Econ 200 Consumer Choice Notes
Consumer Choice Notes
Consumer Theory
Consumer theory focuses on how individuals maximize their utility, given their budget constraints.
Key aspects include:
Understanding how revealed preferences relate to utility.
Analyzing how budget constraints impact utility maximization.
Examining how income affects consumption choices.
Determining how prices affect consumption choices, distinguishing between income and substitution effects.
An introduction to behavioral economics is also provided.
How Consumers Make Decisions
Consumers make decisions based on:
Utility: The satisfaction derived from consuming goods or services.
Budget constraints: The limits on consumption based on income and prices.
Utility Basics
Utility:
Measures the amount of satisfaction a person derives from consuming something.
Incorporates emotions and sensations.
Serves as a universal measure, allowing individuals to compare choices.
Is typically not comparable across individuals.
Rational individuals aim to maximize utility when making choices.
Utility is a quantitative measure of consumers' preferences.
Utility Functions
A utility function is a formula for calculating the total utility a person derives from consuming a particular bundle of goods and services.
Utility functions quantify preferences.
Utility measurements are relative, not absolute.
Example: If Sarah receives a utility of 3 for each serving of mac-n-cheese, 2 for broccoli, and 8 for ice cream:
If she consumes 1 serving of mac-n-cheese, 2 servings of broccoli, and 2 of ice cream, her total utility is .
Marginal Utility
Marginal utility relates to the principle of diminishing marginal benefit.
Diminishing marginal utility:
As individuals consume more of a good or service, the utility from each additional unit decreases.
Marginal utility is the change in total utility from consuming an additional unit of a good or service.
Marginal utility can sometimes be negative.
It’s possible for marginal utility to stay the same or increase initially, but it eventually decreases.
Example: $5 Burrito Special
1st burrito: Benefit = $12, Cost = $5
2nd burrito: Benefit = $7, Cost = $5
3rd burrito: Benefit = $2, Cost = $5
4th burrito: Benefit = $0.05, Cost = $5
5th burrito: Benefit = -$3, Cost = $5
Principle of Diminishing Marginal Utility
States that the additional utility gained from consuming successive units of a good or service tends to be smaller than the utility gained from the previous unit.
Total utility increases with each scoop of ice cream until it reaches a maximum point, after which it may decrease.
Marginal utility measures the per-unit utility from each scoop of ice cream.
An individual maximizes utility when total utility is greatest or marginal utility is zero.
Constrained Utility Maximization
Individuals have many wants but are limited by time and money.
Rational individuals maximize utility within these constraints by spending resources on the bundle that yields the highest possible total utility.
A budget constraint shows all possible combinations of goods and services a consumer can buy with a given income.
Example:
Movie ticket price = $15, Concert ticket price = $30, Income = $120
Point A: All income spent on movies (8 movie tickets).
Point B: Income spent on both goods (4 movie and 2 concert tickets).
Point C: All income spent on concerts (4 concert tickets).
Represents all feasible bundles.
Bundles and Budget Constraints
A bundle is a specific combination of goods and services an individual could consume.
Bundles outside the budget constraint are not feasible.
Example: Feasible bundles with movie ticket price of $15, concert ticket price of $30, and income of $120:
Bundle A: 0 Concert tickets, 8 Movie tickets, Total cost = $120
Bundle B: 1 Concert ticket, 6 Movie tickets, Total cost = $120
Bundle C: 2 Concert tickets, 4 Movie tickets, Total cost = $120
Bundle D: 3 Concert tickets, 2 Movie tickets, Total cost = $120
Bundle E: 4 Concert tickets, 0 Movie tickets, Total cost = $120
Equation: or
Amount spent on Y (movie tickets) + amount spent on X (concert tickets) = income
Maximizing Utility
Example: Movie ticket price = $15, concert ticket price = $30, income = $120
Equation: or
Utility from movie tickets:
Tickets: 1, Marginal utility: 95, Total utility: 95
Tickets: 2, Marginal utility: 95, Total utility: 190
Tickets: 3, Marginal utility: 95, Total utility: 285
Tickets: 4, Marginal utility: 80, Total utility: 365
Tickets: 5, Marginal utility: 65, Total utility: 430
Tickets: 6, Marginal utility: 35, Total utility: 465
Tickets: 7, Marginal utility: 10, Total utility: 475
Tickets: 8, Marginal utility: -10, Total utility: 465
Utility from concert tickets:
Tickets: 1, Marginal utility: 100, Total utility: 100
Tickets: 2, Marginal utility: 85, Total utility: 185
Tickets: 3, Marginal utility: 25, Total utility: 210
Tickets: 4, Marginal utility: 0, Total utility: 210
Maximizing Total Utility
Bundle B (1 concert ticket and 6 movie tickets) has the highest total utility and is the preferred bundle.
