Understanding Consumer Choice Decisions

Introduction
For years, a number of U.S. households have allocated
a significant portion of their budgets to unhealthful
items and a small amount to healthful items.
This trend has reversed recently, as spending on
alcoholic beverages, restaurant meals and tobacco
products has declined, while expenditures on
vegetables have increased.
This chapter will help you understand why such a
change has occurred by demonstrating how people
make choices intended to maximize their levels of
satisfaction.
Copyright ©2014 Pearson Education, Inc. All rights reserved.

20-2

Learning Objectives
• Distinguish between total utility and
marginal utility
• Discuss why marginal utility first rises but
ultimately tends to decline as a person
consumes more of a good or service
• Explain why an individual’s optimal choice
of how much to consume of each good or
service entails equalizing the marginal
utility per dollar spent across all goods and
services

20-3

Learning Objectives (cont'd)
• Describe the substitution effect of a price
change on the quantity demanded of a good
or service
• Understand how the real-income effect of a
price change affects the quantity demanded
of a good or service


20-4

Chapter Outline
•
•
•
•
•

Utility Theory
Graphical Analysis
Diminishing Marginal Utility
Optimizing Consumption Choices
How a Price Change Affects Consumer
Optimum
• The Demand Curve Revisited
• Behavioral Economics and Consumer Choice
Theory


20-5

Did You Know That ...
• A consumer who shops at a typical U.S.
supermarket chooses among 48,750 items?
• Of course, the array of goods from which
consumers choose extends far beyond the
supermarket aisle.
• In this chapter we discuss what is called
utility analysis as a means of examining
how consumers make choices.


20-6

Utility Theory
• Utility
– The want-satisfying power of a good or service

• Utility Analysis
– The analysis of consumer decision making based
on utility maximization


20-7

Utility Theory (cont’d)
• Util
– A representative unit by which utility is
measured
– Developed by philosopher Jeremy Bentham; the
school of thought is called utilitarianism


20-8

Utility Theory (cont'd)
• Marginal Utility
– The change in total utility due to a one-unit
change in the quantity of a good or service
consumed

Change in total utility
Marginal utility =
Change in number of units consumed


20-9

Figure 20-1 Total and Marginal Utility of Utilizing
Apps, Panel (a)


20-10

Figure 20-1 Total and
Marginal Utility of
Utilizing Apps, Panels
(b) and (c)


20-11

Utility Theory (cont'd)
• Observations
– Marginal utility falls as more is consumed
– Marginal utility equals zero when total utility is
at its maximum


20-12

Diminishing Marginal Utility
• Diminishing Marginal Utility
– The principle that as more of any good or service
is consumed, its extra benefit declines
– Increases in total utility from consumption of a
good or service become smaller and smaller as
more is consumed during a given time period.


20-13

Example: Newspaper Vending Machines versus
Candy Vending Machines
• Newspaper machines do not prevent people from
taking more than one paper. Why not dispense
candy the same way?
• The answer is found in the concept of diminishing
marginal utility.
• Can you think of a circumstance under which a
substantial number of newspaper purchasers might
be inclined to take more than one newspaper from
a vending machine?


20-14

• Consumer Optimum
– A choice of a set of goods and services that
maximizes the level of satisfaction for each
consumer, subject to limited income


20-15

Example: High-Priced Blue Jeans as
Part of a Consumer Optimum
• About 1 percent of the nearly $14 billion in
annual U.S. expenditures on blue jeans goes
towards jeans priced above $50.
– The theory of consumer optimum explains why
some people are willing to pay such high prices
for blue jeans.
– For these individuals, it must be the case that
the last dollar spent on a pair of expensive blue
jeans generates the same amount of marginal
utility as a dollar spent on any other item.


20-16

Table 20-1 Total and Marginal Utility from Consuming
Digital Apps and Cappuccinos on an Income of $26


20-17

Table 20-1 Total and Marginal Utility from Consuming
Digital Apps and Cappuccinos on an Income of $26
(cont'd)


20-18

Table 20-2 Steps to Consumer
Optimum


20-19

Optimizing Consumption Choices (cont’d)
• A consumer’s money income should be allocated so
that the last dollar spent on each good purchased
yields the same amount of marginal utility (when
all income is spent), because this rule yields the
largest possible total utility


20-20

(cont'd)
• A little math
– The rule of equal marginal utilities per dollar
spent
• A consumer maximizes personal satisfaction when
allocating money income in such a way that the last
dollars spent on good A, good B, good C, and so on,
yield equal amounts of marginal utility


