1. Chapter 20
Consumer Choice

2. Introduction
Some economists suggest that governments should ban credit cards because the use of credit cards makes consumers more satisfied until they receive their credit-card bills.
As a result, banning credit cards would make people better off.
In this chapter, you will learn how economists study the way people make choices intended to maximize their levels of satisfaction.

3. Learning Objectives
Distinguish between total utility and marginal utility
Discuss why marginal utility first rises but ultimately tends to decline as a person consumes more of a good or service
Explain why an individual’s optimal choice of how much to consume of each good or service entails equalizing the marginal utility per dollar spent across all goods and services

4. Learning Objectives (cont'd)
Describe the substitution effect of a price change on the quantity demanded of a good or service
Understand how the real-income effect of a price change affects the quantity demanded of a good or service

5. Chapter Outline Utility Theory Graphical Analysis
Diminishing Marginal Utility
Optimizing Consumption Choices
How a Price Change Affects Consumer Optimum
The Demand Curve Revisited
Behavioral Economics and Consumer Choice Theory

6. Did You Know That ...
The human brain does its intelligent computing with 100,000,000,000 neurons?
Evidence indicates that all this computing power makes the human brain at least 10,000 times more intelligent than the most artificially constructed supercomputers.
In this chapter we discuss what is called utility analysis.

7. Utility Theory Utility Utility Analysis
The want-satisfying power of a good or service
Utility Analysis
The analysis of consumer decision making based on utility maximization

8. Utility Theory (cont’d)
A representative unit by which utility is measured
Developed by philosopher Jeremy Bentham; the school of thought is called utilitarianism

9. Utility Theory (cont'd)
Marginal Utility
The change in total utility due to a one-unit change in the quantity of a good or service consumed
Marginal utility =
Change in total utility
Change in number of units consumed

10. Figure Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (a)

11. Figure 20-1 Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panels (b) and (c)
Total utility is
maximized...
…where marginal
utility equals zero.

12. Utility Theory (cont'd)
Observations
Marginal utility falls as more is consumed
Marginal utility equals zero when total utility is at its maximum

13. Diminishing Marginal Utility
The principle that as more of any good or service is consumed, its extra benefit declines
Increases in total utility from consumption of a good or service become smaller and smaller as more is consumed during a given time period.

14. Example: Newspaper Vending Machines versus Candy Vending Machines
Newspaper machines do not prevent people from taking more than one paper. Why not dispense candy the same way?
The answer is found in the concept of diminishing marginal utility.
Can you think of a circumstance under which a substantial number of newspaper purchasers might be inclined to take more than one newspaper from a vending machine?

15. Optimizing Consumption Choices
Consumer Optimum
A choice of a set of goods and services that maximizes the level of satisfaction for each consumer, subject to limited income

16. Table Total and Marginal Utility from Consuming Music Album Downloads and Cappuccinos on an Income of $26

17. Table Total and Marginal Utility from Consuming Music Album Downloads and Cappuccinos on an Income of $26 (cont'd)

18. Optimizing Consumption Choices (cont’d)
A consumer’s money income should be allocated so that the last dollar spent on each good purchased yields the same amount of marginal utility (when all income is spent), because this rule yields the largest possible total utility

19. Table 20-2 Steps to Consumer Optimum

20. Optimizing Consumption Choices (cont'd)
A little math
The rule of equal marginal utilities per dollar spent
A consumer maximizes personal satisfaction when allocating money income in such a way that the last dollars spent on good A, good B, good C, and so on, yield equal amounts of marginal utility

21. Optimizing Consumption Choices (cont'd)
A little math
The rule of equal marginal utilities per dollar spent
MU of good A
Price of good A =
MU of good B
Price of good B
MU of good Z
Price of good Z
...

22. Example: Does Consuming More Expensive Items Make People Happier?
Economist Antonio Rangel conducted an experiment in which he offered to let people taste wines.
The experiment with wines revealed that people derive greater satisfaction from consuming the good when they believe that it has a higher explicit price.
This means that when consumers choose to pay higher prices, they derive additional satisfaction. 22

23. Why Not … make consumers happier by requiring them to purchase the quantities the government chooses?
If the government required individuals to reallocate their incomes to purchase more of certain items, then the marginal utilities from consuming those items would decline.
Also, consumers would have less remaining income available to purchase other items, so the marginal utilities of buying those items would rise.
So, the consumers would be less satisfied as their marginal utility per dollar spent would no longer be equal. 23

24. How a Price Change Affects Consumer Optimum
Recall from Table 20-1 Income = $26
Qd = 4
MUd Pd
36.5 5 =
= 7.3
Qs = 2
MUs Ps 22 3

25. How a Price Change Affects Consumer Optimum (cont'd)
Assume Price of Music Falls to $4
Qd = 4
MUd Pd
36.5 4 =
= 9.125
Qs = 2
MUs Ps 22 3
= 7.3

26. How a Price Change Affects Consumer Optimum (cont'd)
Assume Price of Music Falls to $4
Result
Buy more downloads and MUd falls
Now
MUd Pd
>
MUs Ps

27. How a Price Change Affects Consumer Optimum (cont'd)
Consumption decisions are summarized in the law of demand
The amount purchased is inversely related to price
A consumer’s response to a price change
At higher consumption rate, marginal utility falls

