Consumer Choice and Behavioral Economics J.C. Penney Customers Didn't Buy into \"Everyday Low Prices\" In 2010, the J.C. Penney department store chain had nearly 600 \"sales,\" and it sold almost three-quarters of its products at prices marked down by at least 50 percent. However, these sales were illusions because Penney had raised prices before discounting them. The company also often required customers to clip coupons to get the sale price. Soon after being named chief executive officer (CEO) of J.C. Penney in 2011, Ron Johnson, who had had a successful career as head of Apple's retail stores, decided to try a new pricing strategy of \"everyday low prices\" that eliminated most sales and coupons. But the new pricing policy backfired. Pen- ney's sales plunged 25 percent in 2012, and the company fired Johnson after only 17 months. In 2017, Penney was still struggling. With its revenue and profits remaining well below 2010 levels, the company announced that it was closing 140 of its 1,000 stores and would reduce employ- 'ment by 6,000 workers. What was wrong with Johnson's pricing policy? First, the everyday low prices ended up being higher than the sale prices under the previous pricing policy. Some customers noticed and switched to shopping at Walmart and other department stores. Some economists, though, believe that Johnson ran into an even bigger problem: Although econo- mists generally assume that people have enough informa- tion to make optimal buying decisions, this assumption may not always be accurate. For example, many consum- ers have only a rough idea of the typical price of a pair of jeans or a shirt. These consumers have difficulty know- ing whether everyday low prices really are low. Instead, they wait for sales and use coupons because they believe doing so allows them to buy at lower-than-normal prices. Mark Lennihan As Alexander Chernev of Northwestern University put it, \"J.C. Penney might say it's a fair price, but why should con- sumers trust ].C. Penney?\" He argued that consumers \"want a great deal,\" which they believe they get only if a store is having a sale or if they use coupons. We can better understand the failure of Penney's pricing strategy by using insights from behavioral economics, which is the study of situations in which people make choices that do not appear to be economically rational. Firms must understand consumer behavior to determine what strategies are likely to be most effective in selling their products. In this chapter, we will examine how consumers 'make decisions about which products to buy. Sources: Ed Lin, \"J.C. Penney Stock Could Be in a Beauty of a Mess\" barons com, March 29, 2017; Stephanie Clifiord and Catherine Rampel, \"Sometimes, We Want Prices to Fool Us" New York Times, Apri 13, 2013; Wendy Liebmann, \"What Wil We Leam from Ron Johnson's Mistake?\" Forbes, May 8, 2013; and Brad Tuttle, \"The 5 Big Mistakes That Led to Ron Johnson's Ouster at JG Penney,\" Time, Apri 9, 2013, Chapter Outline Learning Objectives @ Utility and Consumer Decision Making, page 326 Define utiity and expiain how consumers choose goods and services fo maximize their utilty. Where Demand Curves Come From, page 334 Use the concept of utility to explain the law of demand. @ Social Influences on Decision Making, page 337 Explain how social influences can affect consumption choices. Behavioral Economics: Do People Make Rational Choices? page 345 Describe the behavioral economics approach to understanding decision making. Appendix: Using Indifference Curves and Budget Lines to Understand Consumer Behavior, page 358 Use indifference curves and budget lines to understand consumer behavior. Economics in Your Life & Career How Should You Price Tickets to a Hit Broadway Show? Suppose you work for a producer of a show running at the Richard Rodgers Theatre on Broadway in New York City, or suppose you work for a concert promoter who books bands to play at the 40 Watt Club in Ath- ens, Georgia. The producer asks you for advice on what to charge for tickets. The answer seems easy: Charge the highest price that will sell all the available tickets. Charging a lower price would seem to reduce the profit that could be earned from the show. In fact, though, charging the highest price is not the strategy most Broadway producers or concert promoters use. Why not? As you read this chapter, try to answer this ques- tion. You can check your answer against the one we provide on page 351 at the end of this chapter. Utility The enjoyment or satisfaction people receive from consuming goods and services. J7"e begin this chapter by exploring how consumers make decisions. We have seen that economists usually assume that people act in a rational, self-interested way. In explaining consumer behavior, economists believe people make choices that will leave them as satisfied as possible, given their tastes, their incomes, and the