IV. New Ways of Explaining Consumer Choices
Behavioral Economics
Behavioral economics studies the ways in which limits on the human brain’s
ability to compute and implement rational decisions inuences economic behavior—
both the decisions that people make and the consequences of those decisions for the
way markets work.
There are three impediments to rational choice: bounded rationality, bounded
will-power, and bounded self-interest.
Bounded Rationality
Bounded rationality is rationality that is bounded by the computing power of the
human brain. Faced with uncertainty, consumers cannot rationally make choices
and instead rely on other decision-making methods such as rules of thumb, listening
to the views of others, or gut instinct.
Bounded Willpower
Bounded willpower is the less-than-perfect willpower that prevents us from
making a decision that we know, at the time of implementing the decision, we will
later regret.
Bounded Self-Interest
Bounded self-interest is the limited self-interest that sometimes results in
suppressing our own interests to help others.
The Endowment Eect
The endowment e!ect is the tendency for people to value something more highly
simply because they own it.
Endowment eect in the housing market: The housing market entered a severe slump
in the late 2000s and took years to even begin to emerge. One factor might have been the
endowment e&ect: The price that home buyers were willing to pay for a house is lower than
what homeowners, with the endowment e&ect, believe their home is worth. Consequently
homes might sit on the market for long periods of time.
Neuroeconomics
Neuroeconomics is the study of the activity of the human brain when a person
makes an economic decision. Di&erent decisions appear to activate di&erent areas
of the brain. Some decisions are made in the pre-frontal cortex, which is where
memories are stored and data are analyzed. These decisions might be deemed
rational. Other decisions are made in the hippocampus, which is where memories of
anxiety and fear are stored. These decisions might be deemed irrational.
Controversy
Whether economics should focus on explaining the decisions we observe or on what
goes on inside people’s heads is the source of controversy.
The Reading Between the Lines case at the end of the chapter about e&orts to outlaw large,
sugary drinks should draw student reaction and interest about the role of government in
helping citizens make better decisions. Although the students have not yet learned about
externalities, part of the discussion can include whether government can protect itself as a
payer of health care costs for the poor and elderly.
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A d d i t i o n a l P r o b l e m s
1. Mary enjoys classical CDs and
travel books and spends $50 a
month on them. The table
shows the utility she gets from
each good.
a. Compare the two utility
schedules. Can you say
anything about Mary’s
preferences?
b. What do the two utility schedules tell you about Mary’s preferences?
c. If a classical CD and a travel book cost $10 each, how does Mary spend the
$50 a month?
2. Rob enjoys rock concerts and
the opera. The table shows the
marginal utility he gets from
each activity. Rob has $100 a
month to spend on concerts. A
rock concert ticket is $20, and
an opera ticket is $10. How
many rock concerts and how
many operas does he attend?
3. In problem 2, Rob’s uncle gives him $30 to spend on concert tickets, so he
now has $130. How many rock concerts and how many operas does he attend
now that he has $130 to spend?
4. In problem 2, if the price of a rock concert decreases to $10, how many rock
concerts and operas will Rob attend?
S o l u t i o n s t o A d d i t i o n a l P r o b l e m s
1. a. Mary gets the same utility from 1 classical CD as from 1 travel book, but at
quantities greater than 1 she gets more utility from any number of classical CDs
than she does from the same number of travel books.
b. Mary receives the same marginal utility from her @rst classical CD as from her @rst
travel book. At quantities greater than 1, Mary gets more marginal utility from an
additional classical CD than she gets from an additional travel book when she has
the same number of each.
c. Mary buys 3 classical CDs and 2 travel books.
When Mary buys 3 classical CDs and 2 travel books she spends $50. Mary
maximizes her utility when she spends all of her money and the marginal utility per
dollar from classical CDs and travel books is the same. When Mary buys 3 classical
CDs her marginal utility per dollar spent is 0.8 units per dollar and when Mary buys
2 travel books her marginal utility per dollar spent is 0.8 units per dollar.
2. To maximize his utility, Rob attends 3 rock concerts and 4 opera concerts.
Rob will spend his $100 such that all of the $100 is spent and that the marginal utility
per dollar from each type of concert is the same. When Rob attends 3 rock concerts
and 4 operas, he spends $60 on rock concerts and $40 on operas—a total of $100.
The marginal utility from the third rock concert is 60 and a rock concert ticket is $20,
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Quantity
per
month
Total utility
from classical
CDs
Total utility
from travel
books
1 30 30
2 40 38
3 48 44
4 54 46
5 58 47
Concerts
per
month
Marginal utility
from rock
concerts
Marginal utility
from operas
1 90 120
2 80 90
3 60 60
4 40 30
5 20 20
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so the marginal utility per dollar from rock concerts is 3. The marginal utility from the
fourth opera is 30 and an opera ticket is $10, so the marginal utility per dollar from
operas is 3. The marginal utility per dollar from rock concerts equals the marginal
utility per dollar from operas.
3. To maximize his utility, Rob attends 4 rock concerts and 5 operas.
Rob will spend his $130 such that all of the $130 is spent and that the marginal utility
per dollar from each type of concert is the same. When Rob attends 4 rock concerts
and 5 operas, he spends $80 on rock concert tickets and $50 on operas—a total of
$130.
The marginal utility from the fourth rock concert is 40 and a rock concert ticket is $20,
so the marginal utility per dollar from rock concerts is 2. The marginal utility from the
@fth opera is 20 and an opera ticket is $10, so the marginal utility per dollar from
opera is 2. The marginal utility per dollar from rock concerts equals the marginal
utility per dollar from operas.
4. To maximize his utility, Rob attends 5 rock concerts and 5 operas.
Rob will spend his $100 such that all of the $100 is spent and that the marginal utility
per dollar from each type of concert is the same. When Rob attends 5 rock concerts
and 5 operas, he spends $50 on rock concert tickets and $50 on opera tickets—a total
of $100.
The marginal utility from the @fth rock concert is 20 and a rock concert ticket is $10,
so the marginal utility per dollar from rock concerts is 2. The marginal utility from the
@fth opera is 20 and an opera ticket is $10, so the marginal utility per dollar from
operas is 2. The marginal utility per dollar from rock concerts equals the marginal
utility per dollar from operas.
A d d i t i o n a l D i s c u s s i o n Q u e s t i o n s
1. Have you ever eaten or drank “too much”? Use the students’ personal
experience with food or drink to show them that the marginal utility for a good
can be increasing, diminishing, or even negative. The example works well for
many types of food and drink consumption, but college students often
especially enjoy sharing their experiences (or their friends’ experiences) with
alcohol.
Can alcohol consumption exhibit increasing marginal utility? The @rst
drink may not induce the euphoric feeling that many students seek, but two
drinks might, with the third drink increasing the euphoria even more than the
second drink. In this range of consumption, the student experiences increasing
marginal utility. Point out that this increasing marginal utility isn’t likely to last
forever.
Can alcohol exhibit diminishing marginal utility? By the fourth or @fth
drink of the evening, the additional euphoria from each drink is not as much
as the prior drink, meaning the student is in the zone of diminishing marginal
utility.
Can alcohol exhibit negative marginal utility? After the @fth or sixth drink
for the evening, most students quickly feel the discomfort of intoxication and
su&er a signi@cant decline in euphoria mixed with a signi@cant increase in
discomfort and disorientation. Continued consumption of alcohol can
eventually bring the onset of alcohol poisoning, when the body starts to reject
further intake of alcohol by ejecting the excess alcohol. Most students would
agree that, at that point, an additional drink would generate negative
marginal utility.
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U T I L I T Y A N D D E M A N D 8 4
2. If the Surgeon General (and the American Medical Association)
concludes that moderate wine and beer consumption can have a
positive in’uence on cardiovascular health, how will utility and
demand be aected? Ask the students to use utility theory to explain how
changes in the marginal utility of beer and wine consumption will cause the
demand for beer and wine to increase, despite unchanged short-run prices or
consumer incomes.
