Consumption And Decision-Making Part 1

CHAPTER 4: CONSUMPTION AND DECISION-MAKING In Chapter 1, we defined economic actors, or economic agents, as people or organizations engaged in any of the four essential economic activities: production, distribution, consumption, and resource management. Economics is about how these actors behave and interact as they engage in economic activities. We begin this chapter with a brief overview of the classical and neoclassical perspectives on economic behavior. The rest of the chapter focuses specifically on consumer behavior—how individuals make decisions on what goods and services to consume. We look at both traditional and contemporary approaches to understanding consumer behavior. 1. HISTORICAL PERSPECTIVES ON ECONOMIC BEHAVIOR Economics is a social science—it is about people and how we organize ourselves to meet our needs and enhance our well-being. All economic outcomes are ultimately determined by human behavior. Thus, economists have traditionally used as a starting point some kind of statement about the motivations behind economic actions. 1.1 CLASSICAL ECONOMIC VIEWS OF HUMAN NATURE The classical economic view of human behavior is largely based on the theoretical framework presented in Adam Smith’s An Inquiry Into the Nature and Causes of the Wealth of Nations, published in 1776. In this book, Smith suggests that an economic system based on markets can effectively promote the general welfare of society. He reasoned that a businessman who is interested in maximizing his own monetary gain would nonetheless serve the social good if the best available means for his monetary gain was to produce high quality goods at a competitive price. The idea that self-interest can unintentionally promote the social good is an important and valuable one. However, it has been often taken out of context to mean that if people only behave with self-interest, they will also always do what is best for the entire society. This interpretation would have astonished Smith, who, in his other famous book, The Theory of Moral Sentiments, emphasized the desire of people to maintain their own self-respect and earn the respect of others. He assumes that this desire motivates people to act honorably, justly, and with empathy for others in their community. Smith recognized that self-interest is important, but he also believed that narrow self-interest will be held in check by people’s “moral sentiments” (the universal desire for self-respect and the respect of others). Thus Smith’s vision of human motivation was one in which individual self-interest was mixed with social motives. Smith was followed by other economists, such as David Ricardo, John Stuart Mill, and Alfred Marshall, who held similarly complex views of human nature and thought quite deeply about ethics. For example, Marshall viewed human motivations as being influenced by a desire to improve the human condition. He specifically focused on the reduction of poverty so as to allow people to develop their higher moral and intellectual faculties rather than being condemned to lives of desperate effort for simple survival. 1.2 THE NEOCLASSICAL MODEL In the twentieth century, the neoclassical model came to dominate economic thinking. This approach took a narrower and simpler view of human motivations. Recall from Chapter 2 that the basic neoclassical model only considers two main types of economic actors—firms and households. This model assumes that firms maximize their profits from producing and selling goods and services, and households maximize their utility (or satisfaction) from consuming goods and services. Economic actors are assumed to be self-interested and “rational,” meaning that people generally make logical decisions that produce the best outcomes for themselves. Also, firms and households are assumed to interact in perfectly competitive markets. In this model, competition (rather than Smith’s “moral sentiments”) is regarded as the check on self-interested behavior of individuals and firms. Competition is understood as being able to prevent firms from charging too much for their product or producing poor-quality goods. neoclassical model: a model that portrays the economy as composed of profit-maximizing firms and utility-maximizing households interacting through perfectly competitive markets Some benefits can be gained from looking at economic behavior in this way. The assumptions reduce the actual (very complicated) economy to something that is much more limited but also easier to analyze. With some additional assumptions, the model can be elegantly expressed in figures, equations, and graphs. This traditional model is particularly well suited for analyzing the determination of prices, the volume of trade, and economic efficiency in certain cases. We will take a closer look at the neoclassical model of consumer behavior in Section 2. Moving into the twenty-first century, most economists have accepted that human motivations are much more complex. As we will see in Section 3, in recent years, economists have devised many creative experiments to explore how people make actual economic decisions, typically showing how context can influence decisions. While this model of economic behavior can’t necessarily be summed up in tidy mathematical equations and graphs, it is more comprehensive, and often more accurate, than the neoclassical model. Discussion Questions 1. Discuss, with an example, how individuals acting in their own self-interest may sometimes lead to outcomes that serve the social good. 2. Do you agree with the assumption of the neoclassical model that human behavior is rational and self-interested? Can you think of some examples of economic behavior that might contradict these assumptions? 2. THE NEOCLASSICAL THEORY OF CONSUMER BEHAVIOR We start our analysis of consumption behavior with the neoclassical model. As mentioned previously, this model is based on simplistic assumptions, but it provides some useful insights. 2.1 CONSUMER SOVEREIGNTY Consumer sovereignty refers to the notion that satisfaction of consumers’ needs and wants is the ultimate economic goal and that firms will always seek to organize their production solely in response to better meeting consumer desires. For example, consider the increase in the sales of sport utility vehicles (SUVs) in the United States in recent decades. The theory of consumer sovereignty would suggest that the primary reason for the growth of SUV sales is a change in consumers’ preferences for larger vehicles over cars. Consumer sovereignty stands in direct contrast to the idea that some firms can manipulate consumer desires through advertising or that some firms might be largely unresponsive to what consumers actually want. consumer sovereignty: the idea that consumers’ needs and wants determine the shape of all economic activities 2.2 THE BUDGET LINE Consumers are constrained in their spending by the amount of their total budget. We can represent this in a simple model in which consumers have only two goods from which to choose. In Figure 4.1 we present a budget line, which shows the combinations of two goods—chocolate bars and bags of nuts—that a consumer can purchase. In this example, our consumer—let’s call him Quong—has a budget of $8. The price of chocolate bars is $1 each, and nuts sell for $2 per bag. budget line: a line showing the possible combinations of two goods that a consumer can purchase Figure 4.1 The Budget Line If Quong spends his $8 only on chocolate, he can buy 8 bars, as indicated by the point where the budget line touches the vertical axis. If he buys only nuts, he can buy 4 bags, as indicated by the (4, 0) point on the horizontal axis. He can also buy any combination in between. For example, the point (2, 4), which indicates 2 bags of nuts and 4 chocolate bars, is also achievable. This is because (2 × $2) + (4 × $1) = $8. (Note that to keep things simple we assume that Quong can buy only whole bars and whole bags, not fractions of them—for example, he can’t buy 2.5 bars of chocolate. However, we draw the budget line as continuous to reflect the more general case with many more alternatives.) A budget line is similar to the concept of a production-possibilities frontier, which we discussed in Chapter 1. A budget line defines the choices that are possible for Quong. Points above and to the right of the budget line are not affordable. Points below and to the left of the budget line are affordable but do not use up the total budget. This simple model assumes that people always want more of at least one of the goods in question; hence, consuming below the budget line would be inefficient. Therefore, a rational consumer will always choose to consume at a point on the budget line. The position of the budget line depends on the size of the total budget (income) and on the prices of the two goods. For example, if Quong has $10 to spend instead of $8, the line would shift outward in a parallel manner, as shown in Figure 4.2. He could now consume more nuts, or more chocolate, or a more generous combination of both. Figure 4.2 Effect of an Increase in Income A change in the price of one of the goods will cause the budget line to rotate around a point on one of the axes. So if the price of nuts dropped to $1 per bag (and Quong’s income was again $8), the budget line would rotate out, as shown in Figure 4.3. Now, if Quong bought only nuts, he could buy 8 bags instead of 4. With the price of chocolate unchanged, however, he still could not buy more than 8 chocolate bars. Figure 4.3 Effect of a Fall in the Price of One Good Note that if both prices change, the budget line could shift in any direction, depending on how the two prices changed. If both prices changed by the same percentage, then the new budget line would be parallel to the original, similar to a change in income. Draw some graphs to prove this to yourself. A budget line tells us all the combinations of purchases that are possible. However, it does not tell us which combination the consumer will choose. To get to this, we must add the theory of utility. 2.3 CONSUMER UTILITY The neoclassical model assumes that individuals have certain preferences (or tastes) for certain goods and services. Consumers seek to satisfy these preferences and thereby derive utility, which is defined as the pleasure or satisfaction received from consuming goods, services, or experiences. Consumers cannot satisfy all their preferences because they are constrained by their budget, so they have to think carefully about what goods to purchase in order to maximize the amount of utility from their given budget. utility: the level of usefulness or satisfaction gained from a particular activity, such as the consumption of a good or service Utility is a somewhat vague concept, like well-being, and cannot be measured quantitatively in the real world. However, for the purposes of this model we assume that we can measure utility in some imaginary unit of “satisfaction.” Table 4.1 presents the total utility that Quong obtains from purchasing different quantities of chocolate bars in a given period, say a day. Table 4.1 Quong’s Utility From Consuming Chocolate Bars Quantity of chocolate bars 0 1 2 3 4 5 6 Total utility 0 10 18 24 28 30 29 Marginal utility — 10 8 6 4 2 −1 We can then plot Quong’s total utility from consuming chocolate bars in Figure 4.4. This relationship between utility and the quantity outlined in Figure 4.4 is an example of a utility function, or a total utility curve. utility function (or total utility curve): a curve showing the relation of utility levels to consumption levels Figure 4.4 Quong’s Utility Function for Chocolate Bars Rather than just looking at total utility, economists tend to focus on how utility changes from one level of consumption to another. The change in utility for a one-unit change in consumption is known as marginal utility. The word “marginal” puts the focus on incremental change rather than total change. marginal utility: the change in a consumer’s utility when consumption of something changes by one unit We can determine Quong’s marginal utility by referring to Table 4.1. We see that Quong obtains 10 units of “satisfaction” from consuming his first chocolate bar. When