Economics principles tools and applications 9th by sullivan sheffrin perez chapter 22

Economics NINTH EDITION Chapter 22 Insert Cover Picture Consumer Choice: Utility Theory and Insights from Neuroscience Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved Learning Objectives 22.1 Explain the equimarginal principle and apply it to consumer choice 22.2 Describe the income and substitution effects of a price change 22.3 Describe the general process involved in the valuation of the benefits and costs of a consumer good 22.4 Apply the insights from neuroscience to consumer decisions about nutrition and saving Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 22.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (1 of 6) Consumer Constraints: The Budget Line A consumer’s budget line shows all the combinations of two goods that exhaust the budget The slope of the budget line is the opportunity cost of a movie in terms of books The budget set (the shaded triangle) shows all the affordable combinations of books and movies, and the budget line (with endpoints r and v) shows the combinations that exhaust the budget Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 22.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (2 of 6) Total and Marginal Utility The consumer’s objective is to maximize utility The upper panel shows the relationship between total utility and the number of movies watched In the lower panel, the marginal utility from movies decreases as the number of movies increases Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 22.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (3 of 6) The Marginal Principle and the Equimarginal Rule MARGINAL PRINCIPLE Increase the level of an activity as long as its marginal benefit exceeds its marginal cost Choose the level at which the marginal benefit equals the marginal cost The marginal utility of movies decreases as the number of movies increases, reflecting the assumption of diminishing marginal utility The marginal utility per dollar equals the marginal utility divided by the price of movies Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 22.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (4 of 6) Conditions for Maximizing Utility MARGINAL PRINCIPLE Increase the level of an activity as long as its marginal benefit exceeds its marginal cost Choose the level at which the marginal benefit equals the marginal cost The consumer picks the affordable bundle at which the marginal utility per dollar on movies equals the marginal utility per dollar on books This is shown by point a (6 movies) and point b (9 books) Starting from any other affordable combination, the consumer can better by reallocating the budget in favor of the good with the larger marginal utility per dollar For example, starting from points c and d, movies have a larger marginal utility per dollar, so the consumer can increase utility by choosing more movies and fewer books Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 22.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (5 of 6) Making Choices Using the Equimarginal Rule ● Equimarginal rule Pick the combination of two activities where the marginal benefit per dollar for marginal benefit per dollar for the second activity Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved the first activity equals the 22.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (6 of 6) Making Choices Using the Equimarginal Rule TABLE 22.1 Utility Maximization Marginal Marginal Marginal Marginal Utility Utility Utility: Utility: Utility per $: Utility per $: from from Total Movies Books Movies Books Movies Books Movies Books Utility 24 51 17 51 216 267 21 48 16 99 210 309 18 45 15 144 198 342 15 42 14 186 180 366 12 39 10 13 10 225 156 381 36 12 12 12 261 126 387 33 14 11 14 294 90 384 30 16 10 16 324 48 372 EQUIMARGINAL RULE Pick the where the marginal benefit per dollar for the first activity equals the marginal benefit per combination of two activities dollar for the second activity Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPLICATION • MEASURING DIMINISHING MARGINAL UTILITY • APPLYING THE CONCEPTS #1: How does marginal utility change with the quantity consumed? • Neuroscientists have used brain imaging techniques to provide some insights into the law of diminishing marginal utility The scientists offered subjects in an experiment varying monetary rewards, and observed the neural activity in a subject's striatum, the region of the brain responsible for the valuation of rewards • As the monetary reward increased, the subjective benefit (the utility value, as measured in neuron activity) increased, but at a decreasing rate In other words, the larger the reward, the lower the marginal utility of the reward money • For example, for a $15 reward, the marginal utility is util per dollar, but for a $150 reward, the marginal utility is only 0.25 utils per dollar Although this experiment does not provide a direct demonstration of the law of diminishing marginal utility for a particular product, it does show that general rewards are subject to diminishing marginal utility Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 22.2 THE LAW OF DEMAND AND THE INDIVIDUAL DEMAND CURVE (1 of 3) The effect of a decrease in price The left panel shows a decrease in price moves the curve up A decrease in price show the original bundle violates the equimarginal rule A decrease in the price of movies shifts the movie benefit curve (MU per $ of movies) upward At the original bundle (6 movies and books), the MU per $ of movies (18 utils at point c) exceeds the MU per $ of books (12 utils at point b), so the consumer Increases the number of movies Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (5 of 7) Cognition and Choice Why people make different choices? • Strength of their gut-feelings • Cognitive weighting Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (6 