Principles of Economics - 3e Chapter 6 Consumer Choices

Consumer Choices FIGURE We generally view higher education as a good investment , if one can afford it , regardless of the state of the economy . Credit of Commencement by , BY ) CHAPTER OBJECTIVES In this chapter , you will learn about Consumption Choices How Changes in Income and Prices Affect Consumption Choices How Consumer Choices Might Not Always be Rational Introduction to Consumer Choices BRING IT HOME Making Choices The Great Recession touched families around the globe , In too many countries , workers found themselves out of a job . In developed countries , unemployment compensation provided a safety net , but families still saw a marked decrease in disposable income and had to make tough spending decisions . Of course , essential , discretionary spending was the first to go . Even so , there was one particular category that saw a universal increase in spending during that 18 uptick in the United States , specifically , You might guess that consumers began eating more meals at home , increasing grocery store spending however , the Bureau of Labor Statistics Consumer Expenditure Survey , which tracks US . food spending over time , showed real total food spending by households declined percent between 2006 and 2009 . So , it was not groceries . What product would people around the world demand

138 Consumer Choices more of during tough economic times , and more importantly , why ?

Find out at chapter end . That question leads us to this chapter how consumers make choices and how changes affect those choices . For instance , do changes in prices matter more or less than changes in a consumer income ?

Can a small change in circumstances alter the consumers perception of a product or even of their own resources ?

While many choices may seem straightforward , there is often much more to consider . seeks to understand the behavior of individual economic agents such as individuals and businesses . Economists believe that we can analyze individuals decisions , such as what goods and services to buy , as choices we make within certain budget constraints . Generally , consumers are trying to get the most for their limited budget . In economic terms they are trying to maximize total utility , or satisfaction , given their budget constraint . Everyone has their own personal tastes and preferences . The French say a son gout , or Each to his own An old Latin saying states , De non est or There no disputing about If people base their decisions on their own tastes and personal preferences , however , then how can economists hope to analyze the choices consumers make ?

An economic explanation for why people make different choices begins with accepting the proverbial wisdom that tastes are a matter of personal preference . However , economists also believe that the choices people make are by their incomes , by the prices of goods and services they consume , and by factors like where they live . This chapter introduces the economic theory of how consumers make choices about what goods and services to buy with their limited income . The analysis in this chapter will build on the budget constraint that we introduced in the Choice in a World of Scarcity chapter . This chapter will also illustrate how economic theory provides a tool to systematically look at the full range consumption choices to predict how consumption responds to changes in prices or incomes . After reading this chapter , consult the appendix Indifference Curves to learn more about representing utility and choice through indifference curves . Consumption Choices LEARNING OBJECTIVES By the end of this section , you will be able to Calculate total utility Propose decisions that maximize utility Explain marginal utility and the of diminishing marginal utility Information on the consumption choices of Americans is available from the Consumer Expenditure Survey carried out by the Bureau of Labor Statistics . Table shows spending patterns for the average household . The row shows income and , after taxes and personal savings are subtracted , it shows that , in 2015 , the average household spent on consumption . The table then breaks down consumption into various categories . The average household spent roughly of its consumption on shelter and other housing expenses , another on food and vehicle expenses , and the rest on a variety of items , as shown . These patterns will vary for households by differing levels of family income , by geography , and by preferences . Average Household Income before Taxes Average Annual Expenditures 48409 Food at home TABLE US . Consumption Choices in 2015 ( Source ) Access for free at

Consumption Choices Food away from home Housing Apparel and services Transportation Healthcare Entertainment Education Personal insurance and pensions All else alcohol , tobacco , reading , personal care , cash contributions , miscellaneous TABLE US . Consumption Choices in 2015 ( Source ) Total Utility and Diminishing Marginal Utility To understand how a household will make its choices , economists look at what consumers can afford , as shown in a budget constraint ( or budget line ) and the total utility or satisfaction derived from those choices . In a budget constraint line , the quantity of one good is on the horizontal axis and the quantity of the other good on the vertical axis . The budget constraint line shows the various combinations of two goods that are affordable given consumer income . Consider Jose situation , shown in Figure 62 . Jose likes to collect and watch movies . In Figure we show the quantity of on the horizontal axis while we show the quantity of movies on the vertical axis . If Jose had unlimited income or goods were free , then he could consume without limit . However , like all of us , faces a budget constraint . Jose has a total of 56 to spend . The price of is 14 and the price of movies is . Notice that the vertical intercept of the budget constraint line is at eight movies and zero ( The horizontal intercept of the budget constraint is four , where spends of all of his money on and no movies ( The slope of the budget constraint line is run or . The choices along the budget constraint line show the combinations of affordable shirts and movies . Movies . UV 09 FIGURE A Choice between Consumption Goods Jose has income of 56 . Movies cost and cost 14 . The points on the budget constraint line show the combinations of affordable movies and . 139

