Managerial Economics and Strategy: Third Edition

Managerial Economics and Strategy
Third Edition
Lecture 4
Chapter 4
Consumer Choice
Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved
Managerial Problem
Paying Employees to Relocate
• How can a manager use consumer theory to optimally compensate employees who are
transferred to other cities?
Solution Approach
• Managers can assess the items employees consume in the original location and entice
them to relocate by offering a compensation that allows them to consume basically the
same in the new location. However, these packages usually overcompensate
employees. To avoid costly overcompensation, managers may use the theory of
consumer choice.
Empirical Methods
• Individual preferences determine the satisfaction people derive from the goods and
services they consume.
• Consumers face constraints or limits on their choices, particularly because their budgets
limit how much they can buy.
• Consumers seek to maximize the level of satisfaction they obtain from consumption,
subject to the constraints they face (“do the best with what they have”).
Learning Objectives (1 of 2)
4.1 Consumer Preferences
Predict consumer choices using underlying properties of
consumer preferences
4.2 Utility
Summarize a consumer’s preferences using a utility function
4.3 The Budget Constraint
Explain how prices and income limit what a consumer can
purchase
Learning Objectives (2 of 2)
4.4 Constrained Consumer Choice
Show how consumers maximize their utility given prices and
limited income
4.5 Deriving Demand Curves
Derive demand curves from underlying consumer preferences
4.6 Behavioral Economics
Discuss the role of behavioral biases in consumer choice
4.1 Consumer Preferences (1 of 6)
• A consumer faces choices involving many goods and must allocate his or her
available budget to buy a bundle of goods.
– Would ice cream or cake make a better dessert? Is it better to rent a
large apartment or rent a single room and use the savings to pay for
concerts?
• How do consumers choose the bundles of goods they buy?
– One possibility is that consumers behave randomly and blindly choose
one good or another without any thought.
– Another is that they make systematic choices.
• To explain consumer behavior, economists assume that consumers have a

set of tastes or preferences that they use to guide them in choosing
between goods.
– These tastes differ substantially among individuals. For example, three
out of four European men prefer colored underwear, while three out of
four American men prefer white underwear.
Properties of Consumer Preferences
Properties of Consumer Preferences
• Completeness
– When a consumer faces a choice between any two bundles of goods,
only one of the following is true. The consumer might prefer the first
bundle to the second, or the second bundle to the first, or be indifferent
between the two bundles. Indifference is allowed, but indecision is not.
• Transitivity
– If a is strictly preferred to b and b is strictly preferred to c, it follows that
a must be strictly preferred to c. Transitivity applies also to weak
preference and indifference relationships.
• More is better
– All else being the same, more of a good is better than less. This is a
nonsatiation property.
Preference Maps
• A preference map is a complete set of indifference curves that summarize a
consumer’s tastes.
– An indifference curve is the set of all bundles of goods that a consumer
views as being equally desirable.
– Panel c of Figure 4.1 shows three of Lisa’s indifference curves: I 1,I 2 , and I 3 .
In this figure, the indifference curves are parallel, but they need not be.
Preferences and Indifference Curves

