Transcript 22. Consumer Choice: Utility Theory and Insights from Neuroscience

Economics
NINTH EDITION
Chapter 22
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Consumer Choice:
Utility Theory and
Insights from
Neuroscience
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Learning Objectives
22.1 Explain the equimarginal principle and apply it to
consumer choice.
22.2 Describe the income and substitution effects of a
price change.
22.3 Describe the general process involved in the
valuation of the benefits and costs of a consumer good.
22.4 Apply the insights from neuroscience to consumer
decisions about nutrition and saving.
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22.1 TRADITIONAL CONSUMER CHOICE:
UTILITY THEORY (1 of 6)
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.
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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22.1 TRADITIONAL CONSUMER CHOICE:
UTILITY THEORY (2 of 6)
Total 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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22.1 TRADITIONAL CONSUMER CHOICE:
UTILITY THEORY (3 of 6)
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.
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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22.1 TRADITIONAL CONSUMER CHOICE:
UTILITY THEORY (4 of 6)
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.
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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22.1 TRADITIONAL CONSUMER CHOICE:
UTILITY THEORY (5 of 6)
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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22.1 TRADITIONAL CONSUMER CHOICE:
UTILITY THEORY (6 of 6)
Making Choices Using the Equimarginal Rule
TABLE 22.1 Utility Maximization
Movies
Books
Marginal
Utility:
Movies
1
2
3
4
5
6
7
8
24
21
18
15
12
9
6
3
51
48
45
42
39
36
33
30
Marginal
Utility:
Books
Marginal
Utility per $:
Movies
Marginal
Utility per $:
Books
Utility
from
Movies
Utility
from
Books
Total
Utility
2
4
6
8
10
12
14
16
17
16
15
14
13
12
11
10
2
4
6
8
10
12
14
16
51
99
144
186
225
261
294
324
216
210
198
180
156
126
90
48
267
309
342
366
381
387
384
372
EQUIMARGINAL RULE
Pick the where the marginal benefit per dollar for the first activity equals the marginal
benefit per combination of two activities dollar for the second activity.
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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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22.2 THE LAW OF DEMAND AND THE
INDIVIDUAL DEMAND CURVE (1 of 3)
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.
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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22.2 THE LAW OF DEMAND AND THE
INDIVIDUAL DEMAND CURVE (2 of 3)
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.
• Income effect
The change in quantity consumed that is
caused by a change in real income, with
relative prices held constant.
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.
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22.2 THE LAW OF DEMAND AND THE
INDIVIDUAL DEMAND CURVE (3 of 3)
The Individual Demand Curve
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 utilitymaximizing quantity for the consumer.
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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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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22.3 THE NEUROSCIENCE OF
CONSUMER CHOICE (1 of 7)
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 as an apple, 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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22.3 THE NEUROSCIENCE OF
CONSUMER CHOICE (2 of 7)
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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22.3 THE NEUROSCIENCE OF
CONSUMER CHOICE (3 of 7)
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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22.3 THE NEUROSCIENCE OF
CONSUMER CHOICE (4 of 7)
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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22.3 THE NEUROSCIENCE OF
CONSUMER CHOICE (5 of 7)
Cognition and Choice
Why do people make different choices?
• Strength of their gut-feelings
• Cognitive weighting
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22.3 THE NEUROSCIENCE OF
CONSUMER CHOICE (6 of 7)
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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22.3 THE NEUROSCIENCE OF
CONSUMER CHOICE (7 of 7)
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 decisionmaking.
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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APPLICATION 3
•
COKE VERSUS PEPSI IN THE PREFRONTAL CORTEX
APPLYING THE CONCEPTS #3: How does cognition affect consumer choice?
•
• In the “Pepsi Challenge” advertisements of the 1970s and 1980s, randomly chosen
consumers tasted Pepsi and Coke. Most preferred Pepsi. However a majority of
buyers chose Coke.
• Thirty years later neuroscientist Read Montague ran a Pepsi challenge while observing
brain activity. When subjects didn’t know what they were drinking, most preferred
Pepsi. When they did know what they were drinking, most preferred Coke.
• A consumer’s choice is based on gut-feeling benefits and costs. Activity in the
prefrontal cortex was stronger for Coke than for Pepsi, presumably reflecting more
favorable images and feelings associated with Coke commercials. Branding affects
brain activity and consumer preference.
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22.4 CONSUMER DECISIONS: INSIGHTS
FROM NEUROSCIENCE (1 of 4)
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.
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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22.4 CONSUMER DECISIONS: INSIGHTS
FROM NEUROSCIENCE (2 of 4)
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.
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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22.4 CONSUMER DECISIONS: INSIGHTS
FROM NEUROSCIENCE (3 of 4)
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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22.4 CONSUMER DECISIONS: INSIGHTS
FROM NEUROSCIENCE (4 of 4)
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.
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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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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KEY TERMS
Budget line
Budget set
Equimarginal rule
Income effect
Law of diminishing marginal utility
Marginal utility
Substitution effect
Util
Utility
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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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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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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 t-shirt. 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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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 high-price player with a capacity of
16 GB (option B).
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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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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