140 Consumer Choices Jose wishes to choose the combination that will provide him with the greatest utility , which is the term economists use to describe a person level of satisfaction or happiness with their choices . Let begin with an assumption , which we will discuss in more detail later , that can measure his own utility with something called . It is important to note that you can not make comparisons between the of individuals . person gets 20 from a cup of coffee and another gets 10 , this does not mean than the person gets more enjoyment from the coffee than the other or that they enjoy the coffee twice as much . The reason why is that are subjective to an individual . The way one person measures is not the same as the way someone else does . Table shows how utility is connected with his or movie consumption . The first column of the table shows the quantity of consumed . The second column shows the total utility , or total amount of satisfaction , that Jose receives from consuming that number of . The most common pattern of total utility , in this example , is that consuming additional goods leads to greater total utility , but at a decreasing rate . The third column shows marginal utility , which is the additional utility provided by one additional unit of consumption . This equation for marginal utility is Notice that marginal utility diminishes as additional units are consumed , which means that each subsequent unit ofa good consumed provides less additional utility . For example , the Jose picks is his favorite and it gives him an addition of 22 . The fourth is just something to wear when all his other clothes are in the wash and yields only 18 additional . This is an example of the law of diminishing marginal utility , which holds that the additional utility decreases with each unit added . Diminishing marginal utility is another example of the more general law of diminishing returns we learned earlier in the chapter on Choice in a World of Scarcity . The rest of Table shows the quantity of movies that Jose attends , and his total and marginal utility from seeing each movie . Total utility follows the expected pattern it increases as the number of movies that Jose watches rises . Marginal utility also follows the expected pattern each additional movie brings a smaller gain in utility than the previous one . The movie Jose attends is the one he wanted to see the most , and thus provides him with the highest level of utility or satisfaction . The movie he attends is just to kill time . Notice that total utility is also the sum of the marginal utilities . Read the next Work It Out feature for instructions on how to calculate total utility . Quantity ) Movies ( Quantity ) 22 22 16 16 43 21 31 15 63 20 45 14 81 18 58 13 97 16 70 12 111 14 81 11 123 12 ' 91 133 10 100 TABLE Total and Marginal Utility Table looks at each point on the budget constraint in Figure , and adds up Jose total utility for five Access for free at

Consumption Choices possible combinations of and movies . Point Movies Total Utility 81 81 63 31 94 43 58 101 22 81 103 100 100 TABLE Finding the Choice with the Highest Utility Calculating Total Utility Let look at how Jose makes his decision in more detail . Step . Observe that , at point ( for example ) consumes three and two movies . Step . Look at Table . You can see from the fourth column that three are worth 63 . Similarly , the second column shows that two movies are worth 31 . Step . From this information , you can calculate that point has a total utility of 94 ( 63 31 ) Step . You can repeat the same calculations for each point on Table , in which the total utility numbers are shown in the last column . For , the highest total utility for all possible combinations of goods occurs at point , with a total utility of 103 from consuming one and six movies . Choosing with Marginal Utility Most people approach their combination of choices in a way . This approach is based on looking at the , measured in terms of marginal utility , of consuming less of one good and more of another . For example , say that starts off thinking about spending all his money on and choosing point , which corresponds to four and no movies , as Figure 62 illustrates . Jose chooses this starting point randomly as he has to start somewhere . Then he considers giving up the last , the one that provides him the least marginal utility , and using the money he saves to buy two movies instead . Table tracks the series needs to make ( Key are 14 , movies are , and income is 56 ) The following Work It Out feature explains how marginal utility can affect decision making . 141

142 Consumer Choices Marginal Gain and Loss of Utility , Compared Try Which Has Total Utility , Conclusion with Previous Choice , 81 from , from movies 81 movies ' 63 from 31 Loss of 18 from less , but gain of 31 from re , from movies 94 more movies , for a net utility gain of 13 movies over , is 43 from 58 Loss of 20 from less , but gain of 27 from . preferred , from movies 101 two more movies for a net utility gain of movies over 22 from 81 Loss of 21 from less , but gain of 23 from ' preferred , from movies 103 two more movies , for a net utility gain of movies over , Sis from 100 Loss of 22 from less , but gain of 19 from , preferred , from movies 100 two more movies , for a net utility loss of movies overT TABLE A Approach to Maximizing Utility Decision Making by Comparing Marginal Utility Jose could use the following thought process ( if he thought in ) to make his decision regarding how many shirts and movies to purchase ep . From Table 62 , can see that the marginal utility of the fourth is 18 . If gives up the fourth , then he loses 18 . ep . Giving up the fourth , however , frees up 14 ( the price of a ) allowing Jose to buy the first two movies ( at each ) ep . Jose knows that the marginal utility of the first movie is 16 and the marginal utility of the second movie is 15 . Thus , if Jose moves from point to point , he gives up 18 ( from the ) but gains 31 ( from the movies ) ep . Gaining 31 and losing 18 is a net gain of 13 . This is just another way of saying that the total at ( 94 according to the last column in Table 63 ) is 13 more than the total utility at ( 81 ) ep . Thus , for Jose , it makes sense to give up the fourth in order to buy two movies . clearly prefers point to point Now repeat this process of decision making with marginal . thinks about giving up the third and surrendering a marginal utility of 20 , in exchange for purchasing two more movies that promise a combined marginal utility of 27 . prefers point to point . What if Jose thinks about going beyond to point ?

