Economics principles tools and applications 9th by sullivan sheffrin perez chapter 22

22.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY 1 of 6Consumer Constraints: The Budget Line A consumer’s budget line shows all the combinations of two goods that exhaust the budget.. 22

NINTH EDITION

Chapter 22

Consumer Choice: Utility Theory and Insights from

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Learning Objectives

22.1 Explain the equimarginal principle and apply it to consumer choice.

22.2 Describe the income and substitution effects of a price change.

22.3 Describe the general process involved in the valuation of the benefits and costs of a consumer good.

22.4 Apply the insights from neuroscience to consumer decisions about nutrition and saving.

22.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (1 of 6)

Consumer Constraints: The Budget Line

A consumer’s budget line shows all the combinations of two goods that exhaust

the budget The slope of the budget line is the opportunity cost of a movie in

terms of books

The budget set (the shaded triangle) shows all the affordable combinations of

books and movies, and the budget line (with endpoints r and v) shows the

combinations that exhaust the budget

22.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (2 of 6)

Total and Marginal Utility

The consumer’s objective is to maximize utility The upper panel shows the

relationship between total utility and the number of movies watched

In the lower panel, the marginal utility from movies decreases as the number of

movies increases

22.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (3 of 6)

The Marginal Principle and the Equimarginal Rule

MARGINAL PRINCIPLE

Increase the level of an activity as long as its marginal benefit

exceeds its marginal cost Choose the level at which the marginal

benefit equals the marginal cost.

The marginal utility of movies decreases as the number of movies

increases, reflecting the assumption of diminishing marginal utility The

marginal utility per dollar equals the marginal utility divided by the price of

movies

22.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (4 of 6)

Conditions for Maximizing Utility

MARGINAL PRINCIPLE

Increase the level of an activity as long as its marginal benefit exceeds its

marginal cost Choose the level at which the marginal benefit equals the

marginal cost.

The consumer picks the affordable bundle at which the marginal utility per

dollar on movies equals the marginal utility per dollar on books This is shown

by point a (6 movies) and point b (9 books) Starting from any other affordable

combination, the consumer can do better by reallocating the budget in favor of

the good with the larger marginal utility per dollar For example, starting from

points c and d, movies have a larger marginal utility per dollar, so the

consumer can increase utility by choosing more movies and fewer books

22.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (5 of 6)

Making Choices Using the Equimarginal Rule

● Equimarginal rule

Pick the combination of two activities where the marginal benefit per dollar for the first activity equals themarginal benefit per dollar for the second activity

22.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (6 of 6)

Making Choices Using the Equimarginal Rule

TABLE 22.1 Utility Maximization

Marginal Utility:

Movies

Marginal Utility:

Books

Marginal Utility per $:

Movies

Marginal Utility per $:

Books

Utility from Movies

Utility from Books

Total Utility

1 2 3 4 5

6

7 8

24 21 18 15 12

9

6 3

51 48 45 42 39

36

33 30

2 4 6 8 10

12

14 16

17 16 15 14 13

12

11 10

2 4 6 8 10

12

14 16

51 99 144 186 225

261

294 324

216 210 198 180 156

126

90 48

267 309 342 366 381

387

384 372

EQUIMARGINAL RULE

Pick the where the marginal benefit per dollar for the first activity equals the marginal benefit per combination of two activities dollar for the second activity.

APPLICATION 1

•

MEASURING DIMINISHING MARGINAL UTILITY

•

APPLYING THE CONCEPTS #1: How does marginal utility change with the quantity consumed?

• Neuroscientists have used brain imaging techniques to provide some insights into the law of diminishing marginal utility The scientists offered subjects in

an experiment varying monetary rewards, and observed the neural activity in a subject's striatum, the region of the brain responsible for the valuation of rewards

• As the monetary reward increased, the subjective benefit (the utility value, as measured in neuron activity) increased, but at a decreasing rate In other words, the larger the reward, the lower the marginal utility of the reward money

• For example, for a $15 reward, the marginal utility is 1 util per dollar, but for a $150 reward, the marginal utility is only 0.25 utils per dollar Although this experiment does not provide a direct demonstration of the law of diminishing marginal utility for a particular product, it does show that general rewards are subject to diminishing marginal utility