prices of the goods and services available to them. We will see how downward-sloping demand curves result from the economic model of consumer behavior. We will also explore how in certain situations, knowing which decision is the best one can be difficult. In these cases, economic reasoning provides a tool for consumers to improve their decision making. Finally, we will see that experimental economics has shown that factors such as social pressure and notions of fairness can affect consumer behavior. We will look at how businesses take these factors into account when setting prices. In the appendix to this chapter, we extend the analysis by using indifference curves and budget lines to understand consumer behavior. Utility and Consumer Decision Making LEARNING OBJECTIVE: Define ufility and explain how consumers choose goods and services to maximize their utility. We have seen that the model of demand and supply is a powerful tool for analyzing how prices and quantities are determined. We have also seen that, according to the law of demand, whenever the price of a good falls, the quantity demanded increases. In this section, we will show how the economic model of consumer behavior leads to the law of demand. An Overview of the Economic Model of Consumer Behavior Imagine browsing the Web sites of your favorite stores, trying to decide how to spend your clothing budget. If you had an unlimited budget, your decision would be easy: Just buy as much of everything as you want. Given that you have a limited budget, what do you do? Economists assume that consumers act so as to make themselves as well off as possible. Therefore, you should choose the one combination of clothes that makes you as well off as possible from among the combinations that you can afford. Stated more generally, the economic model of consumer behavior predicts that consumers will choose to buy the combination of goods and services that makes them as well off as pos- sible from among all the combinations that their budgets allow them to buy. 'Although this prediction may seem obvious and ot particularly useful, we will see that it leads to conclusions that are usefulbut not obvious. MyLab Economics Concept Check Utility The amount of satisfaction you receive from consuming a particular combination of goods and services depends on your tastes or preferences. There is an old saying that \"there's no accounting for taste,\" and economists don't try to. If you buy a bottle of Coca-Cola's smartwater instead of a bottle of PepsiCo's LIFEWTR for the same price, you must receive more enjoyment or satisfaction from drinking smartwater. Econo- mists refer to the enjoyment or satisfaction people receive from consuming goods and services as utility. So we can say that the goal of a consumer is to spend available income so as to maximize utility. But utility is a difficult concept to measure because there is no way of knowing exactly how much enjoyment or satisfaction someone receives from consuming a product. Similarly, it is not possible to compare utility across consumers. There is no way of knowing for sure whether Jill receives more or less satisfaction than Jack from drinking a bottle of smartwater. Two hundred years ago, economists hoped to measure utility in units called utils. The util would be an objective measure in the same way that temperature is: If itis 75 degrees in New York and 75 degrees in Los Angeles, it is just as warm in both cities. These economists wanted to say that if Jack's utility from drinking a bottle of smartwater is 10 utils and Jill's utility is 5 utils, then Jack receives exactly twice the sat- isfaction from drinking a bottle of smartwater as Jill does. In fact, it is not possible to measure utility across people. It turns out that none of the important conclusions of the economic model of consumer behavior depend on utility being directly measurable (a point we demonstrate in the appendix to this chapter). Nevertheless, the economic model of consumer behavior is easier to understand if we assume that utility is some- thing directly measurable, like temperature. MyLab Economics Concept Check The Principle of Diminishing Marginal Utility To make the model of consumer behavior more concrete, let's see how a consumer 'makes decisions in a case involving just two products: pizza and Coke. To begin, con- sider how the utility you receive from consuming a good changes with the quantity of the good you consume. Suppose that you arrive at a Super Bowl party where the hosts are serving pizza and you are very hungry. In this situation, you are likely to receive quite a lot of enjoyment, or utility, from consuming the first slice of pizza. Suppose this satisfaction is measurable and is equal to 20 units of utility, or utils. After eating the first slice, you decide to have a second slice. Because you are no longer as hungry, the satisfaction you receive