McConnell - Microeconomics Chapter 7&8 (Consumer Behavior)

Explain the diamond-water paradox.

- The paradox of value is the apparent contradiction that, although water is on the whole more useful, in terms of survival, than diamonds, diamonds command a higher price in the market. - Total utility of water is much higher, but it is cheaper because much more available.

6 types of cognitive biases?

1) Confirmation bias - refers to the human tendency to pay attention only to information that agrees with one's preconceptions. 2) Self-serving bias - refers to people's tendency to attribute their successes to personal effort or personal character traits while at the same time attributing any failures to factors that were out of their control. 3) Overconfidence effect - refers to people's tendency to be overly confident about how likely their judgments and opinions are to be correct. 4) Hindsight bias - when they retroactively believe that they were able to predict past events 5) Availability heuristic - causes people to base their estimates about the likelihood of an event not on objective facts but on whether or not similar events come to mind quickly and are readily available in their memories. 6) Planning fallacy - is the tendency people have to massively underestimate the time needed to complete a task.

The Implications of Hardwired Heuristics (3)?

1) It may be very difficult for people to alter detrimental behaviors or routines even after you point out what they're doing wrong. 2) People may be easy prey for those who understand their hardwired tendencies. 3) If you want people to make a positive behavioral change, it might be helpful to see if you can put them in a situation where a heuristic will kick in and subconsciously lead them toward the desired outcome.

4 things that motivate consumer behavior?

1) Rational behavior - consumer tries to use his or her money income to maximise their utility. 2) Preferences - each consumer has clear-cut preferences for certain of the goods and services. Buyers also have a good idea of how much marginal utility they will get from successive units of the various products. 3) Budget constraint - at any point in time the consumer has a fixed, limited amount of money income. 4) Prices - goods are scarce relative to the demand for them, so every good carries a price tag. We assume that the price of each good is unaffected by the amount of it that is bought by any particular person.

What is anchoring?

Anchoring - the tendency people have to unconsciously base, or "anchor," the valuation of an item they are currently thinking about on recently considered but logically irrelevant information.

What is budget constraint?

Budget constraint - the limit that the size of a consumer's income (and the prices that must be paid for goods and services) imposes on the ability of that consumer to obtain goods and services.

What are cognitive biases?

Cognitive biases - misperceptions or misunderstandings that cause systematic errors. Most result either (1) from heuristics that are prone to systematic errors or (2) because the brain is attempting to solve a type of problem (such as a calculus problem) for which it was not evolutionarily evolved and for which it has little innate capability.

What is consumer equilibrium?

Consumer equilibrium - in marginal utility theory, the combination of goods purchased that maximizes total utility by applying the utility-maximizing rule. In indifference curve analysis, the combination of goods purchased that maximizes total utility by enabling the consumer to reach the highest indifference curve, given the consumer's budget line (or budget constraint).

Algebraic generalization for utility-maximizing rule?

Economists generalize the utility-maximizing rule by saying that a consumer will maximize her satisfaction when she allocates her money income so that the last dollar spent on product A, the last on product B, and so forth, yield equal amounts of additional, or marginal, utility.

What is endowment effect?

Endowment effect - the tendency people have to place higher valuations on items they possess (are endowed with) than on identical items that they do not possess; perhaps caused by loss aversion.

What is fairness?

Fairness - a person's opinion as to whether a price, wage, or allocation is considered morally or ethically acceptable.

What are framing effects?

Framing effects - in prospect theory, changes in people's decision making caused by new information that alters the context, or "frame of reference," that they use to judge whether options are viewed as gains or losses relative to the status quo.

Explain how we can determine the utility maximization combination of goods by using a budget constraint and indifference curves.

Given the goal of consumers is to maximize utility given their budget constraints, they seek that combination of goods that allows them to reach the highest indifference curve given their budget constraint. This occurs where the indifference curve is tangent to the budget constraint.

What are heuristics?

Heuristics - the brain's low-energy mental shortcuts for making decisions. They are "fast and frugal" and work well in most situations but in other situations result in systematic errors.

What is income effect?

Income effect - a change in the quantity demanded of a product that results from the change in real income (purchasing power) caused by a change in the product's price.

Define an indifference curve and explain what information it shows.

Indifference curve: a graph showing combination of two goods that give the consumer equal satisfaction and utility.

What is loss aversion?

Loss aversion - in prospect theory, the property of most people's preferences that the pain generated by losses feels substantially more intense than the pleasure generated by gains.

What is marginal utility?

Marginal utility is the extra satisfaction a consumer realizes from an additional unit of that product—for example, from the eleventh unit.

What is mental accounting?

Mental accounting - the tendency people have to create separate "mental boxes" (or "accounts") in which they deal with particular financial transactions in isolation rather than dealing with them as part of an overall decision-making process that would consider how to best allocate their limited budgets across all possible options by using the utility-maximizing rule.

What is myopia in economics?

Myopia - refers to the difficulty human beings have with conceptualizing the more distant future. Leads to decisions that overly favor present and near-term options at the expense of more distant future possibilities.

What are precommittments?

Precommitments - actions taken ahead of time that make it difficult for the future self to avoid doing what the present self desires. See time inconsistency and self-control problems.

What is prospect theory?

Prospect theory - a behavioral economics theory of preferences having three main features: (1) people evaluate options on the basis of whether they generate gains or losses relative to the status quo; (2) gains are subject to diminishing marginal utility, while losses are subject to diminishing marginal disutility; and (3) people are prone to loss aversion.

What are self-control problems?

Self-control problems - refers to the difficulty people have in sticking with earlier plans and avoiding suboptimal decisions when finally confronted with a particular decision-making situation. A manifestation of time inconsistency and potentially avoidable by using precommitments.

What is status quo bias?

Status quo bias - the tendency most people have when making choices to select any option that is presented as the default (status quo) option. Explainable by prospect theory and loss aversion.

What is substitution effect? (2)

Substitution effect: (1) A change in the quantity demanded of a consumer good that results from a change in its relative expensiveness caused by a change in the good's own price. (2) The reduction in the quantity demanded of the second of a pair of substitute resources that occurs when the price of the first resource falls and causes firms that employ both resources to switch to using more of the first resource (whose price has fallen) and less of the second resource (whose price has remained the same).

What are systematic errors?

Systematic errors - suboptimal choices that (1) are not rational because they do not maximize a person's chances of achieving his or her goals and (2) occur routinely, repeatedly, and predictably.

What is time inconsistency?

Time inconsistency - the human tendency to systematically misjudge at the present time what will actually end up being desired at a future time. It is as though your present self does not understand what your future self will want.

What is total utility?

Total utility is the total amount of satisfaction or pleasure a person derives from consuming some specific quantity—for example, 10 units—of a good or service.

What is utility-maximizing rule?

Utility-maximizing rule - the principle that to obtain the greatest total utility, a consumer should allocate money income so that the last dollar spent on each good or service yields the same marginal utility (MU). For two goods X and Y.