22.2 THE LAW OF DEMAND AND THE INDIVIDUAL DEMAND CURVE (1 of 3)

The effect of a decrease in price

The left panel shows a decrease in price moves the curve up A decrease

in price show the original bundle violates the equimarginal rule

A decrease in the price of movies shifts the movie benefit curve (MU per $

of movies) upward At the original bundle (6 movies and 9 books), the MU

per $ of movies (18 utils at point c) exceeds the MU per $ of books (12 utils

at point b), so the consumer Increases the number of movies

22.2 THE LAW OF DEMAND AND THE INDIVIDUAL DEMAND CURVE (2 of 3)

The Income and Substitution Effects of a Price Change

For a price of movies of $2, utility is maximized at points d and e, with 10 movies

and 7 books The move from point c to point s is the substitution effect of the

decrease in price, and the move from point s to point d is the income effect of the

decrease in price

22.2 THE LAW OF DEMAND AND THE INDIVIDUAL DEMAND CURVE (3 of 3)

The Individual Demand Curve

An individual demand curve shows the relationship between the price of a product and

the quantity demanded by a rational consumer In other words, the demand curve shows,

for each price, the utility-maximizing quantity for the consumer

The individual demand curve for our hypothetical consumer At the initial price of $3, the

consumer maximizes utility with 6 movies (point i)

A decrease in price to $2 increases the quantity demanded to 10 movies (point j)

The move from point i to point j reflects both the substitution effect and the income effect

of a decrease in price

• This logic is faulty because it ignores the substitution effect of a price change.

• The gas tax decreases the marginal utility per dollar spent on gasoline, which is now less than the marginal utility per dollar spent on other goods Gasoline now generates a lower marginal bang per buck

22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (1 of 7)

The Neuroscience of Benefit Valuation

The calibration of the regions of the brain involved in benefit valuation comes from the brain's dopamine system Dopamine is the reward chemical of the brain‒when it flows over receptors in your brain, you feel good

When you consider buying a product such as an apple, your brain uses its past experience to form a conjecture about the likely pleasure and satisfaction from the product

Learning happens when conjectures about the pleasure from a product are wrong For example, suppose you anticipate a sweet apple and thus have a large dopamine flow, but the first bite generates a sour taste The invalidation of the brain's conjecture causes an abrupt decrease in the dopamine flow, causing an abrupt reduction of the good feelings produced by dopamine

22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (2 of 7)

The Neuroscience of Cost Valuation

On the cost side, the key regions for cost valuation are the insular cortex (insula for short) and the amygdala These interconnected regions express aversion to various actions

PRINCIPLE OF OPPORTUNITY COST

The opportunity cost of something is what you sacrifice to get it.

The money spent on one product cannot be used on another product, so it is natural that the brain reacts in a negative way (in the region that expresses aversion) to the thought of spending money The higher the price of a product, the greater the opportunity cost of the product, and thus the stronger the activity

of the insula

22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (3 of 7)

The Wisdom of Gut Feelings

The Iowa Gambling Task experiment shows gut feelings begin to cause an effect after only 10 draws of the cards

However, it takes about 50 draws for the unconscious learning to take affect and 60 draws for the subject to explain their choices

22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (4 of 7)

Cognition and Choice

To decide whether to take an action, a person compares the anticipated benefit of the action to its anticipated cost

The principal decision-making region of the brain is the prefrontal cortex (PFC)

In other words, the PFC uses gut feelings as inputs into the decision-making process

The PFC is not a simple calculator of gut-feeling benefits and costs, but incorporates other factors into the decision-making process The PFC uses cognition (conscious thought) to consider a broad set of possible consequences of an action

22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (5 of 7)

Cognition and Choice

Why do people make different choices?

• Strength of their gut-feelings

• Cognitive weighting

22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (6 of 7)

Predicting Consumer Choice

Neuroscientists map and measure the brain activity associated with consumer decisions After observing a consumer's brain activity while he or she considers different options, scientists can actually predict the consumer's choice

22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (7 of 7)

Fuel for Cognition

The decision-making process that occurs in the PFC is complex As a result, the cognitive process consumes a large amount of energy in supporting neurons

as they perform their various tasks The brain gets most of its energy from glucose (aka blood sugar), and operates effectively only when it has a plentiful supply of glucose

The fuel requirements of cognition have important implications for consumer decision-making

A consumer may respond to the depletion of brain fuel in one of three ways:

a) simplify matters by focusing on a single dimension of the product (price, color, shine)

b) abandon cognition and make an impulse buy, or

c) abandon the decision-making process altogether and refrain from buying a toothbrush

APPLICATION 3

•

COKE VERSUS PEPSI IN THE PREFRONTAL CORTEX

•

APPLYING THE CONCEPTS #3: How does cognition affect consumer choice?

