Download Optimizing Consumption Choices (cont`d)

Chapter 20
Consumer Choice
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Introduction
Some economists suggest that governments should
ban credit cards because the use of credit cards makes
consumers more satisfied until they receive their
credit-card bills.
As a result, banning credit cards would make people
better off.
In this chapter, you will learn how economists study
the way people make choices intended to maximize
their levels of satisfaction.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-2
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-3
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-4
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-5
Did You Know That ...
• The human brain does its intelligent computing
with 100,000,000,000 neurons?
• Evidence indicates that all this computing power
makes the human brain at least 10,000 times
more intelligent than the most artificially
constructed supercomputers.
• In this chapter we discuss what is called utility
analysis.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-6
Utility Theory
• Utility
– The want-satisfying power of a good or service
• Utility Analysis
– The analysis of consumer decision making
based on utility maximization
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-7
Utility Theory (cont’d)
• Util
– A representative unit by which utility is
measured
– Developed by philosopher Jeremy Bentham;
the school of thought is called utilitarianism
Copyright © 2012 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
Change in total utility
Marginal utility =
Change in number of units consumed
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-9
Figure 20-1 Total and Marginal Utility of
Downloading and Listening to Digital Music Albums,
Panel (a)
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-10
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.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-11
Utility Theory (cont'd)
• Observations
– Marginal utility falls as more is consumed
– Marginal utility equals zero when total utility is
at its maximum
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-12
Diminishing Marginal Utility
• 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.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-13
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?
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-14
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-15
Table 20-1 Total and Marginal Utility from
Consuming Music Album Downloads and Cappuccinos
on an Income of $26
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-16
Table 20-1 Total and Marginal Utility from
Consuming Music Album Downloads and Cappuccinos
on an Income of $26 (cont'd)
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-17
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-18
Table 20-2 Steps to Consumer
Optimum
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-19
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-20
Optimizing Consumption Choices
(cont'd)
• A little math
– The rule of equal marginal utilities per dollar
spent
MU of good A
MU of good B
=
Price of good A
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
MU of good Z
= ... =
Price of good B
Price of good Z
20-21
Example: Does Consuming More Expensive
Items Make People Happier?
• Economist Antonio Rangel conducted an
experiment in which he offered to let people taste
wines.
• The experiment with wines revealed that people
derive greater satisfaction from consuming the
good when they believe that it has a higher
explicit price.
• This means that when consumers choose to pay
higher prices, they derive additional satisfaction.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-22
Why Not … make consumers happier by
requiring them to purchase the quantities
the government chooses?
• If the government required individuals to
reallocate their incomes to purchase more of
certain items, then the marginal utilities from
consuming those items would decline.
• Also, consumers would have less remaining
income available to purchase other items, so the
marginal utilities of buying those items would
rise.
• So, the consumers would be less satisfied as their
marginal utility per dollar spent would no longer
be equal.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-23
How a Price Change Affects
Consumer Optimum
Recall from Table 20-1 Income = $26
Qd = 4
MUd
36.5
= 7.3
=
Pd
5
Qs = 2
MUs
22
=
Ps
3
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
= 7.3
20-24
How a Price Change Affects
Consumer Optimum (cont'd)
Assume Price of Music Falls to $4
Qd = 4
MUd
36.5
= 9.125
=
Pd
4
Qs = 2
MUs
22
=
Ps
3
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
= 7.3
20-25
How a Price Change Affects
Consumer Optimum (cont'd)
Assume Price of Music Falls to $4
Now
Result
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
MUd
MUs
>
Pd
Ps
Buy more downloads
and MUd falls
20-26
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-27
Figure 20-2 Digital Music Download
Prices and Marginal Utility
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-28
How a Price Change Affects
Consumer Optimum (cont'd)
• The Substitution Effect
– The tendency of people to substitute cheaper
commodities for more expensive commodities
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-29
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-30
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-31
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)
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-32
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?
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-33
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-34
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-35
Figure 20-3 The Diamond-Water
Paradox
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-36
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.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-37
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-38
You Are There: Signing Up for “Free” Trial Offers
with TrialPay
• TrialPay offer items at no explicit charge and
instead its customers have to agree to sign up for
a trial offer for a product of another firm, such as
a “free” trial membership with the movie service
Netflix.
• TrialPay ensures that the marginal utility per
dollar spent will be high enough to make a trial
membership part of the consumer optimum for its
customers.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-39
Issues & Applications: Is the Utility from
Using Credit Cards Really Negative?
• Behavioral economists argue that a consumer’s
rationality is bounded, meaning that people often
are unable to assess all aspects of choices that
they confront.
• Some economists suggest the utility from credit
card use is negative on net because the positive
utility that consumers derive from using credit
cards to obtain immediate use of an item is
overwhelmed by a utility decrease from having to
give up other items when they pay their creditcard bill.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-40
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-41
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-42
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-43
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-44
Figure F-1 Combinations That Yield Equal
Levels of Satisfaction
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-45
Appendix F: Properties of Indifference
Curves
• Downward (negative) slope
• Curvature
– not a straight line
– convex with respect to the origin
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-46
Figure F-2 Indifference Curves: Impossibility
of an Upward Slope
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-47
Figure F-3 Implications of a Straight-Line
Indifference Curve
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-48
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-49
Table F-1 Calculating the Marginal Rate of
Substitution
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-50
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-51
Figure F-4 A Set of Indifference Curves
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-52
Appendix F: The Budget Constraint
• Budget constraint
– All of the possible combinations of goods that
can be purchased (at fixed prices) with a
specific budget
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-53
Figure F-5 The Budget Constraint
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-54
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-55
Figure F-6 Consumer Optimum
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-56
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
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-57
Figure F-7 Deriving the Demand Curve,
Panel (a)
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-58
Figure F-7 Deriving the Demand Curve,
Panel (b)
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
20-59