chapter
nine
Consumer Choice and
Behavioral Economics
Prepared by: Fernando & Yvonn Quijano
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
1 LEARNING OBJECTIVE
Utility and Consumer Decision Making
CHAPTER 9: Consumer Choice and
Behavioral Economics
Utility
Utility The enjoyment or satisfaction that people receive from
consuming goods and services.
The Principle of Diminishing Marginal Utility
Marginal utility The additional utility a person receives from
consuming one additional unit of a good or service.
Law of diminishing marginal utility Consumers
experience diminishing additional satisfaction as they consume
more of a good or service during a given period of time.
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
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Utility and Consumer Decision Making
CHAPTER 9: Consumer Choice and
Behavioral Economics
The Rule of Equal Marginal Utility per Dollar Spent
Budget constraint The limited amount of income available
to consumers to spend on goods and services.
9–1
Total Utility and Marginal Utility
from Eating Pizza and Drinking
Coke
NUMBER OF TOTAL UTILITY
SLICES OF FROM EATING
PIZZA
PIZZA
0
1
2
3
4
5
6
0
20
36
46
52
54
51
MARGINAL
UTILITY
FROM THE
LAST SLICE
20
16
10
6
2
3
NUMBER OF
CUPS OF
COKE
TOTAL UTILITY
FROM
DRINKING
COKE
MARGINAL
UTILITY
FROM THE
LAST CUP
0
1
2
3
4
5
6
0
20
35
45
50
53
52
20
15
10
5
3
1
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
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Utility and Consumer Decision Making
CHAPTER 9: Consumer Choice and
Behavioral Economics
The Rule of Equal Marginal Utility per Dollar Spent
9–2
Converting Marginal Utility to
Marginal Utility per Dollar
(1)
Slices
of Pizza
(2)
Marginal Utility
(MUPizza)
1
(3)
Marginal Utility
per Dollar
(6)
Marginal Utility
per Dollar
 MU Pizza 


P
 Pizza 
(4)
Cups
of Coke
(5)
Marginal Utility
(MUCoke)
20
10
1
20
20
2
16
8
2
15
15
3
10
5
3
10
10
4
6
3
4
5
5
5
2
1
5
3
3
6
3
--
6
1
--
 MU Coke 


P
 Coke 
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
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Utility and Consumer Decision Making
CHAPTER 9: Consumer Choice and
Behavioral Economics
The Rule of Equal Marginal Utility per Dollar Spent
9–3
Equalizing Marginal Utility per
Dollar Spent
Combinations of Pizza and Coke with Marginal Utility per Dollar
Equal Marginal Utilities per Dollar
(Marginal Utility/Price)
Total Spending
Total Utility
1 Slice of Pizza and 3 Cups of Coke
10
$2 + $3 = $5
20 + 45 = 65
3 Slices of Pizza and 4 Cups of Coke
5
$6 + $4 = $10
46 + 50 = 96
4 Slices of Pizza and 5 Cups of Coke
3
$8 + $5 = $13
52 + 53 = 105
We can compactly summarize the two conditions for maximizing
utility as follows:
MU Pizza MU Coke

1.
PPizza PCoke
2. Spending on pizza + Spending on Coke = Amount available to be
spent
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
5 of 41
CHAPTER 9: Consumer Choice and
Behavioral Economics
Utility and Consumer Decision Making
The Income Effect and Substitution Effect of a Price
Change
Income effect The change in the quantity demanded of a
good that results from the effect of a change in price on
consumer purchasing power, holding all other factors constant.
Substitution effect The change in the quantity demanded of
a good that results from a change in price making the good
more or less expensive relative to other goods, holding constant
the effect of the price change on consumer purchasing power.
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
6 of 41
CHAPTER 9: Consumer Choice and
Behavioral Economics
Utility and Consumer Decision Making
The Income Effect and Substitution Effect of a Price
Change
9–4
Income Effect and Substitution
Effect of a Price Change
Income Effect
Normal
Good
Substitution Effect
Inferior
Good
Price
Decrease
Increases the
. . . causes
consumer‘s
the quantity
purchasing
demanded to
power, which . . . increase.
. . . causes
the quantity
demanded
to decrease.
Lowers the opportunity cost of
consuming the good, which causes
the quantity of the good demanded
to increase.
Price
Increase
Decreases the
. . . causes
consumer's
the quantity
purchasing
demanded to
power, which . . . decrease.
. . . causes
the quantity
demanded
to increase.
Raises the opportunity cost of
consuming the good, which causes
the quantity of the good demanded
to decrease.
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
7 of 41
CHAPTER 9: Consumer Choice and
Behavioral Economics
Utility and Consumer Decision Making
The Income Effect and Substitution Effect of a Price
Change
9–5
Adjusting Optimal
Consumption to a Lower Price
of Pizza
Marginal Utility
Marginal Utility
per Dollar
per Dollar
Number Marginal Utility
Number Marginal Utility
 MUCoke 
 MU Pi zza 
of Slices from Last Slice
of Cups from Last Cup