• Bundles on indifference curves farther from the origin are preferred to those
on indifference curves closer to the origin.
• There is an indifference curve through every possible bundle.
• Indifference curves cannot cross.
• Indifference curves slope downward.
Figure 4.1 Bundles of Pizzas and
Burritos That Lisa Might Consume
Willingness to Substitute Between Goods
Willingness to Substitute Between Goods
• The Marginal Rate of Substitution (MRS) is the rate at which a consumer can
substitute one good for another while remaining on the same indifference curve.
– If pizza is on the horizontal axis in Figure 4.3 (a), Lisa’s marginal rate of
substitution of burritos for pizza is MRS = ΔB/ΔZ, where ΔB is the number of
burritos Lisa will give up to get ΔZ more pizzas while staying on the same
indifference curve.
– The indifference curves in Figure 4.3 (a) are convex or “bowed in” toward the
origin. This willingness to trade fewer burritos for one more pizza reflects a
diminishing marginal rate of substitution.
Curvature of Indifference Curves
• Convex indifference curves reflect imperfect substitutes (panel a in Figure 4.3 and
panel c in Figure 4.4).
• Straight-line indifference curves reflect perfect substitutes, goods that are essentially
equivalent for the consumer (Panel a, Figure 4.4).
• Right-angle indifference curves reflect perfect complements, goods consumed only in
fixed proportions (Panel b, Figure 4.4).
Figure 4.3 Marginal Rate of Substitution
Figure 4.4 Perfect Substitutes, Perfect
Complements, and Imperfect Substitutes
4.2 Utility (1 of 2)
Utility Functions
• Our consumer behavior model assumes that consumers can compare bundles of goods
and take the one with the greatest satisfaction.
• If we knew the utility function—the relationship between utility measures and every
possible bundle of goods—we could summarize the information in indifference
maps succinctly. Lisa’s utility function U(B,Z )  B Z
• Utility functions do not exist in any fundamental sense.

– If you ask your mother what her utility function is, she would be puzzled. However,
she could easily answer: “Do you want one scoop of ice cream with two pieces of
cake or two scoops of ice cream with one piece of cake?” Also, she may not know
how much more she prefers one bundle to the other.
Ordinal and Cardinal Utility
• Ordinal utility if we know only a consumer’s relative rankings of bundles.
• Cardinal utility if we know absolute numerical comparisons.
• Most of our discussion of consumer choice in this chapter holds if utility has only ordinal
properties. We care only about the relative utility or ranking of the two bundles.
4.2 Utility (2 of 2)
Marginal Utility (MU)
• Marginal utility is the slope of the utility function as we hold the quantity of the
other good constant, MUZ  U / Z .
– Given Lisa’s utility function U (B, Z )  U (10, Z ), Lisa’s marginal utility from
increasing her consumption of pizza from 4 to 5 in Figure 4.5 is
MU Z  U / Z  20 / 1  20.
– Using calculus: If U (B, Z ), then MU Z  U (B, Z ) / Z.
Marginal Rates of Substitution (M RS)

• The MRS depends on the negative of the ratio of the marginal utility of one
good to the marginal utility of another good.
– Lisa’s MRS depends on the negative of the ratio of the MU of pizza to
the MU of burritos, MRS  MUZ / MUB .
Figure 4.5 Utility and Marginal Utility
4.3 The Budget Constraint (1 of 3)
• Consumers maximize their well-being subject to constraints, and the
most important is the budget constraint.
– The budget constraint or budget line shows the bundles of goods
that can be bought if the entire budget is spent on those goods at
given prices.
– In Figure 4.6, Lisa’s budget constraint is pBB + pZZ = Y, where pBB
and pZZ are the amounts she spends on burritos and pizzas.
– How many burritos can Liza buy?
Y pZ
B  Z
pB pB
Lisa can afford to buy more burritos B only if her income Y
increases, the prices of burritos and pizza (pB, pZ) falls, or she
buys fewer pizzas Z.
1
– In Figure 4.6, pB = $2, pZ =$1, Y = $50. So, B  25  Z.
2
• The opportunity set is all the bundles a consumer can buy, including
all the bundles inside the budget constraint and on the budget
constraint.
– In Figure 4.6, the opportunity set is all those bundles of positive Z
and B such that pB B  pZ Z  Y .
Slope of the Budget Line
• It is determined by the relative prices of the two goods and is called the
marginal rate of transformation (MRT   pZ / pB ).
– In Figure 4.6, Lisa’s MRT  1/ 2. She can “trade” an extra pizza
for half a burrito or give up two pizzas to obtain an extra burrito.
Y pZ
• Using calculus, If B   Z, then MRT  dB / dZ   pZ / pB .
pB pB
Figure 4.6 The Budget Line
Effects of a Change in Price on the Opportunity Set
• If the price of pizza doubles but the price of burritos is unchanged, the budget
line swings in toward the origin (Figure 4.7a).
• The new budget line is steeper and lies inside the original one. Unless Lisa
only wants to eat burritos, she is unambiguously worse off, she can no longer
afford the combinations of pizza and burritos in the shaded “Loss” area.
Effects of a Change in Income on the Opportunity Set