from eating the second slice of pizza is less than the satisfac- tion you received from eating the first slice. Consuming the second slice increases your utility by only an additional 16 utils, which raises your total utility from eating the 2slices to 36 utils. If you continue eating slices, each additional slice gives you less and less additional satisfaction. The table in Figure 10.1 shows the relationship between the number of slices of pizza you consume while watching the Super Bowl and the amount of utility you receive. The second column in the table shows the total utility you receive from eating a particular number of slices. The third column shows the additional utility, or marginal utility (MU), you receive from consuming 1 additional slice. (Remember that in eco- nomics, marginal means additional) For example, as you increase your consumption from 2 slices to 3 slices, your total utility increases from 36 to 46, so your marginal utility from consuming the third slice is 10 utils. As the table shows, by the time you cat the fifth slice of pizza that evening, your marginal utility is very low: only 2 utils. If you were to eat asixth slice, you would feel slightly ill, and your marginal utility would actually be a negative 3 utils. Figure 10.1 also plots the numbers from the table as graphs. Panel (2) shows how your total utility rises as you eat the first 5 slices of pizza and then falls as you eat the Sixth slice. Panel (b) shows how your marginal utility declines with each additional slice you eat and finally becomes negative when you eat the sixth slice. The height of the 'marginal utility line at any quantity of pizza in panel (b) represents the change in util- ity as a result of consuming that additional slice. For example, the change in utility asa result of consuming 4 slices instead of 3 is 6 utils, so the height of the marginal utility line in panel (b) for the fourth slice is 6 utils. 'The relationship illustrated in Figure 10.1 between consuming additional units of a product during a period of time and the marginal utility received from consuming each additional unit is called the law of diminishing marginal utility. For nearly every good or service, the more you consume during a period of time, the less you increase your total satisfaction from each additional unit you consume. MyLab Economics Concept Check The Rule of Equal Marginal Utility per Dollar Spent The key challenge for consumers is to decide how to allocate their limited incomes among all the products they want to buy. Every consumer has to make trade-offs: If you have $100 to spend on entertainment for the month, then the more movies you rent or buy online, the fewer movies you can see in the theater. Economists refer to the limited amount of income you have available to spend on goods and services as your budget constraint. The principle of diminishing marginal utility helps us understand how consumers can best spend their limited incomes on the products available to them. Marginal utility (MU) The change intotal ulity a person receives from consuming one additional unit of a good or service. utility The principle that consumers experience diminishing additional satisfaction as they consume more of a good or service during a given period of time. Budget constraint The limited amount of income available to consumers to spend on goods and services. 328 CHAPTER 10 Consumer Choice and Behavioral Economics Utility and Consumer Decision Making 329 MyLab Economics Animation Number Total Utility from Marginal Utility from Marginal Total Marginal MyLab Economics Animation Figure 10.1 of Slices Eating Pizza the Last Slice Eater Number of Total Utility Utility from Number Utility from Utility from Table 10.1 Slices of the Last Drinking Total and Marginal Utility from 0 from Eating of Cups of the Last 20 20 Pizza Pizza Slice Coke Coke Cup Total Utility and Marginal Utility Eating Pizza on Super Bowl O N . 36 16 from Eating Pizza and Drinking 0 0 Sunday O 46 10 Coke The table shows that for the first 5 slices 1 52 20 20 20 20 of pizza, the more you eat, the more your 2 36 16 2 35 15 W N O total satisfaction, or utility, increases. If 3 46 10 45 10 you eat a sixth slice, you start to feel ill from eating too much pizza, and your 4 52 50 5 total utility falls. Each additional slice Total 54 53 increases your utility by less than the utility 52 Total utility 51 -3 52 previous slice, so your marginal utility -1 from each slice is less than your mar- 46 ginal utility from the one before. Panel (a) shows your total utility rising as you eat the first 5 slices and falling with the The change in total utility Unfortunately, you do have a budget constraint: You have only $10 to spend. To buy 5 sixth slice. Panel (b) shows your mar- as a result of consuming slices of pizza (at $2 per slice) and 5 cups of Coke (at $1 per cup), you would need $15. ginal utility falling