Chapter 20 Consumer Choice

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.

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

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

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

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.

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

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

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

Figure 20-1 Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (a)

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.

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

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.

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?

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

Table 20-1 Total and Marginal Utility from Consuming Music Album Downloads and Cappuccinos on an Income of $26

Table 20-1 Total and Marginal Utility from Consuming Music Album Downloads and Cappuccinos on an Income of $26 (cont'd)

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

Table 20-2 Steps to Consumer Optimum

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

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 ...

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

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

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

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

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

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

Figure 20-2 Digital Music Download Prices and Marginal Utility

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

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

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

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)

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?

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

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

Figure 20-3 The Diamond-Water Paradox

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.

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

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.

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.

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

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

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

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

Figure F-1 Combinations That Yield Equal Levels of Satisfaction

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

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

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

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

Table F-1 Calculating the Marginal Rate of Substitution

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

Figure F-4 A Set of Indifference Curves

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

Figure F-5 The Budget Constraint

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

Figure F-6 Consumer Optimum

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

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

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