Chapter 7. Consumer Choice: Utility Theory and Insights from Neuroscience. Microeconomics: Principles, Applications, and Tools NINTH EDITION

Transcription

1 Microeconomics: Principles, Applications, and Tools NINTH EDITION Chapter 7 Consumer Choice: Utility Theory and Insights from Neuroscience Consumer choice often involves a battle between instant and delayed gratification.

2 Learning Objectives 7.1 Explain the equimarginal principle and apply it to consumer choice. 7.2 Describe the income and substitution effects of a price change. 7.3 Describe the general process involved in the valuation of the benefits and costs of a consumer good. 7.4 Apply the insights from neuroscience to consumer decisions about nutrition and saving.

3 7.1 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. 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.

4 7.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY Total 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. utils = marginal utility = = 27

5 7.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY 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. 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.

6 7.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY 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. 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.

7 7.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY 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. Utility is maximized when : Equimarginal rule. The equimarginal rule is satisfied. Affordability. The money spent on the two goods adds up to the fixed budget.

8 7.1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY Making Choices Using the Equimarginal Rule TABLE 7.1 Utility Maximization Movies Books Marginal Utility: Movies Marginal Utility: Books Marginal Utility per $: Movies Marginal Utility per $: Books Utility from Movies Utility from Books Total Utility

9 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.

10 7.2 THE LAW OF DEMAND AND 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 shows the original bundle violates the equimarginal rule. 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.

11 7.2 THE LAW OF DEMAND AND THE INDIVIDUAL DEMAND CURVE 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. Income effect The change in quantity consumed that is caused by a change in real income, with relative prices held constant. 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.

12 7.2 THE LAW OF DEMAND AND THE INDIVIDUAL DEMAND CURVE The Individual Demand Curve 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. 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.

13 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.

14 7.3 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 as an apple, 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.

15 7.3 THE NEUROSCIENCE OF CONSUMER CHOICE 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.

16 7.4 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. 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 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.

17 7.4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE 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. 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.

18 7.4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE 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).

19 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.

20 Learning Objectives 7.1 Explain the equimarginal principle and apply it to consumer choice. 7.2 Describe the income and substitution effects of a price change. 7.3 Describe the general process involved in the valuation of the benefits and costs of a consumer good. 7.4 Apply the insights from neuroscience to consumer decisions about nutrition and saving.

21 KEY TERMS Budget line Budget set Equimarginal rule Income effect Law of diminishing marginal utility Marginal utility Substitution effect Util Utility

22 Questions? Homework Ch7, p , 1.4, 1.7, 1.12