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Chapter 22 Consumer Choice: Utility Theory and Insights from Neuroscience Consumer choice often involves a battle between instant and delayed gratification. Prepared By Brock Williams

Learning Objectives 1. Explain the equimarginal principle and apply it to consumer choice. 2. Describe the income and substitution effects of a price change. 3. Describe the general process involved in the valuation of the benefits and costs of a consumer good. 4. Apply the insights from neuroscience to consumer decisions about nutrition and saving. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -2

22. 1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY 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 ► Figure 22. 1 Budget Set and Budget Line 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -3

22. 1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (cont. ) ► FIGURE 22. 2 Total Utility 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -4

22. 1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (cont. ) 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. ► Figure 22. 3 Marginal Utility and Marginal Utility Per Dollar 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -5

22. 1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (cont. ) 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. ► Figure 22. 4 The Equimarginal Rule: Equalize the Marginal Benefit per Dollar 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -6

22. 1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (cont. ) 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -7

22. 1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (cont. ) 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -8

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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -9

22. 2 THE LAW OF DEMAND THE INDIVIDUAL DEMAND CURVE 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. ► Figure 22. 5 A Decrease in the Price of Movies Increases the Utility-Maximizing Number of Movies 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -10

22. 2 THE LAW OF DEMAND THE INDIVIDUAL DEMAND CURVE (cont. ) 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. ► Figure 22. 6 Income and Substitution Effects of a Decrease in Price 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. • income effect The change in quantity consumed that is caused by a change in real income, with relative prices held constant. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -11

22. 2 THE LAW OF DEMAND THE INDIVIDUAL DEMAND CURVE (cont. ) 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 utility-maximizing quantity for the consumer. FIGURE 22. 7 The Individual Demand Curve 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -12

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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -13

22. 3 THE NEUROSCIENCE OF CONSUMER CHOICE 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, 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -14

22. 3 THE NEUROSCIENCE OF CONSUMER CHOICE (cont. ) 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -15

22. 3 THE NEUROSCIENCE OF CONSUMER CHOICE (cont. ) 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -16

22. 3 THE NEUROSCIENCE OF CONSUMER CHOICE (cont. ) 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -17

22. 3 THE NEUROSCIENCE OF CONSUMER CHOICE (cont. ) Cognition and Choice Why do people make different choices? • Strength of their gut-feelings • Cognitive weighting Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -18

22. 3 THE NEUROSCIENCE OF CONSUMER CHOICE (cont. ) 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -19

22. 3 THE NEUROSCIENCE OF CONSUMER CHOICE (cont. ) 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 decision-making. 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -20

APPLICATION 3 STORES VS. ONLINE RETAILERS APPLYING THE CONCEPTS #3: How do the sales strategies of conventional stores and online retailers differ? • Conventional stores encourage shoppers to buy products by boosting the neural activity in the NAcc, the region of the brain responsible for the valuation of the benefit of a product. • Some of the benefit boosting comes from tactile stimulation--feeling the softness of a cashmere sweater or the bounce of an athletic shoe. Conventional stores also downregulate the insula, the region of the brain responsible for the valuation of the cost of a product. The suppression of insula activity comes from price reductions and low-price guarantees. • On-line retailers can work with the insula by offering discounted prices and low-price guarantees, but they are at a disadvantage in boosting the neural activity in the NAcc. There is currently no substitute for the tactile sensations available in physical stores, so online retailers have an incentive to focus on products for which the stimulation of the NAcc is less critical to making a sale. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -21

22. 4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE 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. Figure 22. 8 Gut Feelings versus Cognition: Donuts versus Apples 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -22

22. 4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE (cont. ) 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. Figure 22. 9 Present Bias and Spending versus Saving 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -23

22. 4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE (cont. ) 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). Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -24

22. 4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE (cont. ) 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. Figure 22. 10 Near-Miss Benefits and Gambling as a Consumer Good 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -25

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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -26

KEY TERMS budget line law of diminishing marginal utility budget set marginal utility equimarginal rule substitution effect income effect utility Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -27

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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -28

APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES 22 A. 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -29

APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES 22 A. 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 tshirt. 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -30

APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES 22 A. 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 highprice player with a capacity of 16 GB (option B). Figure 22 A. 1 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -31

APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES 22 A. 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 22 -32