Chapter 06 - Consumer Behavior

Chapter 06 Consumer Behavior

QUESTIONS

1. Complete the following table and answer the questions below: LO1

a. At which rate is total utility increasing: a constant rate, a decreasing rate, or an increasing rate?
How do you know?
b. “A rational consumer will purchase only 1 unit of the product represented by these data since
that amount maximizes marginal utility.” Do you agree? Explain why or why not.
c. “It is possible that a rational consumer will not purchase any units of the product represented
by these data.” Do you agree? Explain why or why not.

Answer: Missing total utility data, top – bottom: 18; 33. The missing total utility for the second
unity can be found by adding the marginal utility (change in utility) to the total utility for the
first unit. By consuming the second unit, 8 more units of utils are added; thus total utility is 18
(= 10 + 8). Missing marginal utility data, top – bottom: 7; 5; 1. The missing marginal utility
values are found by subtracting the total utility for the previous unit consumed from the total
utility of the unit with the missing value (the change in utility). The marginal utility for the third
unit is 7, which equals 25 (total utility for the third unit) minus 18 (total utility for the second
unit).
(a) A decreasing rate; because marginal utility is declining.
(b) Disagree. The marginal utility of a unit beyond the first may be sufficiently great
(relative to product price) to make it a worthwhile purchase. Consumers are
interested in maximizing total utility, not marginal utility.
(c) Agree. This product’s price could be so high relative to the first unit’s marginal
utility that the consumer would buy none of it.

2. Mrs. Simpson buys loaves of bread and quarts of milk each week at prices of $1 and 80 cents,
respectively. At present she is buying these products in amounts such that the marginal utilities
from the last units purchased of the two products are 80 and 70 utils, respectively. Is she buying
the utility-maximizing combination of bread and milk? If not, how should she reallocate her
expenditures between the two goods? LO2

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Chapter 06 - Consumer Behavior

Answer: Mrs. Wilson is not buying the utility-maximizing combination of bread and milk
because the marginal utility per cent spent on each good is not equal. The marginal
utility per cent of bread is 0.8 (= 80 utils/100 cents); the utility per cent of milk is 0.875
(= 70 utils/80 cents). Mrs. Wilson should buy more milk and less bread.

3. How can time be incorporated into the theory of consumer behavior? Explain the following
comment: “Want to make millions of dollars? Devise a product that saves Americans lots of
time.” LO2

Answer: Time is money. This expression is a time-saving way of making the point that
for a person who can make so much per hour, every hour spent not working is so much
money not made. A person can be said to “consume” a ball game or an evening at the
theater. If the ball game costs $10 and the theater $20, at first sight one could say the ball
game is a better deal. But if the person makes $20 an hour and is forgoing this in taking
the time off, then we must take into account the time spent at the ball game and at the
theater. If the ball game goes into extra innings and takes 4 hours, then its total cost is
$90 (= $10 + $80). If the theater takes 3 hours, its total cost is $80 (= $20 + $60).
Assuming the marginal utility of the ball game and attending the theater are the same, the
theory of consumer behavior (with time taken into account) would therefore have this
consumer going to the theater.

4. Explain: LO2
a. Before economic growth, there were too few goods; after growth, there is too little time.
b. It is irrational for an individual to take the time to be completely rational in economic decision
making.
c. Telling your spouse where you would like to go out to eat for your birthday makes sense in
terms of utility maximization.

Answer:
(a) Before economic growth, most people lived at the subsistence level. By practically
anyone’s definition, this implies “too few goods.” After economic growth, goods are
in relative abundance. To make (or consume) more takes time, but the relative
abundance of goods means that there are already many goods to enjoy. So, now there
is a clash between the use of time to make more goods and the use of time to relax
and enjoy the goods one already has. There just isn’t enough time.
(b) To be completely rational in economic decision making, provided one does not take
time into consideration, one has to take account of every factor. This would take a
great deal of time. One could not, for example, make any purchase without first
searching the classifieds to see whether a better deal could be had, rather than simply
heading for the nearest store. However, this would be most irrational, for time does
have value. While making an extensive search before making any deal, one would be
forgoing the income to make this or any deal. For every penny saved to make the
perfect deal, one would be losing dollars in income because of the time spent in
making the perfect deal.
(c) There is little time sacrificed in making a request to your spouse for the restaurant
where you eat on your birthday. If you eat there, the benefit will likely exceed the
cost. It also reduces the probability of eating at a restaurant where the market value
(purchase price) exceeds the utility to the recipient.

