Consumer Choice
9 c h a p t e r
Individuals do not just follow simple patterns of behavior.
They take action in response to recognized opportunities to advance their goals. This assumption that individuals act to advance their goals— known as the rule of rational choice—merely implies that whatever individuals do, they do with a purpose. In economics, we assume that each individual seeks to maximize his or her own well-being or satisfaction.
UTILITY
To more clearly define the relationship between consumer choice and resource allocation, economists developed the concept of utility—a measure of the relative levels of satisfaction that consumers get from the consumption of goods and services.
Defining one util as equivalent to one unit of satisfaction, economists can indicate relative levels of consumer satisfaction that result from alternative choices. For example, for a java junkie who wouldn’t dream of starting the day without a strong dose of caffeine, a cup of coffee might generate 150 utils of satisfaction while a cup of herb tea might only generate 10 utils.
Inherently, utility varies from individual to individual depending on specific preferences. For example, Jason might get 50 utils of satisfaction from eating his first piece of apple pie, while Brittany may only derive 4 utils of satisfaction from her first piece of apple pie.
UTILITY IS A PERSONAL MATTER
Economists recognize that it is not really possible to make interpersonal utility comparisons. That is, they know that it is impossible to compare the relative satisfactions of different persons. The relative satisfactions gained by two people drinking cups of coffee, for example, simply cannot be measured in comparable terms. Likewise, although we might be tempted to believe that a poorer person would derive greater utility from finding a $100 bill than would a richer person, we should resist the temptation.
We simply cannot prove it. The poorer person may be “monetarily” poor because money and material things are not important to her, and the rich person may have become richer because of his lust for the things money can buy.
TOTAL UTILITY AND MARGINAL UTILITY
Economists recognize two different dimensions of utility: total utility and marginal utility. Total utility
is the total amount of satisfaction derived from the consumption of a certain number of units of a good or service. In comparison, marginal utility is the extra satisfaction generated by an additional unit of a good that is consumed in a particular time period. For example, eating four slices of pizza in an hour might generate a total of 36 utils of satisfaction.
The first three slices of pizza might generate a total of 35 utils, while the last slice generates only 1 util. In this case, the total utility of eating four slices of pizza is 36 utils, and the marginal utility of the fourth slice is 1 util. Notice in Exhibit 1(a) how marginal utility falls as consumption increases, whereas in Exhibit 1(b), total utility increases as consumption increases (there is more total utility after the fourth slice of pizza than after the third).
But notice, too, that the increase in total utility from each additional unit (slice) is less than the unit before.
DIMINISHING MARGINAL UTILITY
Although economists believe that total utility increases with additional consumption, they also argue that the incremental satisfaction—the marginal utility—that results from the consumption of additional units tends to decline as consumption increases.
In other words, each successive unit of a
Consumer Behavior
s e c t i o n
9.1
_ What is utility?
_ Can we make interpersonal utility comparisons?
_ What is the law of diminishing marginal utility?
164 CHAPTER NINE | Consumer Choice Consumer Behavior 165 a. Marginal Utility b. Total Utility
Marginal Utility(per pizza slice)
20 15 10 5 1 2 3 4 0
Marginal utility
Total Utility
40 30 20 10 1 2 3 4 0
Total utility
Quantity of Pizza Slices (per hour) Quantity of Pizza Slices (per hour)
Total and Marginal Utility SECTION 9.1
EXHIBIT 1
As you can see in (a), marginal utility decreases as consumption increases. As you eat more pizza, your satisfaction from each additional slice diminishes. In (b), the total utility from each slice of pizza increases as consumption increases.
“Nothing is more useful than water: but it will not purchase scarce anything. . . . Diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.” —Adam Smith, Wealth of Nations, 1776 Use the concept of marginal utility to evaluate the social value of water versus diamonds.
The classic diamond-water paradox is the observation that sometimes those things that are necessary for life, like water, are inexpensive, and those items that are not necessary for life, like diamonds, are expensive. This paradox puzzled philosophers for centuries. The answer lies in making the distinction between total utility and marginal utility. The amount of total utility is indeed higher for water than for diamonds because of its importance for survival. But price is not determined by total utility, it is determined by marginal utility.
While total utility measures the total amount of satisfaction someone derives from a good, it is marginal utility that determines the price. Market value—the value of the last, or marginal, unit traded—depends on both supply and demand. Thus, the limited supply of diamonds relative to the demand generates a high price, while an abundant supply of water relative to the demand results in a low price.
The total utility (usefulness) for water is very large compared to the marginal utility. Because the price of water is so low, we use so much water that the marginal utility we receive from the last glass of water is small. Diamonds have a much smaller total utility (usefulness) relative to water, but because the price of diamonds is so high, we buy so few diamonds they have a high marginal utility.
Could water ever have a higher marginal utility than diamonds?
Yes, if you had no water and no diamonds, your first cup of water would give you a much higher marginal value than your first cup of diamonds. Furthermore, what if diamonds were very plentiful and water was very scarce, which would have the higher marginal utility? In this case, water would be expensive and diamonds would be inexpensive.
THE DIAMOND-WATER PARADOX: MARGINAL AND TOTAL UTILITY
USING WHAT YOU'VE LEARNED
A Q
Why is water, which is so critical to life, priced lower than diamonds which are less useful?
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good that is consumed generates less satisfaction than did the previous unit. This concept is traditionally referred to as the law of diminishing marginal utility. Exhibit 1(a) demonstrates this graphically, where the marginal utility curve has a negative slope.
It follows from the law of diminishing marginal utility that as a person uses more and more units of a good to satisfy a given want, the intensity of the want, and the utility derived from further satisfying that want, diminishes. For example, as you eat four pieces of pepperoni pizza in an hour, your desire for another piece of pepperoni pizza, and thus the satisfaction you get from satisfying that desire, diminishes with each slice that you eat. Think about it: If you are starving, your desire for that first piece of pizza will be great, but as you eat, you gradually become more and more full, reducing your desire for yet another piece.
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Why do most individuals take only one newspaper from covered, coin-operated newspaper racks when it would be so easy to take more? Do you think potato chips, candy, or sodas could be sold profitably in the same kind of dispenser? Why or why not?
While ethical considerations keep some people from taking additional papers, the law of diminishing marginal utility is also at work here. The second newspaper adds practically zero utility to most individuals on most days, so there is typically no incentive to take more than one. The exception to this case might be on Sundays, when supermarket coupons are present. In that instance, while the marginal utility is still lower for the second paper than for the first, the marginal utility of the second paper may be large enough to tempt some individuals to take additional copies.
On the other hand, if putting money in a vending machine gave access to many bags of potato chips, candy bars, or sodas, the temptation to take more than one might be too great for some people. After all, the potato chip bags would still be good tomorrow. Therefore, vending machines with foods and drinks only dispense one item at a time, because it is likely that, for most people, the marginal utility gained from another unit of food or drink is higher than for a second newspaper.
Why are newspaper racks different from vending machines?
© Robert Manikoff 2001 The New Yorker Collectionfrom Cartoonbank.com © 1998 Don Couch, Photography
WHAT IS THE “BEST” DECISION FOR CONSUMERS?
We have established the fact that marginal utility diminishes as additional units of a good are acquired.
But what significance does this have for consumers? Remember, consumers try to add to their own total utility, so when the marginal utility generated by the purchase of additional units of one good drops too low, it can become rational for the consumer to purchase other goods rather than purchase more of the first good. In other words, a rational consumer will avoid making purchases of any one good beyond the point at which other goods will yield greater satisfaction for the amount spent—the “bang for the buck.” Marginal utility, then, is an important concept in understanding and predicting consumer behavior, especially when combined with information about prices. By comparing the marginal utilities generated by units of the goods that they desire as well as the prices, rational consumers seek the combination of goods that maximizes their satisfaction for a given amount spent. In the next section, we will see how this works.
