Transcript Consumer choice notes (ch.7)

Chapter 22
Consumer Choice:
Utility Theory and
Insights from
Neuroscience
Consumer choice often involves a
battle between instant and delayed
gratification.
Prepared By Brock Williams
Learning Objectives
1. Explain the equimarginal principle and
apply it to consumer choice.
2. Describe the income and substitution
effects of a price change.
3. Describe the general process involved in
the valuation of the benefits and costs of a
consumer good.
4. Apply the insights from neuroscience to
consumer decisions about nutrition and
saving.
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22-2
22.1 TRADITIONAL CONSUMER
CHOICE: UTILITY THEORY
Consumer Constraints: The Budget Line
A consumer’s budget line shows all the
combinations of two goods that exhaust the
budget. The slope of the budget line is the
opportunity cost of a movie in terms of books
► Figure 22.1
Budget Set and Budget Line
The budget set (the shaded triangle)
shows all the affordable combinations
of books and movies, and the budget
line (with endpoints r and v) shows the
combinations that exhaust the budget.
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22-3
22.1 TRADITIONAL CONSUMER
CHOICE: UTILITY THEORY (cont.)
► FIGURE 22.2
Total Utility and Marginal Utility
The consumer’s objective is
to maximize utility. The
upper panel shows the
relationship between total
utility and the number of
movies watched.
In the lower panel, the
marginal utility from movies
decreases as the number of
movies increases.
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22-4
22.1 TRADITIONAL CONSUMER
CHOICE: UTILITY THEORY (cont.)
The Marginal Principle and the Equimarginal Rule
MARGINAL PRINCIPLE
Increase the level of an activity as long as its marginal benefit exceeds its marginal cost.
Choose the level at which the marginal benefit equals the marginal cost.
► Figure 22.3
Marginal Utility and Marginal Utility
Per Dollar
The marginal utility of movies decreases
as the number of movies increases,
reflecting the assumption of diminishing
marginal utility. The marginal utility per
dollar equals the marginal utility divided
by the price of movies.
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22-5
22.1 TRADITIONAL CONSUMER
CHOICE: UTILITY THEORY (cont.)
Conditions for Maximizing Utility
MARGINAL PRINCIPLE
Increase the level of an activity as long as its marginal benefit exceeds its marginal cost.
Choose the level at which the marginal benefit equals the marginal cost.
► Figure 22.4
The Equimarginal Rule: Equalize the
Marginal Benefit per Dollar
The consumer picks the affordable bundle
at which the marginal utility per dollar on
movies equals the marginal utility per dollar
on books. This is shown by point a (6
movies) and point b (9 books). Starting
from any other affordable combination, the
consumer can do better by reallocating the
budget in favor of the good with the larger
marginal utility per dollar. For example,
starting from points c and d, movies have a
larger marginal utility per dollar, so the
consumer can increase utility by choosing
more movies and fewer books.
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22-6
22.1 TRADITIONAL CONSUMER
CHOICE: UTILITY THEORY (cont.)
Making Choices Using the Equimarginal Rule
• equimarginal rule
Pick the combination of two activities
where the marginal benefit per dollar
for the first activity equals the
marginal benefit per dollar for the
second activity.
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22-7
22.1 TRADITIONAL CONSUMER
CHOICE: UTILITY THEORY (cont.)
Making Choices Using the Equimarginal Rule
EQUIMARGINAL RULE
Pick the combination of two activities where the marginal benefit
per dollar for the first activity equals the marginal benefit per
dollar for the second activity.
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22-8
APPLICATION
1
MEASURING DIMINISHING MARGINAL UTILITY
APPLYING THE CONCEPTS #1: How does marginal utility
change with the quantity consumed?
•
Neuroscientists have used brain imaging techniques to provide some insights
into the law of diminishing marginal utility. The scientists offered subjects in an
experiment varying monetary rewards, and observed the neural activity in a
subject's striatum, the region of the brain responsible for the valuation of
rewards.
•
As the monetary reward increased, the subjective benefit (the utility value, as
measured in neuron activity) increased, but at a decreasing rate. In other words,
the larger the reward, the lower the marginal utility of the reward money.
