Subject:
Economics
Material Type:
Module
Provider:
Ohio Open Ed Collaborative
Tags:
Behavioral Economics, Consumer Behavior, Microeconomics, Oss0042
License:
Creative Commons Attribution Non-Commercial
Language:
English
Media Formats:
eBook, Text/HTML

Education Standards (5)

Consumer Behavior Resources

Overview

This lesson discusses why and how consumers make certain choices.  Based on standard neoclassical theory, students are introduced to the concept of utility, budget constraints, and indifference curves.  Given market prices and utility information, students will understand the implicit thought processes that lead to total utility maximization.  In cases when individual behaviors do not adhere to the predictions of standard economic theory, the lesson employs behavioral economics to explain how and when consumer choices might be different under certain conditions including limited information, psychological pricing, bounded rationality, nudges, and loss aversion.

 

Learning Objectives

  1. Understand how utility theory explains consumption choices (1,2,3,7,16)
  2. Describe total utility, marginal utility, and diminishing marginal utility (1,2,3,7)
  3. Explain the rule for utility maximization given diminishing marginal utility (1,2,3,7)
  4. Explain indifference curves, budget constraint, and the condition for optimal behavior (1,2,3,7)
  5. Explain the impacts of price changes on consumer choices (1,2,3,7)
  6. Explain the impacts of income changes on consumer choices (1,2,3,7)
  7. Discuss how utility theory is related to the consumer demand curve (1,2,3,7)
  8. Identify reasons why consumers may be irrational (1,2,3,7,16)
  9. Explain how irrational behavior affects consumer choices (1,2,3,7,16)

NOTE: This Module meets Ohio TAG's 1, 2, 3, 7, and 16 for an Intro to Microeconomics Course OSS004

Recommended Textbook Resources

Principles of Microeconomics 2e: Consumer ChoicesPrinciples of Microeconomics 2e OpenStax Book Cover

This chapter provides a good treatment of consumer behavior. It covers all of the learning objectives, except indifference curves, in reasonable detail. It is chosen because it allows for more intuitive explanations of optimal consumer choices given market prices and the budget constraint, which provides a good link to the discussion on demand in a previous topic. Its introduction to behavioral economics allows for a good extension to irrational consumer choices.  

Full Citation: Greenlaw, S. and Shapiro et al.  Principles of Microeconomics 2e. OpenStax CNX.  June 4, 2018.  OpenStax, Principles of Microeconomics 2e.

 

Microeconomics: Indifference Curve Analysis

This is a good discussion on indifference curve analysis from Lumina Learning.  It combines standard discussion on indifference curves, a video from Marginal Revolution University (presented by Joana Giranta of Arizona State University), and exercises to explain optimal consumer choices using indifference curves and the budget constraint.  It works well in combination with the OpenStax resources, Chapter 6, Consumer Choices.

Supplemental Content/Alternative Resources

Marginal Revolution University

https://mru.org/courses/principles-economics-microeconomics

Under Consumer Choice, Joana Giranta of Arizona State University introduces students to the standard neoclassical consumer theory and covers all the course outcomes except behavioral economics (irrational economic choices), in the following short videos:  Introduction to Consumer choice, Budget Constraints, Indifference Curves, and Consumer Optimization. This is an excellent discussion with relevant examples to enhance student learning. 

Behavioral Economics: Crash Course Economics #27

https://www.youtube.com/watch?v=dqxQ3E1bubI

This short youtube video is approximately eleven minutes and provides very good examples of how behavioral economics seeks to explain why individuals might behave differently than is suggested by standard neoclassical economics on consumer choices. They touch on examples related to limited information, perceptions, psychological pricing, nudges, and loss aversion.

 

Active Learning Exercise

 

In this lesson students would first discuss optimal consumer decisions based on the standard neoclassical results and then consider those decisions in light of developments from behavioral economics.  The following exercises can be accomplished during the class period or given as writing assignments.

Option 1:

As a student you have a limited budget to purchase all the required course materials and meet other expenses for the term.  You have reviewed the syllabi and instructor notes for all courses and think that you have adequate information on the usefulness of the course materials.  What factors will help determine how to allocate your limited budget among your needs? In the end, do you think you will be making an optimal decision on whether to purchase your course materials?  How might economic theory be employed in your decision to purchase some or all of the course materials? Describe how your decision would be different if (a) every other student in a course purchased the materials, (b) you had no information about how course materials will be used in a course, and (c) the college made an arrangement with the publishers to provide course materials to every student at the start of the term, but allow each student to opt out within a specified time period?  Would you still consider your initial decision to be optimal? Why or why not?

Option 2:

Retirement planning is a subject that most students will face during their working lives.  It is complicated by the fact that it is a decision that will challenge consumer behavior over several periods.  With complete information about how much to save each year, the rates of return expected on their investment, the expected sum at the end of their working careers, and the expected payouts given their life expectancy, would you make a decision to start making contributions to a retirement savings account at your earliest eligible year?  Explain your decision. Would you consider your decision optimal or suboptimal? According to behavioral economics, decisions to make adequate contributions to a retirement savings account can be affected by a preference for the status quo when presented with new information, loss aversion, anecdotal evidence (experiences of others, news reports), lack of knowledge/confidence to make a decision, perceptions, and nudging (Knoll, 2010).  Assign a discussion, either verbal or written, that asks students to describe examples, based on personal expectations and/or those of family members, of how each of the behavioral factors will impact or has impacted decisions on retirement savings, personally or by family members.  