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Chapter 06 - Consumer Behavior

5. In the last decade or so there has been a dramatic expansion of small retail convenience stores
(such as 7 Eleven, Kwik Shop, and Circle K), although their prices are generally much higher
than prices in large supermarkets. What explains the success of the convenience stores? LO2

Answer: These stores are selling convenience as well as the goods that are purchased
there. Because of their small size and convenient locations, they save busy consumers
time. In an era when most consumers are working at least 40 hours per week, their time
is valuable, and when only a few items are needed, the time saved must be worth the
additional cost one pays for shopping at these convenience stores. (You seldom, if ever,
see anyone buying a week’s worth of groceries at such shops.)

6. 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. LO3

Answer: The way we pay for a good or service can significantly alter the amount
purchased. An individual living in an apartment complex who paid a share of the water
expense measured by a central meter would have little incentive to conserve. Individual
restraint would not have much impact on the total amount of water used.
Suppose there were 10 apartments in the complex; each apartment would be billed for
one-tenth of the cost of the water. A single gallon of water would carry a price equal to
one-tenth the amount charged by the water district. The very low price per gallon would
encourage the use of water until the marginal utility of an additional gallon was
correspondingly low. If the tenants paid separately for their own water, the full market
price of water would be considered when making their consumption choices.

7. Using the utility-maximization rule as your point of reference, explain the income and
substitution effects of an increase in the price of product B, with no change in the price of product
A. LO4

Answer: The utility-maximization rule compares the marginal utilities per dollar of goods
under consideration (in this case A and B). An increase in the price of product B would
reduce the marginal utility per dollar of B. This would discourage consumption of B, and
with a pure income effect, would not alter consumption of A. If the increased price of B
caused the marginal utility per dollar of the last unit of B to fall below the MU/$ of the
next unit of A, we would expect the consumer to substitute A for B in consumption
(substitution effect).

8. ADVANCED ANAYLSIS A “mathematically fair bet” is one in which the amount won will
on average equal the amount bet, for example when a gambler bets, say, $100 for a 10 percent
chance to win $1000 ($100 = .10 x $1000). Assuming diminishing marginal utility of dollars,
explain why this is not a fair bet in terms of utility. Why is it even a less fair bet when the
“house” takes a cut of each dollar bet? So is gambling irrational? LO4

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Chapter 06 - Consumer Behavior

Answer: Because the marginal utility of money diminishes the more you have, the utility
of the $100 used to make the bet is greater than the $900 that you might gain ($1000 -
$100) if you win the bet.
It is even less of a “fair bet’ when the “house” takes its cut, because the $100 bet has the
possibility of yielding less than $900 in winnings.
Is gambling irrational? Maybe. The activity of gambling may provide enough extra utility
to offset the poor utility odds of winning.

9. Suppose that Ike is loss averse. In the morning, Ike’s stockbroker calls to tell him that he has
gained $1000 on his stock portfolio. In the evening, his accountant calls to tell him that he owes
an extra $1000 in taxes. At the end of the day, does Ike feel emotionally neutral since the dollar
value of the gain in his stock portfolio exactly offsets the amount of extra taxes he has to pay?
Explain. LO5

Answer: If Ike is loss averse he will feel losses more intensely than gains. This implies
that the increase in taxes of $1000 will cause a greater level of disutility than the gain in
utility Ike derives from the $1000 increase in his stock portfolio. In effect, because Ike is
loss averse, he worse off in terms of utility. If we use the intensity figure from the
textbook, the $1000 loss is felt 2.5 more intensely than the $1000 gain.