20-21

(cont'd)
• A little math
– The rule of equal marginal utilities per dollar
spent

MU of good A

MU of good B
=

Price of good A

MU of good Z
= ... =

Price of good B


Price of good Z

20-22

International Example: Inferring Substantial
Marginal Utility from an Oil Change
• Recently, a resident of Qatar decided to arrange for
an oil change on his Lamborghini sports car to be
done in London.
• This required airlifting the car to London.
• The comprehensive cost of the oil change, including
transportation costs, was over $45,000.
• According to the rule of consumer optimum, the
marginal utility per dollar spent on the oil change
would have to be equal to the marginal utility per
dollar spent on other goods and services.


20-23

How a Price Change Affects
Consumer Optimum
Recall from Table 20-1 Income = $26

Qd = 4

MUd
36.5
= 7.3
=
Pd
5

Qs = 2

MUs
22
=
Ps
3


= 7.3

20-24

Consumer Optimum (cont'd)
Assume Price of Digital Apps Falls to $4

Qd = 4

MUd
36.5
= 9.125
=
Pd
4

Qs = 2

MUs
22
=
Ps
3


= 7.3

20-25

Assume Price of Digital Apps Falls to $4

Now
Result


MUd
MUs
>
Pd
Ps
Buy more apps
and MUd falls

20-26

• Consumption decisions are summarized in
the law of demand
– The amount purchased is inversely related to
price

• A consumer’s response to a price change
– At higher consumption rate, marginal utility falls


20-27

Figure 20-2 Digital App Prices and
Marginal Utility


20-28

• The Substitution Effect
– The tendency of people to substitute cheaper
commodities for more expensive commodities


20-29

• The Principle of Substitution
– Consumers and producers shift away from goods
and resources that become priced relatively
higher in favor of goods and resources that are
now priced relatively lower


20-30

• Purchasing Power
– The value of money for buying goods and
services
– If your money income stays the same but the
price of one good that you are buying goes up,
your effective purchasing power falls, not vice
versa


20-31

• Real-Income Effect
– The change in people’s purchasing power that
occurs when, other things being constant, the
price of one good that they purchase changes
– When that price goes up (down), real income, or
purchasing power, falls (increases)


20-32

• What do you think?
– Which would usually have more of an impact on
your purchases—the substitution effect or the
real-income effect?


20-33

The Demand Curve Revisited
• Question
– How is the demand curve derived?

• Answer
– By assuming income, tastes, expectations, and
the price of related goods are not changing as
the price of the good changes


20-34

The Demand Curve Revisited
(cont'd)
• Marginal utility, total utility, and the
diamond-water paradox
– Diamonds are not essential to life but relatively
expensive
– Water is essential to life but relatively cheap.
• Total utility of water exceeds that of diamonds but
marginal utility determines the price


20-35

Figure 20-3 The Diamond-Water
Paradox


20-36

Behavioral Economics and Consumer
Choice Theory
• Does behavioral economics better predict
consumer choices?
– The bounded rationality assumption
– However, people do not be have as if they are
rational. If the rationality assumption does not
apply to actual behavior, behavioralists argue
that utility-based consumer choice theory
cannot, either.


20-37

Behavioral Economics and Consumer
Choice Theory (cont’d)
• Consumer choice theory alive and well
– In spite of the doubts expressed by proponents
of behavioral economics, most economists
continue to apply the assumption that people
behave as if they act rationally with an aim to
maximize utility
– These economists continue to utilize utility theory
because of a fundamental strength of this
approach: It yields clear-cut predictions
regarding consumer choices


20-38

What if . . . the government bans certain
products to try to prevent poor decisions?
• The U.S. government limits choices for certain
products, and U.S. energy secretary Steven Chu
offered such a rationale for banning the sale of
incandescent light bulbs.
• He argues that the quality-adjusted price of
fluorescent bulbs is lower, based on the assumption
that people leave lights burning for long periods.
• But consumers who turn lights on and off frequently
would achieve greater energy efficiency with
incandescent bulbs.


20-39

What if . . . the government bans certain products
to try to prevent poor decisions? (cont’d)

• Banning incandescent bulbs would make
many of these consumers worse off
• Restrictions on choice typically reduce utility
for some consumers


20-40

You Are There: Using a Smartphone to Attain a
Consumer Optimum
• A consumer at Best Buy finds the store price for a
desired GPS device to be higher than what he is
willing to pay.
• On his smartphone, he locates the same item for
half the price through Amazon.
• While still at Best Buy, he uses his phone to order
the item from Amazon, thereby attaining a
consumer optimum.


20-41

Issues & Applications: Why Are Consumers
Making More Healthful Choices?
• Figure 20-4 on the next slide depicts changes in
spending on various products since 2008.
• Spending on alcoholic beverages, restaurant food,
and tobacco products has declined, while
expenditures on vegetables have increased.
• This change could be due to government efforts to
educate consumers about the health effects of
these products, or it could be due to changes in
relative prices of these items.
• Since 2008, the relative price of vegetables has
decreased by 1 percent; relative prices for alcohol,
tobacco, and restaurant meals have risen.


20-42

Figure 20-4 Changes in Spending on Selected Items
by the Typical U.S. Consumer since 2008

Source: Bureau of Labor Statistics.

20-43

Summary Discussion of Learning
Objectives
• Total utility versus marginal utility
– Total utility is total satisfaction from
consumption
– Marginal utility is the additional satisfaction from
consuming an additional unit

• Law of diminishing marginal utility
– Marginal utility ultimately declines as a person
consumes more and more of a good or service


20-44

Objectives (cont'd)
• The consumer optimum
– Occurs when the marginal utility per dollar spent
on the last unit consumed is equalized

• The substitution effect of a price change
– A person will substitute among goods by buying
less of a good when its price increases


20-45

Objectives (cont'd)
• The real-income effect of a price change
– A price change affects the purchasing power of
an individual’s available income


20-46

Appendix F: On Being Indifferent
• What does it mean to be indifferent?
– It usually means that you don’t care one way or
the other about something—you are equally
disposed to either of two alternatives


20-47

Figure F-1 Combinations That Yield Equal
Levels of Satisfaction


20-48

Appendix F: Properties of Indifference
Curves
• Downward (negative) slope
• Curvature
– not a straight line
– convex with respect to the origin


20-49

Figure F-2 Indifference Curves: Impossibility
of an Upward Slope


20-50

Figure F-3 Implications of a Straight-Line
Indifference Curve


20-51

Appendix F: The Marginal Rate of
Substitution
• The marginal rate of substitution is equal to the
change in the quantity of one good that just offsets
a one-unit change in the consumption of another
good, such that total satisfaction remains constant


20-52

Table F-1 Calculating the Marginal Rate of
Substitution


20-53

Appendix F: The Indifference Map
• A set of indifference curves
• A higher indifference curve represents the
possibility of higher rates of consumption of both
goods
• A higher indifference curve is preferred to a lower
one because more is preferred to less


20-54

Figure F-4 A Set of Indifference Curves


20-55

Appendix F: The Budget Constraint
• Budget constraint
– All of the possible combinations of goods that
can be purchased (at fixed prices) with a specific
budget


20-56

Figure F-5 The Budget Constraint


20-57

Appendix F: Consumer Optimum Revisited
• Consumers will try to attain the highest
level of total utility possible, given their
budget constraints
• Graphically, it is the tangency point
between the highest indifference curve and
budget constraint


20-58

Figure F-6 Consumer Optimum


20-59

Appendix F: Deriving the Demand Curve
• Question
– What happens when the price of one good
changes, holding both the price of another good
and income constant?

• Answer
– The budget line rotates, resulting in a new
optimum point
– The demand curve slopes downward


20-60

Figure F-7 Deriving the Demand Curve, Panel
(a)


20-61

Figure F-7 Deriving the Demand Curve, Panel
(b)


20-62

Objectives
• The Budget Constraint
– Indifference curves represent preferences. A
budget constraint represents opportunities:
how much can be purchased with a given level
of income.


20-63

Objectives (cont’d)
• The Marginal Rate of Substitution
– To measure the marginal rate of substitution, we
find out how much of one good has to be given
up in order to allow the consumer to consume
one more unit of the other good while still
remaining on the same indifference curve.


20-64

Objectives (cont’d)
• Slope of the Budget Constraint
– The slope of the budget constraint is the rate of
exchange between two goods.

• Deriving the Demand Curve
– A decrease in the price of an item causes the
budget line to rotate outward. This generates a
new consumer optimum, at which the individual
chooses to consume more units of the item.


20-65

Understanding Consumer Choice Decisions

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