1. Chapter 20 Consumer Choice

2. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-2 Introduction There have been shifts in air travel away from facilities located in larger metro areas. San Francisco International Airport saw a decline in air passenger traffic, while Oakland International Airport had a gain. At Cleveland Hopkins International Airport passenger volume also fell, while Ohio’s Akron-Canton Airport saw volume rise.

3. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-3 Learning Objectives Distinguish between total utility and marginal utility Discuss why marginal utility at 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

4. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-4 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 a good or service Evaluate why the price of diamonds is so much higher than the price of water even though people cannot survive long without water

5. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-5 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

6. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-6 Did You Know That... There has been a proliferation of choices at U.S. grocery stores, which now stock an average of 40,000 items? One way of deriving the law of demand involves an analysis of the logic of consumer choice in a world of limited resources? In this chapter we discuss what is called utility analysis.

7. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-7 Utility Theory Utility  The want-satisfying power of a good or service Utility Analysis  The analysis of consumer decision making based on utility maximization Util  A representative unit by which utility is measured

8. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-8 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

9. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-9 Graphical Analysis We can appreciate total and marginal utility by using graphical analysis.

10. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-10 Figure 20-1 Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (a)

11. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-11 Figure 20-1 Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (b)

12. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-12 Figure 20-1 Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (c)

13. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-13 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.

14. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-14 Graphical Analysis (cont'd) Observations  Marginal utility falls as more is consumed.  Marginal utility equals zero when total utility is at its maximum.

15. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-15 Example: The High Cost of Certain Sources of Negative Marginal Utility Conventional wisdom says that it is impossible to put a price tag on happiness. Economists usually attempt to attach dollar values to economic goods. What is the amount of compensation required for economic “bads”?

16. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-16 Figure 20-2 Compensation for Economic “Bads” That Yield Negative Marginal Utility

17. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-17 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.

18. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-18 Example: Newspaper Vending Machines versus Candy Vending Machines How many people take more than one paper from the vending machine? Why not dispense candy the same way? The answer is found in the concept of diminishing marginal utility.

19. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-19 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

20. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-20 Table 20-1 Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26

21. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-21 Table 20-1 Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26 (cont'd)

22. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-22 Table 20-1 Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26 (cont'd)

23. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-23 Optimizing Consumption Choices 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.

24. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-24 Table 20-2 Steps to Consumer Optimum

25. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-25 Table 20-2 Steps to Consumer Optimum (cont'd)

26. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-26 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.

27. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-27 A little math  The rule of equal marginal utilities per dollar spent Optimizing Consumption Choices (cont'd) MU of good A Price of good A = MU of good B Price of good B MU of good Z Price of good Z ==...

28. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-28 How a Price Change Affects Consumer Optimum Recall from Table 20-1 Income = $26 Q d = 4 MU d PdPd 36.5 5 = = 7.3 Q s = 2 MU s PsPs 22 3 = = 7.3

29. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-29 How a Price Change Affects Consumer Optimum (cont'd) Assume Price of Music Falls to $4 Q d = 4 MU d PdPd 36.5 4 = = 9.125 Q s = 2 MU s PsPs 22 3 = = 7.3

30. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-30 How a Price Change Affects Consumer Optimum (cont'd) Assume Price of Music Falls to $4 Result Buy more downloads and MU d falls Now MU d PdPd > MU s PsPs

31. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-31 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.

32. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-32 Figure 20-3 Digital Music Download Prices and Marginal Utility

33. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-33 How a Price Change Affects Consumer Optimum (cont'd) The Substitution Effect  The tendency of people to substitute cheaper commodities for more expensive commodities

34. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-34 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.

35. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-35 How a Price Change Affects Consumer Optimum (cont'd) Purchasing Power  The value of money for buying goods and services

36. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-36 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).

37. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-37 How a Price Change Affects Consumer Optimum (cont'd) Question  What do you think: Which would usually have more of an impact on your purchases—the substitution effect or the real-income effect?

38. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-38 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

39. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-39 E-Commerce Example: Have You Got My Size? Retailers using Intellifit’s scanners can use data to provide customers with printouts of brands, styles, and sizes likely to fit best. Their objective is to push up prospective customers’ marginal utility at any given price of an apparel item, thereby boosting sales.

40. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-40 The Demand Curve Revisited (cont'd) Marginal utility, total utility, and the diamond-water paradox  Water is essential to life but cheap.  Diamonds are not essential to life but expensive.

41. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-41 Figure 20-4 The Diamond-Water Paradox

42. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-42 Behavioral Economics and Consumer Choice Theory Question  Does behavioral economics better predict consumer choices? Answer  Consumer choice remains alive and well.

43. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-43 Issues and Applications: The Upside of Taking Off from a Less Convenient Airport According to the principle of substitution, people shift away from consuming items that become priced relatively higher in favor of items that are now priced relatively lower. In recent years, the principle of substitution has applied to the services offered by several major airports. Many consumers of air travel are choosing to drive some distance before they depart to their ultimate destinations by plane.

44. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-44 Issues and Applications: The Upside of Taking Off from a Less Convenient Airport (cont'd) Weighing relative marginal utilities and prices Opting to avoid hassles that reduce marginal utility Responding to price changes

45. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-45 Table 20-3 Selected Substitute Airport Pairs in the United States

46. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-46 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.

47. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-47 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.

48. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20-48 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. Why the price of diamonds exceeds the price of water even though people cannot long survive without water  Marginal utility, not total utility, determines how much people are willing to pay.

49. End of Chapter 20 Consumer Choice