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Consumer Behavior -
Consumer Decisions: Utility Maximization
I. Introduction
So, here in Oregon, we continue to get hammered by cold storms. Last week it was
snow down in Portland, and dry, deep snow up in the Cascades (16-20" new
overnight): the stuff that happens once every couple of years in Oregon. Today,
there is another 7" of new snow on the mountain, and snow predicted on/off for the
next two weeks. Base is at 175" and is very consolidated (we have had plenty of
rain with that snow): that is all-natural, non-manmade snow.
But, for some reason, people just stop skiing. WHY? I just don't understand. The
skiing is great, the snow is superb! What else can they do this time of year? Sit
inside and watch it rain? We get BIG dumps, and nobody is on the hill. Likewise
in late April/early May, which has primo spring conditions (and the occasional
good storm, followed by a bluebird day, which doesn't get any better) and again,
nobody is on the hill!
1. Consumer Decisions
2. Producer Decisions
C. Review
1. Definition -- Economics
2. Definition -- Benefit-Cost Analysis
3. Definition -- Utility
The total amount of satisfaction derived from the consumption of a single product or a
combination of products.
3. marginal utility
a. definition
The extra utility a consumer obtains from the consumption of one additional unit of a
good or service;
b. calculation
equal to the change in total utility divided by the change in the quantity consumed.
MU = TU / Qconsumed
c. graph
1. yellow page
2. textbook
b. MU and elasticity
if the price declines, only A LITTLE more will be purchased since LITTLE extra
utility is recieved
Explanation:
if the price declines, A LOT more will be consumed since the MU of these
additional units remains HIGH
B. Consumer Choice and the Budget Constraint: Utility Maximizing Rule
(benefit-cost analysis)
1. assumptions
a. rational behavior
b. preferences are known and measurable
c. budget constraint
d. prices
To obtain the greatest utility the consumer should allocate money income so that the
last dollar spent on each good or service yields the same marginal utility.
a. Benefit-Cost-Analysis:
select all where: MB > MC
up to where: MB = MC
but never where: MB < MC
MBx = MUx/Px
The MB of product X can be measured by finding the MU per dollar spent on product
X
MCx = MUy/Py
The MC of product X can be measured by finding the MU that you are not receiving
from a dollar's worth of your next best alternative (product Y)
Therefore:
MB = MC
or
To obtain the greatest utility the consumer should allocate money income so that the
last dollar spent on each good or service yields the same marginal utility.
4. example 1:
A consumer is consuming the following quantities of two goods both with a price of
$1 and recieving the MU indicated:
Quantity: MU Received from the last unit:
Good A (price $1) 10 60
Good B (price $1) 8 80
If you have $10 and apples cost $1 and oranges cost $2, use the table below to
determine:
If you still have $10 and apples still cost $1 and oranges now cost $1 too, use the
table above to determine:
P = $2; Q = 4
p = $1; Q = 6
WHY?
1.Newspaper vending machines normally allow one to take multiple
papers; publishers allow this because they believe that people rarely
take more than one paper because the marginal utility of the second
paper is often zero, and it has little "shelf life."
Some essential goods like water have lower prices than luxuries like diamonds.
WHY?
Noncash gifts may yield less utility to the receiver than a cash gift of equal
monetary value
V. Prospect Theory
A. Traditional theory asserts that people are always rational and are not
impacted by emotion.
1. Status quo – gains and losses are essentially measured against the change in
the status quo.
2. We know about diminishing marginal utility with goods but there’s also
diminishing marginal disutility with losses where there’s a much greater
decrease in marginal utility with the first loss.
3. People are loss averse and will feel losses to a greater magnitude than gains of
an equal amount.
b. Therefore to makeup for increased costs, Hershey’s decreased the size of their
chocolate bar in order to avoid an increase in price.
c. The important point is that consumers don’t view this as a loss because they
focus on price and price didn’t change (no observable change in status quo).
a. Evaluation of gains and losses largely depends on a person’s mental frame and
when new information is introduced to change a person’s frame their gains/losses
are called framing effects.
b. For example, making $100,000 may be appealing to someone until they find
out they had been earning $140,000.
b. Example: Students asked to write down the last 2 digits of their social security
numbers are then asked to write down the value of a good like a wireless
keyboard. Those with lower ending social security numbers were likely to
provide lower estimates while those with higher ending numbers provided higher
estimates.
c. Credit card companies use anchoring by requiring very low monthly payments
thereby inducing consumers to make smaller payments and increasing the total
amount paid on the debt.
b. When making big-item purchases like a $1,000 TV, the buyer is offered a
warranty. The buyer often looks at this transaction in isolation, viewing this as a
potential $1,000 loss if the TV breaks. The buyer is usually enticed to buy the
warranty even though there’s a small possibility of it breaking because the
consumer doesn’t consider their future income.
a. There is a tendency for people to have a higher value of an item if they own it,
called the endowment effect.
b. For example, a coffee mug that I don’t own is worth $10 to me, but once the
mug is mine the value of the mug increases to $15. As a result of strong
endowment effects, transactions between buyers and sellers are difficult.
c. The endowment effect is in part due to people being loss averse where parting
with an item they own is viewed as a loss and people tend to feel potential losses
2.5 times more than potential gains.
b. for example: