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Chapter 06 - Consumer Behavior

Chapter 06 Consumer Behavior

QUESTIONS 1. Complete the following table and answer the questions below: LO1

a. At which rate is total utility increasing: a constant rate, a decreasing rate, or an increasing rate? How do you know? b. “A rational consumer will purchase only 1 unit of the product represented by these data since that amount maximizes marginal utility.” Do you agree? Explain why or why not. c. “It is possible that a rational consumer will not purchase any units of the product represented by these data.” Do you agree? Explain why or why not. Answer: Missing total utility data, top – bottom: 18; 33. The missing total utility for the second unity can be found by adding the marginal utility (change in utility) to the total utility for the first unit. By consuming the second unit, 8 more units of utils are added; thus total utility is 18 (= 10 + 8). Missing marginal utility data, top – bottom: 7; 5; 1. The missing marginal utility values are found by subtracting the total utility for the previous unit consumed from the total utility of the unit with the missing value (the change in utility). The marginal utility for the third unit is 7, which equals 25 (total utility for the third unit) minus 18 (total utility for the second unit). (a) A decreasing rate; because marginal utility is declining. (b) Disagree. The marginal utility of a unit beyond the first may be sufficiently great (relative to product price) to make it a worthwhile purchase. Consumers are interested in maximizing total utility, not marginal utility. (c) Agree. This product’s price could be so high relative to the first unit’s marginal utility that the consumer would buy none of it. 2. Mrs. Simpson buys loaves of bread and quarts of milk each week at prices of $1 and 80 cents, respectively. At present she is buying these products in amounts such that the marginal utilities from the last units purchased of the two products are 80 and 70 utils, respectively. Is she buying the utility-maximizing combination of bread and milk? If not, how should she reallocate her expenditures between the two goods? LO2

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Chapter 06 - Consumer Behavior

Answer: Mrs. Wilson is not buying the utility-maximizing combination of bread and milk because the marginal utility per cent spent on each good is not equal. The marginal utility per cent of bread is 0.8 (= 80 utils/100 cents); the utility per cent of milk is 0.875 (= 70 utils/80 cents). Mrs. Wilson should buy more milk and less bread. 3. How can time be incorporated into the theory of consumer behavior? Explain the following comment: “Want to make millions of dollars? Devise a product that saves Americans lots of time.” LO2 Answer: Time is money. This expression is a time-saving way of making the point that for a person who can make so much per hour, every hour spent not working is so much money not made. A person can be said to “consume” a ball game or an evening at the theater. If the ball game costs $10 and the theater $20, at first sight one could say the ball game is a better deal. But if the person makes $20 an hour and is forgoing this in taking the time off, then we must take into account the time spent at the ball game and at the theater. If the ball game goes into extra innings and takes 4 hours, then its total cost is $90 (= $10 + $80). If the theater takes 3 hours, its total cost is $80 (= $20 + $60). Assuming the marginal utility of the ball game and attending the theater are the same, the theory of consumer behavior (with time taken into account) would therefore have this consumer going to the theater. 4. Explain: LO2 a. Before economic growth, there were too few goods; after growth, there is too little time. b. It is irrational for an individual to take the time to be completely rational in economic decision making. c. Telling your spouse where you would like to go out to eat for your birthday makes sense in terms of utility maximization. Answer: (a) Before economic growth, most people lived at the subsistence level. By practically anyone’s definition, this implies “too few goods.” After economic growth, goods are in relative abundance. To make (or consume) more takes time, but the relative abundance of goods means that there are already many goods to enjoy. So, now there is a clash between the use of time to make more goods and the use of time to relax and enjoy the goods one already has. There just isn’t enough time. (b) To be completely rational in economic decision making, provided one does not take time into consideration, one has to take account of every factor. This would take a great deal of time. One could not, for example, make any purchase without first searching the classifieds to see whether a better deal could be had, rather than simply heading for the nearest store. However, this would be most irrational, for time does have value. While making an extensive search before making any deal, one would be forgoing the income to make this or any deal. For every penny saved to make the perfect deal, one would be losing dollars in income because of the time spent in making the perfect deal. (c) There is little time sacrificed in making a request to your spouse for the restaurant where you eat on your birthday. If you eat there, the benefit will likely exceed the cost. It also reduces the probability of eating at a restaurant where the market value (purchase price) exceeds the utility to the recipient.

