  given, it is impossible to determine whether Mr.
  Rational is maximizing utility.
• Key MUX/PX MUY/PY
• 30/3
• How to adjust purchases to achieve equilibrium,
  MUX/PX MUY/PY
• ? Apply the Principle of DMU.
• Buy less of X (so ?MUX) and more Y (?MUY) until
  consumer equilibrium is achieved. So
• the Choice is C

10
The Downward Slope of the Demand Curve

• The inverse relation between price and quantity
  demanded arises from diminishing marginal utility
  and consumer equilibrium, i.e. P QD are
  inversely related because of DMU
• A change in the price of any good disturbs the
  consumers equilibriumthe ratio of MU/P on the
  last unit of each good will no longer be equal.
• The consumer must reallocate income across goods.
• With income fixed, if the price of one good
  rises, the consumer is able to buy fewer goods
  and services, causing demand to fall.

11
Consumer Surplus

• An individual consumers demand curve measures
  the value that the consumer places on each unit
  of good being considered.
• Consumer surplus is a measure of the difference
  between what a consumer is willing and able to
  pay for a unit of the good and the market price
  of a good that the consumer actually has to pay.

12
Consumer Surplus and the Demand for Used CDs
Consumer surplus 0 at 1 price
13
Demand Curve for Used CDs
14
Shifts of Demand

• When the price of one good falls (P?) while
  everything
• else is constant, two things occur
• Other goods become relatively more expensive, so
  consumers buy more of the less expensive good and
  less of the more expensive goods. This is called
  the substitution effect. Always ensures a
  downward-sloping demand curve.
• The consumer can buy more total goods with the
  same income. This is called the income effect.
• If the good is inferior, the income effect moves
  in opposite direction to the substitution effect
  and yields a positively-sloped demand curve!
• If the good is normal, then both the income
  substitution effects yield a down-sloping demand
  curve.
• Evidence shows that for most goods, outcome B is
  the rule
• Outcome A (Giffen good) has not been found in
  practice.

15
Shifts of Demand, Continued

• The individual demand curve is defined by income,
  tastes and preferences, the price of the good,
  and the price of related goods.
• If any of these things change, the individuals
  demand curve will change. For each change, a new
  demand curve is derived.
• The market demand curve is the sum of all the
  individual demand curves. Anything that affects
  individual demand curves, affects the market
  demand curve.
• The number of consumers also affects the market
  demand curve.

16
Beyond Rationality Behavioral Economics
Neuroeconomics

• Bounded rationality admits that complete and
  perfect information is unlikely and that people
  make decisions that may seem irrational, but in
  reality are the rational results of a brain that
  is economizing.
• Behavioral economics study of decision making
  that assume people are rational in a broad sense-
  attempts to catalogue the biases (from a mix of
  logic and emotions) that result from bounded
  rationality.

17
Biases Affecting Logic i.e. non-rationality1

• Overconfidence and illusion people tend to
  think they are better and do things better than
  is really the case.e.g. 80-year olds who think
  they are good drivers!
• Mental Accounting the value people place on
  money depends on where that money comes from.
• Status Quo people would rather leave things as
  they are, i.e. aversion to loss
• Loss Aversion gains and losses are calculated
  relative to a reference. If gas price increases
  from 2 to 3, they see a 1 loss instead of 3!
• Framing the context in which the decision is
  made is important hotels quote the highest
  price on reservations to frame your mind.

18
Biases Affecting Logic2

• Familiarity people are more comfortable with a
  familiar situation than an unfamiliar
  one.(Familiar) New York is well-known for murder
  BUT suicide is higher (fact). Most people would
  cite NY for murder because that represents
  familiarity in the news!
• Anchoring the tendency to rely too heavily on
  one piece of information (first numbers) when
  making decisions.E.g. which series produces the
  largest number?
• A 1x2x3X4X5 Or B 5x4X3X2X1. Truth is both yield
  120!
• Sunk Costs costs that are not recoverable. When
  individuals put effort into something, most are
  reluctant to back out even if staying on the same
  course leads more loss. e.g. continuing US
  presence in Iraq??

19
Neuroeconomics

• Neuroeconomics study of how the embodied brain
  interacts with its external environment to
  produce economic behavior.
• Some economists have joined forces with
  biologists and neurologists to attempt to see how
  the brain handles economic decisions. Thus, it is
  important for predicting behavior e.g. marketing
  campaigns!
• MRI scans have revealed the two parts of the
  brain in which most decisions take place logical
  part (prefrontal lobe) and emotional part
  (amygdala).
• Most of traditional economics completely ignored
  the emotional part and focused on rationality
  only!
• In turns out that decision-making is often a
  conflict between logic (pre-frontal lobe)
  involving cost-benefit analysis as outlined early
  in this chapter and emotions (amygdala).
• Often amygdala takes over (gambling) for
  immediate gratification when the pre-frontal lobe
  would suggest otherwise!

20
The Anatomy of the Brain
MRI scans have revealed the two parts of the
brain in which most decisions take place.
Well-known that different sectors of the human
pre-frontal cortex has distinctive cognitive
behavioral functions The logical part is the pre
frontal cortex. (a) Frontal lobe (10 11)
decision-making where strategic thinking occurs
(b) orbital frontal lobe (CFC) (12) --- pleasure
or pain of monetary rewards punishment
(gambling wins/losses). Rewards punishment are
processed in a different part of the brain the
right CFC. The emotional part is the limbic
system (especially the amygdala).