with each additional 4 slices rather than 3 is 6 . . . To select the best way to spend your $10, remember this key economic principle: slice you eat and becoming negative Optimal decisions are made at the margin. That is, most of the time economic decision with the sixth slice. The height of the marginal utility line at any quantity of makers-consumers, firms, and the government-are faced with decisions about pizza in panel (b) represents the change whether to do a little more of one thing or a little more of an alternative. In this case, in utility as a result of consuming that you are choosing to consume a little more pizza or a little more Coke. Tesla chooses additional slice. For example, the change 2 whether to manufacture more high-price Models S cars or more lower-price Model 3 in utility as a result of consuming 4 slices Quantity of pizza cars in its California factory. Congress and the president choose whether to spend more instead of 3 is 6 utils, so the height of the (a) Total utility for research on heart disease or more to repair highways. Everyone faces a budget con- marginal utility line in panel (b) for the fourth slice is 6 utils. straint, and everyone faces trade-offs. Marginal utility The key to making the best consumption decision is to maximize utility by fol- 20 lowing the rule of equal marginal utility per dollar spent. As you decide how to spend your income, you should buy pizza and Coke up to the point where the last slice of pizza and the last cup of Coke purchased give you equal increases in utility per dollar. By using this approach, you will maximize your total utility, given your budget constraint. . . so the height of the I utility line for It is important to remember that to follow this rule, you must equalize your mar- the fourth slice is 6. ginal utility per dollar spent, not your marginal utility from each good. (Or, to use a familiar phrase, you want to get "the most bang for your buck.") Buying season tick- ets for your favorite National Football League (NFL) team or for the symphony or buy- ing a BMW may give you a lot more satisfaction than drinking a cup of Coke, but the NFL tickets may well give you less satisfaction per dollar spent. To decide how many slices of pizza and cups of Coke to buy, you must convert the values for marginal utility in Marginal utility Table 10.1 into marginal utility per dollar. You can do this by dividing marginal utility 0 by the price of each good, as shown in Table 10.2. Quantity In column (3), we calculate marginal utility per dollar spent on pizza. Because of pizza the price of pizza is $2 per slice, the marginal utility per dollar from eating 1 slice (b) Marginal utility (3) (6) MyLab Economics Animation Marginal Marginal Table 10.2 Suppose you attend a Super Bowl party at a restaurant, and you have $10 to spend (1) (2) Utility Utility Number of Marginal per Dollar (4) Marginal er Dollar Converting Marginal Utility to on refreshments. Pizza is selling for $2 per slice, and Coke is selling for $1 per cup Slices Utility MUpizza Cups of Utility MU Coke Marginal Utility per Dollar Table 10.1 shows the relationship between the amount of pizza you eat, the amount of Pizza MU Pizza) Ppizza Coke MU Coke) Pcoke of Coke you drink, and the amount of satisfaction, or utility, you receive. The values for pizza are repeated from the table in Figure 10.1. The values for Coke also follow the 20 10 20 20 principle of diminishing marginal utility. 16 15 15 W N How many slices of pizza and how many cups of Coke should you buy if you 10 10 10 want to maximize your utility? If you did not have a budget constraint, you would - W U1 0O CI A W N buy 5 slices of pizza and 5 cups of Coke because that would give you total utility of 107(= 54 + 53) which is the maximum utility you can achieve. Eating another slice of pizza or drinking another cup of Coke during the evening would lower your utility. -1.5330 CHAPTER 10 Consumer Choice and Behavioral Economics Utility and Consumer Decision Making 331 Table 10.3 Combinations of Pizza and Coke Marginal Utility a. Ed inspects this table and concludes, "Lee's optimal cones and how many bottles of smartwater will he con- Equalizing Marginal Utility per with Equal Marginal Utilities per Dollar choice would be to consume 4 ice cream cones and sume? (Assume that Lee cannot consume more than Dollar Spent per Dollar (MU/P) Total Spending Total Utility 5 bottles of smartwater because with that combina- 6 ice cream cones or 6 cans of smartwater.) 