10. You just accepted a campus job helping to raise money for your school’s athletic program.
You are told to draft a fundraising letter. The bottom of the letter asks recipients to write down a
donation amount. If you want to raise as much money as possible, would it be better if the text of
that section mentioned that your school is #3 in the nation in sports or that you are better than
99% of other schools at sports? Explain. LO5

Answer: The framing effect suggests that we might raise more revenue by stating that
the school is better in sports than 99% of other schools. This is because the value 99
serves as an "anchor" number and may increase the size of the donation. That is, if an
individual has been exposed to a larger number prior to making the donation they will
likely use this number as a reference point. If, on the other hand, we stated the school was
#3 in sports, the donations might be lower because people will use 3 as their reference
number or "anchor."

11. LAST WORD What do you think of the ethics of using unconscious nudges to alter people’s
behavior? Before you answer, consider the following argument made by economists Richard
Thaler and Cass Sunstein, who favor the use of nudges. They argue that in most situations we
couldn’t avoid nudging even if we wanted to because whatever policy we choose will contain
some set of unconscious nudges and incentives that will influence people. Thus, they say, we
might as well choose the wisest set of nudges.

Answer: The argument by Thaler and Sunstein is correct. For example, if the default
option is not to enroll in a company's retirement plan, then the 'nudge' is not to enroll.
However, if the default option is to enroll in the retirement plan, then the 'nudge' is to
enroll. In either case there is a 'nudge'; it is just a matter of direction. Why not choose the
direction that is best for society. Or is this question and answer just a 'nudge' to get you to
think the way we do? The question and answer obviously include a bit of 'framing'.

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Chapter 06 - Consumer Behavior

PROBLEMS

1. Mylie’s total utility from singing the same song over and over is 50 utils after one repetition,
90 utils after two repetitions, 70 utils after three repetitions, 20 utils after four repetitions, -50
utils after five repetitions, and -200 utils after six repetitions. Write down her marginal utility for
each repetition. Once Mylie’s total utility begins to decrease, does each additional singing of the
song hurt more than the previous one or less than the previous one? LO1

Answers: 50, 40, -20, -50, -70, -150; More than the previous one.

Feedback: Consider the following values: Mylie’s total utility from singing the same
song over and over is 50 utils after one repetition, 90 utils after two repetitions, 70 utils
after three repetitions, 20 utils after four repetitions, -50 utils after five repetitions, and -
200 utils after six repetitions.

Mylie's marginal utility can be found by calculating the change in total utility as she sings
the song one more time. The utility from singing the song the first time is 50, which is the
total utility of singing the song the first time, 50, minus the total utility of not singing the
song at all, 0. The utility from singing the song the second time is 40, which is the total
utility from singing the song the second time, 90, minus the total utility from singing the
song the first time, 50. Apply the same procedure to following repetitions of the song.
The marginal utility of the third time is -20 (= 70 - 90). The fourth time, -50 (= 20 - 70),
the fifth time, -70 (= -50 - 20). The sixth time, -150 (= -200 - (-50) = -200 + 50).

Once Mylie's total utility begins to decrease, each additional song hurts more than the
previous one because she is becoming worse in terms of utility (which is a measure of
individual welfare). As we can see above, after the second repetition, Mylie is actually
worse off. Also, the decline in utility increases after the second repetition.

2. 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? LO1

Answers: Increasing; Yes; Yes.

Feedback: Consider the following values: 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. Also, assume John has $3 in his pocket and Cokes cost $1
each.

John's marginal utility equals the change in total utility as he consumes an additional unit.
Thus, his marginal utility from the first Coke is 10 (= 10 - 0), his second Coke is 15 (= 25
- 10), and his third Coke is 25 (= 50 -25). Since his marginal utility is increasing at an
increasing rate he shows increasing marginal utility for Coke.

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Chapter 06 - Consumer Behavior

If John consumes the first can of Coke, we know that his marginal utility per dollar was
sufficient to induce the purchase. Since his marginal utility increases as he consumes
more Coke, his marginal utility per dollar will also increase (price does not change). This
implies that he will purchase the second Coke because it provides even more marginal
utility per dollar than the first Coke did. The same is true for the third can of Coke. He
will spend his entire income on Coke, thus it is fair to say he is addicted to Coke.

