Consumer Choice and Behavioral Economics - Chapter 10 Summary

10.1 Utility and Consumer Decision Making

• Utility: The enjoyment or satisfaction people receive from consuming goods and services.
• Marginal Utility (MU): The change in total utility from consuming one more unit of a good or service.
• Law of Diminishing Marginal Utility: Satisfaction decreases as more of a good/service is consumed.
• Budget Constraint: The limit on consumer spending due to income.
• Rule of Equal Marginal Utility per Dollar Spent: Consumers maximize utility by making sure that the last unit of each good consumed provides equal utility per dollar. This requires two conditions:
  • Spending all available income.
  • Equalizing marginal utility per dollar across all goods.
• If the rule doesn't hold (e.g., more utility per dollar from Coke than pizza), utility can be increased by shifting spending until the rule is satisfied.
• Income Effect: Change in quantity demanded due to altered purchasing power from a price change.
• Substitution Effect: Change in quantity demanded due to a change in relative prices.

10.2 Where Demand Curves Come From

• Market demand curves slope downward due to income and substitution effects.
• For normal goods, both effects increase quantity demanded when the price falls.
• For inferior goods, the income effect reduces quantity demanded when the price falls, working against the substitution effect.
• The rule of equal marginal utility per dollar (MU/P) is used to analyze consumer decisions when prices change.

Extra Solved Problem

• Jake has $20 to spend on chicken wings and chili dogs.
• The initial price of wings is $4, and chili dogs is $2.
• After the price of chili dogs inceases to $4 each Jake adjusts based on MU/P to maximize utility.

10.3 Social Influences on Decision Making

• Social factors influence consumer choices.
• Celebrity Endorsements: Increase demand if consumers believe celebrities use or are knowledgeable about the product.
• Network Externality: Usefulness of a product increases as more people use it.
  • Can lead to consumers sticking with inferior technologies due to switching costs and path dependence, possibly causing market failure.
• Fairness: Consumers value fair treatment and may react negatively to perceived unfair price increases, even if it reduces profits.
  • Firms might avoid raising prices during high demand to maintain customer satisfaction.
• Uber's surge pricing model has faced criticism because consumers perceive price increases due to demand surges as unfair, compared to price increases due to cost increases.
• Framing prices as discounts rather than surge pricing may mitigate negative perceptions.

10.4 Behavioral Economics: Do People Make Rational Choices?

• Behavioral Economics: Studies situations where people's choices don't appear economically rational.
• Opportunity Cost: The value of the next best alternative that is foregone.
• Sunk Cost: A cost that has already been incurred and cannot be recovered.
• Consumers often make mistakes:
  • Ignoring nonmonetary opportunity costs.
  • Failing to ignore sunk costs.
  • Being unrealistic about future behavior.
• Endowment Effect: People value goods they own more highly than goods they don't own.
• People often have inconsistent preferences over time, leading to issues like overeating.
• Nudges: Using behavioral insights to guide people toward better decisions (e.g., automatic enrollment in 401(k) plans).
• Anchoring: Consumers often relate—or anchor—a product's value to another known value, especially when uncertain about its true worth.

Extra Solved Problem

• Automatically enrolling employees in 401(k) plans increases participation rates because opting out requires confronting the inconsistency between short-term spending and long-term savings goals.
• Employees may remain at the default savings rate (e.g., 3%) even if they would have chosen a higher rate initially, due to inertia and the intention to increase savings later.

Extra Apply the Concept

• Vaccination:
  • Nudges, such as a video, financial incentives, and convenient links, were tested to increase COVID-19 vaccination rates.
  • The tested nudges did not significantly raise vaccination rates in a study with Medicaid recipients.

Appendix: Using Indifference Curves and Budget Lines to Understand Consumer Behavior

• Consumer preferences rank combinations of goods by utility.
• Preferences are assumed to be transitive: If A is preferred to B, and B to C, then A is preferred to C.
• Indifference Curve: Shows combinations of goods that provide the same utility.
  • Consumers are indifferent between bundles on the same curve.
  • Curves further to the right represent greater utility.
• Marginal Rate of Substitution (MRS): Rate at which a consumer will trade one good for another.
  • MRS decreases as an indifference curve becomes less steep (convex).
• Indifference curves cannot cross, as it would violate transitivity.
• Budget Constraint: Limits spending based on income.
  • Represented by a downward-sloping line; bundles on or inside the line are affordable.
  • Slope equals the negative ratio of prices.
• Utility maximization occurs at the tangency between the budget line and the highest attainable indifference curve.
• Demand curves slope downward because a price drop allows consumers to reach higher indifference curves, increasing quantity demanded.
• The substitution effect of price change is measured by finding a point along the same indifference curve I1 and it's the change in consumption of pizza along I1.
• The income effect of price change is measured by finding change in consumption from the tangency of the line parallel to the new budget line and I1 to the tangency of the new budget line and I2
• Increased income shifts the budget line outward, allowing consumption on a higher indifference curve.
• At optimal consumption:
  • MRS equals the ratio of prices.
  • Rate at which a consumer is willing to trade goods equals the rate at which they can trade them.
  • Marginal utility per dollar spent is the same for every good.