of 7) Predicting Consumer Choice Neuroscientists map and measure the brain activity associated with consumer decisions After observing a consumer's brain activity while he or she considers different options, scientists can actually predict the consumer's choice Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (7 of 7) Fuel for Cognition The decision-making process that occurs in the PFC is complex As a result, the cognitive process consumes a large amount of energy in supporting neurons as they perform their various tasks The brain gets most of its energy from glucose (aka blood sugar), and operates effectively only when it has a plentiful supply of glucose The fuel requirements of cognition have important implications for consumer decision-making A consumer may respond to the depletion of brain fuel in one of three ways: a) simplify matters by focusing on a single dimension of the product (price, color, shine) b) abandon cognition and make an impulse buy, or c) abandon the decision-making process altogether and refrain from buying a toothbrush Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPLICATION • COKE VERSUS PEPSI IN THE PREFRONTAL CORTEX • APPLYING THE CONCEPTS #3: How does cognition affect consumer choice? • In the “Pepsi Challenge” advertisements of the 1970s and 1980s, randomly chosen consumers tasted Pepsi and Coke Most preferred Pepsi However a majority of buyers chose Coke • Thirty years later neuroscientist Read Montague ran a Pepsi challenge while observing brain activity When subjects didn’t know what they were drinking, most preferred Pepsi When they did know what they were drinking, most preferred Coke • A consumer’s choice is based on gut-feeling benefits and costs Activity in the prefrontal cortex was stronger for Coke than for Pepsi, presumably reflecting more favorable images and feelings associated with Coke commercials Branding affects brain activity and consumer preference Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 22.4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE (1 of 4) Dietary Choice: Donut vs Apple Some scientists speculate that the evolutionary development of the DLPFC in humans increased our fitness (likelihood of survival) because it gave us the ability to incorporate long-term considerations into the decision-making process For a decision based exclusively on gut feelings, a consumer using the equimarginal rule chooses points a and b (9 donuts and apple) The engagement of the cognitive process decreases the perceived MU per $ of donuts, so at the original bundle (9 donuts, apple), the MU per $ is utils for donuts (point c), compared to 12 utils for apples (point b) The new utility-maximizing choice is shown by points e and d: cognitive engagement decreases donut consumption from to and increases apple consumption from to Equimarginal rule For each good, the marginal utility per dollar is 12 utils Affordability The consumer spends $9 on donuts and $1 on apples, for a total of $10 In this case, a consumer who simply goes with his or her gut feelings eats a lot of donuts Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 22.4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE (2 of 4) Present bias: spending vs savings Gut feelings are visceral, in-the-moment sensations, and humans are myopic with respect to gut feelings In other words, humans a poor job imagining the strength of future gut feelings, including the gut-feeling benefits of future consumption A consumer subject to present bias chooses points a and b (spend $19 and save $1) Cognition that reduces present bias increases the perceived MU per $ of saving, so at the original bundle (spend $19, save $1), the MU per dollar is higher for saving (point c versus point a) The new utility-maximizing choice shown by points e and d: cognitive Engagement increases saving from $1 to $7 and decreases spending (consumption now) from $19 to $13 In the left panel, the benefit curve shows the marginal utility per dollar spent in the present For current consumption, gut feelings accurately represent the benefit of consumption In the right panel, the lower curve shows the benefit of saving (the benefit of future consumption) for a consumer subject to present bias: the consumer systematically underestimates the future benefit of consumption Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 22.4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE (3 of 4) Present Bias and Credit Cards Credit cards cause a different sort of temporal mismatch between benefits and costs In this case, the benefit of a product will be experienced now, but the cost will be delayed until some future date Using a credit card weakens our gut feeling aversion to spending money Present Bias and Smoking The decision to smoke cigarettes is subject to present bias because there is a temporal mismatch between the present benefit (the good feeling from nicotine) and a future cost (health problems) Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 22.4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE (4 of 4) Gambling as a Consumer Good Why people gamble when the expected reward is negative? For example, the typical state-run lottery pays out roughly half of what it takes in, so on average a person who plays the lottery for $10 can expect a payoff of roughly $5 Neuroscientists have discovered a possible reason for this seemingly irrational behavior If you draw ball #3, you win $12 The expected monetary value of drawing a ball from the urn is $4 = 1/3 × $12 Suppose the dopamine benefit of winning is 12 utils, while the dopamine benefit for a near win (drawing ball #2) is utils The expected dopamine value of drawing a ball is utils = 1/3 × + 1/3 × 12 Numbers that are close to a gambler’s number seem to be a near miss to the gambler and encourages continued gambling in spite of the fact that numbers have an equal chance