• If the consumer’s income increases, the consumer can buy more of all goods.
• A change in income affects only the position and not the slope of the budget
line.
• If Lisa’s income increases and relative prices do not change, her budget line
shifts outward (away from the origin) and is parallel to the original constraint
(Figure 4.7b)
Figure 4.7 Changes in the Budget Line
4.4 Constrained Consumer Choice (1 of 4)
The Consumer’s Optimal Bundle
• The optimal bundle must lie on an indifference curve that touches the budget
line but does not cross it.
– So, MRS = MRT
– For the case of Lisa that only consumes pizza Z and burritos B,
MRS = MRT becomes MUZ / MUB   pZ / pB .
– Rearranging terms, MU Z / pZ  MUB / pB .
In words, the marginal utility per dollar spent on pizza is equal to the
marginal utility per dollar spent on burritos.
– Thus, Lisa maximizes her utility if the last dollar she spends on pizza gets
her as much extra utility as the last dollar she spends on burritos. If the
last dollar spent on pizza gave Lisa more extra utility than the last dollar
spent on burritos, Lisa could increase her happiness by spending more on
pizza and less on burritos.
• There are two ways to reach an optimal bundle, interior and corner
solutions.
Interior Solutions
• An interior solution occurs when the optimal bundle has positive
quantities of both goods and lies between the ends of the budget line.
– In Figure 4.8, bundle e with 30 pizzas and 10 burritos per
semester is on indifference curve I 2 . It is an optimum interior
solution.
Corner Solutions
• A corner solution occurs when the optimal bundle is at one end of the
budget line, where the budget line forms a corner with one of the axes.
– In Figure 4.9, bundle e with 0 pizzas and 25 burritos per semester
is on indifference curve I 2 . It is an optimum corner solution.
Figure 4.8 Consumer Maximization,
Interior Solution
Figure 4.9 Consumer Maximization,
Corner Solution
Promotions
• Managers induce consumers to buy more units with promotions. The two most used are
buy one, get one free (BOGO) and buy one, get the second at a half price.
Buy One, Get One Free (B OGO)
• The BOGO promotion creates a kink in the budget line and its acceptance depends on
the shape of the indifference curves.
– In Figure 4.10, with the B OGO promotion “buy 3 nights, get the 4th free” the new
2
budget line is L for both Angela and Betty.
1
– In panel a, without the promotion, Angela’s indifference curve l 1 is tangent to L
at point x, so she chooses to spend two nights at the resort. With the B OGO
1
promotion, her indifference curve l cuts the new budget line L . There’s a higher
2
indifference curve, l 2 , that touches L2 at point y, where she chooses to stay four
nights.
– In panel b, without the promotion, Betty chooses to stay two nights at x where her
indifference curve I 3 is tangent to L1. Because I 3 does not cut the new budget line
L2 , no higher indifference curve can touch L2 , so Betty stays only two nights, at x,
and does not take advantage of the B OGO promotion.
Figure 4.10 BOGO Promotions
Managerial Implication: Designing Promotions
• When deciding whether to use a BOGO promotion, a manager should
compare the benefit to the cost.
– For example, offering such a promotion is more likely to raise the
hotel’s profit if it has excess capacity, so that the cost of providing
a room for an extra night’s stay is very low.
• To design an effective promotion, a manager should use experiments
to learn about customers’ preferences.
– For example, a manager could offer each promotion for a short
period and keep track of how many customers respond to each
promotion, how many nights they choose to stay, and by how
much the promotion increases the firm’s profit.
4.5 Deriving Demand Curves
• We use consumer theory to show how much the quantity demanded of a good falls as its
price rises.
• An individual chooses an optimal bundle of goods by picking the point on the highest
indifference curve that touches the budget line.
– In panel a of Figure 4.11 , e1 is the highest indifference curve that touches L1.
• A change in price causes the budget line to rotate, so that the consumer chooses a new
optimal bundle.
– In panel a of Figure 4.11, a price change from £2 to £1 makes the budget line to
rotate from L1 to L2 . The new optimal bundle is e2.
