© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. c h a p t e r nine Prepared by: Fernando & Yvonn Quijano Consumer Choice and Behavioral Economics

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 2 of 41 After studying this chapter, you should be able to: Define utility and explain how consumers choose goods and services to maximize their utility. Use the concept of utility to explain how the law of demand results from consumers adjusting their consumption choices to changes in prices. Explain how social influences can affect consumption choices. Describe how people can improve their decision making by taking into account nonmonetary opportunity costs, ignoring sunk costs, and being more realistic about their future behavior. Can LeBron James Get You to Drink Powerade? LEARNING OBJECTIVES Firms must understand consumer behavior to determine whether strategies such as using celebrities in their advertising are likely to be effective.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 3 of 41 Utility and Consumer Decision Making LEARNING OBJECTIVE 1 Utility Utility The enjoyment or satisfaction that people receive from consuming goods and services. The Principle of Diminishing Marginal Utility Marginal utility The additional utility a person receives from consuming one additional unit of a good or service. Law of diminishing marginal utility Consumers experience diminishing additional satisfaction as they consume more of a good or service during a given period of time.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 4 of 41 Utility and Consumer Decision Making Total and Marginal Utility from Eating Pizza on Super Bowl Sunday

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 5 of 41 Utility and Consumer Decision Making 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. Total Utility and Marginal Utility from Eating Pizza and Drinking Coke 9 – 1 NUMBER OF SLICES OF PIZZA TOTAL UTILITY FROM EATING PIZZA MARGINAL UTILITY FROM THE LAST SLICE NUMBER OF CUPS OF COKE TOTAL UTILITY FROM DRINKING COKE MARGINAL UTILITY FROM THE LAST CUP  652 11

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 6 of 41 Utility and Consumer Decision Making The Rule of Equal Marginal Utility per Dollar Spent Converting Marginal Utility to Marginal Utility per Dollar 9 – 2 (1) Slices of Pizza (2) Marginal Utility (MU Pizza ) (3) Marginal Utility per Dollar (4) Cups of Coke (5) Marginal Utility (MU Coke ) (6) Marginal Utility per Dollar  --6 11

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 7 of 41 We can compactly summarize the two conditions for maximizing utility as follows: Spending on pizza + Spending on Coke = Amount available to be spent Utility and Consumer Decision Making The Rule of Equal Marginal Utility per Dollar Spent Equalizing Marginal Utility per Dollar Spent 9 – 3 Combinations of Pizza and Coke with Equal Marginal Utilities per Dollar Marginal Utility per Dollar (Marginal Utility/Price)Total SpendingTotal Utility 1 Slice of Pizza and 3 Cups of Coke10$2 + $3 = $ = 65 3 Slices of Pizza and 4 Cups of Coke5$6 + $4 = $ = 96 4 Slices of Pizza and 5 Cups of Coke3$8 + $5 = $ = 105

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 8 of 41 Finding the Optimal Level of Consumption Number of Ice Cream Cones Total Utility from Ice Cream Cones Marginal Utility from Last Cone Number of Cans of Lime Fizz Total Utility from Cans of Lime Fizz Marginal Utility from Last Can LEARNING OBJECTIVE 1

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 9 of 41 Finding the Optimal Level of Consumption (continued) LEARNING OBJECTIVE 1 Ice Cream ConesCans of Lime Fizz QuantityMU Equalize Marginal Utilities per Dollar

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 10 of 41 Utility and Consumer Decision Making The Income Effect and Substitution Effect of a Price Change 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.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 11 of 41 Utility and Consumer Decision Making The Income Effect and Substitution Effect of a Price Change Income EffectSubstitution Effect Normal Good Inferior Good Price Decrease Increases the consumer‘s purchasing power, which causes the quantity demanded to increase.... causes the quantity demanded to decrease. Lowers the opportunity cost 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.... causes the quantity demanded to increase. Raises the opportunity cost of consuming the good, which causes the quantity of the good demanded to decrease. Income Effect and Substitution Effect of a Price Change 9 – 4

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 12 of 41 Utility and Consumer Decision Making The Income Effect and Substitution Effect of a Price Change Adjusting Optimal Consumption to a Lower Price of Pizza 9 – 5 Number of Slices of Pizza Marginal Utility from Last Slice (MU Pizza ) Marginal Utility per Dollar Number of Cups of Coke Marginal Utility from Last Cup (MU Coke ) Marginal Utility per Dollar  –6 11 –

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 13 of 41 Where Demand Curves Come From LEARNING OBJECTIVE Deriving the Demand Curve for Pizza

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 14 of 41 Social Influences on Decision Making LEARNING OBJECTIVE 3 Network Externalities Network externalities Network externalities exist when the usefulness of a product increases with the number of consumers who use it.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 15 of 41 Why Do Firms Pay Tiger Woods to Endorse Their Products? When consumers buy the same products as celebrities they feel fashionable and closer to the celebrities.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 16 of 41 Social Influences on Decision Making Does Fairness Matter? BUSINESS IMPLICATIONS OF FAIRNESS The Market for Tickets to the Producers

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 17 of 41 Professor Krueger Goes to the Super Bowl Should the NFL charge the highest price it can for Super Bowl tickets?