Giving up the second means a marginal utility loss of 21 , and the marginal utility gain from the and sixth movies would combine to make a marginal utility gain , so prefers point to Access for free at Consumption Choices 143 However , if Jose seeks to go beyond point to point , he that the loss of marginal utility from giving up the is 22 , while the marginal utility gain from the last two movies is only a total of 19 . were to choose point , his utility would fall to 100 . Through these stages of thinking about marginal , Jose again concludes that , with one and six movies , is the choice that will provide him with the highest level of total utility . This approach will reach the same conclusion regardless of Jose starting point . We can develop a more systematic way this approach by focusing on satisfaction per dollar . If an item costing yields 10 , then it worth per dollar spent . Marginal utility per dollar is the amount of additional utility Jose receives divided by the product price . Table shows the marginal utility per dollar for Jose shirts and movies . marginal utility marginal utility per dollar Prim wants to maximize the utility he gets from his limited budget , he will always purchase the item with the greatest marginal utility per dollar of expenditure ( assuming he can afford it with his remaining budget ) Jose starts with no purchases . If he purchases a , the marginal utility per dollar spent will be . If he purchases a movie , the marginal utility per dollar spent will be . Therefore , Jose purchase will be the movie . Why ?

Because it gives him the highest marginal utility per dollar and is affordable . Next , Jose will purchase another movie . Why ?

Because the marginal utility of the next movie ( is greater than the marginal utility of the next ( Note that when Jose has no shirts , the next one is the one . Jose will continue to purchase the next good with the highest marginal utility per dollar until he exhausts his budget . He will continue purchasing movies because they give him a greater bang for the buck until the sixth movie which gives the same marginal utility per dollar as the purchase . Jose has just enough budget to purchase both . So in total , will purchase six movies and one . Quantity of Total Marginal Marginal Utility Quantity of Total Marginal Marginal Utility Utility Utility per Dollar Movies Utility Utility per Dollar 22 22 16 16 43 21 31 15 63 20 45 14 81 18 58 13 97 16 70 12 111 14 81 11 ' 123 12 91 10 TABLE Marginal Utility per Dollar A Rule for Maximizing Utility This process of decision making suggests a rule to follow when maximizing utility . Since the price of is twice as high as the price of movies , to maximize utility the last that chose needs to provide exactly twice the marginal utility ( MU ) of the last movie . If the last provides less than twice the marginal utility of the last movie , then the is providing less bang for the buck ( marginal utility per dollar spent ) than Jose would receive from spending the same money on movies . If this is so , Jose should trade the for more movies to increase his total utility .

144 Consumer Choices If the last provides more than twice the marginal utility of the last movie , then the is providing more bang for the buck or marginal utility per dollar , than if the money were spent on movies . As a result , should buy more . Notice that at Jose optimal choice of point , the marginal utility from the first , of 22 is exactly twice the marginal utility of the sixth movie , which is 11 . At this choice , the marginal utility per dollar is the same for both goods . This is a signal that Jose has found the point with highest total utility . We can write this argument as a general rule Ifyou always choose the item with the greatest marginal utility per dollar spent , when your budget is exhausted , the utility maximizing choice should occur where the marginal utility per dollar spent is the same for both goods . A sensible economizer will pay twice as much for something only if , in the marginal comparison , the item confers twice as much utility . Notice that the formula for the table above is 14 The following Work It Out feature provides step by step guidance for this concept of choices . Maximizing Utility The general rule , means that the last dollar spent on each good provides exactly the same marginal utility . This is the case at points . So Step . If we traded a dollar more of movies for a dollar more of , the marginal utility gained from would exactly offset the marginal utility lost from fewer movies . In other words , the net gain would be zero . Step . Products , however , usually cost more than a dollar , so we can not trade a dollar worth of movies . The best we can do is trade two movies for another , since in this example cost twice what a movie does . Step . If we trade two movies for one , we would end up at point ( two and four movies ) Step . Choice in Table shows that if we move to point , we would gain 21 from one more , but lose 23 from two fewer movies , so we would end up with less total utility at point In short , the general rule shows us the choice , which is called the consumer equilibrium . There is another equivalent way to think about this . We can also express the general rule as the ratio ofthe prices of the two goods should be equal to the ratio of the marginal utilities . When we divide the price of good by the price of good , at the point this will equal the marginal utility of good divided by the marginal utility of good . Along the budget constraint , the total price of the two goods remains the same , so the ratio of the prices does not change . However , the marginal utility of the two goods changes with the quantities consumed . At the optimal choice of one and six movies , point , the ratio of marginal utility to price for ( 22214 ) matches the ratio of marginal utility to price for movies ( of 1127 ) Access for free at

How Changes in Income and Prices Affect Consumption Choices 145 Measuring Utility with Numbers This discussion of utility began with an assumption that it is possible to place numerical values on utility , an assumption that may seem questionable . You can buy a thermometer for measuring temperature at the hardware store , but what store sells a for measuring utility ?