6-2 © 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 06 - Consumer Behavior

5. In the last decade or so there has been a dramatic expansion of small retail convenience stores (such as 7 Eleven, Kwik Shop, and Circle K), although their prices are generally much higher than prices in large supermarkets. What explains the success of the convenience stores? LO2 Answer: These stores are selling convenience as well as the goods that are purchased there. Because of their small size and convenient locations, they save busy consumers time. In an era when most consumers are working at least 40 hours per week, their time is valuable, and when only a few items are needed, the time saved must be worth the additional cost one pays for shopping at these convenience stores. (You seldom, if ever, see anyone buying a week’s worth of groceries at such shops.) 6. Many apartment-complex owners are installing water meters for each apartment and billing the occupants according to the amount of water they use. This is in contrast to the former procedure of having a central meter for the entire complex and dividing up the collective water expense as part of the rent. Where individual meters have been installed, water usage has declined 10 to 40 percent. Explain that drop, referring to price and marginal utility. LO3 Answer: The way we pay for a good or service can significantly alter the amount purchased. An individual living in an apartment complex who paid a share of the water expense measured by a central meter would have little incentive to conserve. Individual restraint would not have much impact on the total amount of water used. Suppose there were 10 apartments in the complex; each apartment would be billed for one-tenth of the cost of the water. A single gallon of water would carry a price equal to one-tenth the amount charged by the water district. The very low price per gallon would encourage the use of water until the marginal utility of an additional gallon was correspondingly low. If the tenants paid separately for their own water, the full market price of water would be considered when making their consumption choices. 7. Using the utility-maximization rule as your point of reference, explain the income and substitution effects of an increase in the price of product B, with no change in the price of product A. LO4 Answer: The utility-maximization rule compares the marginal utilities per dollar of goods under consideration (in this case A and B). An increase in the price of product B would reduce the marginal utility per dollar of B. This would discourage consumption of B, and with a pure income effect, would not alter consumption of A. If the increased price of B caused the marginal utility per dollar of the last unit of B to fall below the MU/$ of the next unit of A, we would expect the consumer to substitute A for B in consumption (substitution effect). 8. ADVANCED ANAYLSIS A “mathematically fair bet” is one in which the amount won will on average equal the amount bet, for example when a gambler bets, say, $100 for a 10 percent chance to win $1000 ($100 = .10 x $1000). Assuming diminishing marginal utility of dollars, explain why this is not a fair bet in terms of utility. Why is it even a less fair bet when the “house” takes a cut of each dollar bet? So is gambling irrational? LO4

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Chapter 06 - Consumer Behavior

Answer: Because the marginal utility of money diminishes the more you have, the utility of the $100 used to make the bet is greater than the $900 that you might gain ($1000 $100) if you win the bet. It is even less of a “fair bet’ when the “house” takes its cut, because the $100 bet has the possibility of yielding less than $900 in winnings. Is gambling irrational? Maybe. The activity of gambling may provide enough extra utility to offset the poor utility odds of winning. 9. Suppose that Ike is loss averse. In the morning, Ike’s stockbroker calls to tell him that he has gained $1000 on his stock portfolio. In the evening, his accountant calls to tell him that he owes an extra $1000 in taxes. At the end of the day, does Ike feel emotionally neutral since the dollar value of the gain in his stock portfolio exactly offsets the amount of extra taxes he has to pay? Explain. LO5

Answer: If Ike is loss averse he will feel losses more intensely than gains. This implies that the increase in taxes of $1000 will cause a greater level of disutility than the gain in utility Ike derives from the $1000 increase in his stock portfolio. In effect, because Ike is loss averse, he worse off in terms of utility. If we use the intensity figure from the textbook, the $1000 loss is felt 2.5 more intensely than the $1000 gain. 10. You just accepted a campus job helping to raise money for your school’s athletic program. You are told to draft a fundraising letter. The bottom of the letter asks recipients to write down a donation amount. If you want to raise as much money as possible, would it be better if the text of that section mentioned that your school is #3 in the nation in sports or that you are better than 99% of other schools at sports? Explain. LO5

Answer: The framing effect suggests that we might raise more revenue by stating that the school is better in sports than 99% of other schools. This is because the value 99 serves as an "anchor" number and may increase the size of the donation. That is, if an individual has been exposed to a larger number prior to making the donation they will likely use this number as a reference point. If, on the other hand, we stated the school was #3 in sports, the donations might be lower because people will use 3 as their reference number or "anchor." 11. LAST WORD What do you think of the ethics of using unconscious nudges to alter people’s behavior? Before you answer, consider the following argument made by economists Richard Thaler and Cass Sunstein, who favor the use of nudges. They argue that in most situations we couldn’t avoid nudging even if we wanted to because whatever policy we choose will contain some set of unconscious nudges and incentives that will influence people. Thus, they say, we might as well choose the wisest set of nudges.

Answer: The argument by Thaler and Sunstein is correct. For example, if the default option is not to enroll in a company's retirement plan, then the 'nudge' is not to enroll. However, if the default option is to enroll in the retirement plan, then the 'nudge' is to enroll. In either case there is a 'nudge'; it is just a matter of direction. Why not choose the direction that is best for society. Or is this question and answer just a 'nudge' to get you to think the way we do? The question and answer obviously include a bit of 'framing'.