CONSUMER EQUILIBRIUM
To reach consumer equilibrium, consumers must allocate their incomes in such a way that the marginal utility per dollar’s worth of any good is the same for every good. That is, the “bang for the buck” must be equal for all goods at consumer equilibrium. When this goal is realized, one dollar’s worth of additional gasoline will yield the same marginal utility as one dollar’s worth of additional bread or apples or movie tickets or soap. This concept will become clearer to you as we work through an example illustrating the forces present when consumers are not at equilibrium.
Given a fixed budget, if the marginal utilities per dollar spent on additional units of two goods are not the same, you can increase total satisfaction by buying more of one good and less of the other. For example, assume that the price of a loaf of bread is $1, the price of a bag of apples is $1, the marginal utility of a dollar’s worth of apples is 1 util , and the marginal utility of a dollar’s worth of bread is 5 utils. In this situation, your total satisfaction can be increased by buying more bread and fewer apples,
The Consumer’s Choice 167
1. Utility is the amount of satisfaction an individual receives from consumption of a good or service.
2. Economists recognize that it is not possible to make interpersonal utility comparisons.
3. Total utility is the amount of satisfaction derived from all units of goods and services consumed. Total utility increases as consumption increases.
4. Marginal utility is the change in utility from consuming one additional unit of a good or service.
5. According to the law of diminishing marginal utility, as a person consumes additional units of a given good, marginal utility declines.
1. How do economists define utility?
2. Why can’t interpersonal utility comparisons be made?
3. What is the relationship between total utility and marginal utility?
4. Why could you say that a millionaire gets less marginal utility from a second piece of pizza than from the first piece, but you couldn’t say that the millionaire derives more or less marginal utility from a second piece of pizza than someone else who has a much lower level of income?
5. Are you likely to get as much marginal utility from your last piece of chicken at an all-you-can-eat restaurant as at a restaurant where you pay $2 per piece of chicken?
s e c t i o n c h e c k
The Consumer’s Choice
9.2
_ How do consumers maximize satisfaction?
_ What is the connection between the law of demand and the law of diminishing marginal utility?
because bread is currently giving you greater satisfaction per dollar than apples—5 utils versus 1 util, for a net gain of 4 utils to your total satisfaction. By buying more bread, though, you alter the marginal utility of both bread and apples. Consider what would happen if, next week, you buy one more loaf of bread and one less bag of apples. Because you are consuming more of it now, the marginal utility for bread will fall, say to 4 utils. On the other hand, the marginal utility for apples will rise, perhaps to 2 utils, because you now have fewer apples.
A comparison of the marginal utilities for these goods in week 2 versus week 1 would look something like this:
Week 1
MUbread/$1 . MUapples/$1 5 utils/$1 . 1 utils/$1
Week 2
MUbread/$1 . MUapples/$1 4 utils/$1 . 2 utils/$1 Notice that although the marginal utilities of bread and apples are now closer, they are still not equal. Because of this, it is still in the consumer’s interest to purchase an additional loaf of bread rather than the last bag of apples; in this case, the net gain would be 2 utils (3 utils for the unit of bread added at a cost of 1 util for the apples given up). By buying yet another loaf of bread, you once again push further down your marginal utility curve for bread, and as a result, the marginal utility for bread falls. With that, the relative value to you of apples increases again, changing the ratio of marginal utility to dollar spent for both goods in the following way:
Week 3
MUbread/$1 5 MUapples/$1 3 utils/$1 5 3 utils/$1 What this example shows is that, to achieve maximum satisfaction —consumer equilibrium
—consumers have to allocate income in such a way that the ratio of the marginal utility to the price of the goods is equal for all goods purchased.
In other words, in a state of consumer equilibrium,
MU1/P1 5 MU2/P2 5 MU3/P3 5 . . . MUN /PN
In this situation, each good provides the consumer with the same level of marginal utility per dollar spent.
