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Copyright © 2017 Pearson Education, Inc. All Rights Reserved

Economics6th edition

Chapter 10 Consumer Choice and Behavioral Economics


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Chapter Outline10.1 Utility and Consumer Decision Making

10.2 Where Demand Curves Come From

10.3 Social Influences on Decision Making

10.4 Behavioral Economics: Do People Make Their Choices Rationally?

Appendix Using Indifference Curves and Budget Lines to Understand Consumer Behavior


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10.1 Utility and Consumer Decision MakingDefine utility and explain how consumers choose goods and services to maximize their utility

In our study of consumers so far, we have looked at what they do, but not why they do what they do.

Economics is all about the choices that people make; a better understanding of those choices furthers our understanding of economic behavior.

At the same time, we need to know the limits of our understanding. This chapter will examine what we know, and what we can’t explain, about how consumers behave.


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Rationality and its implicationsAs a starting point, economists assume that consumers are rational: making choices intended to make themselves as well-off as possible.

We examine these choices when consumers make their decisions about how much of various items to buy, given their scarce resources (income).

Facing this budget constraint, how do people choose?

Budget constraint: The limited amount of income available to consumers to spend on goods and services.


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Utility: measuring happinessEconomists refer to the enjoyment or satisfaction that people obtain from consuming goods and services as utility.Utility cannot be directly measured; but for now, suppose that it could. What would we see?• As people consumed more of an item (say, pizza) their total

utility would change.The amount by which total utility would change when consuming an extra unit of a good or service is called the marginal utility (MU).• Remember: in economics, “marginal” means “additional”.


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Diminishing marginal utility and budgetsWe generally expect to see the first items consumed produce the most marginal utility, so that subsequent items give diminishing marginal utility.

Law of diminishing marginal utility: The principle that consumers experience diminishing additional satisfaction as they consume more of a good or service during a given period of time.

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Figure 10.1 Total and marginal utility from eating pizza on Super Bowl Sunday (1 of 2)

The table shows the total utility you might derive from eating pizza on Super Bowl Sunday.

The numbers, in utils, represent happiness: higher is better.

A graph of this utility is initially rising quickly, then more slowly; and eventually, it turns downward (as you get sick of pizza).

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Figure 10.1 Total and marginal utility from eating pizza on Super Bowl Sunday (2 of 2)

The increase in utility from one slice to the next is the marginal utility of a slice of pizza.

We can calculate marginal utility for every slice of pizza…

… then graph the results. The graph of marginal utility is decreasing, showing the Law of Diminishing Marginal Utility directly.


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Allocating your resourcesGiven unlimited resources, a consumer would consume every good and service up until the maximum total utility.• But resources are scarce; consumers have a budget constraint.Budget constraint: The limited amount of income available to consumers to spend on goods and services.The concept of utility can help us figure out how much of each item to purchase.• Each item purchased gives some (possibly negative) marginal

utility; by dividing by the price of the item, we obtain the marginal utility per dollar spent; that is, the rate at which that item allows the consumer to transform money into utility.

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Table 10.1 Total utility and marginal utility from eating pizza and drinking Coke

Suppose you can now obtain utility by eating pizza and drinking Coke.

The table gives the total and marginal utility derived from each activity.

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Table 10.2 Converting marginal utility to marginal utility per dollar

Suppose that pizza costs $2 per slice, and Coke $1 per cup.• Marginal utility of pizza per dollar is just marginal utility of pizza

divided by the price, $2.• Similarly for Coke: divide by $1.

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Table 10.3 Equalizing marginal utility per dollar spent (1 of 2)

Suppose the marginal utility per dollar obtained from pizza was greater than that obtained from Coke.• Then you should eat more pizza, and drink less Coke.

This implies the Rule of Equal Marginal Utility per Dollar Spent: consumers should seek to equalize the “bang for the buck”.• Some combinations satisfying this rule are given above.

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Table 10.3 Equalizing marginal utility per dollar spent (2 of 2)

The actual combination to purchase would depend on your budget constraint:• With $5 to spend, you would purchase 1 slice of pizza and 3

cups of Coke.• With $10 to spend, you would purchase 3 slices of pizza and 4

cups of Coke.

In each case, you seek to exhaust your budget, since spending additional money gives more utility.