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 18 of 41 Behavioral Economics: Do People Make Their Choices Rationally? LEARNING OBJECTIVE 4 Consumers commonly commit the following three mistakes when making decisions:  They take into account monetary costs but ignore nonmonetary opportunity costs.  They fail to ignore sunk costs.  They are overly optimistic about their future behavior. Behavioral economics The study of situations in which people act in ways that are not economically rational.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 19 of 41 Behavioral Economics: Do People Make Their Choices Rationally? Ignoring Nonmonetary Opportunity Costs Opportunity cost The highest-valued alternative that must be given up in order to engage in an activity. Endowment effect The tendency of people to be unwilling to sell something 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.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 20 of 41 Behavioral Economics: Do People Make Their Choices Rationally? Failing to Ignore Sunk Costs Sunk cost A cost that has already been paid and that cannot be recovered.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 21 of 41 Why Don’t Students Study More? If the payoff to studying is so high, why don’t students study more? LEARNING OBJECTIVE 4 How Do You Get People to Save More of Their Income? a.Use your understanding of consumer decision making to show how a savings plan may work.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 22 of 41 A Celebrity Endorser Who Doesn't Offend? Slim Chance

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 23 of 41 Behavioral economics Budget constraint Endowment effect Income effect Law of diminishing marginal utility Marginal utility Network externalities Opportunity cost Substitution effect Sunk cost Utility

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 24 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior CONSUMPTION BUNDLE A CONSUMPTION BUNDLE B 2 slices of pizza and 1 can of Coke 1 slice of pizza and 1 can 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 receives equal utility from either bundle. Consumer Preferences

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 25 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Consumer Preferences Indifference Curves Indifference curve A curve that shows the combinations of consumption bundles that give the consumer the same utility.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 26 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Consumer Preferences Indifference Curves 9A - 1 Plotting Dave’s Preferences for Pizza and Coke

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 27 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Consumer Preferences The Slope of an Indifference Curve Marginal rate of substitution (MRS) The slope of an indifference curve; represents the rate at which a consumer would be willing to trade off one good for another.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 28 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Consumer Preferences Can Indifference Curves Ever Cross? 9A - 2 Indifference Curves Cannot Cross

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 29 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior The Budget Constraint 9A - 3 Dave’s Budget Constraint

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 30 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Choosing the Optimal Consumption of Pizza and Coke 9A - 4 Finding Optimal Consumption

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 31 of 41 Dell Determines the Optimal Mix of Products Dell has to determine which mix of computer components matches consumers’ preferences.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 32 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Choosing the Optimal Consumption of Pizza and Coke How a Price Change Affects Optimal Consumption 9A - 5 How a Price Increase Affects the Budget Constraint

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 33 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Choosing the Optimal Consumption of Pizza and Coke How a Price Change Affects Optimal Consumption 9A - 6 How a Price Change Affects Optimal Consumption

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 34 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Choosing the Optimal Consumption of Pizza and Coke Deriving the Demand Curve 9A - 7 Deriving a Demand Curve

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 35 of 41 When Does a Price Change Make a Consumer Better Off? 9A - 1 Budget constraint, indifference curve, and point of optimal consumption for original prices. Dave is better off as a result of the price change because he can now reach a higher indifference curve.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 36 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Choosing the Optimal Consumption of Pizza and Coke The Income Effect and the Substitution Effect of a Price Change 9A - 8 Income and Substitution Effects of a Price Change

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 37 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Choosing the Optimal Consumption of Pizza and Coke How a Change in Income Affects Optimal Consumption 9A - 9 How a Change in Income Affects the Budget Constraint

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 38 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior Choosing the Optimal Consumption of Pizza and Coke How a Change in Income Affects Optimal Consumption 9A - 10 How a Change in Income Affects Optimum Consumption

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 39 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior The Slope of the Indifference Curve, the Slope of the Budget Line, and the Rule of Equal Marginal Utility per Dollar 9A - 11 At the Optimum Point, the Slopes of the Indifference Curve and Budget Constraint Are the Same

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 40 of 41 Appendix 9A: Using Indifference Curves and Budget Lines to Understand Consumer Behavior The Slope of the Indifference Curve, the Slope of the Budget Line, and the Rule of Equal Marginal Utility per Dollar The Rule of Equal Marginal Utility per Dollar Revisited –(Change in the quantity of Coke x MU Coke ) = (Change in the quantity of pizza x MU Pizza ) Loss in utility from consuming less Coke Gain in utility from consuming more pizza At the optimal point of consumption:

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 9: Consumer Choice and Behavioral Economics 41 of 41 Indifference curveMarginal rate of substitution (MRS)