•
For example, for a $15 reward, the marginal utility is 1 util per dollar, but for a
$150 reward, the marginal utility is only 0.25 utils per dollar. Although this
experiment does not provide a direct demonstration of the law of diminishing
marginal utility for a particular product, it does show that general rewards are
subject to diminishing marginal utility.
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22-9
22.2 THE LAW OF DEMAND AND THE
INDIVIDUAL DEMAND CURVE
The effect of a decrease in price
The left panel shows a decrease in price moves the curve up. A decrease in price
show the original bundle violates the equimarginal rule.
► Figure 22.5
A Decrease in the Price of Movies
Increases the Utility-Maximizing Number
of Movies
A decrease in the price of movies shifts the
movie benefit curve (MU per $ of movies)
upward. At the original bundle (6 movies
and 9 books), the MU per $ of movies (18
utils at point c) exceeds the MU per $ of
books (12 utils at point b), so the consumer
Increases the number of movies.
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22-10
22.2 THE LAW OF DEMAND AND THE
INDIVIDUAL DEMAND CURVE (cont.)
The Income and Substitution Effects of a Price Change
• substitution effect
The change in quantity
consumed that is caused
by a change in the
relative price of the good,
with real income held
constant.
► Figure 22.6
Income and Substitution Effects of a Decrease in Price
For a price of movies of $2, utility is maximized at points d and e, with 10
movies and 7 books. The move from point c to point s is the substitution
effect of the decrease in price, and the move from point s to point d is the
income effect of the decrease in price.
• income effect
The change in quantity
consumed that is caused
by a change in real
income, with relative
prices held constant.
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22-11
22.2 THE LAW OF DEMAND AND THE
INDIVIDUAL DEMAND CURVE (cont.)
An individual demand curve shows the relationship between the price of a product
and the quantity demanded by a rational consumer. In other words, the demand
curve shows, for each price, the utility-maximizing quantity for the consumer.
 FIGURE 22.7
The Individual Demand Curve
The individual demand curve for
our hypothetical consumer. At the
initial price of $3, the consumer
maximizes utility with 6 movies
(point i).
A decrease in price to $2
increases the quantity demanded
to 10 movies (point j).
The move from point i to point j
reflects both the substitution
effect and the income effect of a
decrease in price.
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22-12
APPLICATION
2
A REVENUE-NEUTRAL GASOLINE TAX
APPLYING THE CONCEPTS #2: How would a simultaneous increase in the
gasoline tax and a decrease in the income tax affect gasoline consumption?
• Suppose the government imposes a new tax of $3 per gallon gasoline, which will
bring gasoline taxation in the U.S. closer to the levels experienced in Europe. And
suppose the gasoline tax is combined with cut in income taxes to ensure that total
tax revenue doesn’t change. In other words, the gasoline tax is revenue neutral.
• It may be tempting to conclude that the change in tax policy will not change gasoline
consumption. After all, the policy doesn’t change the tax liability of the typical
taxpayer: the increase in gasoline taxes is offset by a decrease in income taxes.
• This logic is faulty because it ignores the substitution effect of a price change.
• The gas tax decreases the marginal utility per dollar spent on gasoline, which is now
less than the marginal utility per dollar spent on other goods. Gasoline now
generates a lower marginal bang per buck .
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22-13
22.3 THE NEUROSCIENCE OF
CONSUMER CHOICE
The Neuroscience of Benefit Valuation
The calibration of the regions of the brain involved in benefit valuation comes from
the brain's dopamine system. Dopamine is the reward chemical of the brain--when it
flows over receptors in your brain, you feel good.
When you consider buying a product such, your brain uses its past experience to
form a conjecture about the likely pleasure and satisfaction from the product.
Learning happens when conjectures about the pleasure from a product are wrong.
For example, suppose you anticipate a sweet apple and thus have a large dopamine
flow, but the first bite generates a sour taste. The invalidation of the brain's
conjecture causes an abrupt decrease in the dopamine flow, causing an abrupt
reduction of the good feelings produced by dopamine.
