Chapter
9
Consumer Choice
and Behavioral
Economics
Prepared by:
Fernando & Yvonn Quijano
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
Can Jay-Z Get You to
Drink Cherry Coke?
Learning Objectives
9.1 Define utility and explain how
consumers choose goods and
services to maximize their utility.
9.2 Use the concept of utility to explain
the law of demand.
9.3 Explain how social influences can
affect consumption choices.
Firms must understand
consumer behavior to
determine whether
strategies such as using
celebrities in their
advertising are likely to
be effective.
9..4 Describe the behavioral economics
approach to understanding decision
Making.
APPENDIX Use indifference curves and
budget lines to understand consumer
behavior.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 9.1
Chapter 9: Consumer Choice and Behavioral Economics
Utility and Consumer Decision Making
The Economic Model of Consumer Behavior in a Nutshell
The economic model of consumer behavior predicts
that consumers will choose to buy the combination
of goods and services that makes them as well off
as possible from among all the combinations that
their budgets allow them to buy.
Utility
Utility
The enjoyment or satisfaction people receive from
consuming goods and services.
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Learning Objective 9.1
Utility and Consumer Decision Making
Chapter 9: Consumer Choice and Behavioral Economics
The Principle of Diminishing Marginal Utility
Marginal utility (MU) The change in
total utility a person receives from
consuming one additional unit of a good
or service.
Law of diminishing marginal utility
The principle that consumers experience
diminishing additional satisfaction as they
consume more of a good or service
during a given period of time.
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Learning Objective 9.1
Utility and Consumer Decision Making
Chapter 9: Consumer Choice and Behavioral Economics
The Principle of Diminishing Marginal Utility
FIGURE 9-1
Total and Marginal
Utility from Eating Pizza
on Super Bowl Sunday
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Learning Objective 9.1
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.
Table 9-1
Total Utility and Marginal Utility from Eating Pizza and Drinking Coke
NUMBER OF
SLICES OF
PIZZA
TOTAL UTILITY
FROM EATING
PIZZA
MARGINAL
UTILITY
FROM THE
LAST SLICE
0
0
--
0
0
--
1
20
20
1
20
20
2
36
16
2
35
15
3
46
10
3
45
10
4
52
6
4
50
5
5
54
2
5
53
3
6
51
3
6
52
1
NUMBER OF
CUPS OF
COKE
TOTAL UTILITY MARGINAL UTILITY
FROM
FROM THE
DRINKING COKE
LAST CUP
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 9.1
Utility and Consumer Decision Making
Chapter 9: Consumer Choice and Behavioral Economics
The Rule of Equal Marginal Utility per Dollar Spent
Table 9-2
Converting Marginal Utility to Marginal Utility per Dollar
(6)
Marginal Utility
per Dollar
 MU Coke 


 PCoke 
(1)
Slices
of Pizza
(2)
Marginal Utility
(MUPIZZA)
(3)
Marginal Utility
per Dollar
 MU Pizza 


 PPizza 
1
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
--
(4)
Cups
of Coke
(5)
Marginal Utility
(MUCOKE)
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 9.1
Utility and Consumer Decision Making
Chapter 9: Consumer Choice and Behavioral Economics
The Rule of Equal Marginal Utility per Dollar Spent
Table 9-3
Equalizing Marginal Utility per Dollar Spent
Combinations of Pizza and Coke
with Equal Marginal Utilities
per Dollar
Marginal Utility 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
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Learning Objective 9.1
Utility and Consumer Decision Making
Chapter 9: Consumer Choice and Behavioral Economics
The Rule of Equal Marginal Utility per Dollar Spent
We can summarize the two conditions for maximizing utility:
1
2
MU Pizza MU Coke