 P

 P

of Pizza
(MUPizza)
of
Coke
(MU
)
Pi zza 
Coke 


Coke
1
20
13.33
1
20
20
2
16
10.67
2
15
15
3
10
6.67
3
10
10
4
6
4
4
5
5
5
2
1.33
5
3
3
6
3
–
6
1
–
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
8 of 41
2 LEARNING OBJECTIVE
CHAPTER 9: Consumer Choice and
Behavioral Economics
Where Demand Curves Come From
9-2
Deriving the Demand Curve for
Pizza
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
9 of 41
4 LEARNING OBJECTIVE
CHAPTER 9: Consumer Choice and
Behavioral Economics
Behavioral Economics:
Do People Make Their Choices Rationally?
Behavioral economics The study of situations in which
people act in ways that are not economically rational.
Consumers commonly commit the following three
mistakes when making decisions:
 They take into account monetary costs but ignore
nonmonetary opportunity costs.
 They fail to ignore sunk costs.
 They are overly optimistic about their future
behavior.
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
10 of 41
CHAPTER 9: Consumer Choice and
Behavioral Economics
Behavioral Economics:
Do People Make Their Choices Rationally?
Ignoring Nonmonetary Opportunity Costs
Opportunity cost The highest-valued alternative
that must be given up in order to engage in an activity.
Endowment effect The tendency of people to be
unwilling to sell something they already own even if
they are offered a price that is greater than the price
they would be willing to pay to buy the good if they
didn’t already own it.
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
11 of 41
CHAPTER 9: Consumer Choice and
Behavioral Economics
Behavioral Economics:
Do People Make Their Choices Rationally?
Failing to Ignore Sunk Costs
Sunk cost A cost that has already
been paid and that cannot be
recovered.
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
12 of 41
CHAPTER 9: Consumer Choice and
Behavioral Economics
Behavioral
economics
Budget constraint
Endowment effect
Income effect
Law of diminishing
marginal utility
Marginal utility
Network externalities
Opportunity cost
Substitution effect
Sunk cost
Utility
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
13 of 41
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
CHAPTER 9: Consumer Choice and
Behavioral Economics
Consumer Preferences
CONSUMPTION BUNDLE A
CONSUMPTION BUNDLE B
2 slices of pizza and 1 can of Coke
1 slice of pizza and 1 can of Coke
We assume that the consumer will always be able to
decide which of the following is true:
 The consumer prefers bundle A to bundle B.
 The consumer prefers bundle B to bundle A.
 The consumer is indifferent between bundle A and
bundle B; that is, the consumer receives equal
utility from either bundle.
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
14 of 41
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
CHAPTER 9: Consumer Choice and
Behavioral Economics
Consumer Preferences
Indifference Curves
Indifference curve A curve that shows the combinations
of consumption bundles that give the consumer the same
utility.
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
15 of 41
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
CHAPTER 9: Consumer Choice and
Behavioral Economics
Consumer Preferences
Indifference Curves
9A - 1
Plotting Dave’s Preferences for
Pizza and Coke
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
16 of 41
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
CHAPTER 9: Consumer Choice and
Behavioral Economics
Consumer Preferences
The Slope of an Indifference Curve
Marginal rate of substitution (MRS) The slope of
an indifference curve; represents the rate at which
a consumer would be willing to trade off one good
for another.
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
17 of 41
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
CHAPTER 9: Consumer Choice and
Behavioral Economics
Consumer Preferences
Can Indifference Curves Ever Cross?
9A - 2
Indifference Curves Cannot
Cross
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
18 of 41
CHAPTER 9: Consumer Choice and
Behavioral Economics
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
The Budget Constraint
9A - 3
Dave’s Budget Constraint
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
19 of 41
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
CHAPTER 9: Consumer Choice and
Behavioral Economics
Choosing the Optimal Consumption of Pizza and Coke
9A - 4
Finding Optimal Consumption
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
20 of 41
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
CHAPTER 9: Consumer Choice and
Behavioral Economics
Choosing the Optimal Consumption of Pizza and Coke
How a Price Change Affects Optimal Consumption
9A - 5
How a Price Increase Affects the
Budget Constraint
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
21 of 41
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
CHAPTER 9: Consumer Choice and
Behavioral Economics
Choosing the Optimal Consumption of Pizza and Coke
How a Price Change Affects Optimal Consumption
9A - 6
How a Price Change Affects
Optimal Consumption
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
22 of 41
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
CHAPTER 9: Consumer Choice and
Behavioral Economics
Choosing the Optimal Consumption of Pizza and Coke
Deriving the Demand Curve
9A - 7
Deriving a Demand Curve
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
23 of 41
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
CHAPTER 9: Consumer Choice and
Behavioral Economics
Choosing the Optimal Consumption of Pizza and Coke
The Income Effect and the Substitution Effect of a Price Change
9A - 8
Income and Substitution Effects
of a Price Change
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
24 of 41
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
CHAPTER 9: Consumer Choice and
Behavioral Economics
Choosing the Optimal Consumption of Pizza and Coke
How a Change in Income Affects Optimal Consumption
9A - 9
How a Change in Income Affects
the Budget Constraint
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
25 of 41
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
CHAPTER 9: Consumer Choice and
Behavioral Economics
Choosing the Optimal Consumption of Pizza and Coke
How a Change in Income Affects Optimal Consumption
9A - 10
How a Change in Income Affects
Optimum Consumption
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
26 of 41
CHAPTER 9: Consumer Choice and
Behavioral Economics
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
The Slope of the Indifference Curve, the Slope of the Budget Line,
and the Rule of Equal Marginal Utility per Dollar
9A - 11
At the Optimum Point, the Slopes
of the Indifference Curve and
Budget Constraint Are the Same
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
27 of 41
CHAPTER 9: Consumer Choice and
Behavioral Economics
Appendix 9A: Using Indifference Curves and
Budget Lines to Understand Consumer Behavior
The Slope of the Indifference Curve, the Slope of the Budget Line,
and the Rule of Equal Marginal Utility per Dollar
The Rule of Equal Marginal Utility per Dollar Revisited
–(Change in the quantity of Coke x MUCoke) = (Change in the quantity of pizza x MUPizza)
Loss in utility
from consuming
less Coke
Gain in utility
from consuming
more pizza
At the optimal point of consumption:
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
28 of 41
CHAPTER 9: Consumer Choice and
Behavioral Economics
Indifference curve
Marginal rate of
substitution (MRS)
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
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