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Conditions for maximizing utilityThis gives us two conditions for maximizing utility:

1. Satisfy the Rule of Equal Marginal Utility per Dollar Spent:

2. Exhaust your budget:Spending on pizza + Spending on Coke = Budget


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What if we “disobey” the rule?It should be clear that failing to spend all your money will result in less utility—each item you buy increases our utility.• But what if you buy a combination which doesn’t satisfy the

Rule of Equal Marginal Utility per Dollar?

For example, you could buy 4 slices of pizza and 2 cups of Coke for $10. From Table 10.1, this would give you 52 + 35 = 87 utils, less than the 96 utils that you get from 3 slices and 4 cups.• Marginal utility per dollar from fourth slice: 3 utils per dollar• Marginal utility per dollar from second cup: 15 utils per dollar

Since you get so much more marginal utility per dollar from Coke, you ought to drink more Coke and eat less pizza—and indeed, that would increase utility.


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What if prices change?If the price of pizza changes from $2 to $1.50, then the Rule of Equal Marginal Utility per Dollar Spent will no longer be satisfied.• You must adjust your purchasing decision.

We can think of this adjustment in two ways:1. You can afford more than before; this is like having a higher

income. 2. Pizza has become cheaper relative to Coke.

We refer to the effect from 1. as the income effect, and the effect from 2. as the substitution effect.


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1. Income effectIncome 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.We know that some goods are normal (goods that we consume more of as our income rises) and some are inferior (goods that we consume less of as our income rises).• If pizza is a normal good, the income effect of its price

decreasing will cause you to consume more pizza.• If pizza is an inferior good, the income effect of its price

decreasing will cause you to consume less pizza.

Is pizza a normal or inferior good for you?


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2. Substitution effectSubstitution 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.If the price of pizza falls, pizza becomes cheaper relative to Coke.• The opportunity cost of consuming a slice of pizza falls.• This suggests eating more pizza.

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Table 10.4 Income effect and substitution effect of a price change

The table summarizes the income and substitution effects.

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Table 10.5 Adjusting optimal consumption to a lower price of pizzaSuppose the price of pizza falls to $1.50 per slice:• A possible new combination of items is 4 slices of pizza and 4

cups of Coke, costing 4 x $1.50 + 4 x $1.00 = $10.00.• The marginal utility per dollar is not quite equal, but it is as

close as we can get without allowing fractional goods.


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10.2 Where Demand Curves Come FromUse the concept of utility to explain the law of demand

Recall the law of demand: whenever the price of a product falls, the quantity demanded increases.

We are now in a position to see why this happens for an individual, by considering the income and substitution effects:• The substitution effect tells us that the product has become

relatively cheaper, so we consume more of it.• The income effect tells us our income is effectively higher, so

(at least for normal goods) we consume more of it.

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Figure 10.2 Deriving the demand curve for pizza

We can use our two previous observations of consumer behavior (with pizza prices of $2.00 and $1.50) to trace out your demand curve for pizza.

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Figure 10.3 Deriving the market demand curve from individual demand curves

Each individual has a demand curve for pizza.• By adding the individual

demand at each price, we obtain the market demand for pizza.


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Making the Connection: Could a demand curve slope upward?For a demand curve to be upward sloping, the good would have to be an inferior good making up a very large portion of consumers’ budgets with a greater income effect than substitution effect.

A 2006 economic experiment revealed that for poor regions in China, decreases in the price of rice led to some very poor people consuming less rice.

A good with an upward-sloping demand curve is known as a Giffen good.


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10.3 Social Influences on Decision MakingExplain how social influences can affect consumption choices

In most standard economic models, people are assumed to make choices independently of others.Such models sometimes incorrectly predict consumer behavior, by ignoring the social aspects of decision-making.“The utility from drugs, crime, going bowling… depends on whether friends and neighbors take drugs, commit crime, go bowling…” Gary Becker and Kevin Murphy

in Social Economics: Market Behavior in a Social Environment


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Examples of social influences on demand (1 of 2)

Celebrity endorsements: Firms use celebrity endorsements regularly. They work. Consumers might believe:• “The celebrity knows more about the product than I do”; or• “By buying this product, I will become more like the celebrity.”Network externalities: Situations in which the usefulness of a product increases with the number of consumers who use it.Examples: Facebook; Blu-ray discs; dating apps.Network externalities might result in market failure, if enough people become locked into inferior products.Example: QWERTY keyboards are less efficient for thumb-typing on phones than some alternatives, but switching is hard.