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22-14
22.3 THE NEUROSCIENCE OF
CONSUMER CHOICE (cont.)
The Neuroscience of Cost Valuation
On the cost side, the key regions for cost valuation are the insular cortex (insula for
short) and the amygdala. These interconnected regions express aversion to various
actions.
PRINCIPLE OF OPPORTUNITY COST
The opportunity cost of something is what you sacrifice to get it.
The money spent on one product cannot be used on another product, so it is natural
that the brain reacts in a negative way (in the region that expresses aversion) to the
thought of spending money. The higher the price of a product, the greater the
opportunity cost of the product, and thus the stronger the activity of the insula.
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22-15
22.3 THE NEUROSCIENCE OF
CONSUMER CHOICE (cont.)
The Wisdom of Gut Feelings
The Iowa Gambling Task experiment shows gut feelings begin to cause an effect
after only 10 draws of the cards.
However, it takes about 50 draws for the unconscious learning to take affect and 60
draws for the subject to explain their choices.
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22-16
22.3 THE NEUROSCIENCE OF
CONSUMER CHOICE (cont.)
Cognition and Choice
To decide whether to take an action, a person compares the anticipated benefit of the
action to its anticipated cost.
The principal decision-making region of the brain is the prefrontal cortex (PFC).
In other words, the PFC uses gut feelings as inputs into the decision-making
process.
The PFC is not a simple calculator of gut-feeling benefits and costs, but incorporates
other factors into the decision-making process. The PFC uses cognition (conscious
thought) to consider a broad set of possible consequences of an action.
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22-17
22.3 THE NEUROSCIENCE OF
CONSUMER CHOICE (cont.)
Cognition and Choice
Why do people make different choices?
• Strength of their gut-feelings
• Cognitive weighting
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22-18
22.3 THE NEUROSCIENCE OF
CONSUMER CHOICE (cont.)
Predicting Consumer Choice
Neuroscientists map and measure the brain activity associated with
consumer decisions. After observing a consumer's brain activity while he
or she considers different options, scientists can actually predict the
consumer's choice.
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22-19
22.3 THE NEUROSCIENCE OF
CONSUMER CHOICE (cont.)
Fuel for Cognition
The decision-making process that occurs in the PFC is complex. As a result, the
cognitive process consumes a large amount of energy in supporting neurons as
they perform their various tasks. The brain gets most of its energy from glucose
(aka blood sugar), and operates effectively only when it has a plentiful supply of
glucose.
The fuel requirements of cognition have important implications for consumer
decision-making.
A consumer may respond to the depletion of brain fuel in one of three ways:
a)simplify matters by focusing on a single dimension of the product (price, color,
shine)
b)abandon cognition and make an impulse buy, or
c)abandon the decision-making process altogether and refrain from buying a
toothbrush.
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22-20
APPLICATION
3
STORES VS. ONLINE RETAILERS
APPLYING THE CONCEPTS #3: How do the sales strategies of
conventional stores and online retailers differ?
• Conventional stores encourage shoppers to buy products by boosting the neural activity
in the NAcc, the region of the brain responsible for the valuation of the benefit of a
product.
• Some of the benefit boosting comes from tactile stimulation--feeling the softness of a
cashmere sweater or the bounce of an athletic shoe. Conventional stores also downregulate the insula, the region of the brain responsible for the valuation of the cost of a
product. The suppression of insula activity comes from price reductions and low-price
guarantees.
• On-line retailers can work with the insula by offering discounted prices and low-price
guarantees, but they are at a disadvantage in boosting the neural activity in the NAcc.
There is currently no substitute for the tactile sensations available in physical stores, so
online retailers have an incentive to focus on products for which the stimulation of the
NAcc is less critical to making a sale.
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22-21
22.4 CONSUMER DECISIONS:
INSIGHTS FROM NEUROSCIENCE
Dietary Choice: Donut vs. Apple
Some scientists speculate that the evolutionary development of the DLPFC in
humans increased our fitness (likelihood of survival) because it gave us the ability
to incorporate long-term considerations into the decision-making process.