THE LAW OF DEMAND AND THE LAW OF DIMINISHING MARGINAL UTILITY
The law of demand states that when the price of a good is reduced, the quantity of that good demanded will increase. But why is this the case? By examining the law of diminishing marginal utility in action, we can determine the basis for this relationship between price and quantity demanded. Indeed, the demand curve merely translates marginal utility into dollar terms.
For example, let’s say that you are in consumer equilibrium when the price of a personal-sized pizza is $4 and the price of a hamburger is $1. Further, in equilibrium, the marginal utility on the last pizza consumed is 40 utils, and the marginal utility on the last hamburger is 10 utils. So in consumer equilibrium, the MU/P ratio for both the pizza and the hamburger is 10 utils per dollar:
MUpizza (40 utils)/$4 5
MUhamburger (10 utils)/$1 Now suppose the price of the personal-sized pizza falls to $2, ceteris paribus. Instead of the MU/P ratio of the pizza being 10 utils per dollar, it is now 20 utils per dollar (40 utils/$2).
This implies, ceteris paribus,
that you will now buy more pizza at the lower price because you are getting relatively more satisfaction for each dollar you spend on pizza.
MUpizza (40 utils)/$2 .
MUhamburger (10 utils) / $1 In other words, because the price of the personal-sized pizza fell, you are now willing to purchase more pizzas and fewer hamburgers.
168 CHAPTER NINE | Consumer Choice
If you are currently deriving more satisfaction per dollar from bread than for apples, how will you spend your next dollar?
© 1998 Don Couch Photography © PhotoDisc
The Consumer’s Choice 169
In the models presented in traditional economics we assume that individuals are self interested and rational. Most economists believe that is a good first approximation for the sake of the theory. However, important strides have been made in economics over the last 30 years by behavioral economists that have been drawing on traits identified by experimental psychologists that are challenging the idea that individuals act rationally —equating marginal this to marginal that.
For example, people appear to be disproportionately influenced by the fear of feeling regret, and will often pass up even benefits within reach to avoid a small risk of feeling they have failed. They are also prone to cognitive dissonance: holding beliefs that are in conflict with one another. People look for ways to resolve their dissonance—changing one belief to make it consistent with the other. For example, suppose you decide to buy an expensive car and you believed that expensive cars should be comfortable cars. You then discover that the car you purchased is not very comfortable on long drives. In order to reconcile this dissonance, you might decide that the car’s comfort does not matter since it is primarily being used on short trips (reducing the importance of the dissonant belief) or focusing on the strenghts of the car: safety, appearance, handling, and so on (adding more consonant beliefs).
And then there is anchoring: people are often overly influenced by outside suggestion. People can be influenced even when they know that the suggestion is not being made by someone who is better informed. In one experiment, volunteers were asked a series of questions whose answers were in percentages —such as what percentage of African countries is in the United Nations? A wheel with numbers from one to 100 was spun in front of them; they were then asked to say whether their answer was higher or lower than the number on the wheel, and then to give their answer. These answers were strongly influenced by the randomly selected, irrelevant number on the wheel. The average guess when the wheel showed 10 was 25%; when it showed 65 it was 45%.
Experiments show that most people apparently also suffer from status quo bias: they are willing to take bigger gambles to maintain the status quo than they would be to acquire it in the first place. In one common experiment, mugs are allocated randomly to some people in a group. Those who have them are asked to name a price to sell their mug; those without one are asked to name a price at which they will buy. Usually, the average sales price is considerably higher than the average offer price.
Expected-utility theory assumes that people look at individual decisions in the context of the big picture. But psychologists have found that, in fact, they tend to compartmentalize, often on superficial grounds. They then make choices about things in one particular mental compartment without taking account of the implications for things in other compartments.
There is also a huge amount of evidence that people are persistently, and irrationally, over-confident. Asked to answer a factual question, then asked to give the probability that their answer was correct, people typically overestimate this probability. This may be due to a representativeness heuristic: a tendency to treat events as representative of some well-known class or pattern. This gives people a sense of familiarity with an event and thus confidence that they have accurately diagnosed it. This can lead people to “see” patterns in data even where there are none. A closely related phenomenon is the availability heuristic: people focus excessive attention on a particular fact or event, rather than the big picture, simply because it is more visible or fresher in their mind.