3. Suppose that Omar’s marginal utility for cups of coffee is constant at 1.5 utils per cup, no
matter how many cups he drinks. On the other hand, his marginal utility per doughnut is 10 for
the first doughnut he eats, 9 for the second he eats, 8 for the third he eats, and so on (that is,
declining by 1 util per additional doughnut). In addition, suppose that coffee costs $1 per cup,
doughnuts cost $1 each, and Omar has a budget that he can spend only on doughnuts, coffee, or
both. How big would that budget have to be before he would spend a dollar buying a first cup of
coffee? LO2

Answer: $10.

Feedback: Consider the following example: Suppose that Omar’s marginal utility for
cups of coffee is constant at 1.5 utils per cup, no matter how many cups he drinks. On the
other hand, his marginal utility per doughnut is 10 for the first doughnut he eats, 9 for the
second he eats, 8 for the third he eats, and so on (that is, declining by 1 util per additional
doughnut). In addition, suppose that coffee costs $1 per cup, doughnuts cost $1 each, and
Omar has a budget that he can spend only on doughnuts and/or coffee.

To answer this question, we first need to calculate the marginal utility per dollar for
doughnuts. Recall that the marginal utility per dollar for a good is the marginal utility
divided by the price of the good (=MU/P). For the first doughnut we have 10 (=10/$1),
the second doughnut 9 (=9/$1), third 8, fourth 7, fifth 6, sixth 5, seventh 4, eighth 3, ninth
2, and tenth 1.

The marginal utility per dollar for every cup of coffee is 1.5 (=1.5/$1).

To determine how big the budget would have to be before John would spend a dollar
buying his first cup of coffee, we compare the marginal utility per dollar values. John will
purchase the first doughnut before he buys a cup of coffee because the marginal utility
per dollar for the doughnut is greater than the marginal utility per dollar for the cup of
coffee (10>1.5). The same is true for the second through the ninth doughnut. This implies
John will buy 9 doughnuts at the price of $1 before he buys his first cup of coffee.
Therefore his budget will need to $10 before he buys his first cup of coffee, $9 on the
doughnuts and $1 for the cup of coffee.

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 Chapter 06 - Consumer Behavior

4. Columns 1 through 4 in the table below show the marginal utility, measured in utils, that
Ricardo would get by purchasing various amounts of products A, B, C, and D. Column 5 shows
the marginal utility Ricardo gets from saving. Assume that the prices of A, B, C, and D are,
respectively, $18, $6, $4, and $24 and that Ricardo has an income of $106. LO2

a. What quantities of A, B, C, and D will Ricardo purchase in maximizing his utility?

b. How many dollars will Ricardo choose to save?
c. Check your answers by substituting them into the algebraic statement of the utility-maximizing
rule (verify that all of the income has been exhausted between the various goods and savings).

Answer: (a) 4 units of good A, 3 units of good B, 3 units of good C, zero units of good D; (b)
$4; (c) $106 (= $18x4 + $6x3 +$4x3 + $24x0 + $4)

Feedback: Consider the following information and use the table above: the prices of A,
B, C, and D are, respectively, $18, $6, $4, and $24 and Ricardo has an income of $106.

The first step is to convert the marginal utility values into marginal utility per dollar
values. Recall this is MU/P.

Marginal Marginal Marginal Marginal Marginal Marginal Marginal Marginal units

Utility Utility Utility Utility Utility Utility Utility Utility
per dollar per dollar per dollar per dollar per dollar per dollar per dollar per dollar
unit 1 unit 2 unit 3 unit 4 unit 5 unit 6 unit 7 unit 8
Column 1 4.00 3.00 2.50 2.00 1.50 1.00 0.83 0.67 4
Good A
Column 2 4.00 2.50 2.00 1.50 1.17 0.83 0.33 0.17 3
Good B
Column 3 3.75 3.00 2.00 1.75 1.25 1.00 0.88 0.75 3
Good C
Column 4 1.50 1.25 1.00 0.75 0.54 0.29 0.17 0.08 0
Good D
Column 5 5.00 4.00 3.00 2.00 1.00 0.50 0.25 0.13 4
Saving

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Chapter 06 - Consumer Behavior

is marginal utility per dollar for good A). The columns represent the marginal utility per
dollar for the different goods for each unit consumed and saving (for example, column 1
'Marginal Utility per dollar unit 1' tells us the marginal utility per dollar for the first unit
of every good and savings). This will makes the comparison a little easier.