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Examples of social influences on demand (2 of 2)

Fairness: People like to be treated fairly, and prefer to treat each other fairly even if it is bad for them financially.• Example: People tend to tip their servers, even if they never

plan to go back to the restaurant.

Smart businesses learn from this, and attempt to appear fair even when it will cost them profits.• Example: The NFL sells tickets to the Super Bowl at $800-

$2000 (2015 prices); but these tickets get resold for much more.• Surveys reveal that NFL fans would consider it unfair if the NFL

raised ticket prices; instead, fans believe the current system of randomly distributing tickets to applicants is fairer.

• The NFL forgoes potential profit to avoid alienating fans.


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Experimental economicsOver the last two decades some economists have emulated psychologists by performing laboratory experiments on human subjects.• This field is known as experimental economics.

People are recruited to participate in these experiments and rewarded with money for their performance, in efforts to mimic real-world decision-making scenarios.

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Figure 10.4 The ultimatum game (1 of 3)

A common laboratory game is shown on the right, called the Ultimatum Game.• An allocator decides

how to split $20 between her and a recipient.

• The recipient accepts (in which case each receive the allocated split)…

• or rejects (in which case each receives nothing).

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How would you play this game?• If no-one cares about

fairness, offer the recipient $0.01, which he would accept.

• But in real life play, allocators usually offer 40+ percent to the recipient; and recipients offered <10 percent usually reject.

• What does this say about how people act?

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An alternative version of this game is the Dictator Game; now, the recipient cannot reject.

When 161 Cornell students played this game, and were only allowed $10/$10 or $18/$2 splits…… 122 chose the $10/$10 split!


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Are laboratory experiments reliable?1. The dollar-amounts chosen may not be large enough to

generate “real-world” behavior.– As the amount in question goes up, people tend to be

less generous in their offers, and reject unfair offers less.

2. People tend to choose “middle” actions when one is available.– In the dictator game, if people can also take money from

their partner, they often do so, and rarely give any.

3. People are less likely to give away money they feel entitled to.– If subjects work for a short time period to “earn” their

money in the dictator game, they are much less likely to give or take anything.


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Making the Connection: Is Uber price-gouging?Uber is a taxi-like app-based service.

Uber uses “surge-pricing”, changing the amount it charges based on demand and supply.• A ride on New Years’

Eve might cost 8 times as much as on a regular night.

• Do you think this is fair?


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10.4 Behavioral Economics: Do People Make Their Choices Rationally?Describe the behavioral economics approach to understanding decision making

In recent years, some economists have started studying situations in which people make choices that do not appear to be economically rational.• This field of study is known as behavioral economics.

Three common mistakes made by consumers are:1. Taking into account monetary costs but ignoring nonmonetary

opportunity costs2. Failing to ignore sunk costs3. Being unrealistic about their own future behavior


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1. Ignoring nonmonetary costsPeople often treat monetary and nonmonetary costs differently, even though they are both opportunity costs.Example: People who won the NFL lottery for Super Bowl tickets were asked the following two questions:1. If you had not won the lottery, would you have been willing to

pay $3000 for the ticket?2. If, after winning the lottery, someone had offered you $3000 for

your ticket, would you have sold it?Traditional economists believe that if you answer “no” to the first question, you should answer “yes” to the second; both questions rely on whether you value the ticket at $3,000 or more.


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Super Bowl ticket question resultsPeople did not answer those questions similarly; far from it:• 94 percent said they would not have bought the ticket for

$3,000; but• 92 percent said they would not sell the ticket for $3,000 either!Behavioral economists refer to this difference to the endowment effect: the tendency of people to be unwilling to sell a good 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.• In simpler terms, people don’t like losing what they have; they

consider losing an object to hurt them more than gaining a similar object would help them.


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2. Failing to ignore sunk costsA sunk cost is a cost that has already been paid, and cannot be recovered.

Once you have paid money and can’t get it back, you should ignore that money in any future decisions you make. But people often allow past costs to influence future decisions.• Example: NFL teams persist with first-round-pick quarterbacks

much longer than later-round picks with similar performance, because they have “paid” more for the first-rounder.

Admitting mistakes and moving on is crucial, but people often find that difficult to do.