While measuring utility with numbers is a convenient assumption to clarify the explanation , the key assumption is not that an outside party can measure utility but only that individuals can decide which of two alternatives they prefer . To understand this point , think back to the process of the choice with highest total utility by comparing the marginal utility you gain and lose from different choices along the budget constraint . As Jose compares each choice along his budget constraint to the previous choice , what matters is not the numbers that he places on his whether he uses any numbers at only that he personally can identify which choices he prefers . In this way , the process of choosing the highest level resembles rather closely how many people make consumption decisions . We think about what will make us the happiest . We think about what things cost . We think about buying a little more ofone item and giving up a little of something else . We choose what provides us with the greatest level of satisfaction . The vocabulary of comparing the points along a budget constraint and total and marginal utility is just a set of tools for discussing this everyday process in a clear and manner . It is welcome news that utility numbers are not central to the argument , since a good is hard to . Do not we can not measure , by the end of the next module , we will have transformed our analysis into something we can . How Changes in Income and Prices Affect Consumption Choices LEARNING OBJECTIVES By the end of this section , you will be able to Explain how income , prices , and preferences affect consumer choices Contrast the substitution effect and the income effect Utilize concepts to analyze consumer choices Apply choices to governments and businesses Just as we can use utility and marginal utility to discuss making consumer choices along a budget constraint , we can also use these ideas to think about how consumer choices change when the budget constraint shifts in response to changes in income or price . Because we can use the budget constraint framework to analyze how quantities demanded change because of price movements , the budget constraint model can illustrate the underlying logic behind demand curves . How Changes in Income Affect Consumer Choices Let begin with a concrete example illustrating how changes in income level affect consumer choices . Figure shows a budget constraint that represents Kimberly choice between concert tickets at 50 each and getting away overnight to a for 200 per night . Kimberly has per year to spend between these two choices . After thinking about her total utility and marginal utility and applying the decision rule that the ratio of the marginal utilities to the prices should be equal between the two products , Kimberly chooses point , with eight concerts and three overnight getaways as her choice .

146 Consumer Choices Concert Tickets 10 15 Overnight Stays FIGURE How a Change in Income Affects Consumption Choices The choice on the original budget constraint is The dashed horizontal and vertical lines point allow you to see at a glance whether the quantity consumed of goods on the new budget constraint is higher or lower than on the original budget constraint . On the new budget constraint , Kimberly will make a choice like if both goods are normal goods . If overnight stays is an inferior good , Kimberly will make a choice like If concert tickets are an inferior good , Kimberly will make a choice like . Now , assume that the income Kimberly has to spend on these two items rises to per year , causing her budget constraint to shift out to the right . How does this rise in income alter her choice ?

Kimberly will again consider the utility and marginal utility that she receives from concert tickets and overnight getaways and seek her choice on the new budget line , but how will her new choice relate to her original choice ?

We can replace the possible choices along the new budget constraint into three groups , which the dashed horizontal and vertical lines that pass through the original choice in the divide . All choices on the upper left of the new budget constraint that are to the left of the vertical dashed line , like choice with two overnight stays and 32 concert tickets , involve less of the good on the horizontal axis but much more of the good on the vertical axis . All choices to the right of the vertical dashed line and above the horizontal dashed choice with overnight getaways and 20 concert more consumption of both goods . Finally , all choices that are to the right of the vertical dashed line but below the horizontal dashed line , like choice with four concerts and nine overnight getaways , involve less of the good on the vertical axis but much more of the good on the horizontal axis . All of these choices are theoretically possible , depending on Kimberly personal preferences as expressed through the total and marginal utility she would receive from consuming these two goods . When income rises , the most common reaction is to purchase more of both goods , like choice , which is to the upper right relative to Kimberly original choice , although exactly how much more of each good will vary according to personal taste . Conversely , when income falls , the most typical reaction is to purchase less of both goods . As we in the chapter on Demand and Sup and again in the chapter on Elasticity , we call goods and services normal goods when a rise in income leads to a rise in the quantity consumed of that good and a fall in income leads to a fall in quantity consumed . However , depending on Kimberly preferences , a rise in income could cause consumption ofone good to increase while consumption of the other good declines . A choice like means that a rise in income caused her quantity consumed of overnight stays to decline , while a choice like would mean that a rise in income caused her quantity of concerts to decline . Goods where demand declines as income rises ( or conversely , where the demand rises as income falls ) are called inferior An inferior good occurs when people trim back on a good as income rises , because they can now afford the more expensive choices that they prefer . For example , a Access for free at