he eats an additional chocolate bar, his total utility increases from 10 to 18 units (10 + 8 = 18). Here, his total utility is the units of satisfaction obtained from consuming the two bars, while his marginal utility from consuming the second chocolate bar is only 8 units. Consuming his third chocolate bar, he obtains a marginal utility of 6 units. Total utility continues to increase, but in smaller installments since the marginal utility is progressively decreasing. If marginal utility becomes negative, total utility decreases. Figure 4.4 provides a visual picture of how Quong’s utility curve levels off as his consumption of chocolate bars increases. This is generally expected—that successive units of something consumed provide less utility than the previous unit. In other words, consumers’ utility functions generally display diminishing marginal utility. Notice that after six bars of chocolate the marginal utility is negative. In other words, the sixth bar of chocolate has left Quong with negative pleasure (i.e., pain). Perhaps that sixth bar of chocolate gave him an upset stomach. diminishing marginal utility: the tendency for additional units of consumption to add less to utility than did previous units of consumption We can now apply the concept of utility to the budget line that Quong faces. Realize that Quong will also have a utility function for bags of nuts, which will display a similar pattern of diminishing marginal utility. Let’s assume that his first bag of nuts provides him with 20 units of utility, his second bag with 15 additional units, and his third bag with 10 additional units (more bags result in even fewer units of utility). How can Quong allocate his limited budget to provide him with the highest amount of total utility? We provide a formal model of utility maximization in an online Appendix to this chapter, but using marginal thinking, we can easily see how Quong can approach his problem in a purely rational manner. Suppose that Quong is thinking about how he will spend his first $2. With $2, he can buy either two chocolate bars or one bag of nuts. If he buys two chocolate bars, he will obtain 18 total units of utility, as shown in Table 4.1. If he buys one bag of nuts instead, he will obtain 20 units of utility. Thus, Quong will receive greater utility by spending his first $2 on a bag of nuts. What about his next $2? If he spends this on his second bag of nuts, he obtains an additional 15 units of utility. But if he instead purchases his first two chocolate bars, he will obtain 18 units of utility. So, by spending his next $2 on chocolate bars, he increases his utility by a greater amount. After spending $4, Quong has purchased one bag of nuts and two chocolate bars, thus obtaining a total utility of 38 units. Quong can continue to apply marginal thinking to maximize his utility until he has eventually spent his entire budget. (Test yourself: How will Quong spend his third $2, by buying another bag of nuts or two more bars of chocolate?)1 The basic decision rule to maximize utility is to allocate each additional dollar on the good or service that provides the greatest marginal utility for that dollar.2 We suspect that you have never thought about how to spend your money in a manner similar to Quong’s marginal analysis of chocolate and nuts. As we will see in the following sections, people may not always act rationally by maximizing their utility, as suggested by the neoclassical model. Additionally, this model does not tell us anything interesting about why consumers make particular choices; that is, preferences are taken as given. The contemporary models, which we discuss in the following sections, present a more realistic analysis of consumer behavior by considering how preferences may be influenced by contextual factors. Discussion Questions 1. Budget lines can be used to analyze various kinds of tradeoffs. Suppose that you have a total “time budget” for recreation of two hours. Think of two activities you might like to do for recreation, and draw a budget line diagram illustrating the recreational opportunities open to you. What if you had a time budget of three hours instead? 2. Explain in words why the total utility curve has the shape that it does in Figure 4.4. 3. MODERN PERSPECTIVES ON CONSUMER BEHAVIOR Over the past few decades, the neoclassical view of human behavior is being increasingly replaced by an alternative approach that is commonly called behavioral economics. Behavioral economics gathers insights from numerous disciplines, including economics, psychology, sociology, anthropology, neuroscience, and biology, to predict how people actually make decisions. Behavioral economics tests theories by conducting experiments and gathering empirical evidence. This work has proven valuable in explaining behavior that may appear to be irrational. behavioral economics: a subfield of economics that uses insights from various social and biological sciences to explore how people make actual economic decisions 3.1 BEHAVIORAL ECONOMICS AND RATIONALITY Let us start by examining the neoclassical assumption that people are completely rational, meaning they have all the information about the costs and benefits of every single choice available to them and that they can accurately calculate the optimal choice that maximizes their utility. While it may be possible to make a rational choice between a chocolate bar and a bag of nuts, as discussed in the example previously, it becomes much more complicated when we are faced with a wide set of choices. We may not have complete information about each choice. Furthermore, we may not even be able to accurately process and weigh the information that we do possess. Consider a famous experiment. Researchers at a supermarket in California set up a display table with six different flavors of jam. Shoppers could taste any (or all) of the six flavors and receive a discount coupon to purchase any flavor. About 30 percent of those who tried one or more jams ended up buying some.3 The researchers then repeated this experiment but instead offered 24 flavors of jam for tasting. In