3. Would people voluntarily pay for something seemingly undesirable?
Get students to see that the utility they get from one good is oftentimes
dependent on the level of other goods and services consumed. Ask the
students to use utility theory to explain:
1) Why do people regularly put themselves through undesirable, rigorous
exercise programs? (better health increases our marginal utility of engaging in
other activities)
2) Why do students forgo lots of leisure time to take college classes? (better
education increases our appreciation of the world and allows us make better
choices in our lives)
Help the students see that consumers invest in apparently undesirable goods
the same way society invests in capital to increase future consumption—
except it is human capital that consumers are investing in.
4. How could utility theory help us understand the dierence between a
federal income tax and a federal sales tax on consumer consumption
patterns? This is a real-world application of utility theory designed to boost
student con@dence.
Mention that federal sales tax proponents point out that sales taxes do not
penalize savings whereas income taxes penalize both savings and
consumption, motivating consumers to save less and consume more.
Recall how Chapter 2 used the production possibilities frontier model to
show that higher present consumption and lower present investment
(which is largely based on savings) decreases future consumption for
society through slower economic growth.
Explain how consumers allocate their income across a&ordable
consumption and savings combinations by equating the ratio of marginal
utility per dollar for both. If the same tax revenue was collected by a
federal sales tax rather than the income tax, the tax price for savings
would decrease and the tax price for consumption would increase. (Make
sure you explain that “savings” is an example of a “good.” In the examples
used in the text, there is no savings. All income is spent on goods. When
savings exists, not all of a consumer’s income is spent, but all of the
income is allocated to either consumption goods or savings.)
Show how consumers adjust these ratios by increasing the marginal utility
of consumption through less consumption and decreasing the marginal
utility of savings by saving more. Utility is maximized at a higher level of
savings when consumption is penalized through a consumption tax
instead of an income tax.
5. How does utility theory dierentiate a “need” from a “want”? If you
are really in the mood for a very heated discussion on utility analysis, just ask
the students what the marginal utility function for a “necessity” looks like. The
students should recognize that it is perfectly vertical, where no increase in
price is suLciently large to cause the person to decrease consumption of a
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necessity in order to equate the marginal utility per dollar ratios across all
goods and services. All income is spent on necessity until the consumer is
sated, and remaining income is allocated across goods and services until the
marginal utility per dollar ratios equalize. (This type of a utility function
reects lexicographic preference orderings.)
Is a vertical utility function a reasonable outcome to expect for any
good, even medicine or food? Point out that even the poorest of people
allocate their meager incomes across more than just one good or service (the
necessities). Somehow the income is allocated despite the supposed vertical
marginal utility curve.
How is income allocated across multiple “necessities” if all have
vertical marginal utility functions? Point out that if there is more than one
“necessity,” then there is more than one marginal utility function involved in
allocating income. Help students to recognize that because in the real world
the poor allocate their income across multiple goods, then the marginal utility
per dollar ratios involved cannot be vertical, but they may be very steep.
Emphasize that for these consumers to maximize their utilities, each of the
marginal utility per dollar ratios will need to be equalized, making the income
allocation process indistinguishable from mere “wants.”
Is it even meaningful to dierentiate needs from wants among
multiple goods or services? There is no positive answer to this question—
only a normative one. Utility analysis has just proven that there is no positive
de@nition of a necessity. Now step back and let the sparks y!
6. It is often di*cult to create incentives for behavior that is very good
for us in the long run but not necessarily pleasurable in the short run
(studying, eating right, and exercising) and disincentives for
activities that lead to future pain but present pleasure (smoking,
eating whatever is convenient and tasty, sleeping through class).
Have students suggest possible incentives/disincentives that they
think might address this problem. Attendance and being prepared for
class, eating right and moving more, and all kinds of other things promote our
long run best interests but we live in world where diabetes is a growth industry
and where many students think that access to notes in classroom technology
packages means they don’t need to attend or read the book. What do they
think would work, both personally and at the level of social policy? How does
this relate to marginal utility theory?
7. Type 2 Diabetes is often related to poor diets and lack of exercise. If
it is avoidable, how does the material in this chapter help us
understand why it is on the rise around the world? The answer to this
question might well be related to bounded rationality. It de@nitely ties in well
with a discussion of the Reading Between the Lines case.
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