Melissa A. Z. Knoll “The Role of Behavioral Economics and Behavioral Decision Making in Americans’ Retirement Savings Decisions” Social Security Bulletin, Vol 7, No. 4, 2010, 1-23 

https://www.ssa.gov/policy/docs/ssb/v70n4/v70n4p1.pdf

Option 3:

Is college education worth it?  This is a question that elicits different answers from students.  What constitutes a rational decision to attend college and obtain loans, might be different depending on a student’s subjective evaluation of college education, price of college education, and expected lifetime benefits.  Ask students to respond to this question based on discussions in consumer theory and behavioral economics. The following links are sources of data on education and human capital, and student debt.

https://www.federalreserve.gov/publications/2017-economic-well-being-of-us-households-in-2016-higher-education-capital.htm

https://www.federalreserve.gov/publications/2017-economic-well-being-of-us-households-in-2016-education-debt-loans.htm

Questions and Problems

Questions and Problems

  1. A consumer has sufficient budget and faces prices of bottled water and coffee of $1.00 and $2.00, respectively.  If at the current consumption level, the marginal utility of water is 18 utils and for coffee is 20 utils, can the consumer still increase total utility by reallocating the remainder of her budget?  How?

  2. The following represents hypothetical information on the satisfaction that a consumer derives from the purchase of pizza in a day at the state fair.  Determine the marginal utility for each unit consumed after the first unit. Does total utility or marginal utility determine a consumer’s willingness to pay for each successive unit? 

 

Units of Pizza

Total Utility (TU)

1

10

2

17

3

22

4

25

5

25

6

23

  1. Assume that the price of clothing is $20 and the price of a movie ticket is $10, and the consumer’s weekly budget is $100.  In constructing the budget line clothing is on the y-axis and movies are on the x-axis. What is the slope of the budget line?  If the consumer’s weekly budget increases to $200, while prices remain fixed, what will happen to the slope of the budget line?

  2. Along an indifference curve representing two goods, clothing and movies, if an individual increases her consumption of movies, she will be willing to give up more clothing for each additional unit of movies consumed.  Do you agree or disagree with this statement? Explain your reasoning.

  3. According to consumer theory, a consumer faced with a budget and the purchase of two goods, clothing and movies, makes an optimal decision at the point when an indifference curve is tangent to his budget line, with respect to the two goods.  What is the importance of this optimal condition?

  4. How do the income effect and the substitution effect of a change in the price of sport utility vehicles (SUV) explain why you would expect its demand curve to be downward sloping?

  5. Assume that an individual has $50,000 and has two investment options. One is a certificate of deposit (CD) that pays 2.5 percent annually and is FDIC insured.  The other is a stock (equity) investment that might return 7.5 percent or a loss of 5 percent, and there is a fifty percent chance of returning 7.5 percent. Which investment would you choose and why?  What role does loss aversion play in your decision?

  6. The students in your principles of economics course are now enrolled with a textbook publisher to have automatic access to the textbook (course materials) by the first day of class.  Each student may opt out within the first two weeks of the course. Without automatic enrollment, only 60 percent of the students will be expected to have the textbook by the end of the second week of class.  With automatic enrollment, only 5 percent opted out. If the cost is the same for automatic enrollment and independent purchase, how do you explain this behavior by students?  

 

Answers:

       

  1. Marginal utility per dollar spent on water is 18 (18/1) and the marginal utility per dollar spent on coffee is 10 (20/2).  Hence, the consumer can allocate more of the budget to the consumption of water until the marginal utility per dollar spent is the same for both goods, and the entire budget is spent.

 

  1. MU: 7, 5, 3, 0, -2; Marginal utility is a measure of marginal satisfaction and is more related to the consumer’s willingness to pay.  In spite of diminishing marginal utility beyond the first unit, TU increases up to the 4th unit of pizza.  

 

  1. The slope of the budget line is (10/20), 1/2. The slope of the budget line will still be ½ since there will just be a parallel shift outward without a change in the price ratio.

 

  1. Disagree.  Along an indifference curve, as the consumer increases her consumption of movies, each unit of clothing becomes more valuable in terms of marginal utility.  Hence, the consumer would be willing to give up less clothing for each additional unit of movies. This may be explained using the concept of marginal rate of substitution.

 

  1. The budget line gives you the maximum combinations of both goods that can be purchased, given the prices of the two goods and the consumer’s budget.  Its slope represents the tradeoff that can be made of one good for another. Along an indifference curve the consumer maintains the same level of total utility, and the slope of the curve shows the consumer’s willingness to substitute one for the other, its marginal rate of substitution.  The optimal condition shows that a consumer makes the best decision possible (the decision that makes her the happiest) given the realities of a budget and market prices.

 

  1. If we consider an SUV to be a normal good, an increase in the price of an SUV, ceteris paribus, will lead to a decrease in the consumer’s real income and hence a decrease in the number of SUVs purchased.  An increase in the price of an SUV, ceteris paribus, will cause its relative price (SUV price relative to the price of sedans) to increase, and consumers will substitute sedans for SUVs. This is expected to also cause a decrease in the number of SUVs purchased.

 

  1. The expected return on the CD is the same as the stock investment.  A consumer who is risk averse will select the CD since the return is guaranteed, in spite of the fact that the investor may earn up to 7.5 percent on the stock.  An aversion to a loss, even at 2.5 percent, compared to the upside of 7.5 percent is very relevant to several investors.

 

  1. One approach to this is to have students think of tradeoffs involved when students have a limited budget for non-tuition expenses, and have to consider the marginal benefits and costs involved in their decisions.  In this case, they are being nudged to make a particular decision, and are more likely to not opt out and actually keep the textbook. Ask if their decision will still be considered optimal based on consumer theory.

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