How Changes in Income and Prices Affect Consumption Choices 147 household might eat fewer hamburgers or be less likely to buy a used car , and instead eat more steak and buy a new car . How Price Changes Affect Consumer Choices For analyzing the possible effect ofa change in price on consumption , let again use a concrete example . Figure represents Sergei consumer choice , who chooses between purchasing baseball bats and cameras . A price increase for baseball bats would have no effect on the ability to purchase cameras , but it would reduce the number Sergei could afford to buy . Thus a price increase for baseball bats , the good on the horizontal axis , causes the budget constraint to rotate inward , as if on a hinge , from the vertical axis . As in the previous section , the point labeled represents the originally preferred point on the original budget constraint , which Sergei has chosen after contemplating his total utility and marginal utility and the involved along the budget constraint . In this example , the units along the horizontal and vertical axes are not numbered , so the discussion must focus on whether Sergei will consume more or less of certain goods , not on numerical amounts . Cameras Baseball Bats FIGURE How a Change in Price Affects Consumption Choices The original choice is When the price rises , the budget constraint rotates clockwise . The dashed lines make it possible to see at a glance new consumption choice involves less of both goods , or less of one good and more of the other . The new possible choices would be fewer baseball bats and more cameras , like point , or less of both goods , as at point . Choice would mean that the higher price of bats led to exactly the same quantity of bat consumption , but fewer cameras . Theoretically possible , but unlikely in the real world , we rule out choices like because they would mean that a higher price for baseball bats means a greater consumption of baseball bats . After the price increase , Sergei will make a choice along the new budget constraint . Again , we can divide his choices into three segments by the dashed vertical and horizontal lines . In the upper left portion of the new budget constraint , at a choice like , Sergei consumes more cameras and fewer bats . In the central portion of the new budget constraint , at a choice like , he consumes less of both goods . At the righthand end , at a choice like , he consumes more bats but fewer cameras . The typical response to higher prices is that a person chooses to consume less of the product with the higher price . This occurs for two reasons , and both effects can occur simultaneously . The substitution effect occurs when a price changes and consumers have an incentive to consume less of the good with a relatively higher price and more of the good with a relatively lower price . The income effect is that a higher price means , in effect , the buying power of income has been reduced ( even though actual income has not changed ) which leads to buying less of the good ( when the good is normal ) In this example , the higher price for baseball bats would cause Sergei to buy fewer bats for both reasons . Exactly how much will a higher price for bats cause Sergei bat consumption to fall ?

Figure suggests a range of possibilities . Sergei might react to a higher price for baseball bats by purchasing the same quantity of bats , but cutting his camera consumption . This choice is the point on the new budget constraint , straight below the original choice Alternatively , Sergei

148 Consumer Choices might react by dramatically reducing his bat purchases and instead buy more cameras . The key is that it would be imprudent to assume that a change in the price of one good will only affect consumption of that good . In our example , since Sergei purchases all his products out of the same budget , a change in the price bats can also have a range of effects , either positive or negative , on his purchases of cameras . Since Sergei purchases all his products out of the same budget , a change in the price of one good can also have a range of effects , either positive or negative , on the quantity consumed of other goods . In short , a higher price typically causes reduced consumption of the good in question , but it can affect the consumption goods as well . LINK up Read this article about the potential prices in vending machines . The Foundations of Demand Curves Changes in the price of a good lead the budget constraint to rotate . A rotation in the budget constraint means that when individuals are seeking their highest utility , the quantity that is demanded of that good will change . In this way , the logical foundations of demand show a connection between prices and quantity based on the underlying idea of individuals seeking utility . Figure ( a ) shows a budget constraint with a choice between housing and everything else . Putting everything else on the vertical axis can be a useful approach in some cases , especially when the focus of the analysis is on one particular good . We label the preferred choice on the original budget constraint that provides the highest possible utility . The other three budget constraints represent successively higher prices for housing of , and . As the budget constraint rotates in , and in , and in again , we label the choices , and , and the quantity demanded of housing falls from to to to . Access for free at

How Changes in Income and Prices Affect Consumption Choices Original housing price PU Housing price rises for the time to , Housing prices rises for the second time to Housing prices rises for the third Everything Else Housing vi I a Pi , on Quantity of Housing ( Deriving a demand curve FIGURE The Foundations of a Demand Curve An Example of Housing ( a ) As the price increases from to to to , the budget constraint on the upper part of the diagram rotates clockwise . The choice changes from Mo to to to . As a result , the quantity demanded of housing shifts from to to to , The demand curve graphs each combination of the price of housing and the quantity of housing demanded , The quantities of housing are the same at the points on both ( a ) and ( Thus , the original price of housing ( Po ) and the original quantity of housing ( 00 ) appear on the demand curve as point . The higher price of housing ( and the corresponding lower quantity demanded of housing ( 01 ) appear on the demand curve as point . Thus , as the price of housing rises , the budget constraint rotates clockwise and the quantity consumed of housing falls , meaning , with all other things being the same ) We graph this price of housing rising from to to to , while the quantity of housing demanded falls from to to to the demand curve in Figure ( The vertical dashed lines stretching between the top and bottom of Figure show that the quantity of housing demanded at each point is the same in both ( a ) and ( We ultimately determine the shape of a demand curve by the underlying choices about maximizing utility subject to a budget constraint . While economists may not be able to measure , they can certainly measure price and quantity demanded . Applications in Government and Business The budget constraint framework for making choices offers a reminder that people can react to a change in price or income in a range of different ways . For example , in the winter months , costs for heating homes increased in many parts of the country as prices for natural gas and electricity soared , due in large part to the disruption caused by Hurricanes Katrina and Rita . Some people 149