• In the “Pepsi Challenge” advertisements of the 1970s and 1980s, randomly chosen consumers tasted Pepsi and Coke Most preferred Pepsi However

a majority of buyers chose Coke

• Thirty years later neuroscientist Read Montague ran a Pepsi challenge while observing brain activity When subjects didn’t know what they were drinking, most preferred Pepsi When they did know what they were drinking, most preferred Coke

• A consumer’s choice is based on gut-feeling benefits and costs Activity in the prefrontal cortex was stronger for Coke than for Pepsi, presumably reflecting more favorable images and feelings associated with Coke commercials Branding affects brain activity and consumer preference

22.4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE (1 of 4)

Dietary Choice: Donut vs Apple

Some scientists speculate that the evolutionary development of the DLPFC in humans increased our

fitness (likelihood of survival) because it gave us the ability to incorporate long-term considerations

into the decision-making process

For a decision based exclusively on gut feelings, a consumer using the equimarginal rule chooses

points a and b (9 donuts and 1 apple) The engagement of the cognitive process decreases the

perceived MU per $ of donuts, so at the original bundle (9 donuts, 1 apple), the MU per $ is 2 utils

for donuts (point c), compared to 12 utils for apples (point b) The new utility-maximizing choice is

shown by points e and d: cognitive engagement decreases donut consumption from 9 to 4 and

increases apple consumption from 1 to 6.

1. Equimarginal rule For each good, the marginal utility per dollar is 12 utils

2. Affordability The consumer spends $9 on donuts and $1 on apples, for a total of $10 In this case,

a consumer who simply goes with his or her gut feelings eats a lot of donuts.

22.4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE (2 of 4)

Present bias: spending vs savings

Gut feelings are visceral, in-the-moment sensations, and humans are myopic with respect to gut

feelings In other words, humans do a poor job imagining the strength of future gut feelings,

including the gut-feeling benefits of future consumption.

A consumer subject to present bias chooses points a and b (spend $19 and save $1) Cognition

that reduces present bias increases the perceived MU per $ of saving, so at the original bundle

(spend $19, save $1), the MU per dollar is higher for saving (point c versus point a) The new

utility-maximizing choice shown by points e and d: cognitive Engagement increases saving from

$1 to $7 and decreases spending (consumption now) from $19 to $13.

In the left panel, the benefit curve shows the marginal utility per dollar spent in the present For

current consumption, gut feelings accurately represent the benefit of consumption In the right

panel, the lower curve shows the benefit of saving (the benefit of future consumption) for a

consumer subject to present bias: the consumer systematically underestimates the future benefit

of consumption.

22.4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE (3 of 4)

Present Bias and Credit Cards

Credit cards cause a different sort of temporal mismatch between benefits and costs In this case, the benefit of a product will be experienced now, but the cost will be delayed until some future date

Using a credit card weakens our gut feeling aversion to spending money

Present Bias and Smoking

The decision to smoke cigarettes is subject to present bias because there is a temporal mismatch between the present benefit (the good feeling from nicotine) and a future cost (health problems)

22.4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE (4 of 4)

Gambling as a Consumer Good

Why do people gamble when the expected reward is negative? For example, the

typical state-run lottery pays out roughly half of what it takes in, so on average a

person who plays the lottery for $10 can expect a payoff of roughly $5

Neuroscientists have discovered a possible reason for this seemingly irrational

behavior

If you draw ball #3, you win $12 The expected monetary value of drawing a ball

from the urn is $4 = 1/3 × $12 Suppose the dopamine benefit of winning is 12

utils, while the dopamine benefit for a near win (drawing ball #2) is 9 utils The

expected dopamine value of drawing a ball is 7 utils = 1/3 × 9 + 1/3 × 12

Numbers that are close to a gambler’s number seem to be a near miss to the

gambler and encourages continued gambling in spite of the fact that numbers

have an equal chance of selection

APPLICATION 4

•

TAXING CIGARETTES TO OFFSET PRESENT BIAS

•

APPLYING THE CONCEPTS #4: What is the appropriate cigarette tax?

• The present bias that leads some people to smoke cigarettes raises an important policy question: Can we use taxes on cigarettes to offset present bias and actually make people better off in the process? A recent study concludes that to fully offset the present bias that underlies the decision to smoke, the appropriate tax is roughly

$11 per pack of cigarettes

• The study focused on the effects of smoking on premature death Smoking cuts the lifespan of the typical smoker by roughly 6 years, and given the economic value of one year of life, we can translate the cost associated with premature death into a cost of roughly $36 per pack of cigarettes If smokers did not suffer from present bias, their present choices would fully reflect this future cost, meaning that they would compare the benefit of smoking (the nicotine experience) to the full cost of a pack of cigarettes (the purchase price plus the $36 cost associated with premature death)

• The study suggest that the cigarette tax would actually be beneficial for low-income households The reason is that low-income households are relatively responsive to changes in the price of cigarettes, so they would experience a relatively large reduction in smoking, and a relatively large increase in lifespan