PPizza
PCoke
Spending on pizza + Spending on Coke
= Amount available to be spent
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Learning Objective 9.1
Solved Problem
9-1
Chapter 9: Consumer Choice and Behavioral Economics
Finding the Optimal Level of Consumption
Number of
Ice Cream
Cones
Total
Utility from
Ice Cream
Cones
Marginal
Utility
from Last
Cone
Total
Utility from
Cans of
Lime Fizz
Number of
Cans of
Lime Fizz
0
0
--
0
0
--
1
30
30
1
40
40
2
55
25
2
75
35
3
75
20
3
101
26
4
90
15
4
119
18
5
100
10
5
134
15
6
105
5
6
141
7
Marginal
Utility From
Last Can
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Learning Objective 9.1
Solved Problem
9-1
Chapter 9: Consumer Choice and Behavioral Economics
Finding the Optimal Level of Consumption (continued)
Ice Cream Cones
Cans of Lime Fizz
Quantity
MU
MU
P
MU
MU
P
1
30
15
40
40
2
25
12.5
35
35
3
20
10
26
26
4
15
7.5
18
18
5
10
5
15
15
6
5
7
7
2.5
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Learning Objective 9.1
Chapter 9: Consumer Choice and Behavioral Economics
Utility and Consumer Decision Making
What if the Rule of Equal Marginal Utility
per Dollar Does Not Hold?
The idea of getting the maximum utility by equalizing
the ratio of marginal utility to price for the goods you
are buying can be difficult to grasp.
Don’t Let This Happen to YOU!
Equalize Marginal Utilities per Dollar
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 9.1
Utility and Consumer Decision Making
Chapter 9: Consumer Choice and Behavioral Economics
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.
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Learning Objective 9.1
Utility and Consumer Decision Making
Chapter 9: Consumer Choice and Behavioral Economics
The Income Effect and Substitution Effect of a Price Change
Table 9-4
Income Effect and Substitution
Effect of a Price Change
INCOME
EFFECT
SUBSTITUTION
EFFECT
PRICE
DECREASE
Increases the
consumer‘s
purchasing
power, which . . .
. . . if a normal
good, causes
the quantity
demanded to
increase.
. . . if an inferior
good, 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
consumer's
purchasing
power, which . . .
. . . if a normal
good, causes
the quantity
demanded to
decrease.
. . . if an inferior
good, causes
the quantity
demanded to
increase.
Raises the opportunity
cost of consuming the
good, which causes the
quantity of the good
demanded to decrease.
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Learning Objective 9.1
Utility and Consumer Decision Making
Chapter 9: Consumer Choice and Behavioral Economics
The Income Effect and Substitution Effect of a Price Change
Table 9-5
Adjusting Optimal Consumption
to a Lower Price of Pizza
Marginal Utility
Number Marginal Utility
Number
per Dollar
of Slices from Last Slice
of Cups
 MU Pi zza 




of Pizza
(MUPIZZA)
of Coke
 PPi zza 
Marginal Utility
from Last Cup
(MUCOKE)
Marginal Utility
per Dollar
 MUCoke 