of selection Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPLICATION • TAXING CIGARETTES TO OFFSET PRESENT BIAS • APPLYING THE CONCEPTS #4: What is the appropriate cigarette tax? • The present bias that leads some people to smoke cigarettes raises an important policy question: Can we use taxes on cigarettes to offset present bias and actually make people better off in the process? A recent study concludes that to fully offset the present bias that underlies the decision to smoke, the appropriate tax is roughly $11 per pack of cigarettes • The study focused on the effects of smoking on premature death Smoking cuts the lifespan of the typical smoker by roughly years, and given the economic value of one year of life, we can translate the cost associated with premature death into a cost of roughly $36 per pack of cigarettes If smokers did not suffer from present bias, their present choices would fully reflect this future cost, meaning that they would compare the benefit of smoking (the nicotine experience) to the full cost of a pack of cigarettes (the purchase price plus the $36 cost associated with premature death) • The study suggest that the cigarette tax would actually be beneficial for low-income households The reason is that low-income households are relatively responsive to changes in the price of cigarettes, so they would experience a relatively large reduction in smoking, and a relatively large increase in lifespan Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved KEY TERMS Budget line Budget set Equimarginal rule Income effect Law of diminishing marginal utility Marginal utility Substitution effect Util Utility Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES Economists and psychologists have identified several types of puzzling consumer behavior • Spending choices sometimes depends on the source of income • The willingness to pay for a product sometimes is affected by irrelevant information • Product choices are sometimes influenced by irrelevant alternatives • Decisions are sometimes based on percentage differences rather than absolute differences Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES 22A.1 MENTAL ACCOUNTING AND BUNDLING One way to economize on decision-making is to separate decisions into different type or accounts For example, a consumer could establish separate accounts for food ($300 per month) and entertainment ($100 per month) An important application of mental accounting concerns the classification of money from different sources Consider the treatment of income that comes unexpectedly, for example, a $50 birthday gift or $50 found on the street For many people, unexpected income is “play money” that is frequently spent on fun or frivolous purchases In contrast, people are more careful with regular income Another mental shortcut is to monitor consumption by bundles rather than individual units People tend to track consumption by the bundles in which a product is delivered rather than the actual consumption of the product Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES 22A.2 ANCHORING In the classic experiment, each participant writes down the last two digits of his or her social security number, and then bids (expresses a willingness to pay) for a t-shirt The bizarre result is the larger the participant's social-security number, the higher the bid on the t-shirt In other words, the social-security number provides an anchor for an unrelated mental task One way to plant an anchoring number is to be the first to state a price In other words, there is a first-mover advantage in negotiations over price This provides one reason for relatively high (and negotiable) sticker prices on new and used cars Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES 22A.3 THE DECOY EFFECT One the most puzzling quirks of consumer decision-making is the decoy effect In the left panel, there are two options: a low-price player with a capacity of GB (option A), and a high-price player with a capacity of 16 GB (option B) The right panel introduces a third option, a decoy Option C has the same capacity as option B, but its price is $20 higher The comparison of B versus C is quick and easy: the consumer doesn't have to think about any tradeoffs, but simply recognizes that the extra $20 spent on C doesn't buy anything The typical consumer will then choose option B over options A and C Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES 22A.4 THE APPEAL OF PERCENTAGE CHANGES The natural inclination is to translate a numerical change into a percentage change For example, a change in price from $1.00 to $0.90 is a 10 percent change, and so is a change from $200 to $180 The translation into percentages means that all 10% changes appear to be alike, despite the fact that 10% of $200 is much larger than 10% of $1.00 In general, low-price hotels include Internet service as part of the room charge, while high-price hotels have a separate charge In a low-price hotel ($50 per night), a separate charge of $10 per day is a 20% surcharge, a relatively large surcharge in percentage term Consumers subject to percentage bias are likely to react strongly to the seemingly large surcharge In a hotel with a price $200 per night, a separate charge of $10 is only 5% of the price, a small enough percentage that the consumer response is likely to be relatively small Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved ... Reserved 22. 2 THE LAW OF DEMAND AND THE INDIVIDUAL DEMAND CURVE (2 of 3) The Income and Substitution Effects of a Price Change • Substitution effect The change in quantity consumed that is caused by. .. THE INDIVIDUAL DEMAND CURVE (3 of 3) 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...Learning Objectives 22. 1 Explain the equimarginal principle and apply it to consumer choice 22. 2 Describe the income and substitution effects of a price change 22. 3 Describe the general