21-2 copyright © 2011 pearson education, inc. all rights...

Copyright ©2011 by Pearson Education, Inc.All rights reserved.

Chapter 21

Consumer Choice

21-2Copyright © 2011 Pearson Education, Inc. All rights reserved.

Introduction

Researchers frequently ask samples of people in different countries how happy or satisfied they are. Then they compare expressed levels of satisfaction both within countries and across countries.

For more than two centuries, economists have been contemplating how people seek to maximize their happiness levels when making choices.

In this chapter, you will learn about economists’ traditional measure of happiness, called utility, which economists apply to developing an understanding of how people make choices.


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

• Evaluate why the price of diamonds is so much higher than the price of water even though people cannot survive long without water


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...

• 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.


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

– Developed by philosopher Jeremy Bentham and the school of thought 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 21-1 Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (a)


Figure 21-1Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panels (b) and (c)

Total utility ismaximized...

…where marginalutility equals zero.


Utility Theory (cont'd)

• Observations

– Marginal utility falls as more is consumed.

– Marginal utility equals zero when total utility is at its maximum.


E-Commerce Example: Movie Makers Try to Avoid Projecting Negative Marginal Utility

• In an average week during 1948, 90 million people paid to view a motion picture at a movie theater. Today, the average weekly number of moviegoers is only 30 million.

• Since the late 1940s, a steady wave of close substitutes—television, videocassettes, DVDs—has reduce the number of movies people choose to see at theaters.

• Theaters now hope that digital 3D movies will lure viewers back, but viewing 3D movies that are longer than 90 minutes can have side effects like dizziness or nausea.

• Why do you suppose that some in Hollywood are predicting that most movies initially made in digital 3D formats will be action packed, but relatively short?


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.


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


Table 21-1 Total and Marginal Utility from Consuming Music Album Downloads and Cappuccinos on an Income of $26


Table 21-1 Total and Marginal Utility from Consuming Music Album Downloads and Cappuccinos on an Income of $26 (cont'd)


Table 21-1 Total and Marginal Utility from Consuming Music Album Downloads and Cappuccinos on an Income of $26 (cont'd)


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.


Table 21-2 Steps to Consumer Optimum


Table 21-2 Steps to Consumer Optimum (cont'd)


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.


• 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= =...


How a Price Change Affects Consumer Optimum

Recall from Table 21-1 Income = $26

Qd = 4MUd

Pd

36.55= = 7.3

Qs = 2 MUs

Ps

223= = 7.3


How a Price Change Affects Consumer Optimum (cont'd)

Assume Price of Music Falls to $4

Qd = 4MUd

Pd

36.54= = 9.125

Qs = 2 MUs

Ps

223= = 7.3



Assume Price of Music Falls to $4

Result Buy more downloads and MUd falls

Now MUd

Pd>

MUs

Ps



• 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 21-2 Digital Music Download Prices and Marginal Utility



• The Substitution Effect

– The tendency of people to substitute cheaper commodities for more expensive commodities



• 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.



• 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.



• 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).



• 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 21-3 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.


E-Commerce Example:Help, I’m Shopping and I Can’t Stop!

• Researchers have measured what they believe to be satisfaction that people receive from the act of shopping.

• Economists argue that for many individuals, the short-term enjoyment of shopping for its own sake leads to purchases that the individuals later regret.

• Thus, some consumers may get more satisfaction from the act of choosing among alternative items than they actually derive from the items they decide to purchase.


Issues and Applications: A Renewed Interest in Measuring Utility

• Economists of the latter part of the nineteenth century and twentieth century generally concluded that objective measures on utility could not be measure.

• Now, in the twenty-first century, economists have rejuvenated the idea of measuring utility through the use of “happiness studies.”

• Considerable research is under way to evaluate whether satisfaction measures, such as numerical ratings derived from surveys, are consistent for individuals and among groups of people.


• One approach to evaluating life satisfaction surveys has been to utilize psychiatric measures of people’s moods to check for the reliability of happiness measures.

• Another is measuring hypertension levels.

• Why would evidence of inconsistency of measured happiness levels for single individuals cast considerable doubt on the appropriateness of comparing happiness levels across individuals?

Issues and Applications: A Renewed Interest in Measuring Utility (cont’d)


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.

• 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.


Figure E-1 Combinations That Yield Equal Levels of Satisfaction


Figure E-2 Indifference Curves: Impossibility of an Upward Slope


Figure E-3 Implications of a Straight-Line Indifference Curve


Table E-1 Calculating the Marginal Rate of Substitution


Figure E-4 A Set of Indifference Curves


Figure E-5 The Budget Constraint


Figure E-6 Consumer Optimum


Figure E-7 Income-Consumption Curve


Figure E-8 Price-Consumption Curve


Figure E-9 Deriving the Demand Curve, Panel (a)


Figure E-9 Deriving the Demand Curve, Panel (b)

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