Another delightfully human habit is magical thinking: attributing to one’s own actions something that had nothing to do with them, and thus assuming that one has a greater influence over events than is actually the case. For instance, an investor who luckily buys a share that goes on to beat the market may become convinced that he is a skilful investor rather than a merely fortunate one. He may also fall prey to quasi-magical thinking—behaving as if he believes his thoughts can influence events, even though he knows that they can’t.
Most people, say psychologists, are also vulnerable to
hindsight bias: once something happens, they overestimate the extent to which they could have predicted it. Closely related to this is memory bias: when something happens people often persuade themselves that they actually predicted it, even when they didn’t.
Finally, who can deny that people often become emotional, cutting off their noses to spite their faces. One of the psychologists’ favorite experiments is the “ultimatum game” in which one player, the proposer, is given a sum of money, say $10, and offers some portion of it to the other player, the responder.
The responder can either accept the offer, in which case he gets the sum offered and the proposer gets the rest, or reject the offer in which case both players get nothing. In experiments, very low offers (less than 20% of the total sum) are often rejected, even though it is rational for the responder to accept any offer (even one cent!) which the proposer makes. And yet responders seem to reject offers out of sheer indignation at being made to accept such a small proportion of the whole sum, and they seem to get more satisfaction from taking revenge on the proposer than in maximizing their own financial gain.
The psychological idea that has so far had the greatest impact on economics is “prospect theory”. This was developed by Nobel Laureate Daniel Kahneman of Princeton University and the late Amos Tversky of Stanford University. It brings together several aspects of psychological research and differs in crucial respects from expected-utility theory—although, equally crucially, it shares its advantage of being able to be modeled mathematically.
It is based on the results of hundreds of experiments in which people have been asked to choose between pairs of gambles.
What Messrs Kahneman and Tversky claim to have found is that people are “loss averse”: they have an asymmetric attitude to gains and losses, getting less utility from gaining, say, $100 than they would lose if they lost $100. This is not the
BEHAVIORAL ECONOMICS
In The NEWS
170 CHAPTER NINE | Consumer Choice
same as “risk aversion”, any particular level of which can be rational if consistently applied. But those suffering from loss aversion do not measure risk consistently. They take fewer risks that might result in suffering losses than if they were acting as rational utility maximizers. Prospect theory also claims that people regularly miscalculate probabilities: they assume that outcomes which are very probable are less likely than they really are, that outcomes which are quite unlikely are more likely than they are, and that extremely improbable, but still possible, outcomes have no chance at all of happening. They also tend to view decisions in isolation, rather than as part of a bigger picture.
Colin Camerer, an economist at the California Institute of Technology, provides several real-world examples of how this theory can explain human decisions. Many New York taxi drivers, points out Mr Camerer, decide when to finish work each day by setting themselves a daily income target, and on reaching it they stop. This means that they typically work fewer hours on a busy day than on a slow day. Rational labor-market theory predicts that they will do the opposite, working longer on the busy day when their effective hourly wage-rate is higher, and less on the slow day when their wage-rate is lower.
Prospect theory can explain this irrational behavior: failing to achieve the daily income target feels like incurring a loss, so drivers put in longer hours to avoid it, and beating the target feels like a win, so once they have done that, there is less incentive to keep working.
RACING AND THE EQUITY PREMIUM
People betting on horse races back long-shots over favorites far more often than they should. Prospect theory suggests this is because they attach too low a probability to likely outcomes and too high a probability to quite unlikely ones. Gamblers also tend to shift their bets away from favorites towards long-shots as the day’s racing nears its end. Because of the cut taken by the bookies, by the time later races are run most racegoers have lost some money. For many of them, a successful bet on an outsider would probably turn a losing day into a winning one.
Mathematically, and rationally, this should not matter. The last race of the day is no different from the first race of the next day.
But most r...
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