150 Consumer Choices reacted by reducing the quantity demanded of energy for example , by turning down the thermostats in their homes by a few degrees and wearing a heavier sweater inside . Even so , many home heating bills rose , so people adjusted their consumption in other ways , too . As you learned in the chapter on Elasticity , the short run demand for home heating is generally inelastic . Each household cut back on what it valued least on the margin . For some it might have been some dinners out , or a vacation , or postponing buying a new refrigerator or a new car . Sharply higher energy prices can have effects beyond the energy market , leading to a widespread reduction in purchasing throughout the rest of the economy . A similar issue arises when the government imposes taxes on certain products , such as on gasoline , cigarettes , and alcohol . Say that a tax on alcohol leads to a higher price at the liquor store . The higher price of alcohol causes the budget constraint to pivot left , and alcoholic beverage consumption is likely to decrease . However , people may also react to the higher price of alcoholic beverages by cutting back on other purchases . For example , they might cut back on snacks at restaurants like chicken wings and nachos . It would be unwise to assume that the liquor industry is the only one affected by the tax on alcoholic beverages . Read the next Clear It Up to learn about how who controls the household income buying decisions . The Unifying Power ofthe Budget Set Framework An interaction between prices , budget constraints , and personal preferences determine household choices . The and powerful terminology gives economists a vocabulary for bringing these elements together . Not even economists believe that people walk around mumbling about their marginal utilities before they walk into a shopping mall , accept a job , or make a deposit in a savings account . However , economists do believe that individuals seek their own satisfaction or utility and that people often decide to try a little less of one thing and a little more of another . Ifwe accept these assumptions , then the idea households facing budget constraints becomes highly plausible . CLEAR IT UP Does who controls household income make a difference ?

In the , the United Kingdom made an interesting policy change in its child allowance policy . This program provides a amount of money per child to every family , regardless of family income . Traditionally , the child allowance had been distributed to families by withholding less in taxes from the paycheck of the family wage the father in this time period . The new policy instead provided the child allowance as a cash payment to the mother . As a result of this change , households have the same level of income and face the same prices in the market , but the money is more likely to be in the mother purse than in the father wallet . Should this change in policy alter household consumption patterns ?

Basic models of consumption decisions , of the sort that we examined in this chapter , assume that it does not matter which parent or guardian receives the money , because both seek to maximize the family utility as a whole . In effect , this model assumes that everyone in the family has the same makeup or has the same preferences . There has not been extensive research on diverse family structures and sex and gender related to spending . However , the older research on families with one man and one woman parent indicates that gender does affect spending decisions . When the mother controls a larger share of family income a number of studies , in the United Kingdom and in a wide variety of other countries , have found that the family tends to spend more on restaurant meals , child care , and women clothing , and less on alcohol and tobacco . As the mother controls a larger share of household resources , children health improves , too . These suggest that when providing assistance to families , in countries and countries alike , the monetary amount of assistance is not all that matters it also matters which family member actually receives the money . Access for free at

Behavioral Economics An Alternative Framework for Consumer Choice 151 The budget constraint framework serves as a constant reminder to think about the full range of effects that can arise from changes in income or price , notjust effects on the one product that might seem most immediately affected . Behavioral Economics An Alternative Framework for Consumer Choice LEARNING OBJECTIVES By the end of this section , you will be able to Evaluate the reasons for making choices Interpret an budget constraint Analyze why people in America tend to save such a small percentage of their income As we know , people sometimes make decisions that seem irrational and not in their own best interest . People decisions can seem inconsistent from one day to the next and they even deliberately ignore ways to save money or time . The traditional economic models assume rationality , which means that people take all available information and make consistent and informed decisions that are in their best interest . In fact , economics professors often delight in pointing out irrational behavior each semester to their new students , and present economics as a way to become more rational . However , a new group of economists , known as behavioral economists , argue that the traditional method omits something important people state of mind . For example , one can think differently about money if one is feeling revenge , optimism , or loss . These are not necessarily irrational states of mind , but part ofa range of emotions that can affect anyone on a given day . In addition , actions under these conditions are predictable , if one better understands the underlying environment . Behavioral economics seeks to enrich our understanding by integrating the insights into economics . It does this by investigating how given dollar amounts can mean different things to individuals depending on the situation . This can lead to decisions that appear outwardly inconsistent , or irrational , to the outside observer . The way the mind works , according to this view , may seem inconsistent to traditional economists but is actually far more complex than an unemotional adding machine . For example , a traditional economist would say that ifyou lost a 10 bill today , and also received an extra 10 in your paycheck , you should feel perfectly neutral . After all , 10 10 . You are the same as you were before . However , behavioral economists have conducted research that shows many people will feel some negative emotion , such as anger or frustration , after those two things happen . We tend to focus more on the loss than the gain . We call this loss aversion , where a loss pains us times more than a gain helps us , according to the economists Daniel and Amos in a famous 1979 article in the journal . This insight has implications for investing , as people tend to overplay the stock market by reacting more to losses than to gains . This behavior looks irrational to traditional economists , but is consistent once we understand better how the mind works , these economists argue . Traditional economists also assume human beings have complete self control , but , for instance , people will buy cigarettes by the pack instead of the carton even though the carton saves them money , to keep usage down . They purchase locks for their refrigerators and overpay on taxes to force themselves to save . In other words , we protect ourselves from our worst temptations but pay a price to do so . One way behavioral economists are responding to this is by establishing ways for people to keep themselves free of these temptations . This includes what we call nudges toward more rational behavior rather than mandatory regulations from government . For example , up to 20 percent of new employees do not enroll in retirement savings plans immediately , because or feeling overwhelmed by the different choices . Some companies are now moving to a new system , where employees are automatically enrolled unless they opt Almost opts out in this program and employees begin saving at the early years , which are most critical for retirement . Another area that seems illogical is the idea of mental accounting , or putting dollars in different mental

