Consumer Choice and Behavioral Economics

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Consumer Choice andBehavioral Economics
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Utility and Consumer Decision Making
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.
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Utility and Consumer Decision Making
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Utility and Consumer Decision Making
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.
NUMBER OFSLICES OF PIZZA TOTAL UTILITYFROM EATING PIZZA MARGINAL UTILITYFROM THELAST SLICE NUMBER OF CUPS OFCOKE TOTAL UTILITYFROMDRINKING COKE MARGINAL UTILITYFROM THELAST CUP
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
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Utility and Consumer Decision Making
The Rule of Equal Marginal Utility per Dollar
Spent
(1) Slices of Pizza (2) Marginal Utility (MUPizza) (3)Marginal Utilityper Dollar (4) Cups of Coke (5) Marginal Utility (MUCoke) (6)Marginal Utilityper Dollar
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 --
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Utility and Consumer Decision Making
The Rule of Equal 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
The two conditions for maximizing utility are as
follows 1. 2. Spending on pizza Spending
on Coke Amount available to be spent
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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.
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Utility and Consumer Decision Making
The Income Effect and Substitution Effect of a
Price Change
  Income Effect Income Effect Income Effect Substitution Effect
    Normal Good Inferior Good  
Price Decrease Increases the consumers purchasing power, which . . . . . . causes the quantity demanded to 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 consumer's purchasing power, which . . . . . . causes the quantity demanded to 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.
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Utility and Consumer Decision Making
The Income Effect and Substitution Effect of a
Price Change
Numberof Slices of Pizza Marginal Utility from Last Slice (MUPizza) Marginal Utility per Dollar Number of Cups of Coke Marginal Utility from Last Cup (MUCoke) Marginal Utility per Dollar
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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Social Influences on Decision Making
Network Externalities Network externalities
Network externalities exist when the usefulness
of a product increases with the number of
consumers who use it.
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Social Influences on Decision Making
Does Fairness Matter? BUSINESS IMPLICATIONS OF
FAIRNESS
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Behavioral EconomicsDo 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.

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Behavioral EconomicsDo 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 didnt already own it.
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Behavioral EconomicsDo People Make Their
Choices Rationally?
Failing to Ignore Sunk Costs Sunk cost A cost
that has already been paid and that cannot be
recovered.