28. Figure 20-2 Digital Music Download Prices and Marginal Utility

29. How a Price Change Affects Consumer Optimum (cont'd)
The Substitution Effect
The tendency of people to substitute cheaper commodities for more expensive commodities

30. How a Price Change Affects Consumer Optimum (cont'd)
The Principle of Substitution
Consumers and producers shift away from goods and resources that become priced relatively higher in favor of goods and resources that are now priced relatively lower

31. How a Price Change Affects Consumer Optimum (cont'd)
Purchasing Power
The value of money for buying goods and services
If your money income stays the same but the price of one good that you are buying goes up, your effective purchasing power falls, not vice versa

32. How a Price Change Affects Consumer Optimum (cont'd)
Real-Income Effect
The change in people’s purchasing power that occurs when, other things being constant, the price of one good that they purchase changes
When that price goes up (down), real income, or purchasing power, falls (increases)

33. How a Price Change Affects Consumer Optimum (cont'd)
What do you think?
Which would usually have more of an impact on your purchases—the substitution effect or the real-income effect?

34. The Demand Curve Revisited
Question
How is the demand curve derived?
Answer
By assuming income, tastes, expectations, and the price of related goods are not changing as the price of the good changes

35. The Demand Curve Revisited (cont'd)
Marginal utility, total utility, and the diamond-water paradox
Diamonds are not essential to life but relatively expensive
Water is essential to life but relatively cheap.
Total utility of water exceeds that of diamonds but marginal utility determines the price

36. Figure 20-3 The Diamond-Water Paradox

37. Behavioral Economics and Consumer Choice Theory
Does behavioral economics better predict consumer choices?
The bounded rationality assumption
However, people do not be have as if they are rational. If the rationality assumption does not apply to actual behavior, behavioralists argue that utility-based consumer choice theory cannot, either.

38. Behavioral Economics and Consumer Choice Theory (cont’d)
Consumer choice theory alive and well
In spite of the doubts expressed by proponents of behavioral economics, most economists continue to apply the assumption that people behave as if they act rationally with an aim to maximize utility
These economists continue to utilize utility theory because of a fundamental strength of this approach: It yields clear-cut predictions regarding consumer choices

39. You Are There: Signing Up for “Free” Trial Offers with TrialPay
TrialPay offer items at no explicit charge and instead its customers have to agree to sign up for a trial offer for a product of another firm, such as a “free” trial membership with the movie service Netflix.
TrialPay ensures that the marginal utility per dollar spent will be high enough to make a trial membership part of the consumer optimum for its customers.

40. Issues & Applications: Is the Utility from Using Credit Cards Really Negative?
Behavioral economists argue that a consumer’s rationality is bounded, meaning that people often are unable to assess all aspects of choices that they confront.
Some economists suggest the utility from credit card use is negative on net because the positive utility that consumers derive from using credit cards to obtain immediate use of an item is overwhelmed by a utility decrease from having to give up other items when they pay their credit-card bill.

41. Summary Discussion of Learning Objectives
Total utility versus marginal utility
Total utility is total satisfaction from consumption
Marginal utility is the additional satisfaction from consuming an additional unit
Law of diminishing marginal utility
Marginal utility ultimately declines as a person consumes more and more of a good or service

42. Summary Discussion of Learning Objectives (cont'd)
The consumer optimum
Occurs when the marginal utility per dollar spent on the last unit consumed is equalized
The substitution effect of a price change
A person will substitute among goods by buying less of a good when its price increases

43. Summary Discussion of Learning Objectives (cont'd)
The real-income effect of a price change
A price change affects the purchasing power of an individual’s available income

44. Appendix F: On Being Indifferent
What does it mean to be indifferent?
It usually means that you don’t care one way or the other about something—you are equally disposed to either of two alternatives 44

45. Figure F-1 Combinations That Yield Equal Levels of Satisfaction

46. Appendix F: Properties of Indifference Curves
Downward (negative) slope
Curvature
not a straight line
convex with respect to the origin 46

47. Figure F-2 Indifference Curves: Impossibility of an Upward Slope

48. Figure F-3 Implications of a Straight-Line Indifference Curve

49. Appendix F: The Marginal Rate of Substitution
The marginal rate of substitution is equal to the change in the quantity of one good that just offsets a one-unit change in the consumption of another good, such that total satisfaction remains constant 49

50. Table F-1 Calculating the Marginal Rate of Substitution

51. Appendix F: The Indifference Map
A set of indifference curves
A higher indifference curve represents the possibility of higher rates of consumption of both goods
A higher indifference curve is preferred to a lower one because more is preferred to less 51

52. Figure F-4 A Set of Indifference Curves

53. Appendix F: The Budget Constraint
All of the possible combinations of goods that can be purchased (at fixed prices) with a specific budget 53

54. Figure F-5 The Budget Constraint

55. Appendix F: Consumer Optimum Revisited
Consumers will try to attain the highest level of total utility possible, given their budget constraints
Graphically, it is the tangency point between the highest indifference curve and budget constraint 55

56. Figure F-6 Consumer Optimum

57. Appendix F: Deriving the Demand Curve
Question
What happens when the price of one good changes, holding both the price of another good and income constant?
Answer
The budget line rotates, resulting in a new optimum point
The demand curve slopes downward 57

58. Figure F-7 Deriving the Demand Curve, Panel (a)

59. Figure F-7 Deriving the Demand Curve, Panel (b)