152 Consumer Choices categories where they take different values . Economists typically consider dollars to be fungible , or having equal value to the individual , regardless of the situation . You might , for instance , think of the 25 you found in the street differently from the 25 you earned from three hours working in a fast food restaurant . You might treat the street money as mad money with little rational regard to getting the best value . This is in one sense strange , since it is still equivalent to three hours of hard work in the restaurant . Yet the easy go mentality replaces the rational economizer because of the situation , or context , in which you attained the money . In another example of mental accounting that seems inconsistent to a traditional economist , a person could carry a credit card debt of that has a 15 yearly interest cost , and simultaneously have a savings account that pays only per year . That means she pays 150 a year to the credit card company , while collecting only 40 annually in bank interest , so she loses 110 a year . That does seem wise . The rational decision would be to pay off the debt , since a savings account with in debt is the equivalent net worth , and she would now net 20 per year . Curiously , it is not uncommon for people to ignore this advice , since they will treat a loss to their savings account as higher than the off their credit card . They do not treat the dollars as fungible so it looks irrational to traditional economists . Which view is right , the behavioral economists or the traditional view ?

Both have their advantages , but behavioral economists have at least trying to describe and explain behavior that economists have historically dismissed as irrational . If most of us are engaged in some irrational behavior , perhaps there are deeper underlying reasons for this behavior in the first place . BRING IT HOME Making Choices In what category did consumers worldwide increase their spending Great Recession ?

Higher education . According to the United Nations Educational , and Cultural Organization ( enrollment in colleges and universities rose in China and almost in Saudi Arabia , nearly doubled in Pakistan , tripled in , and surged by three the United States . Why were consumers willing to spend on education during lean times ?

Both individuals and countries View higher education as the way to prosperity . Many feel that increased earnings are a of attending college . Bureau of Labor Statistics data from May 2012 supports this view , as Figure shows . They show a positive correlation between earnings and education . The data also indicate that unemployment rates fall with higher levels of education and training . Why spend the money to go to college during recession ?

Because if you are unemployed ( or , working fewer hours than you would like ) the opportunity cost of your time is low . If you unemployed , you have to give up work hours and income by going to college . Access for free at Behavioral Economics An Alternative Framework for Consumer Choice 153 Professional Degree 1735 Doctoral Degree 1524 35 I Median weekly earnings Masters Degree Bachelors Degree Unemployment rate 785 Associates Degree Some college 727 High school diploma 652 Less than a High school 471 diploma FIGURE The Impact of Education on Earnings and Unemployment Rates , 2012 Those with the highest degrees in 2012 had substantially lower unemployment rates whereas , those with the least formal education suffered from the highest unemployment rates . The national median average weekly income was 815 , and the nation unemployment average in 2012 was . Source Bureau of Labor Statistics , May 22 , 2013 )

154 Key Terms Key Terms behavioral economics a branch of economics that seeks to enrich the understanding of by integrating the insights and by investigating how given dollar amounts can mean different things to individuals depending on the situation budget constraint ( or budget line ) shows the possible combinations of two goods that are affordable given a consumer limited income consumer equilibrium point on the budget line where the consumer gets the most satisfaction this occurs when the ratio of the prices of goods is equal to the ratio of the marginal utilities . diminishing marginal utility the common pattern that each marginal unit ofa good consumed provides less of an addition to utility than the previous unit fungible the idea that units of a good , such as dollars , ounces of gold , or barrels of oil are capable of mutual substitution with each other and carry equal value to the individual income effect a higher price means that , in effect , the buying power of income has been reduced , even though actual income has not changed always happens simultaneously with a substitution effect marginal utility the additional utility provided by one additional unit of consumption marginal utility per dollar the additional satisfaction gained from purchasing a good given the price of the product substitution effect when a price changes , consumers have an incentive to consume less of the good with a relatively higher price and more of the good with a relatively lower price always happens simultaneously with an income effect total utility satisfaction derived from consumer choices Key Concepts and Summary Consumption Choices Economic analysis of household behavior is based on the assumption that people seek the highest level of utility or satisfaction . Individuals are the of their own utility . In general , greater consumption of a good brings higher total utility . However , the additional utility people receive from each unit of greater consumption tends to decline in a pattern marginal utility . We can the choice on a consumption budget constraint in several ways . You can add up total utility of each choice on the budget line and choose the highest total . You can select a starting point at random and compare the marginal utility gains and losses of moving to neighboring thus eventually seek out the preferred choice . Alternatively , you can compare the ratio of the marginal utility to price of good with the marginal utility to price of good and apply the rule that at the optimal choice , the two ratios should be equal How Changes in Income and Prices Affect Consumption Choices The budget constraint framework suggest that when income or price changes , a range of responses are possible . When income rises , households will demand a higher quantity of normal goods , but a lower quantity of inferior goods . When the price ofa good rises , households will typically demand less of that whether they will demand a much lower quantity or only a slightly lower quantity will depend on personal preferences . Also , a higher price for one good can lead to more or less demand of the other good . Behavioral Economics An Alternative Framework for Consumer Choice People regularly make decisions that seem less than rational , decisions that contradict traditional consumer theory . This is because traditional theory ignores people state of mind or feelings , which can behavior . For example , people tend to value a dollar lost more than a dollar gained , even though the amounts Access for free at