A rational consumer spends all income on the combination of movie and concert tickets that maximizes utility.
To maximize total utility, the total utility of each feasible bundle is identified and compared.
Example:
Bundle A: 0 Concert tickets, 8 Movie tickets, Utility from movie tickets: 465, Utility from concert tickets: 0, Total utility: 465
Bundle B: 1 Concert ticket, 6 Movie tickets, Utility from movie tickets: 465, Utility from concert tickets: 100, Total utility: 565
Bundle C: 2 Concert tickets, 4 Movie tickets, Utility from movie tickets: 365, Utility from concert tickets: 185, Total utility: 550
Bundle D: 3 Concert tickets, 2 Movie tickets, Utility from movie tickets: 190, Utility from concert tickets: 210, Total utility: 400
Bundle E: 4 Concert tickets, 0 Movie tickets, Utility from movie tickets: 0, Utility from concert tickets: 210, Total utility: 210
Utility falls as one moves away from the preferred bundle, B.
Income Changes
When income increases, more bundles of goods and services become affordable.
When income decreases, fewer bundles are affordable, and consumers will likely cut consumption of some goods.
An increase in income is represented by shifting the entire budget line outward.
Effect of an Increase in Income
An increase in income allows individuals to afford more goods.
The entire budget line shifts outward.
Example: Income increases from $120 to $180, new budget constraint:
The consumer can now afford as many as 12 movie tickets or 6 concert tickets.
Responding to Changes in Prices
When prices change, an individual’s budget constraint is affected in two ways:
Income effect: Consumption changes due to increased effective wealth from a lower price.
Substitution effect: Change in consumption results from a change in the relative price of goods.
The opportunity cost of consuming a good changes as prices change.
A price change causes the budget line to rotate.
Effect of a Price Change
When the price of one good changes, the budget constraint rotates outward.
Example: The price of a movie ticket decreases from $15 to $10, new budget constraint:
12 movie tickets are now affordable.
Income and Substitution Effects Example:
Sam has $200 a month to spend on tanning sessions and rounds of golf.
Tanning sessions are $20 each; a round of golf is $40.
Sam currently consumes six tanning sessions and two rounds of golf each month.
If the price of a round of golf drops to $20, the income effect predicts that Sam will increase his consumption of both rounds of golf and tanning sessions.
The income and substitution effects will cause Sam's consumption of tanning sessions to change, but the direction depends on which effect is stronger.
Introduction to Behavioral Economics
Behavioral economics studies why individuals appear to act irrationally by applying insights from psychology.
Key topics include:
Time inconsistency and its effects on procrastination and self-control.
Why sunk costs should be ignored in decision-making.
Opportunity costs that people often undervalue and how this distorts decision-making.
Time Inconsistency
Occurs when present self and future self are at odds.
Individuals struggle with procrastination and temptation, failing to complete planned actions.
Characterized by individuals changing their minds about what they want simply because of the timing of the decision.
Individuals can hold two inconsistent sets of preferences:
What we would like to want in the future.
What we will want in the future, when the future comes.
Optimal decision at one point in time is not optimal at another point.
Procrastination
Time inconsistency helps explain behaviors like procrastination and lack of self-control.
Characterized by two selves:
Future-oriented self: Clear-sighted preferences to get things done.
Present-oriented self: Backslides when faced with alternative choices now.
Time Inconsistency and Commitment
Individuals aware of their time-inconsistent preferences often seek ways to remove temptation.
A commitment device can be used to help fulfill a plan for future behavior that would otherwise be difficult.
Increasing the cost of engaging in certain activities.
Blocking that activity from your choice set.
Irrational Thinking About Costs
People weigh the trade-off between costs and benefits to make decisions.
Rational people act if the benefits of doing something are greater than the opportunity cost.
Individuals don't always weigh costs and benefits rationally due to:
Failing to ignore sunk costs.
Undervaluing opportunity costs.
This erroneous decision-making is an example of cognitive bias.
Sunk-Cost Fallacy
Individuals remain engaged in an activity even though the benefit of continuing is less than the opportunity cost, especially if a cost was incurred to engage in the activity.
It is hard for individuals to accept losses.
Costs that cannot be recovered are irrelevant to whether an individual should remain engaged in the activity or select a new activity.
Undervaluing Opportunity Cost
When making a decision, sometimes the alternative is not readily apparent.
This causes individuals to overvalue the benefits and undervalue the opportunity cost of the not-selected alternative.
People tend to undervalue opportunity costs when they are nonmonetary:
Individuals’ time cost.
Implicit cost of ownership: Overvaluing items that are owned.
Summary
For many decisions, individuals act rationally.
For some decisions, it appears that individuals are not acting in what is in their best interest.
Many of these irrationalities are due to pitfalls in the way humans think.
Understanding these human tendencies can help individuals avoid common decision-making pitfalls.