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1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (6 of 6)

1 TRADITIONAL CONSUMER CHOICE: UTILITY THEORY (6 of 6)

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APPLICATION 1



MEASURING DIMINISHING MARGINAL UTILITY



APPLYING THE CONCEPTS #1: How does marginal utility change with the quantity consumed?



Neuroscientists have used brain imaging techniques to provide some insights into the law of diminishing marginal utility. The scientists offered subjects in
an experiment varying monetary rewards, and observed the neural activity in a subject's striatum, the region of the brain responsible for the valuation of
rewards.



As the monetary reward increased, the subjective benefit (the utility value, as measured in neuron activity) increased, but at a decreasing rate. In other
words, the larger the reward, the lower the marginal utility of the reward money.



For example, for a $15 reward, the marginal utility is 1 util per dollar, but for a $150 reward, the marginal utility is only 0.25 utils per dollar. Although this
experiment does not provide a direct demonstration of the law of diminishing marginal utility for a particular product, it does show that general rewards are
subject to diminishing marginal utility.

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22.2 THE LAW OF DEMAND AND THE INDIVIDUAL DEMAND CURVE (1 of 3)
The effect of a decrease in price
The left panel shows a decrease in price moves the curve up. A decrease
in price show the original bundle violates the equimarginal rule.
A decrease in the price of movies shifts the movie benefit curve (MU per $
of movies) upward. At the original bundle (6 movies and 9 books), the MU
per $ of movies (18 utils at point c) exceeds the MU per $ of books (12 utils
at point b), so the consumer Increases the number of movies.

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22.2 THE LAW OF DEMAND AND THE INDIVIDUAL DEMAND CURVE (2 of 3)
The Income and Substitution Effects of a Price Change



Substitution effect
The change in quantity consumed that is caused by a change in
the relative price of the good, with real income held constant .



Income effect
The change in quantity consumed that is caused by a change in
real income, with relative prices held constant.

For a price of movies of $2, utility is maximized at points d and e, with 10 movies
and 7 books. The move from point c to point s is the substitution effect of the
decrease in price, and the move from point s to point d is the income effect of the
decrease in price.

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22.2 THE LAW OF DEMAND AND THE INDIVIDUAL DEMAND CURVE (3 of 3)
The Individual Demand Curve

An individual demand curve shows the relationship between the price of a product and
the quantity demanded by a rational consumer. In other words, the demand curve shows,
for each price, the utility-maximizing quantity for the consumer.

The individual demand curve for our hypothetical consumer. At the initial price of $3, the
consumer maximizes utility with 6 movies (point i).

A decrease in price to $2 increases the quantity demanded to 10 movies (point j).

The move from point i to point j reflects both the substitution effect and the income effect
of a decrease in price.

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APPLICATION 2



A REVENUE-NEUTRAL GASOLINE TAX



APPLYING THE CONCEPTS #2: How would a simultaneous increase in the gasoline tax and a decrease in the income tax affect gasoline

consumption?



Suppose the government imposes a new tax of $3 per gallon gasoline, which will bring gasoline taxation in the U.S. closer to the levels experienced in
Europe. And suppose the gasoline tax is combined with cut in income taxes to ensure that total tax revenue doesn’t change. In other words, the gasoline tax
is revenue neutral.



It may be tempting to conclude that the change in tax policy will not change gasoline consumption. After all, the policy doesn’t change the tax liability of the
typical taxpayer: the increase in gasoline taxes is offset by a decrease in income taxes.



This logic is faulty because it ignores the substitution effect of a price change.



The gas tax decreases the marginal utility per dollar spent on gasoline, which is now less than the marginal utility per dollar spent on other goods. Gasoline
now generates a lower marginal bang per buck.

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22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (1 of 7)

The Neuroscience of Benefit Valuation
The calibration of the regions of the brain involved in benefit valuation comes from the brain's dopamine system. Dopamine is the reward chemical of the
brain‒when it flows over receptors in your brain, you feel good.

When you consider buying a product such as an apple, your brain uses its past experience to form a conjecture about the likely pleasure and satisfaction
from the product.

Learning happens when conjectures about the pleasure from a product are wrong. For example, suppose you anticipate a sweet apple and thus have a
large dopamine flow, but the first bite generates a sour taste. The invalidation of the brain's conjecture causes an abrupt decrease in the dopamine flow,
causing an abrupt reduction of the good feelings produced by dopamine.

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22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (2 of 7)

The Neuroscience of Cost Valuation
On the cost side, the key regions for cost valuation are the insular cortex (insula for short) and the amygdala. These interconnected regions express aversion to
various actions.

PRINCIPLE OF OPPORTUNITY COST
The opportunity cost of something is what you sacrifice to get it.

The money spent on one product cannot be used on another product, so it is natural that the brain reacts in a negative way (in the region that expresses
aversion) to the thought of spending money. The higher the price of a product, the greater the opportunity cost of the product, and thus the stronger the activity
of the insula.

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22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (3 of 7)

The Wisdom of Gut Feelings
The Iowa Gambling Task experiment shows gut feelings begin to cause an effect after only 10 draws of the cards.

However, it takes about 50 draws for the unconscious learning to take affect and 60 draws for the subject to explain their choices.

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22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (4 of 7)

Cognition and Choice
To decide whether to take an action, a person compares the anticipated benefit of the action to its anticipated cost.

The principal decision-making region of the brain is the prefrontal cortex (PFC).

In other words, the PFC uses gut feelings as inputs into the decision-making process.

The PFC is not a simple calculator of gut-feeling benefits and costs, but incorporates other factors into the decision-making process. The PFC uses cognition
(conscious thought) to consider a broad set of possible consequences of an action.

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22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (5 of 7)

Cognition and Choice
Why do people make different choices?



Strength of their gut-feelings



Cognitive weighting

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22.3 THE NEUROSCIENCE OF CONSUMER CHOICE (6 of 7)

Predicting Consumer Choice
Neuroscientists map and measure the brain activity associated with consumer decisions. After observing a consumer's brain activity while he or she considers
different options, scientists can actually predict the consumer's choice.

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