Questions 155 are the same . Similarly , many people over withhold on their taxes , essentially giving the government a free loan until they their tax returns , so that they are more likely to get money back than have to pay money on their taxes . Questions . Jeremy is deeply in love with Jasmine . Jasmine lives where cell phone coverage is poor , so he can either call her on the phone for cents per minute or he can drive to see her , at a cost of in gasoline money . He has a total of 10 per week to spend on staying in touch . To make his preferred choice , Jeremy uses a handy that measures his total utility from personal visits and from phone minutes . Using the values in Ta 10 , out the points on Jeremy consumption choice budget constraint ( it may be helpful to do a sketch ) and identify his point . Round Trips Total Utility Phone Minutes Total Utility 80 20 200 150 40 380 210 60 540 260 80 680 300 100 800 330 120 900 200 140 980 180 160 1040 160 180 1080 10 140 200 1100 TABLE . Take Jeremy total utility information in Exercise , and use the marginal utility approach to the choice of phone minutes and round trips that maximize Jeremy utility . Explain all the reasons why a decrease in a product price would lead to an increase in purchases . As a college student you work at a job , but your parents also send you a monthly Suppose one month your parents forgot to send the check . Show graphically how your budget constraint is affected . Assuming you only buy normal goods , what would happen to your purchases of goods ?

Review Questions Who determines how much utility an individual will receive from consuming a good ?

Would you expect total utility to rise or fall with additional consumption of a good ?

Why ?

Would you expect marginal utility to rise or fall with additional consumption ofa good ?

Why ?

Is it possible for total utility to increase while marginal utility diminishes ?

Explain .

156 Critical Thinking Questions . If people do not have a complete mental picture of total utility for every level of consumption , how can they 10 . 11 . their consumption choice ?

What is the rule relating the ratio of marginal utility to prices of two goods at the optimal choice ?

Explain why , if this rule does not hold , the choice can not be . As a general rule , is it safe to assume that a change in the price ofa good will always have its most impact on the quantity demanded of that good , rather than on the quantity demanded of other goods ?

Explain . Why does a change in income cause a parallel shift in the budget constraint ?

Critical Thinking Questions 13 . 14 . 15 . Think back to a purchase that you made recently . How would you describe your thinking before you made that purchase ?

The rules of politics are not always the same as the rules of economics . In discussions of setting budgets for government agencies , there is a strategy called closing the Washington Monument . When an agency faces the unwelcome prospect of a budget cut , it may decide to close a attraction enjoyed by many people ( like the Washington Monument ) Explain in terms of diminishing marginal utility why the Washington Monument strategy is so misleading . Hint Ifyou are really trying to make the best of a budget cut , should you cut the items in your budget with the highest marginal utility or the lowest marginal utility ?

Does the Washington Monument strategy cut the items with the highest marginal utility or the lowest marginal utility ?

Income effects depend on the income elasticity of demand for each good that you buy . If one of the goods you buy has a negative income elasticity , that is , it is an inferior good , what must be true of the income elasticity of the other good you buy ?

Problems 16 . 17 . who lived in ancient Greece , derives utility from reading poems and from eating cucumbers . gets 30 units of marginal utility from her first poem , 27 units of marginal utility from her second poem , 24 units of marginal utility from her third poem , and so on , with marginal utility declining by three units for each additional poem . gets six units of marginal utility for each of her three cucumbers consumed , five units of marginal utility for each of her next three cucumbers consumed , four units of marginal utility for each of the following three cucumbers consumed , and so on , with marginal utility declining by one for every three cucumbers consumed . A poem costs three bronze coins but a cucumber costs only one bronze coin . has 18 bronze coins . Sketch budget set between poems and cucumbers , placing poems on the vertical axis and cucumbers on the horizontal axis . Start off with the choice of zero poems and 18 cucumbers , and calculate the changes in marginal utility of moving along the budget line to the next choice of one poem and 15 cucumbers . Using this process based on marginal utility , create a table and identify choice . Compare the marginal utility of the two goods and the relative prices at the optimal choice to see if the expected relationship holds . Hint Label the table columns ) Choice , Marginal Gain from More Poems , Marginal Loss from Fewer Cucumbers , Overall Gain or Loss , Is the previous choice optimal ?

Label the table rows ) Poems and 18 Cucumbers , Poem and 15 Cucumbers , Poems and 12 Cucumbers , Poems and Cucumbers , Poems and Cucumbers , Poems and Cucumbers , Poems and Cucumbers . 10 decrease in the price ofone product that you buy causes an increase in quantity demanded of that product , will another 10 decrease in the price cause another increase ( no more and no less ) in quantity demanded ?

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