To determine the optimal amount of goods that Ricardo will purchase, we choose the
goods with the highest marginal utility per dollar as we move from left to right. We
continue to do this until income is exhausted. We see that the first unit of savings ($1)
provides $5.00 worth of utility per dollar, so Ricardo makes this choice. Next he
purchases one unit of good A and good B with a marginal utility per dollar of 4 He will
also save the second dollar (an additional $1) because the marginal utility per dollar is 4.
The next decision leads Ricardo to purchase the first unit of good C with a marginal
utility per dollar of 3. Then he moves on to purchase the second unit of good A, the
second unit of good B, and he saves an additional dollar because the marginal utility per
dollar is 3for these goods. After these purchases, he has an income left of $53. Since he
has income left, he continues to buy more goods using the approach above.

In conclusion, Ricardo will consume 4 units of good A, 3 units of good B, 3 units of good
C, zero units of good D, and saves $4. This will exhaust his income $106 (= $18 x 4 + $6
x 3 +$4 x 3 + $24 x 0 + $4).

5. You are choosing between two goods, X and Y, and your marginal utility from each is as
shown in the table below. If your income is $9 and the prices of X and Y are $2 and $1,
respectively, what quantities of each will you purchase to maximize utility? What total utility will
you realize? Assume that, other things remaining unchanged, the price of X falls to $1. What
quantities of X and Y will you now purchase? Using the two prices and quantities for X, derive a
demand schedule (prices and quantities demanded table) for X. LO3

Answer: X = 2 units, Y = 5 units; total utility = 48; X = 4, Y = 5; Demand schedule =

Price Demanded Quantity Demanded
2 2
1 4

Feedback: Consider the following table and information as an example:

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Chapter 06 - Consumer Behavior

Your income is $9 and the prices of X and Y are $2 and $1, respectively.

The first step is to convert the marginal utility values into marginal utility per dollar
values. Recall this is MU/P. See the table below.

Marginal Marginal Marginal Marginal Marginal Marginal Units

Utility Utility Utility Utility Utility Utility
per per per per per per
dollar dollar dollar dollar dollar dollar
unit 1 unit 2 unit 3 unit 4 unit 5 unit 6
Good Y 8.00 7.00 6.00 5.00 4.00 3.00 5
(first price)
Good X 5.00 4.00 3.00 2.00 1.50 1.00 2
(first price)
Good Y 8.00 7.00 6.00 5.00 4.00 3.00 5
(second
price)
Good X 10.00 8.00 6.00 4.00 3.00 2.00 4
(second
price)

The first two rows define the marginal utility per dollar for goods X and Y when the price
of good X is $2 and the price of Good Y is $1. Each column is the marginal utility for the
unit consumed (Marginal utility per dollar for unit 1 is for the first unit consumed,
Marginal utility per dollar for unit 2 is for the second unit consumed, etc...).

To determine the optimal number of goods to purchase we choose the goods with the
highest marginal utility per dollar as we move from left to right. We continue to do this
until income is exhausted.

First, we only consider the first two rows for Goods X and Y for the first price of good X
(price of X is $2). We purchase the first unit of good Y with a marginal utility per dollar
of 8. Next we purchase the second unit of good Y with a marginal utility per dollar of 7.
Followed by the third unit of good Y with a marginal utility per dollar of 6. Continuing
on, we purchase the fourth and fifth unit of Good Y and the first and second unit of good
X 5and4marginal utility per dollar). Thus, we purchase 5 units of good Y and 2 units of
good X. The total cost is $9 (= $5 x 5 + $2 x 2), which exhausts income.