 Figure 22.8
Gut Feelings versus Cognition:
Donuts versus Apples
For a decision based exclusively on
gut feelings, a consumer using the
equimarginal rule chooses points a
and b (9 donuts and 1 apple). The
engagement of the cognitive process
decreases the perceived MU per $ of
donuts, so at the original bundle (9
donuts, 1 apple), the MU per $ is 2
utils for donuts (point c), compared to
12 utils for apples (point b). The new
utility-maximizing choice is shown by
points e and d: cognitive engagement
decreases donut consumption from 9
to 4 and increases apple consumption
from 1 to 6.
1. Equimarginal rule. For each good, the marginal utility per dollar is 12 utils.
2. Affordability. The consumer spends $9 on donuts and $1 on apples, for a
total of $10. In this case, a consumer who simply goes with his or her gut
feelings eats a lot of donuts.
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22-22
22.4 CONSUMER DECISIONS: INSIGHTS
FROM NEUROSCIENCE (cont.)
Present bias: spending vs. savings
Gut feelings are visceral, in-the-moment sensations, and humans are myopic with respect to gut feelings. In other words,
humans do a poor job imagining the strength of future gut feelings, including the gut-feeling benefits of future consumption.
 Figure 22.9
Present Bias and Spending versus
Saving
A consumer subject to present bias
chooses points a and b (spend $19 and
save $1). Cognition that reduces present
bias increases the perceived MU per $ of
saving, so at the original bundle (spend
$19, save $1), the MU per dollar
is higher for saving (point c versus point
a). The new utility-maximizing choice
shown by points e and d: cognitive
Engagement increases saving from $1 to
$7 and decreases spending (consumption
now) from $19 to $13.
In the left panel, the benefit curve shows the marginal utility per dollar spent in the present. For current consumption,
gut feelings accurately represent the benefit of consumption. In the right panel, the lower curve shows the benefit of
saving (the benefit of future consumption) for a consumer subject to present bias: the consumer systematically
underestimates the future benefit of consumption.
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22-23
22.4 CONSUMER DECISIONS: INSIGHTS
FROM NEUROSCIENCE (cont.)
Present Bias and Credit Cards
Credit cards cause a different sort of temporal mismatch between benefits and costs. In
this case, the benefit of a product will be experienced now, but the cost will be delayed
until some future date.
Using a credit card weakens our gut feeling aversion to spending money.
Present Bias and Smoking
The decision to smoke cigarettes is subject to present bias because there is a temporal
mismatch between the present benefit (the good feeling from nicotine) and a future cost
(health problems).
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22-24
22.4 CONSUMER DECISIONS: INSIGHTS
FROM NEUROSCIENCE (cont.)
Gambling as a Consumer Good
Why do people gamble when the expected reward is negative? For example, the typical state-run lottery pays out
roughly half of what it takes in, so on average a person who plays the lottery for $10 can expect a payoff of roughly $5.
Neuroscientists have discovered a possible reason for this seemingly irrational behavior.
 Figure 22.10
Near-Miss Benefits and Gambling as a Consumer Good
If you draw ball #3, you win $12. The expected monetary value of drawing a ball from the urn is $4 = 1/3 × $12.
Suppose the dopamine benefit of winning is 12 utils, while the dopamine benefit for a near win (drawing ball #2) is 9
utils. The expected dopamine value of drawing a ball is 7 utils = 1/3 × 9 + 1/3 × 12.
Numbers that are close to a gambler’s number seem to be a near miss to the gambler and encourages continued
gambling in spite of the fact that numbers have an equal chance of selection.
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22-25
APPLICATION
4
TAXING CIGARETTES TO OFFSET PRESENT BIAS
APPLYING THE CONCEPTS #4: What is the appropriate
cigarette tax?
• The present bias that leads some people to smoke cigarettes raises an important policy
question: Can we use taxes on cigarettes to offset present bias and actually make
people better off in the process? A recent study concludes that to fully offset the present
bias that underlies the decision to smoke, the appropriate tax is roughly $11 per pack of
cigarettes.