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Chapter 06 - Consumer Behavior

PROBLEMS 1. Mylie’s total utility from singing the same song over and over is 50 utils after one repetition, 90 utils after two repetitions, 70 utils after three repetitions, 20 utils after four repetitions, -50 utils after five repetitions, and -200 utils after six repetitions. Write down her marginal utility for each repetition. Once Mylie’s total utility begins to decrease, does each additional singing of the song hurt more than the previous one or less than the previous one? LO1 Answers: 50, 40, -20, -50, -70, -150; More than the previous one. Feedback: Consider the following values: Mylie’s total utility from singing the same song over and over is 50 utils after one repetition, 90 utils after two repetitions, 70 utils after three repetitions, 20 utils after four repetitions, -50 utils after five repetitions, and -200 utils after six repetitions. Mylie's marginal utility can be found by calculating the change in total utility as she sings the song one more time. The utility from singing the song the first time is 50, which is the total utility of singing the song the first time, 50, minus the total utility of not singing the song at all, 0. The utility from singing the song the second time is 40, which is the total utility from singing the song the second time, 90, minus the total utility from singing the song the first time, 50. Apply the same procedure to following repetitions of the song. The marginal utility of the third time is -20 (= 70 - 90). The fourth time, -50 (= 20 - 70), the fifth time, -70 (= -50 - 20). The sixth time, -150 (= -200 - (-50) = -200 + 50). Once Mylie's total utility begins to decrease, each additional song hurts more than the previous one because she is becoming worse in terms of utility (which is a measure of individual welfare). As we can see above, after the second repetition, Mylie is actually worse off. Also, the decline in utility increases after the second repetition. 2. John likes Coca-Cola. After consuming one Coke, John has a total utility of 10 utils. After two Cokes, he has a total utility of 25 utils. After three Cokes, he has a total utility of 50 utils. Does John show diminishing marginal utility for Coke or does he show increasing marginal utility for Coke? Suppose that John has $3 in his pocket. If Cokes cost $1 each and John is willing to spend one of his dollars on purchasing a first can of Coke, would he spend his second dollar on a Coke, too? What about the third dollar? If John’s marginal utility for Coke keeps on increasing no matter how many Cokes he drinks, would it be fair to say that he is addicted to Coke? LO1 Answers: Increasing; Yes; Yes. Feedback: Consider the following values: After consuming one Coke, John has a total utility of 10 utils. After two Cokes, he has a total utility of 25 utils. After three Cokes, he has a total utility of 50 utils. Also, assume John has $3 in his pocket and Cokes cost $1 each. John's marginal utility equals the change in total utility as he consumes an additional unit. Thus, his marginal utility from the first Coke is 10 (= 10 - 0), his second Coke is 15 (= 25 - 10), and his third Coke is 25 (= 50 -25). Since his marginal utility is increasing at an increasing rate he shows increasing marginal utility for Coke.

6-5 © 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 06 - Consumer Behavior

If John consumes the first can of Coke, we know that his marginal utility per dollar was sufficient to induce the purchase. Since his marginal utility increases as he consumes more Coke, his marginal utility per dollar will also increase (price does not change). This implies that he will purchase the second Coke because it provides even more marginal utility per dollar than the first Coke did. The same is true for the third can of Coke. He will spend his entire income on Coke, thus it is fair to say he is addicted to Coke.

3. Suppose that Omar’s marginal utility for cups of coffee is constant at 1.5 utils per cup, no matter how many cups he drinks. On the other hand, his marginal utility per doughnut is 10 for the first doughnut he eats, 9 for the second he eats, 8 for the third he eats, and so on (that is, declining by 1 util per additional doughnut). In addition, suppose that coffee costs $1 per cup, doughnuts cost $1 each, and Omar has a budget that he can spend only on doughnuts, coffee, or both. How big would that budget have to be before he would spend a dollar buying a first cup of coffee? LO2 Answer: $10. Feedback: Consider the following example: Suppose that Omar’s marginal utility for cups of coffee is constant at 1.5 utils per cup, no matter how many cups he drinks. On the other hand, his marginal utility per doughnut is 10 for the first doughnut he eats, 9 for the second he eats, 8 for the third he eats, and so on (that is, declining by 1 util per additional doughnut). In addition, suppose that coffee costs $1 per cup, doughnuts cost $1 each, and Omar has a budget that he can spend only on doughnuts and/or coffee. To answer this question, we first need to calculate the marginal utility per dollar for doughnuts. Recall that the marginal utility per dollar for a good is the marginal utility divided by the price of the good (=MU/P). For the first doughnut we have 10 (=10/$1), the second doughnut 9 (=9/$1), third 8, fourth 7, fifth 6, sixth 5, seventh 4, eighth 3, ninth 2, and tenth 1. The marginal utility per dollar for every cup of coffee is 1.5 (=1.5/$1). To determine how big the budget would have to be before John would spend a dollar buying his first cup of coffee, we compare the marginal utility per dollar values. John will purchase the first doughnut before he buys a cup of coffee because the marginal utility per dollar for the doughnut is greater than the marginal utility per dollar for the cup of coffee (10>1.5). The same is true for the second through the ninth doughnut. This implies John will buy 9 doughnuts at the price of $1 before he buys his first cup of coffee. Therefore his budget will need to $10 before he buys his first cup of coffee, $9 on the doughnuts and $1 for the cup of coffee.

6-6 © 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 06 - Consumer Behavior

4. Columns 1 through 4 in the table below show the marginal utility, measured in utils, that Ricardo would get by purchasing various amounts of products A, B, C, and D. Column 5 shows the marginal utility Ricardo gets from saving. Assum...