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Chapter 06 - Consumer Behavior

The total utility is then found by adding up the marginal utility values for the goods
consumed using the values in the original table. The total utility from good Y is 30 (=8 +
7 + 6 + 5 + 4) and the total utility from good X is 18 (=10 + 8). The sum of these two
values is the total utility, which equals 48 (=30 + 18).

Now we consider the case where the price of good X falls to $1.

Here, we only consider the last two rows for Goods X and Y for the second price of good
X. Here our first purchase is the first unit of good X with a marginal utility per dollar of
10. Next we purchase the second unit of good X and the first unit of good Y with a
marginal utility per dollar of 8.00. We continue this process until income is exhausted.
The optimal consumption level for good X is 4 and for good Y is 5.

This gives us the ordered pairs for good X: (P = 2, Q = 2) and (P = 1, Q = 4). We can use
these ordered pairs to graph the demand schedule (not required).

6. ADVANCED ANAYLSIS Let MUA = z = 10 - x and MUB = z = 21 - 2y, where z is marginal

utility per dollar measured in utils, x is the amount spent on product A, and y is the amount spent
on product B. Assume that the consumer has $10 to spend on A and B—that is, x + y = 10. How
is the $10 best allocated between A and B? How much utility will the marginal dollar yield? LO3

Answer: $7 on good B; $3 on good A; MUA = 7, MUB = 7.

Feedback: To solve this system of equations we set the MUA=MUB. This is required if
we are maximizing utility. This leaves with only x and y to solve for using the
individual's budget constraint.

Consider the following equations: Let MUA = z = 10 - x and MUB = z = 21 - 2y, where z
is marginal utility per dollar measured in utils, x is the amount spent on product A, and y
is the amount spent on product B. Also, assume that the consumer has $10 to spend on A
and B—that is, x + y = 10.

We know from our optimization rule that MUA=MUB, which implies 10 - x = 21 - 2y. Or,
after some rearranging, 2y - x = 11. Combining this equation with our budget constraint,
x + y =10, we have two equations and two unknowns (x and y).

Use the budget constraint to solve for x, or x = 10 - y. Substitute x from this equation into
our optimality rule (2y - x = 11), which gives us 2y - (10 -y) = 11. Again after some
rearranging, we have 2y - 10 + y = 11, or 3y = 21. Thus, we spend $7 on good B. Using
our budget constraint x + y =10, this implies we spend $3 on good A.

To check our answer, substitute these values into the marginal utility equations: MUA=
10 - x, or MUA = 10 -3 = 7 and MUB = 21 - 2y = 21 -2x7 = 7. Thus, MUA=MUB.

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Chapter 06 - Consumer Behavior

7. Suppose that with a budget of $100, Deborah spends $60 on sushi and $40 on bagels when
sushi costs $2 per piece and bagels cost $2 per bagel. But then, after the price of bagels falls to $1
per bagel, she spends $50 on sushi and $50 on bagels. How many pieces of sushi and how many
bagels did Deborah consume before the price change? At the new prices, how much money
would it have cost Deborah to buy those same quantities (the ones that she consumed before the
price change)? Given that it used to take Deborah’s entire $100 to buy those quantities, how big
is the income effect caused by the reduction in the price of bagels? LO4

Answers: 30 pieces of sushi and 20 bagels; $80 (= 30*$2 + 20*$1); $20.

Feedback: Consider the following values as an example. Suppose that with a budget of
$100, Deborah spends $60 on sushi and $40 on bagels when sushi costs $2 per piece and
bagels cost $2 per bagel. But then, after the price of bagels falls to $1 per bagel, she
spends $50 on sushi and $50 on bagels.

This implies that Deborah bought 30 pieces of Sushi (=$60/$2) and she bought 20 bagels
(=$40/2) before the price change.

If Deborah purchased the same quantities of Sushi and bagels with the new prices it
would only cost her $80. She still spends $60 on Sushi because the price hasn't changed
(still $2) and she was consuming 30 pieces. However, the cost of the 20 bagels has fallen
to $20 because the price of the bagel is only $1 now.

This implies Deborah has an additional $20 to spend as a result of the price decrease on
bagels (= $100 (original cost) - $80 (new cost)).

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