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Making the Connection: A blogger who understands sunk costs (1 of 2)

In 2000, Arnold Kim began blogging about Apple products. By 2008, Kim’s site had become very successfully, and he was earning more than $100,000 per year from paid advertising.

Sounds good, right? The “problem” was, Kim was a medical doctor who had invested over $200,000 in his education.


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Making the Connection: A blogger who understands sunk costs (2 of 2)

What should Kim do? He believed he would ultimately make more as a blogger than as a doctor, but committing to blogging full-time would mean “wasting” his education.

Kim realized his education costs were sunk—unrecoverable regardless of what career choice he made. So he went with what he wanted to do: blogging full time.• Could you have made the same

choice?


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3. Being unrealistic about future behaviorPeople often make decisions that are inconsistent with their long-run intentions.• Example: In 2010, 69 percent of smokers reported wanting to

quit, and 52 percent actually attempted to quit. But despite their intentions, few actually quit; they found it hard to control their future behavior.

Economists try to understand this by arguing that many people have preferences that are not consistent over time.• Short-run preferences are often not consistent with long-run

preferences.


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Is our theory of rational economic actors useless?Our theory of utility maximization suggests we should compare the marginal utility per dollar spent on every item we buy.

But when you go grocery shopping, buying dozens of items, would you really do this? Likely, no.

Does this invalidate our theory? Traditional economists often answer “no”, because:1. Unrealistic assumptions are necessary to simplify complex

decision making problems, in order to focus on the most important factors.

2. Models are best judged by the success of their predictions, rather than the accuracy of their assumptions.

Indeed, models like our standard one are quite successful in predicting many types of consumer behavior.


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The behavioral economics of shoppingBehavioral economists say that it does matter that consumers do not usually make “optimal” consumption choices.• They believe modeling how people actually make decisions is

important.

Some important “irrational” consumption behaviors include:

Rules of Thumb: Making general rules that often, but not always, produce optimal results.• This can save on decision-making time

Anchoring: “Irrelevant” information can often influence behavior.• Example: posting “limit 10 items per customer” will often induce

people to buy 10 items, even they would have bought fewer without the sign


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Making the Connection: J.C. Penney meets behavioral economicsWhen Ron Johnson became CEO of J.C. Penney, he instituted a new pricing strategy of “everyday low prices”, instead of artificially high “regular” prices, and normal “sale” prices.

Johnson thought customers saw through the artificial prices; but the new strategy resulted in people buying less, and Johnson being fired.• This is an example of “anchoring”;

the “regular” price acts as an anchor, making people believe they are getting a good deal.


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Appendix: Using Indifference Curves and Budget Lines to Understand Consumer BehaviorUse indifference curves and budget lines to understand consumer behavior

Suppose Dave is faced with the choice of the above two weekly “consumption bundles”.It seems reasonable to assume that either:• Dave prefers bundle B to bundle F• Dave prefers bundle F to bundle B• Dave is indifferent between bundles B and F; that is, Dave

would be equally happy with either B or F.In the first situation, we would say Dave gets higher utility from B than from F; in the third, that the utility from B and F was the same.

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Figure 10A.1 Plotting Dave’s preferences for pizza and Coke (1 of 4)

Suppose Dave is indeed indifferent between B and F, and suppose we could find all of the bundles that Dave liked exactly as much.• Perhaps bundle E: 2 slices of

pizza and 8 cans of Coke would make Dave just as happy.

The curve marked I3 is an indifference curve for Dave: a curve showing the combinations of consumption bundles that give the consumer the same utility.

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Figure 10A.1 Plotting Dave’s preferences for pizza and Coke (2 of 4)Lower indifference curves represent lower levels of utility; higher indifference curves represent higher levels of utility.

Bundle A is on I1, a lower indifference curve; and it is clearly worse than E, B, or F, since it has less pizza and Coke than any of those bundles.

Bundle C is on a higher indifference curve, and is clearly better than B (more pizza and Coke).

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Figure 10A.1 Plotting Dave’s preferences for pizza and Coke (3 of 4)

Comparing B and D is a little trickier.

• A reasonable person could prefer D to B, say if he only cared about how much Coke he received.

• But the indifference curves reveal that Dave prefers B to D, since D is on a lower indifference curve to B.

