CHAPTER 7
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People compare the perceived costs and benefits of alternatives and select those that they believe give them the greatest relative benefits.
Utility is a measure of the satisfaction received from possessing or consuming goods and services.
Tastes and preferences are given, and play a large role in decision making.
Consumers make choices that give them the greatest utility—they maximize utility .
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Marginal utility : the extra utility derived from consuming one more unit of a good or service.
marginal utility
 change in total utility change in quantity
Principle of diminishing marginal utility : the more of a good that one obtains in a specific period of time, the less the additional utility derived from an additional unit of the good.
Disutility : dissatisfaction
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Utility diminishes over time —the shorter the time period, the more quickly marginal utility diminishes.
Consumers are not identical —the rate at which marginal utility diminishes depends on individual tastes and preferences, and so differs across consumers.
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“All You Can Eat” promotions assume that you will stop eating when your marginal utility falls to zero.
Red Lobster’s “Endless Crab” promotion charged customers $20 for an all-you-can-eat crab dinner, but it wasn't enough.
Most people’s marginal utility rate is about 2.25 pounds of crab. But for too many Red Lobster customers, devouring piles of crab became a contest. One party of five ate 18 pounds of crab, another had 30 refills of crab legs.
As the wholesale prices of crab climbed to $5 a pound and higher, the consumption rate made the promotion unprofitable for Red Lobster.
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Each consumer allocates a specific budget to expenditure, and then allocates the expenditure to maximize utility.
If two goods offer the same marginal utility, the consumer will be indifferent between the two.
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Equimarginal principle : To maximize utility, consumers allocate their incomes among goods so as to equate the marginal utilities per dollar (MU/P) of the expenditure on the last unit of each good purchased.
This is also referred to as the consumer equilibrium .
MU
CD
P
CD

MU gas
P gas

MU movie
P movie
  
MU
X
P
X
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The inverse relation between price and quantity demanded arises from diminishing marginal utility and consumer equilibrium.
A change in the price of any good disturbs the consumer’s equilibrium— the ratio of MU to P on the last unit of each good will no longer be equal.
The consumer must reallocate income across goods.
With income fixed, if the price of one good rises, the consumer is able to buy fewer goods and services, causing demand to fall.
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When the price of one good falls while everything else is constant, two things occur:
◦ Other goods become relatively more expensive, so consumers buy more of the less expensive good and less of the more expensive goods. This is called the substitution effect .
◦ The consumer can buy more total goods with the same income. This is called the income effect .
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The individual demand curve is defined by income, tastes and preferences, the price of the good, and the price of related goods.
If any of these things change, the individual’s demand curve will change.
For each change, a new demand curve is derived.
The market demand curve is the sum of all the individual demand curves. Anything that affects individual demand curves, affects the market demand curve.
The number of consumers also affects the market demand curve.
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Bounded rationality admits that complete and perfect information is unlikely and that people make decisions that may seem irrational, but in reality are the rational results of a brain that is economizing.
Behavioral economics attempts to catalogue the biases that result from bounded rationality.
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Overconfidence : people tend to think they are better and do things better than is really the case.
Mental Accounting : the value people place on money depends on where that money comes from.
Status Quo : people would rather leave things as they are.
Loss Aversion and Framing : gains and losses are calculated relative to a reference.
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Familiarity : people are more comfortable with a familiar situation than an unfamiliar.
Anchoring : the tendency to rely too heavily on one piece of information when making decisions.
Sunk Costs : costs that are not recoverable. When individuals put effort into something, most are reluctant to back out even if staying on the same course leads more loss.
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Some economists have joined forces with biologists and neurologists to attempt to see how the brain handles economic decisions.
MRI scans have revealed the two parts of the brain in which most decisions take place.
The emotional part is the limibiclimbic system (especially the amygdala).
The logical part is the pre-frontal cortex.
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