• By varying one price and holding other prices and income constant, we determine
how the quantity demanded changes as the price changes, which is the information
we need to draw the demand curve.
– In panel b of Figure 4.11, E1, E2, and E3 are the points of the demand curve
derived from price changes, budget lines, and indifference curves in panel a.
Figure 4.11 Deriving an Individual’s
Demand Curve
4.6 Behavioral Economics (1 of 3)
• So far, we have assumed that consumers are rational, maximizing
individuals.
• Behavioral economics adds insights from psychology and empirical
research on human cognitive and emotional biases to the rational
economic model to better predict economic decision making.
– We discuss three applications of behavioral economics: tests of
transitivity, endowment effects, and salience.
Tests of Transitivity
• It is appropriate to assume that adults exhibit transitivity for most
economic decisions. But, it is not appropriate for children or when
novel goods are introduced.
– Some argue that children need some form of protection because
they lack of transitivity to maximize their well-being.
Endowment Effects
• People place a higher value on a good if they own it than they do if
they are considering buying it.
– One implication of the endowment effect is that consumer’s
behavior may differ depending on how a choice is posed.
– However, the common belief (common confusion) is that people
respond the same way to equivalent questions.
Salience
• People are more likely to consider information if it is presented in a
way that grabs their attention or if it takes relatively little thought or
calculation to understand.
– If tax requires calculations, buyers may just ignored it because of
costly calculations (bounded rationality).
Managerial Implication: Simplifying Consumer Choices
• Today’s consumers often feel overwhelmed by choices, for instance,
hundreds of channels in Cable TV subscriptions. Because consumers
have bounded rationality, most dislike considering all the possibilities
and making decisions. At the end, many consumers do not buy these
services just to avoid this problem.
• Good managers can make decision making easier for consumers.
They may offer default bundles so consumers don’t have to make
difficult decisions.
– For example, Cable TV companies package groups of channels
by content, sports, or movie packages. Rather than thinking
through each option, the customer can make a much easier
decision, such as “I like sports” or “I like movies,” and is more
likely to make a purchase.
Managerial Solution
Paying Employees to Relocate
• How can a manager use consumer theory to optimally compensate employees who are
transferred to other cities?
Solution
• Managers collect information about the cost of living in various cities. They know that it is
more expensive to buy the same bundle of goods in one city than another and that relative
prices differ across cities.
• Typical relocation: Alex’s firm wants to transfer him from Seattle to London, where he will
face different prices and cost of living. Alex spends his money on housing and
entertainment and gets a bundle s that maximizes his satisfaction in Seattle. The firm
offers him enough money to buy bundle s in London.
– Alex may be better off: entertainment is relatively cheaper in London, but Alex is paid
enough to buy bundle s. So, he can substitute housing with entertainment and reach
a higher indifference curve.
• The firm may offer him less income: There is a lower budget constraint that can put Alex in
London at the same indifference curve as in Seattle with less income than the previous
solution.
Figure 4.2 Impossible Indifference Curves
Table 4.1 Allocations of a $50 Budget
Between Burritos and Pizza
Bundle Burritos, $2 each Pizza, $1 each

a 25 0
b 20 10
c 10 30
d 0 50
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Managerial Economics and Strategy

• To explain consumer behavior, economists assume that consumers have a

Preferences and Indifference Curves

• Utility functions do not exist in any fundamental sense.

Marginal Rates of Substitution (M RS)

Effects of a Change in Income on the Opportunity Set

Bundle Burritos, $2 each Pizza, $1 each

This work is protected by United States copyright laws and is

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