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Figure 10A.1 Plotting Dave’s preferences for pizza and Coke (4 of 4)Marginal Rate of Substitution (MRS) is the rate at which the consumer is willing to trade off one product for another, while keeping the consumer’s utility constant.• Graphically, this is the slope of

the indifference curve.• From E to B, Dave is willing to

trade 4 cans of Coke for 1 slide of pizza; his MRS is 4 between E and B.

• MRS tends to decrease as we move to the right, giving indifference curves a convex shape.

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Figure 10A.2 Indifference curves cannot cross (1 of 2)

Bundles X and Z are on the same indifference curve, so Dave is indifferent between them.• Similarly for bundles X and Y.

We generally assume that preferences are transitive, so that if a consumer is indifferent between X and Z, and X and Y, then he must also be indifferent between Y and Z.

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Figure 10A.2 Indifference curves cannot cross (2 of 2)

But Dave will prefer Y to Z, since Y has more pizza and Coke.

Since transitivity is such an intuitively sensible assumption, we conclude that indifference curves will never cross.

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Figure 10A.3 Dave’s budget constraint

A consumer’s budget constraint is the amount of income he or she has available to spend on goods and services.

The table shows bundles Dave can buy with $10, if pizza costs $2 per slice and Coke costs $1 per can.

The slope of the budget constraint is the (negative of the) ratio of prices; it represents the rate at which Dave is allowed to trade Coke for pizza: 2 cans of Coke per 1 slice of pizza.

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Figure 10A.4 Finding optimal consumption (1 of 2)

Dave would like to reach the highest indifference curve that he can.

He cannot reach I4; no bundle on I4 is within his budget constraint.

The highest indifference curve he can reach is I3; bundle B is Dave’s best choice, given his budget constraint.

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Figure 10A.4 Finding optimal consumption (2 of 2)

To maximize utility, a consumer needs to be on the highest indifference curve, given his budget constraint.

Notice that at this point, the indifference curve is just tangent to the budget line.

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Figure 10A.5 How a price decrease affects the budget constraint

When the price ofpizza falls, Dave canbuy more pizza than before.

If pizza falls to $1.00 per slice, Dave can buy 10 slices of pizza per week; he can still afford 10 cans of Coke per week.

The budget constraint rotates out along the pizza-axis to reflect this increase in purchasing power.


Figure 10A.6 How a price change affects optimal consumptionAs the price of pizza falls and the budget constraint rotates out, Dave’s optimal bundle will change.

When pizza cost $2.00 per slice, Dave bought 3 slices.• Now that pizza costs

$1.00 per slice, Dave buys 7 slices.

These are two points on Dave’s demand curve for pizza (assuming he has $10, and Coke costs $1 per can).

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Figure 10A.7 Income and substitution effects of a price change (1 of 2)

When the price of pizza falls, Dave changes his consumption from A to C.We can think of this as two separate effects:1. A change in relative

price keeping utility constant, causing a movement along indifference curve I1; this is the substitution effect.

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Figure 10A.7 Income and substitution effects of a price change (2 of 2)

When the price of pizzafalls, Dave changes his consumption from A to C.We can think of this as two separate effects:2. An increase in

purchasing power, causing a movement from B to C; this is the income effect.

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Figure 10A.8 How a change in income affects the budget constraint

When the income Dave has to spend on pizza and Coke increases from $10 to $20, his budget constraint shifts outward.

With $10, Dave could buy a maximum of 5 slices of pizza or 10 cans of Coke.

With $20, he can buy a maximum of 10 slices of pizza or 20 cans of Coke.

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Figure 10A.9 How a change in income affects optimal consumptionAn increase in income leads Dave to consume more Coke…

… and more pizza.

For Dave, both Coke and pizza are normal goods.

A different consumer might have different preferences, and an increase in income might decrease the demand for Coke, for example; in this case, Coke would be an inferior good.

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Figure 10A.10 At the optimum point, the slopes of the indifference curve and the budget constraint are the same


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Relating MRS and marginal utilitySuppose Dave is indifferent between two bundles, A and B. A has more Coke than B, so B must have more pizza than A.

As Dave moves from A to B, the loss (in utility) from consuming less coke must be just offset by the gain (in utility) from consuming more pizza. We can write:

Rearranging terms gives:

And this first term is the slope of the indifference curve: the MRS.


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The rule of equal marginal utility per dollar spentThe last two slides have given us:

and

So now we know:

Rearrange to obtain our desired rule: