1. 22-1 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory Copyright © 2012 Pearson Prentice Hall. All rights reserved.

2. Consumer Choice Using Utility Theory Brock Williams P R E P A R E D B Y In February 2010, Apple Computer sold its 10 billionth song at its iTunes music store. CHAPTER 22 Copyright © 2012 Pearson Prentice Hall. All rights reserved.

3. 22-3 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory How does a tax on one good affect the demand for substitute goods? A Tax on Soft Drinks What is the substitution effect of a price increase? The Price of Pirate Songs How do consumers respond to free goods? The Big Difference between $0.20 and FREE! How does product branding affect consumers’ brain activity? Neuroscience and the Cola Challenge 1 2 3 4 A P P L Y I N G T H E C O N C E P T S

4. 22-4 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory utility The satisfaction experienced from consuming a good. util One unit of utility. TOTAL AND MARGINAL UTILITY 22.1

5. 22-5 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory ► FIGURE 22.1 Total Utility and Marginal Utility TOTAL AND MARGINAL UTILITY (cont’d) 22.1 In Panel A, the total utility or satisfaction from downloaded songs increases with the number of songs, but at a decreasing rate. In Panel B, the marginal utility from songs decreases as the number of songs increases.

6. 22-6 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory marginal utility The change in total utility from one additional unit of a good. law of diminishing marginal utility As the consumption of a particular good increases, marginal utility decreases. TOTAL AND MARGINAL UTILITY (cont’d) 22.1

7. 22-7 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory budget line The line connecting the combinations of two goods that exhaust a consumer’s budget. Consumer Constraints: The Budget Line budget set A set of points that includes all the combinations of two goods that a consumer can afford, given the consumer’s income and the prices of the goods. CONSUMER CHOICE 22.2

8. 22-8 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory Consumer Constraints: The Budget Line  FIGURE 22.2 Budget Set and Budget Line CONSUMER CHOICE (cont’d) 22.2 The budget set (the shaded triangle) shows all the affordable combinations of books and movies, and the budget line (with endpoints a and k) shows the combinations that exhaust the budget.

9. 22-9 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory 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 the marginal benefit per dollar for the second activity. CONSUMER CHOICE (cont’d) 22.2

10. 22-10 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory Making Choices Using the Equimarginal Rule E Q U I M A R G I N A L R U L E Pick the combination of two activities where the marginal benefit per dollar for the first activity equals the marginal benefit per dollar for the second activity. CONSUMER CHOICE (cont’d) 22.2

11. 22-11 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory Online music stores provide an alternative to buying bundles of songs on CDs. We can use the theory of consumer choice to explain the logic behind this recent development.  FIGURE 22.3 Internet Music Piracy and iTunes When music is sold as 15-song bundles on CDs, the consumer has three budget points (a, c, and d) rather than an entire budget line. If songs are sold individually, the consumer has a complete budget line and can legally reach his or her ideal combination of 6 songs and 48 arcade games (point b). Bundling of Goods and iTunes CONSUMER CHOICE (cont’d) 22.2

12. 22-12 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory A TAX ON SOFT DRINKS APPLYING THE CONCEPTS #1: How does a tax on one good affect the demand for substitute goods? In response to the obesity problem among young people some policy makers have proposed a tax on soft drinks. They are responsible for 10 percent of caloric intake of adolescents. Although estimates vary, a mid-range estimate of elasticity suggests 0.5 which would mean a 20 percent increase in price would result in a decrease in consumption of 10 percent. Using the equimarginal rule: if before the tax the marginal bang for buck is 12 (6 utils / $.50), a 20 percent tax will decrease the marginal bang for buck to 10 (6 utils / $.60). The bang for buck for juice would then exceed that for soft drinks. A P P L I C A T I O N 1

13. 22-13 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory  FIGURE 22.4 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 22.3 When the price of a movie is $3, Maxine maximizes utility at point i, with four movies. If the price drops to $2, she maximizes utility at point j, with seven movies.

14. 22-14 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory substitution effect The change in quantity consumed that is caused by a change in the relative price of the good, with real income held constant. The Income and Substitution Effects of a Price Change income effect The change in quantity consumed that is caused by a change in real income, with relative prices held constant. THE INDIVIDUAL DEMAND CURVE (cont’d) 22.3

15. 22-15 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory The Income and Substitution Effects of a Price Change Points on the Demand Curve In general, each point on a demand curve shows the utility- maximizing choice for a particular price. THE INDIVIDUAL DEMAND CURVE (cont’d) 22.3

16. 22-16 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory Example: Substitution Effect of a Gasoline Tax If the government raises the gasoline tax and cuts income taxes, will gasoline consumption decrease? Initial price of gas = $4 per gallon Price of another good = $1 per unit When the consumer maximizes utility, gas consumption is 1,000 gallons per year and the marginal utility of gas = 12 utils. The marginal utility of the other good = 3 utils. This yields the equimarginal principle: Then, a tax of $2 is imposed on gasoline. The price of gas after tax = $4 + $2 = $6, and the equimarginal principle is affected as follows: The citizen will cut back on gasoline and spend more on the other good. The decrease in gas consumption is the substitution effect in action.

17. 22-17 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory THE PRICE OF PIRATE SONGS APPLYING THE CONCEPTS #2: What is the substitution effect of a price increase? Scarlett loves songs about pirates. Her parents give her money each month to keep her utility level constant. If the price increased $0.20 and she normally bought 10 songs, her parents would pay her an additional $2.00. How will she respond? The substitution effect tells us she will consume fewer pirate songs even though she can afford to buy the same number. The increase in the price relative to other goods will cause her to substitute other goods. A P P L I C A T I O N 2

18. 22-18 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory THE BIG DIFFERENCE BETWEEN $0.20 AND FREE! APPLYING THE CONCEPTS #3: How do consumers respond to free goods? A few years ago Amazon.com introduced free shipping for U.S. orders over $25. A consumer who bought a single book for less than $25 would pay about $4 in shipping, but if adding a second book to the order brought the book total to at least $25, shipping was free. The free-shipping offer decreased the effective price of any book that pushed the book order over $25, and sales increased dramatically. In France, the company offered cheap—but not free—shipping for orders over $25. Crossing the $25 threshold cut the shipping charge to only 1 franc, about $0.20. In contrast with the U.S. experience, book sales increased by a relatively small amount. The Amazon experiences in the United States and France illustrate a puzzle in consumer behavior. Cutting the shipping charge from $4 to zero had a huge effect, but cutting the charge to $0.20 didn’t have much of an effect. Consumers are highly responsive to freebies, and many firms incorporate free goods and services into their marketing. CONSUMER PUZZLES—FREE GOODS AND BRANDING 22.4 A P P L I C A T I O N 3

19. 22-19 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory NEUROSCIENCE AND THE COLA CHALLENGE APPLYING THE CONCEPTS #4: How does product branding affect consumers’ brain activity? In the “Pepsi Challenge” advertisements, randomly chosen consumers tasted Pepsi and Coke, and a majority preferred Pepsi. In an advertising campaign running at the same time, Coca-Cola proclaimed that a majority of consumers who tasted both products actually preferred Coke. Can both companies be correct? There was a subtle difference between the two taste tests. Pepsi used blind tasting, while Coca-Cola used non-blind tasting. When consumers don’t know what brand they are drinking, Pepsi has the edge. In other words, branding makes a difference. Neuroscientists ran the cola challenge while monitoring the brain activity of the tasters. When the participants knew which brand they were drinking, the portion of the brain involved in higher order functions—working memory, associations, higher-order cognitions, and ideas—was stimulated, and the activation was much greater with Coke than with Pepsi. In other words, branding affects brain activity and consumer preference. A P P L I C A T I O N 4

20. 22-20 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory budget line budget set equimarginal rule income effect law of diminishing marginal utility marginal utility substitution effect util utility K E Y T E R M S

21. 22-21 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory To determine whether a consumer is making the best choice, what single question can you ask? What’s Your MRS? How do consumers respond to free goods? The Big Difference between $0.20 and FREE! What is the substitution effect of a price increase? The Price of Pirate Songs CONSUMER CHOICE WITH INDIFFERENCE CURVES A P P E N D I X A A P P L Y I N G T H E C O N C E P T S 1 3 2 2 2 2

22. 22-22 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory Consumer Constraints: The Budget Set and Budget Line CONSUMER CONSTRAINTS AND PREFERENCES 22A.1 budget set A set of points that includes all the combinations of two goods that a consumer can afford, given the consumer’s income and the prices of the goods. price ratio The price of the good on the horizontal axis divided by the price of the good on the vertical axis. budget line The line connecting all the combinations of two goods that exhaust a consumer’s budget. CONSUMER CHOICE WITH INDIFFERENCE CURVES A P P E N D I X A

23. 22-23 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory Consumer Constraints: The Budget Set and Budget Line  FIGURE 22A.1 Budget Set and Budget Line The budget set (the shaded triangle) shows all the affordable combinations of books and movies. The budget line (with endpoints a and k) shows the combinations that exhaust the budget. CONSUMER CONSTRAINTS AND PREFERENCES (cont’d) 22A.1 CONSUMER CHOICE WITH INDIFFERENCE CURVES A P P E N D I X A

24. 22-24 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory Consumer Preferences: Indifference Curves indifference curve A curve showing the different combinations of two goods that generate the same level of utility or satisfaction. utility The satisfaction experienced from consuming a good. marginal rate of substitution (MRS) The rate at which a consumer is willing to trade or substitute one good for another. CONSUMER CHOICE WITH INDIFFERENCE CURVES CONSUMER CONSTRAINTS AND PREFERENCES (cont’d) 22A.1 A P P E N D I X A

25. 22-25 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory  FIGURE 22A.2 Indifference Curve and the Marginal Rate of Substitution The indifference curve shows the different combinations of movies and books that generate the same utility level. The slope is the marginal rate of substitution (MRS) between the two goods. The MRS is eight books per movie between points b and i, but only one book per movie between points m and n. The indifference curve passing through points b, i, m, and n separates the combinations of books and movies into three groups: 1 Superior combinations. 2 Inferior combinations. 3 Equivalent combinations. CONSUMER CHOICE WITH INDIFFERENCE CURVES A P P E N D I X A CONSUMER CONSTRAINTS AND PREFERENCES (cont’d) 22A.1

26. 22-26 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory  FIGURE 22A.3 Indifference Curve Map An indifference curve map shows a set of indifference curves, with utility increasing as we move northeasterly to higher indifference curves (from I 1 to I 2 to I 3 ). indifference curve map A set of indifference curves, each with a different utility level. CONSUMER CHOICE WITH INDIFFERENCE CURVES A P P E N D I X A CONSUMER CONSTRAINTS AND PREFERENCES (cont’d) 22A.1

27. 22-27 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory The Tangency Condition  FIGURE 22A.4 Maximizing Utility: MRS Equals the Price Ratio To maximize utility, the consumer finds the combination of books and movies where an indifference curve is tangent to the budget line. At the utility-maximizing combination (point e), the marginal rate of substitution (the consumer’s own trade-off, shown by the slope of the indifference curve) equals the price ratio (the market trade-off, shown by the slope of the budget line). MAXIMIZING UTILITY 22A.2 CONSUMER CHOICE WITH INDIFFERENCE CURVES A P P E N D I X A

28. 22-28 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory The Utility-Maximizing Rule: MRS = Price Ratio utility-maximizing rule Pick the combination that makes the marginal rate of substitution equal to the price ratio. CONSUMER CHOICE WITH INDIFFERENCE CURVES A P P E N D I X A MAXIMIZING UTILITY (cont’d) 22A.2

29. 22-29 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory  FIGURE 22A.5 Internet Music Piracy and iTunes When music is sold as 15-song bundles on CDs, the consumer has three budget points (a, c, and d) rather than an entire budget line. If songs are sold individually, the consumer has a full budget line and can legally reach his or her ideal combination of 6 songs and 48 arcade games (point b). A P P E N D I X A MAXIMIZING UTILITY (cont’d) 22A.2

30. 22-30 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory WHAT’S YOUR MRS? APPLYING THE CONCEPTS #1: To determine whether a consumer is making the best choice, what single question can you ask? We can use the utility-maximizing rule to determine whether consumers are doing the best they can. Suppose a firm has a fixed budget of $200 to spend on punch and cookies for its holiday party. The price of punch is $2 per cup and the price of cookies is $1 per cookie; both goods will, of course, be provided free of charge to workers at the party. The firm’s objective is to maximize the utility of the typical employee, and your job is to determine whether the company spent this year’s party budget wisely. Assume that all employees have identical tastes for cookies and punch, so data from a single person will apply to every employee. You can ask the typical employee a single question. What’s your question? “How many cookies would you be willing to trade for one cup of punch?” If the answer is “two cookies per cup of punch,” the MRS equals the price ratio, and the firm did the best it could. On the other hand, if the answer is “five cookies per cup of punch,” the MRS exceeds the price ratio, and the firm could have generated higher utility with its $200 by providing more punch and fewer cookies. A P P E N D I X A A P P L I C A T I O N 1

31. 22-31 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory THE BIG DIFFERENCE BETWEEN $0.20 AND FREE! APPLYING THE CONCEPTS #2: How do consumers respond to free goods? A few years ago Amazon.com introduced free shipping for U.S. orders over $25. A consumer who bought a single book for less than $25 would pay about $4 in shipping, but if adding a second book to the order brought the book total to at least $25, shipping was free. The free-shipping offer decreased the effective price of any book that pushed the book order over $25, and sales increased dramatically. In France, the company offered cheap—but not free—shipping for orders over $25. Crossing the $25 threshold cut the shipping charge to only 1 franc, about $0.20. Book sales increased by a relatively small amount. The Amazon experiences in the United States and France illustrates a puzzle in consumer behavior. Cutting the shipping charge from $4 to zero had a huge effect, but cutting the charge to $0.20 didn’t have much of an effect. Consumers are highly responsive to freebies, and many firms incorporate free goods and services into their marketing. A P P E N D I X A A P P L I C A T I O N 2

32. 22-32 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory With so many curves floating around, it is worth reviewing their roles in consumer decision making: The budget line shows the affordable combinations of two goods, representing the consumer’s constraints. An indifference curve shows the different combinations of two goods that generate the same utility level, representing the consumer’s preferences. The demand curve shows how much of a single product a consumer is willing to buy at a particular price. To get the demand curve, we use both the budget line and indifference curves. The Negatively Sloped Demand Curve CONSUMER CHOICE WITH INDIFFERENCE CURVES DRAWING THE INDIVIDUAL DEMAND CURVE 22A.3 A P P E N D I X A

33. 22-33 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory The Negatively Sloped Demand Curve  FIGURE 22A.6 Drawing the Demand Curve A decrease in the price of movies tilts the budget line outward. In Panel A, the indifference curve is tangent to the new budget line at point t, with a larger quantity of movies (7 instead of 4). In Panel B, when the price of movies is $3, the consumer maximizes utility with 4 movies. A decrease in price to $2 increases the utility-maximizing number of movies to 7, illustrating the law of demand. CONSUMER CHOICE WITH INDIFFERENCE CURVES A P P E N D I X A DRAWING THE INDIVIDUAL DEMAND CURVE (cont’d) 22A.3

34. 22-34 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory The Income and Substitution Effects of a Price Change substitution effect The change in quantity consumed that is caused by a change in the relative price of the good, with real income held constant. income effect The change in quantity consumed that is caused by a change in real income, with relative prices held constant. CONSUMER CHOICE WITH INDIFFERENCE CURVES A P P E N D I X A DRAWING THE INDIVIDUAL DEMAND CURVE (cont’d) 22A.3

35. 22-35 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory The Income and Substitution Effects of a Price Change Let’s take a closer look at a consumer’s response to a change in price. We will break down Maxine’s response to a decrease in price into two effects: Substitution effect. A decrease in the price of movies decreases the price of movies relative to the price of other goods, such as books. As movies become less costly relative to books, Maxine substitutes movies for books. Income effect. A decrease in the price of movies increases Maxine’s real income (the purchasing power of her nominal income), and she will buy more of all normal goods. If watching movies is a normal good, she will watch more movies. CONSUMER CHOICE WITH INDIFFERENCE CURVES A P P E N D I X A DRAWING THE INDIVIDUAL DEMAND CURVE (cont’d) 22A.3

36. 22-36 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory  FIGURE 22A.7 The Substitution Effect of a Decrease in Price To observe the substitution effect, shown by the move from point e to point s, we offset the decrease in price of movies (from $3 to $2) by decreasing the consumer’s income to $26, thereby making the original choice (point e) just affordable. At the original choice, the MRS (three books per movie) exceeds the new price ratio (two books per movie), so the consumer can do better. Moving from point e to point s, utility increases and the quantity of movies increases from four to six. The Income and Substitution Effects of a Price Change CONSUMER CHOICE WITH INDIFFERENCE CURVES A P P E N D I X A DRAWING THE INDIVIDUAL DEMAND CURVE (cont’d) 22A.3

37. 22-37 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory  FIGURE 22A.8 The Income Effect of a Decrease in Price To observe the income effect, shown by the move from point s to point t, we restore the consumer’s original nominal income of $30 (up from the $26 used to reveal the substitution effect) while keeping a price of $2 per movie. The budget line shifts outward, and the consumer maximizes utility at point t, so the quantity of movies increases from six to seven. The Income and Substitution Effects of a Price Change CONSUMER CHOICE WITH INDIFFERENCE CURVES A P P E N D I X A DRAWING THE INDIVIDUAL DEMAND CURVE (cont’d) 22A.3

38. 22-38 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory The Income and Substitution Effects of a Price Change  FIGURE 22A.9 Increasing the Gas Tax and Decreasing the Income Tax If a $2 gasoline tax is combined with a $2,000 decrease in the income tax, a person who initially buys 1,000 gallons (point a) can still afford the initial choice. But the increase in the relative price of gasoline means that the initial point no longer maximizes utility. At point a, the MRS is less than the new price ratio, and the substitution effect moves the consumer from point a to point b, reducing gasoline consumption from 1,000 to 700 gallons. CONSUMER CHOICE WITH INDIFFERENCE CURVES A P P E N D I X A DRAWING THE INDIVIDUAL DEMAND CURVE (cont’d) 22A.3

39. 22-39 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory THE PRICE OF PIRATE SONGS APPLYING THE CONCEPTS #3: What is the substitution effect of a price increase? Scarlett loves songs about pirates. Her parents give her money each month to keep her utility level constant. If the price increased $.20 and she normally bought 10 songs, her parents would pay here an additional $2.00. How will she respond? The substitution effect tells us she will consume fewer pirate songs even though she can afford to buy the same number. The increase in the price relative to other goods will cause her to substitute other goods. A P P E N D I X A A P P L I C A T I O N 3

40. 22-40 Copyright © 2012 Pearson Prentice Hall. All rights reserved. C H A P T E R 22 Consumer Choice Using Utility Theory budget line budget set income effect indifference curve indifference curve map marginal rate of substitution (MRS) price ratio substitution effect utility utility-maximizing rule K E Y T E R M S A P P E N D I X A