22.1 Traditional Consumer Choice: Utility Theory

• A consumer’s ability to purchase movies and other goods is limited by their income and the prices of the movies and other products.

• Suppose the consumer has a fixed income of $27 per month, which she spends entirely on movies and books. The price of movies is $3 and the price of books is $1.

• A consumer’s budget line shows all the combinations of two goods that exhaust the budget.

  • If the consumer spends her entire $27 budget on books, she gets 27 books and no movies. At the other extreme, she can spend her entire budget on movies, getting nine movies at a price of $3 per movie.

  • The slope of the budget line is the opportunity cost of a movie in terms of books. In this example, the slope is three books per movie: a movie is three times as expensive as a book, so the opportunity cost of a movie is the three books that could be purchased instead.

• A consumer’s budget set is the set of affordable combinations of two goods which includes the budget line and combinations that cost less than the consumer has to spend, leaving the consumer with the leftover money.

• The budget line shows the different combinations of two goods that a consumer can buy. In contrast, the demand curve shows the quantity of a single good that a consumer is willing to buy at different prices.

• The consumer’s objective is to maximize its utility.

  • As the number of movies increases, total utility increases, but at a decreasing rate.

• The first unit of a product generates more additional unity than the third, and so on.

• The marginal unity curve shows the slope of the total unity curve, so by the law of diminishing marginal utility, it is negatively sloped.

• The Marginal Principle is to increase the level of an activity as long as its marginal benefits exceed the marginal cost p. Choose the level at which the marginal benefit equals the marginal cost.

• To maximize utility, a consumer picks the quantity of a product at which the marginal benefit of the product equals its marginal cost.

  • MB - MUm

  • The law diminishing returns tells us that the marginal benefit decreases as the number of movies increases.

• For consumers who buy movies and books, the opportunity cost of a movie is the utility sacrificed by getting one movie rather than some number of books.

  • The equation is represented as:

    • Books per Movie - Pm/Pb

• The Equimarginal Rule is where they 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.

• The consumer’s objective is to maximize the utility generated by a fixed budget. The utility is maximized when the chosen bundle of goods satisfies two conditions.

  • Equimaginal rule

  • Affordability

• The consumer chooses the affordable bundle that satisfies the equimarginal rule.

• The bundle is affordable and satisfies the equimarginal rule, so it generates the highest affordable utility level.

22.2 The Law of Demand and the Individual Demand Curve

• The decrease in the price of movies means that the original bundle violates the equimarginal rule.

• The bundle satisfies the two conditions for utility maximization:

  • Equimarginal rule

  • Affordability

• An increase in price decreases the marginal utility per dollar on movies, shifting the marginal-bang-per-buck curve downward.

• The consumer will respond by reallocating the budget away from movies, consistent with the law of demand:

  • An increase in price decreases the quantity of movies demanded.

• The substitution effect is a decrease in the price of movies decreases the price of movies relative to the price of books, causing the consumer to substitute movies for books.

• An income effect is a decrease in the price of movies that increases the consumer’s real income, and the consumer will buy more “normal” goods, including movies.

• A substitution effect is an increase in the price of movies increases the price of movies relative to the price of books, causing the consumer to substitute books for movies.

• An income effect is an increase in the price of movies that decreases the consumer’s real income, and the consumer will buy less of all “normal” goods, including movies.

22.3 The Neuroscience of Consumer Choice

• Recent work in neuroscience shows that different regions of the brain are involved in the valuation of the benefits and costs of possible actions.

• Starting on the benefit side, the key region for the valuation of benefits is the nucleus accumbens (NAcc), the main part of the ventral striatum.

  • When a person considers taking an action, the NAcc is activated, and the greater the anticipated benefit from the action, the NAcc is activated, the stronger the NAcc activity.

• 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 to receptors in your brain, you feel good.

• The greater the conjectured satisfaction, the greater the flow of dopamine to the receptors in your brain.

• Learning happens when a consumer’s conjectures about the pleasure of consuming a product wrong.

• These benefit valuations are gut feelings that occur without any thinking or reflection.

• The principle of opportunity cost is 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 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.

• People differ in two ways that are relevant to consumer decisions:

  • One way is the strength of their gut feeling. On the benefit side, consumers differ in the gut-feeling benefit of consuming a product. On the cost side, consumers differ in the gut-feeling cost of spending money.

  • The second way is cognitive weighting. Consumers who are relatively inactive in a cognitive sense tend to make impulsive purchases. In contrast, cognitively active consumers tend to exercise more self-control and make more thoughtful purchases.

22.4 Consumer Decisions: Insights from Neuroscience

• Recent experiments by neuroscientists have shown that the more a person thinks about the health consequences of unhealthy food, the lower the perceived benefit of the unhealthy food.

• Our gut feelings for food and nutrition are biased toward high-fat and high-calorie food, meaning that impulsive choices generally lead to unhealthy choices.

• Experiments by psychologists and neuroscientists have consistently shown that people systematically underestimate the strength of future gut feelings, both positive and negative.

  • We accurately incorporate the present consequences of an action, but either ignore or underestimate the future consequences.

• Present bias occurs because there is a mismatch in the timing of benefits and costs.