 P

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
–
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Learning Objective 9.2
Chapter 9: Consumer Choice and Behavioral Economics
Where Demand Curves Come From
FIGURE 9-2
Deriving the Demand Curve for Pizza
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Learning Objective 9.2
Chapter 9: Consumer Choice and Behavioral Economics
Where Demand Curves Come From
FIGURE 9-3
Deriving the Market
Demand Curve
from Individual
Demand Curves
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Learning Objective 9.3
Chapter 9: Consumer Choice and Behavioral Economics
Social Influences on Decision Making
Sociologists and anthropologists have argued that social factors
such as culture, customs, and religion are very important in
explaining the choices consumers make.
Economists have traditionally seen such factors as being
relatively unimportant, if they take them into consideration at all.
Recently, however, some economists have begun to study how
social factors influence consumer choice.
The Effects of Celebrity Endorsements
In many cases, it is not just the number of people who use a
product that makes it desirable but the types of people who
use it.
If consumers believe that movie stars or professional athletes
use a product, demand for the product will often increase.
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Learning Objective 9.3
Making
the
Chapter 9: Consumer Choice and Behavioral Economics
Connection
Why Do Firms Pay Tiger Woods to
Endorse Their Products?
In 2006, Tiger Woods earned
$12 million from playing golf
and $100 million from product
endorsements.
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Learning Objective 9.3
Chapter 9: Consumer Choice and Behavioral Economics
Social Influences on Decision Making
Network Externalities
Network externality This situation
where the usefulness of a product
increases with the number of
consumers who use it.
Does Fairness Matter?
A Test of Fairness in the Economic laboratory:
The Ultimatum Game Experiment
Economists have used experiments to increase
their understanding of the role that fairness plays
in consumer decision making.
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Learning Objective 9.3
Chapter 9: Consumer Choice and Behavioral Economics
Social Influences on Decision Making
Does Fairness Matter?
Business Implications of Fairness
FIGURE 9-4
The Market for Tickets to
The Producers
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Learning Objective 9.3
Making
the
Chapter 9: Consumer Choice and Behavioral Economics
Connection
Professor Krueger Goes
to the Super Bowl
Should the NFL raise the price of Super Bowl tickets?
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Learning Objective 9.4
Chapter 9: Consumer Choice and Behavioral Economics
Behavioral Economics: Do People
Make Their Choices Rationally?
Behavioral economics The study of
situations in which people make choices
that do not appear to be 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.
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Learning Objective 9.4
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 to engage in an activity.
Endowment effect The tendency of people to be
unwilling to sell a good 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.
Business Implications of Consumers Ignoring
Nonmonetary Opportunity Costs
Behavioral economist Richard Thaler has studied several
examples of how businesses make use of consumers’
failure to take into account opportunity costs.
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Learning Objective 9.4
Making
the
Chapter 9: Consumer Choice and Behavioral Economics
Connection
Why Do Hilton Hotels and other
Firms Hide Their Prices?
Some hotels hide what they charge
for room service and Internet access.
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Learning Objective 9.4
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 cannot be recovered.
Being Unrealistic about Future Behavior
If you are unrealistic about your future
behavior, you underestimate the costs
of choices that you make today.
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Learning Objective 9.4
Making
the
Why Don’t Students Study More?
Chapter 9: Consumer Choice and Behavioral Economics
Connection
If the payoff to studying is
so high, why don’t students
study more?
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Learning Objective 9.4
Solved Problem
9-4
Chapter 9: Consumer Choice and Behavioral Economics
How Do You Get People to
Save More of Their Income?
Use your understanding of
consumer decision making
to show how a savings
plan may work.
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Chapter 9: Consumer Choice and Behavioral Economics
An Inside LOOK
Can Mariah Carey Get You to
Buy Elizabeth Arden Perfume?
Mariah Signs Scent Deal with Arden
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Chapter 9: Consumer Choice and Behavioral Economics
Key Terms
Behavioral economics
Network externality
Budget constraint
Opportunity cost
Endowment effect
Substitution effect
Income effect
Sunk cost
Law of diminishing marginal utility
Marginal utility (MU)
Utility
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Appendix
Chapter 9: Consumer Choice and Behavioral Economics
Using Indifference Curves and Budget Lines to
Understand Consumer Behavior
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 the two bundles.
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Appendix
Consumer Preferences
Chapter 9: Consumer Choice and Behavioral Economics
Indifference Curves
Indifference curve A curve
that shows the combinations of
consumption bundles that give
the consumer the same utility.
FIGURE 9A-1
Plotting Dave’s Preferences
for Pizza and Coke
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Appendix
Consumer Preferences
Chapter 9: Consumer Choice and Behavioral Economics
The Slope of an Indifference Curve
Marginal rate of substitution (MRS)
The slope of an indifference curve,
which represents the rate at which a
consumer would be willing to trade off
one good for another.
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Appendix
Consumer Preferences
Chapter 9: Consumer Choice and Behavioral Economics
Can Indifference Curves Ever Cross?
FIGURE 9A-2
Indifference Curves
Cannot Cross
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Appendix
Chapter 9: Consumer Choice and Behavioral Economics
The Budget Constraint
FIGURE 9A-3
Dave’s Budget Constraint
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Appendix
Chapter 9: Consumer Choice and Behavioral Economics
Choosing the Optimal Consumption of Pizza and Coke
FIGURE 9A-4
Finding Optimal Consumption
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Making Dell Determines the Optimal Mix
the
Chapter 9: Consumer Choice and Behavioral Economics
Connection
of Products
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Appendix
Choosing the Optimal Consumption of Pizza and Coke
Chapter 9: Consumer Choice and Behavioral Economics
How a Price Change Affects Optimal Consumption
FIGURE 9A-5
How a Price Decrease Affects
the Budget Constraint
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Appendix
Choosing the Optimal Consumption of Pizza and Coke
Chapter 9: Consumer Choice and Behavioral Economics
How a Price Change Affects Optimal Consumption
FIGURE 9A-6
How a Price Change Affects
Optimal Consumption
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Appendix
Solved Problem
9A-3
Chapter 9: Consumer Choice and Behavioral Economics
When Does a Price Change Make a Consumer Better Off?
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Appendix
Choosing the Optimal Consumption of Pizza and Coke
Chapter 9: Consumer Choice and Behavioral Economics
Deriving the Demand Curve
FIGURE 9A-7
Deriving a Demand Curve
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Appendix
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
FIGURE 9A-8
Income and Substitution Effects
of a Price Change
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Appendix
Choosing the Optimal Consumption of Pizza and Coke
Chapter 9: Consumer Choice and Behavioral Economics
How a Change in Income Affects Optimal Consumption
FIGURE 9A-9
How a Change in Income
Affects the Budget Constraint
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Appendix
Choosing the Optimal Consumption of Pizza and Coke
Chapter 9: Consumer Choice and Behavioral Economics
How a Change in Income Affects Optimal Consumption
FIGURE 9A-10
How a Change in Income
Affects Optimal Consumption
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Chapter 9: Consumer Choice and Behavioral Economics
Appendix
The Slope of the Indifference Curve,
the Slope of the Budget Line, and the Rule
of Equal Marginal Utility per Dollar Spent
FIGURE 9A-11
At the Optimum Point, the
Slopes of the Indifference
Curve and Budget Constraint
Are the Same
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Chapter 9: Consumer Choice and Behavioral Economics
Appendix
The Slope of the Indifference Curve,
the Slope of the Budget Line, and the Rule
of Equal Marginal Utility per Dollar Spent
The Rule of Equal Marginal Utility per Dollar Spent Revisited
(Change in the quanity of Coke x MUCoke)  (Change in the quanity of pizza x MUPizza)
At the optimal point of consumption:
MUPizza PPizza

MUCoke PCoke
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