1 slice of pizza and 3 cups of Coke $2 = $3 = $5 20 + 45 = 65 tion, his marginal utility from ice cream cones is c. Suppose that Lee has $7 per week to spend on ice cream 3 slices of pizza and 4 cups of Coke 5 $6 + $4 = $10 46 + 50 = 96 equal to his marginal utility from smartwater." Do cones and bottles of smartwater. The price of an ice 4 slices of pizza and 5 cups of Coke 3 you agree with Ed's reasoning? Briefly explain. cream cone is $2, and the price of a bottle of smartwa- $8 + $5 = $13 52 + 53 = 105 b. Suppose that Lee has an unlimited budget to spend ter is $1. If Lee wants to maximize his utility, how many on ice cream cones and bottles of smartwater. ice cream cones and how many bottles of smartwater equals 20 divided by $2, or 10 utils per dollar. Similarly, we show in column (6) that Under these circumstances, how many ice cream should he buy? because the price of Coke is $1 per cup, the marginal utility per dollar from drinking 1 cup of Coke equals 20 divided by $1, or 20 utils per dollar. To maximize the total util- Solving the Problem ity you receive, you must make sure that the utility per dollar of pizza for the last slice Step 1: Review the chapter material. This problem involves finding the optimal of pizza is equal to the utility per dollar of Coke for the last cup. Table 10.2 shows that consumption of two goods, so you may want to review the section "The Rule there are three combinations of slices of pizza and cups of Coke where marginal utility of Equal Marginal Utility per Dollar Spent," which begins on page 327. per dollar is equalized. Table 10.3 lists the combinations, the total amount of money Step 2: Answer part (a) by analyzing Ed's reasoning. Ed's reasoning is incorrect needed to buy each combination, and the total utility received from consuming each o maximize utility, Lee needs to equalize marginal utility per dollar for the combination. two goods As shown in the bottom row of the table, if you buy 4 slices of pizza, the last slice Step 3: Answer part (b) by determining how Lee would maximize utility with gives you 3 utils per dollar. If you buy 5 cups of Coke, the last cup also gives you 3 utils an unlimited budget. With an unlimited budget, consumers maximize util- per dollar, so you have equalized your marginal utility per dollar. Unfortunately, as the ity by continuing to buy each good as long as their utility is increasing. In this third column in the table shows, to buy 4 slices and 5 cups, you would need $13, and case, Lee will maximize utility by buying 6 ice cream cones and 6 bottles of you have only $10. The top row of the table shows that you could also equalize your smartwater, given that we are assuming he cannot buy more than 6 units of marginal utility per dollar by buying 1 slice and 3 cups, but that would cost just $5, either good. leaving you with $5 not spent. As the middle row shows, only when you buy 3 slices Step 4: Answer part (c) by determining Lee's optimal combination of ice and 4 cups have you equalized your marginal utility per dollar and spent neither more cream cones and bottles of smartwater. Lee will maximize his util- nor less than the $10 available. ity if he spends his $7 per week so that the marginal utility of ice cream We can summarize the two conditions for maximizing utility as follows: cones divided by their price is equal to the marginal utility of smartwater MUpiza MU Coke divided by its price. We can use the following table to solve this part of the Ppizza PCoke problem: This condition states that the marginal utility per dollar spent must be the same for Ice Cream Cones Bottles of Smartwater both goods. 2. Spending on pizza + Spending on Coke = Amount available to be spent Quantity MU MU MU M P P This condition is the budget constraint, which states that total spending on both 30 15 40 40 goods must equal the amount available to be spent. 2 25 12.5 35 35 Of course, these conditions for maximizing utility apply not just to pizza and Coke 20 10 26 26 but to any pairs of goods. MyLab Economics Concept Check 15 7.5 18 18 10 5 15 15 Solved Problem 10.1 MyLab Economics Interactive Animation 5 2.5 Finding the Optimal Level of Consumption Lee will maximize his utility by buying 1 ice cream cone and 5 bottles of The following table shows Lee's utility from consuming ice cream cones and bottles of smartwater: smartwater. At this combination, the marginal utility of each good divided by its price equals 15. He has also spent all of his $7. Total Utility Your Turn: For more practice, do related problems 1.9 and 1.10 on page 352-353 at the end of this MyLab Economics Study Plan Number of Ice Total Utility from Marginal Utility Number of Bottles from Bottles of Marginal Utility Cream Cones Ice Cream Cones Smartwater chapter. from Last Cone of Smartwater from Last Bottle 0 0 0 30 30 40 40 2 55 25 75 35 What if the Rule of Equal Marginal Utility per Dollar 75 20 101 26 Does Not Hold? 90 15 a MI A W N 119 18 The idea of getting the maximum utility by equalizing the ratio of marginal utility to 100 10 134 15 price for the goods you are buying can be difficult to grasp, so it is worth thinking 105 141 about it in another way. Suppose that instead of buying 3 slices of pizza and 4 cups of Coke, you buy 4 slices and 2 cups. This combination costs $10, so you would meet your