Chapter 20 Consumer Choice

Introduction For years, a number of U.S. households have allocated a significant portion of their budgets to unhealthful items and a small amount to healthful items. This trend has reversed recently, as spending on alcoholic beverages, restaurant meals and tobacco products has declined, while expenditures on vegetables have increased. This chapter will help you understand why such a change has occurred by demonstrating how 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 ... A consumer who shops at a typical U.S. supermarket chooses among 48,750 items? Of course, the array of goods from which consumers choose extends far beyond the supermarket aisle. In this chapter we discuss what is called utility analysis as a means of examining how consumers make choices.

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 Utilizing Apps, Panel (a)

Figure 20-1 Total and Marginal Utility of Utilizing Apps, Panels (b) and (c)

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

Example: High-Priced Blue Jeans as Part of a Consumer Optimum About 1 percent of the nearly $14 billion in annual U.S. expenditures on blue jeans goes towards jeans priced above $50. The theory of consumer optimum explains why some people are willing to pay such high prices for blue jeans. For these individuals, it must be the case that the last dollar spent on a pair of expensive blue jeans generates the same amount of marginal utility as a dollar spent on any other item.

Table 20-1 Total and Marginal Utility from Consuming Digital Apps and Cappuccinos on an Income of $26

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

Table 20-2 Steps to Consumer Optimum

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

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 ...

International Example: Inferring Substantial Marginal Utility from an Oil Change Recently, a resident of Qatar decided to arrange for an oil change on his Lamborghini sports car to be done in London. This required airlifting the car to London. The comprehensive cost of the oil change, including transportation costs, was over $45,000. According to the rule of consumer optimum, the marginal utility per dollar spent on the oil change would have to be equal to the marginal utility per dollar spent on other goods and services.

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 Digital Apps 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 Digital Apps Falls to $4 Result Buy more apps 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 App 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

What if . . . the government bans certain products to try to prevent poor decisions? The U.S. government limits choices for certain products, and U.S. energy secretary Steven Chu offered such a rationale for banning the sale of incandescent light bulbs. He argues that the quality-adjusted price of fluorescent bulbs is lower, based on the assumption that people leave lights burning for long periods. But consumers who turn lights on and off frequently would achieve greater energy efficiency with incandescent bulbs.

Restrictions on choice typically reduce utility for some consumers What if . . . the government bans certain products to try to prevent poor decisions? (cont’d) Banning incandescent bulbs would make many of these consumers worse off Restrictions on choice typically reduce utility for some consumers

You Are There: Using a Smartphone to Attain a Consumer Optimum A consumer at Best Buy finds the store price for a desired GPS device to be higher than what he is willing to pay. On his smartphone, he locates the same item for half the price through Amazon. While still at Best Buy, he uses his phone to order the item from Amazon, thereby attaining a consumer optimum.

Issues & Applications: Why Are Consumers Making More Healthful Choices? Figure 20-4 on the next slide depicts changes in spending on various products since 2008. Spending on alcoholic beverages, restaurant food, and tobacco products has declined, while expenditures on vegetables have increased. This change could be due to government efforts to educate consumers about the health effects of these products, or it could be due to changes in relative prices of these items. Since 2008, the relative price of vegetables has decreased by 1 percent; relative prices for alcohol, tobacco, and restaurant meals have risen.

Figure 20-4 Changes in Spending on Selected Items by the Typical U. S Figure 20-4 Changes in Spending on Selected Items by the Typical U.S. Consumer since 2008 Source: Bureau of Labor Statistics.

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 47

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 49

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 52

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 54

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 56

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 58

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 60

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

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

Summary Discussion of Learning Objectives The Budget Constraint Indifference curves represent preferences. A budget constraint represents opportunities: how much can be purchased with a given level of income.

Summary Discussion of Learning Objectives (cont’d) The Marginal Rate of Substitution To measure the marginal rate of substitution, we find out how much of one good has to be given up in order to allow the consumer to consume one more unit of the other good while still remaining on the same indifference curve.

Summary Discussion of Learning Objectives (cont’d) Slope of the Budget Constraint The slope of the budget constraint is the rate of exchange between two goods. Deriving the Demand Curve A decrease in the price of an item causes the budget line to rotate outward. This generates a new consumer optimum, at which the individual chooses to consume more units of the item.