Econ 200 Consumer Choice Notes

Consumer Choice

Today’s Learning Objectives

• Consumer theory: maximizing utility subject to budget constraints.
• How revealed preferences relate to utility.
• How budget constraints affect utility maximization.
• How income affects consumption choices.
• How prices affect consumption choices and how to distinguish between income and substitution effects.
• Introduction to Behavioral Economics

How Consumers Make Decisions

• Utility
• Budget constraints

Utility Basics

• Utility is a measure of the amount of satisfaction a person derives from something.
• Incorporates emotions and sensations.
• A universal measure that allows individuals to compare choices.
• Not typically comparable across individuals.
• Rational individuals 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 that a particular person derives from consuming a combination of goods and services (called a bundle).
• 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, then if she eats 1 serving of mac-n-cheese, 2 servings of broccoli, and 2 of ice cream, then her total utility is calculated as follows:
  $\text{total utility} = (3 \times 1) + (2 \times 2) + (8 \times 2) = 23$

Marginal Utility

• Diminishing marginal benefit.

• Marginal decision making.

• When individuals continue to engage in an activity or consume more of one good or service, the utility from the next unit is not as great as the last unit (principle of diminishing marginal utility).

• Marginal utility: the change in total utility from consuming an additional unit of a good or service.

• Sometimes, marginal utility becomes negative.

• Marginal utility may stay the same or even increase after the first one, but it eventually decreases.

• Example: $5 burrito special

  Burrito	Benefit from one more burrito	Cost of one more burrito
  1st burrito	$12	$5
  2nd burrito	$7	$5
  3rd burrito	$2	$5
  4th burrito	$.05	$5
  5th burrito	-$3	$5

• 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.

• An individual maximizes utility when total utility is greatest or marginal utility is zero.

Constrained Utility Maximization

• People have many wants and are constrained by the time and money available to them.
• Rational individuals maximize utility within those constraints by spending their resources on the bundle that yields the highest possible total utility.
• A budget constraint provides all possible combinations of goods and services a consumer can buy for a given income.
• Example with movie tickets and concert tickets:
  • 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.
  • Opportunity costs.
• A bundle is a specific combination of goods and services an individual could consume.

Feasible Bundles

• Example Problem: Find all feasible bundles using a movie ticket price of $15, a concert ticket price of $30, and an income of $120.

  Bundle	Concert tickets	Movie tickets	Total cost
  A	0	8	120
  B	1	6	120
  C	2	4	120
  D	3	2	120
  E	4	0	120

• Equation:
  $15Y + 30X = 120$
  $P<em>y Imes Y + P</em>x Imes X = \text{Income}$
  Amount spent on Y + amount spent on X = income

Maximizing Total Utility

• Utility increases with each movie ticket until 7 tickets, at which total utility is maximized.

• Utility increases with each concert ticket until 3 tickets, at which total utility is maximized.

• Example:

  Tickets	Marginal utility	Total utility
  1	95	95
  2	95	190
  3	95	285
  4	80	365
  5	65	430
  6	35	465
  7	10	475
  8	-10	465

  Utility from concert tickets

  Tickets	Marginal utility	Total utility
  1	100	100
  2	85	185
  3	25	210
  4	0	210

Maximizing Total Utility (Continued)

• Bundle B with 1 concert tickets and 6 movie tickets has the highest total utility and is the preferred bundle.

• Given this budget, 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 then compared to each other.

  Bundle	Concert tickets	Movie tickets	Utility from movie tickets	Utility from concert tickets	Total utility
  A	0	8	0	465	465
  B	1	6	100	465	565
  C	2	4	185	365	550
  D	3	2	210	190	400
  E	4	0	210	0	210

• Utility falls as one moves away from the preferred bundle, B.

• When a person’s income increases, more bundles of goods and services become affordable.

• When income decreases, fewer bundles are affordable, and consumers will probably have to cut consumption of some things.

• An increase in income is represented by shifting the entire budget line outward.

The Effect of an Increase in Income

• An increase in income allows individuals to afford more goods.
• The entire budget line shifts outward.
• Example:
  • Original budget constraint: $15Y + 30X = 120$
  • New budget constraint: $15Y + 30X = 180$
• Responding to changes in prices:
  • When prices change, an individual’s budget constraint is affected in two ways:
    • An income effect occurs as consumption changes from increased effective wealth due to a lower price.
    • The substitution effect is the change in consumption that 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.

The Effect of a Price Change

• When the price of one good changes, the budget constraint rotates outward.
• Example:
  • Original budget constraint: $15Y + 30X = 120$
  • New budget constraint: $10Y + 30X = 120$

Behavioral Economics

• Behavioral economics studies why individuals appear to act irrationally by applying insights from psychology.
• Focus on:
  • What time inconsistency is and how it accounts for procrastination and other problems with self-control.
  • Why sunk costs should not be taken into account in deciding what to do next.
  • What types of opportunity cost people often undervalue and why undervaluing them distorts decision making.

Time Inconsistency

• Present self and Future self are at odds
• Dealing with temptation and procrastination.
• Individuals struggle with procrastination and temptation.
• They do not complete the actions they had planned to do.
• Individuals change their minds about what they want simply because of the timing of the decision; they exhibit time inconsistency.
• Present and future self are at odds!
• 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 to explain behaviors like procrastination and lack of self-control. It is as if there are two selves inhabiting our thoughts.
  • 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 who are aware of their time-inconsistent preferences often seek out 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.

Thinking Irrationally About Costs

• People weigh the trade-off between costs and benefits to arrive at a decision.
  • If the benefits of doing something are greater than the opportunity cost, rational people are assumed to do it.
  • If the benefits are smaller than the opportunity cost, they won’t choose to do it.
• In reality, people don’t always weigh costs and benefits rationally.
  • Failing to ignore sunk costs.
  • Undervaluing opportunity costs.
• This erroneous decision making is an example of cognitive bias.

Sunk Costs

• Many times 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.
• This is referred to as the sunk-cost fallacy.
• 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 that humans think.
• Understanding these human tendencies can help individuals avoid common decision-making pitfalls.