the standard (neo-classical) model of consumer behavior

The standard economic model of consumer behavior and some problems with it

Dr. Russell James III, Texas Tech University

What is it?

• The standard, or neo-classical, economic model is the dominant framework for thinking about consumer welfare and consumer choice.

• It is what you will learn in any introductory microeconomics course.

Assumptions of the Standard Economic Model of Consumer Behavior

1. People have known preferences.

Assumptions of the Standard Economic Model of Consumer Behavior

1. People have known preferences.

Full Internal Knowledge

Assumptions of the Standard Economic Model of Consumer Behavior

1. People have known preferences.

2. People act with full information.

Full Internal Knowledge

Assumptions of the Standard Economic Model of Consumer Behavior

1. People have known preferences.

2. People act with full information.

Full Internal Knowledge

Full External Knowledge

Assumptions of the Standard Economic Model of Consumer Behavior

1. People have known preferences.

2. People act with full information.

3. People choose rationally so as to maximize utility.

Full Internal Knowledge

Full External Knowledge

Maximizing Choices

Assumptions of the Standard Economic Model of Consumer Behavior

1. People have known preferences.

2. People act with full information.

3. People choose rationally so as to maximize utility.

Full Internal Knowledge

Full External Knowledge

Maximizing Choices

Assumptions of the Standard Economic Model of Consumer Behavior

1. People have known preferences.

Full Internal Knowledge

Find one or two partners. Whoever’s last name is first, alphabetically, describe the first concept to your partner as if they had never heard of it before.

Assumptions of the Standard Economic Model of Consumer Behavior

1. People have known preferences.

2. People act with full information.

3. People choose rationally so as to maximize utility.

Full Internal Knowledge

Full External Knowledge

Maximizing Choices

Now switch and the other person describes the second one.Then switch again for the third one.

Advantages of the standard model

1. From these three assumptions, consumer behavior can be modeled using beautiful, internally consistent, mathematical models.

2. These models often correspond to actual behavior.

Beautiful models?

Beautiful models!

More beautiful models!

Beautiful models of color!

Chart of attainable Pareto and Kaldor-Hicks improvements among the space of exchanges between two participants

Enough beautiful models?

Perhaps you prefer less “graphic” models?

Beautiful mathematical models

A model of consumer utility for minivans From Petrin, A. (2002) Quantifying the benefits of new products: The case of the minivan. Journal of Political Economy, 110(4),

705-729.

Advantages of the standard model

1. From these three assumptions, consumer behavior can be modeled using beautiful, internally consistent, mathematical models.

2. These models often correspond to actual behavior

Advantages of the standard model

1. From these three assumptions, consumer behavior can be modeled using beautiful, internally consistent, mathematical models.

2. These models often correspond to actual behavior

1. From these three assumptions, consumer behavior can be modeled using beautiful, internally consistent, mathematical models.

2. These models often correspond to actual behavior

Pssst. Sometimes the basic assumptions are false

Advantages of the standard model

Assumptions of the Standard Economic Model of Consumer Behavior

1. People have known preferences.

2. People act with full information.

3. People choose rationally so as to maximize utility.

Full Internal Knowledge

Full External Knowledge

Maximizing Choices

Do people always choose rationally so as to maximize their utility?

How often do people choose rationally so as to maximize their utility (or happiness)?

A) Always and without exceptionsB) Almost always, but with rare exceptionsC) Usually, but there are common exceptionsD) A little more than half the timeE) Less than half the time

Do people always choose rationally so as to maximize their utility?

• Work with one, two, or three others around you.

• How many examples can you think of where

people do not choose rationally so as to maximize their utility (or happiness)?

• Have one person write down all the examples and write all of your names on the page.

For each bad choice: Was the problem 1, 2, or 3?

1. People have known preferences.

2. People act with full information.

3. People choose rationally so as to maximize utility.

Full Internal Knowledge

Full External Knowledge

Maximizing Choices

Can we study “irrational” behavior?

• Yes, if it is predictably “irrational”• The study of these predictable errors that

violate the economic assumption of rationality is called…

Can we study “irrational” behavior?

• Yes, if it is predictably “irrational”• The study of these predictable errors that

violate the economic assumption of rationality is called…

Behavioral economics

http://www.youtube.com/watch?v=Fa-mIosWOK8

In the next class, we begin our study of behavioral economics…

Slides by: Russell James III, J.D., Ph.D., CFP®Associate Professor Division of Personal Financial Planning Texas Tech Universityrussell.james@ttu.edu

Please use these slides!

If you think you might use anything here in a classroom,

please CLICK HERE to let me know.

Thanks!

The outline for this behavioral economics series is at http://www.slideshare.net/rnja8c/outline-for-behavioral-economics-course-component