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4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE (4 of 4)

4 CONSUMER DECISIONS: INSIGHTS FROM NEUROSCIENCE (4 of 4)

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APPLICATION 4



TAXING CIGARETTES TO OFFSET PRESENT BIAS



APPLYING THE CONCEPTS #4: What is the appropriate cigarette tax?



The present bias that leads some people to smoke cigarettes raises an important policy question: Can we use taxes on cigarettes to offset present bias and actually
make people better off in the process? A recent study concludes that to fully offset the present bias that underlies the decision to smoke, the appropriate tax is roughly
$11 per pack of cigarettes.



The study focused on the effects of smoking on premature death. Smoking cuts the lifespan of the typical smoker by roughly 6 years, and given the economic value of
one year of life, we can translate the cost associated with premature death into a cost of roughly $36 per pack of cigarettes. If smokers did not suffer from present bias,
their present choices would fully reflect this future cost, meaning that they would compare the benefit of smoking (the nicotine experience) to the full cost of a pack of
cigarettes (the purchase price plus the $36 cost associated with premature death).



The study suggest that the cigarette tax would actually be beneficial for low-income households. The reason is that low-income households are relatively responsive to
changes in the price of cigarettes, so they would experience a relatively large reduction in smoking, and a relatively large increase in lifespan.

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KEY TERMS

Budget line
Budget set
Equimarginal rule
Income effect
Law of diminishing marginal utility
Marginal utility
Substitution effect
Util
Utility

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APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES
Economists and psychologists have identified several types of puzzling consumer behavior.



Spending choices sometimes depends on the source of income.



The willingness to pay for a product sometimes is affected by irrelevant information.



Product choices are sometimes influenced by irrelevant alternatives.



Decisions are sometimes based on percentage differences rather than absolute differences.

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APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES
22A.1 MENTAL ACCOUNTING AND BUNDLING
One way to economize on decision-making is to separate decisions into different type or accounts. For example, a consumer could establish separate accounts for
food ($300 per month) and entertainment ($100 per month).

An important application of mental accounting concerns the classification of money from different sources. Consider the treatment of income that comes
unexpectedly, for example, a $50 birthday gift or $50 found on the street. For many people, unexpected income is “play money” that is frequently spent on fun or
frivolous purchases. In contrast, people are more careful with regular income.

Another mental shortcut is to monitor consumption by bundles rather than individual units. People tend to track consumption by the bundles in which a product is
delivered rather than the actual consumption of the product.

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APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES
22A.2 ANCHORING
In the classic experiment, each participant writes down the last two digits of his or her social security number, and then bids (expresses a willingness to pay) for a
t-shirt. The bizarre result is the larger the participant's social-security number, the higher the bid on the t-shirt. In other words, the social-security number provides
an anchor for an unrelated mental task.

One way to plant an anchoring number is to be the first to state a price. In other words, there is a first-mover advantage in negotiations over price. This provides
one reason for relatively high (and negotiable) sticker prices on new and used cars.

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APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES
22A.3 THE DECOY EFFECT
One the most puzzling quirks of consumer decision-making is the decoy
effect. In the left panel, there are two options: a low-price player with a
capacity of 8 GB (option A), and a high-price player with a capacity of 16 GB
(option B).

The right panel introduces a third option, a decoy. Option C has the same
capacity as option B, but its price is $20 higher. The comparison of B versus
C is quick and easy: the consumer doesn't have to think about any tradeoffs,
but simply recognizes that the extra $20 spent on C doesn't buy anything.
The typical consumer will then choose option B over options A and C.

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APPENDIX A MENTAL SHORTCUTS AND CONSUMER PUZZLES
22A.4 THE APPEAL OF PERCENTAGE CHANGES
The natural inclination is to translate a numerical change into a percentage change. For example, a change in price from $1.00 to $0.90 is a 10 percent
change, and so is a change from $200 to $180. The translation into percentages means that all 10% changes appear to be alike, despite the fact that 10% of
$200 is much larger than 10% of $1.00.

In general, low-price hotels include Internet service as part of the room charge, while high-price hotels have a separate charge. In a low-price hotel ($50 per
night), a separate charge of $10 per day is a 20% surcharge, a relatively large surcharge in percentage term. Consumers subject to percentage bias are
likely to react strongly to the seemingly large surcharge. In a hotel with a price $200 per night, a separate charge of $10 is only 5% of the price, a small
enough percentage that the consumer response is likely to be relatively small.

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