Course: Principles of Microeconomics
Module 3: Consumer Behavior
Goals
After completing this module, you will be able to do the following:
• Discuss price elasticity of demand and how it is calculated.
• Explain the usefulness of the total revenue test for price elasticity of demand.
• List the factors that affect price elasticity of demand and describe some applications of price elasticity of demand.
• Describe price elasticity of supply and how it can be applied.
• Apply cross elasticity of demand and income elasticity of demand.
• Define and explain the relationship between total utility, marginal utility, and the law of diminishing marginal utility.
• Describe how rational consumers maximize utility by comparing the marginal utility-to-price ratios of all the products they could possibly purchase.
• Explain how a demand curve can be derived by observing the outcomes of price changes in the utility-maximization model.
• Discuss how the utility-maximization model helps highlight the income and substitution effects of a price change.
• Give examples of several real-world phenomena that can be explained by applying the theory of consumer behavior.
• Relate how the indifference curve model of consumer behavior derives demand curves from budget lines, indifference curves, and utility maximization.
• Define behavioral economics and explain how it contrasts with neoclassical economics.
• Discuss the evidence for the brain being modular, computationally restricted, reliant on heuristics, and prone to various forms of cognitive error.
• Relate how prospect theory helps to explain many consumer behaviors, including framing effects, mental accounting, anchoring, loss aversion, and the endowment effect.
• Describe how time inconsistency and myopia cause people to make suboptimal long-run decisions. Define fairness and give examples of how it affects behavior in the economy and in the dictator and ultimatum games.
Overview
Price elasticity of demand measures consumer response to price changes. If consumers are relatively sensitive to price changes, demand is elastic. If they are relatively unresponsive to price changes, demand is inelastic. If total revenue changes in the opposite direction from prices, demand is elastic. If price and total revenue change in the same direction, demand is inelastic. Where demand is of unit elasticity, a change in price leaves total revenue unchanged.
The number of available substitutes, the size of an item’s price relative to one’s budget, whether the product is a luxury or a necessity, and length of time to adjust are all determinants of elasticity of demand. Elasticity of supply depends on the ease of shifting resources between alternative uses, which varies directly with the time producers have to adjust to a price change. Cross elasticity of demand indicates how sensitive the purchase of one product is to changes in the price of another product.
Utility is the benefit or satisfaction a person receives from consuming a good or a service. The law of diminishing marginal utility indicates that gains in satisfaction become smaller as successive units of a specific product are consumed. Diminishing marginal utility provides a simple rationale for the law of demand.
The theory of consumer behavior assumes that, with limited income and a set of product prices, consumers make rational choices on the basis of well-defined preferences. A consumer maximizes utility by allocating income so that the marginal utility per dollar spent is the same for every good purchased. A down sloping demand curve can be derived by changing the price of one product in the consumer-behavior model and noting the change in the utility-maximizing quantity of that product demanded. By providing insights on the income effect and substitution effect of a price decline, the utility-maximization model helps explain why demand curves are down sloping. The utility-maximization model illuminates the income and substitution effects of a price change.
The theory of consumer behavior can explain many real world phenomena, including the rapid adoption of popular consumer goods like the iPad that feature disruptive technologies, the over-consumption of products like health care that have artificially low prices, and why people often prefer gifts of cash to receiving particular items or objects of the same monetary value as gifts.
Neoclassical economics bases its predictions about human behavior on the assumption that people are fully rational decision-makers who have no trouble making mental calculations and no problems dealing with temptation. While some of its predictions are accurate, many are not.
Read: Microeconomics: Principles, Problems, and Policies: Chapter 6- 8
Assignment:
1. Danny “Dimes” Donahue is a neighborhood’s 9-year-old entrepreneur. His most recent venture is selling homemade brownies that he bakes himself. At a price of $1.50 each, he sells 100. At a price of $1 each, he sells 300. Is demand elastic or inelastic over this price range? If demand had the same elasticity for a price decline from $1.00 to $0.50 as it does for the decline from $1.50 to $1, would cutting the price from $1.00 to $0.50 increase or decrease Danny’s total revenue?
2. 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.
3. 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?
4. One type of systematic error arises because people tend to think of benefits in percentage terms rather than in absolute dollar amounts. As an example, Samir is willing to drive 20 minutes out of his way to save $4 on a grocery item that costs $10 at a local market. But he is unwilling to drive 20 minutes out of his way to save $10 on a laptop that costs $400 at a local store. In percentage terms, how big is the savings on the grocery item? On the laptop? In absolute terms, how big is the savings on the grocery item? On the laptop? If Samir is willing to sacrifice 20 minutes of his time to save $4 in one case, shouldn’t he also be willing to sacrifice 20 minutes of his time to save $10?