• The study focused on the effects of smoking on premature death. Smoking cuts the
lifespan of the typical smoker by roughly 6 years, and given the economic value of one
year of life, we can translate the cost associated with premature death into a cost of
roughly $36 per pack of cigarettes. If smokers did not suffer from present bias, their
present choices would fully reflect this future cost, meaning that they would compare the
benefit of smoking (the nicotine experience) to the full cost of a pack of cigarettes (the
purchase price plus the $36 cost associated with premature death).
• The study suggest that the cigarette tax would actually be beneficial for low-income
households. The reason is that low-income households are relatively responsive to
changes in the price of cigarettes, so they would experience a relatively large reduction
in smoking, and a relatively large increase in lifespan.
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22-26
KEY TERMS
budget line
law of diminishing marginal utility
budget set
marginal utility
equimarginal rule
substitution effect
income effect
util
utility
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22-27
APPENDIX A MENTAL SHORTCUTS AND CONSUMER
PUZZLES
Economists and psychologists have identified several types of puzzling
consumer behavior.
•Spending choices sometimes depends on the source of income.
•The willingness to pay for a product sometimes is affected by irrelevant
information.
•Product choices are sometimes influenced by irrelevant alternatives.
•Decisions are sometimes based on percentage differences rather than
absolute differences.
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22-28
APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES
22A.1 MENTAL ACCOUNTING AND
BUNDLING
One way to economize on decision-making is to separate decisions into different
type or accounts. For example, a consumer could establish separate accounts for
food ($300 per month) and entertainment ($100 per month).
An important application of mental accounting concerns the classification of
money from different sources. Consider the treatment of income that comes
unexpectedly, for example, a $50 birthday gift or $50 found on the street. For
many people, unexpected income is “play money” that is frequently spent on fun
or frivolous purchases. In contrast, people are more careful with regular income.
Another mental shortcut is to monitor consumption by bundles rather than
individual units. People tend to track consumption by the bundles in which a
product is delivered rather than the actual consumption of the product.
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22-29
APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES
22A.2 ANCHORING
In the classic experiment, each participant writes down the last two digits of his or
her social security number, and then bids (expresses a willingness to pay) for a tshirt. The bizarre result is the larger the participant's social-security number, the
higher the bid on the t-shirt. In other words, the social-security number provides
an anchor for an unrelated mental task.
One way to plant an anchoring number is to be the first to state a price. In other
words, there is a first-mover advantage in negotiations over price. This provides
one reason for relatively high (and negotiable) sticker prices on new and used
cars.
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22-30
APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES
22A.3 THE DECOY EFFECT
One the most puzzling quirks of consumer decision-making is the decoy effect. In the left
panel, there are two options: a low-price player with a capacity of 8 GB (option A), and a highprice player with a capacity of 16 GB (option B).
 Figure 22A.1
The right panel introduces a third option, a decoy. Option C has the same capacity as option B, but its price is $20
higher. The comparison of B versus C is quick and easy: the consumer doesn't have to think about any tradeoffs,
but simply recognizes that the extra $20 spent on C doesn't buy anything. The typical consumer will then choose
option B over options A and C.
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22-31
APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES
22A.4 THE APPEAL OF PERCENTAGE
CHANGES
The natural inclination is to translate a numerical change into a percentage
change. For example, a change in price from $1.00 to $0.90 is a 10 percent
change, and so is a change from $200 to $180. The translation into percentages
means that all 10% changes appear to be alike, despite the fact that 10% of $200
is much larger than 10% of $1.00.
In general, low-price hotels include Internet service as part of the room charge,
while high-price hotels have a separate charge. In a low-price hotel ($50 per
night), a separate charge of $10 per day is a 20% surcharge, a relatively large
surcharge in percentage term. Consumers subject to percentage bias are likely to
react strongly to the seemingly large surcharge. In a hotel with a price $200 per
night, a separate charge of $10 is only 5% of the price, a small enough
percentage that the consumer response is likely to be relatively small.
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22-32