this case, only 3 percent of those who tasted a jam went on to buy some. In theory, it would seem that more choice would increase the chances of finding a jam that one really liked and would be willing to buy. But, instead, the additional choices decreased one’s motivation to make a decision to buy a jam. Because we often have trouble processing all the available information, we often employ mental heuristics, which are rules of thumb or mental shortcuts that we use to make decisions. While heuristics can often help us make quick and effective decisions, they can often lead to biases based on people’s viewpoints or thinking process. Research by Nobel Laureate Daniel Kahneman has found that people tend to give excessive weight to information that is easily available or vivid, something he called the availability heuristic. For example, if you regularly watch crime shows on television, you may over-rate the risk of being a victim of crime yourself. heuristic: a rule of thumb or mental shortcut that we use to make decisions availability heuristic: placing undue importance on particular information because it is readily available or vivid Kahneman has also shown that the way a decision is presented to people can significantly influence their choices, an effect he refers to as framing. For example, consider a gas station that advertises a special 5-cent-per-gallon discount for paying cash. Meanwhile, another station with the same price instead indicates that they charge a 5-cent-per-gallon surcharge to customers who pay by credit card. Although the prices end up exactly the same, experiments suggest that consumers respond more favorably to the station that advertises the apparent discount. framing: changing the way a particular decision is presented to people in order to influence their behavior Advertisers and politicians have long been known to use framing techniques to influence the behavior of consumers and voters. For example, beverage or automobile companies show their products in beautiful natural settings or with beautiful female models to make the consumer feel as if purchasing these products will bring the feelings of pleasure or well-being they may associate with natural or human beauty. Similarly, politicians are also often adept at framing issues to trigger emotions of greed or fear rather than offering sound information on which voters can make good decisions. An effect similar to framing is known as anchoring, in which people rely on a piece of information that is not necessarily relevant as a reference point in making a decision. In one powerful example, graduate students at the MIT Sloan School of Management were first asked to write down the last two digits of their Social Security numbers. A short time later, they were asked whether they would pay this amount, in dollars, for various products. The subjects with the highest Social Security numbers indicated a willingness to pay about 300 percent more than those with the lowest numbers! The students had unconsciously used their Social Security numbers as an “anchor” in evaluating the worth of the products.4 In a real-world example of anchoring, the kitchen equipment company Williams Sonoma was able to increase the sales of its $279 bread maker after it introduced a “deluxe” model for $429. The introduction of the deluxe model created an anchoring effect that made the $279 bread maker seem like a relative bargain.5 anchoring effect: overreliance on a piece of information that may or may not be relevant as a reference point when making a decision In some circumstances, people tend to go with the “default option” when presented with a choice, even if the default option is not necessarily the rational choice. One classic example of the power of defaults looks at whether people are registered to donate their organs at death. 6 In some European countries, such as Austria, Belgium, and France, people are automatically registered as organ donors, but can opt out if they choose to. In these countries, about 98–99 percent of people stay registered. But in other European countries, such as Denmark, Germany, and the United Kingdom, people must sign up to be organ donors. In other words, the default option is that they are not registered. In these countries, less than 20 percent of people register to be organ donors. Such cases, where people prefer things to stay the same by doing nothing or favor the option that is familiar or expected, is referred to as status quo bias. status quo bias: a cognitive bias in favor of that which is familiar, expected, or automatic 3.2 THE ROLE OF TIME, EMOTIONS, AND OTHER INFLUENTIAL FACTORS Much evidence suggests that people seem to place undue emphasis on gains or benefits received today without considering the implications of their decisions for the future. A good example of this is the large number of people who have acquired significant high-interest credit card debt due to excessive spending. According to one study, about 6 percent of Americans are considered “compulsive shoppers,” who seek instant gratification with little concern for the troublesome consequences of running up a great deal of debt. Economists say that someone who does not pay much attention to the future consequences of his or her actions has a high time discount rate. This means that in his or her mind, future events are heavily discounted when weighed against the pleasures of today. On the other hand, people who have a low time discount rate would place more relevance on future consequences. For example, people who invest in a college education have a relatively low time discount rate, because they are willing to forgo current income or relaxation, and pay substantial tuition, to study for some expected future gain. Various studies have shown how people who have high discount rates are more likely to make seemingly irrational, or unhealthy choices inconsistent with their long-term goals. A 2016 study reported that those with high time discount rates are consistently found to be more likely to smoke, abuse alcohol, take illicit drugs, and engage in risky sexual behaviors.7 time discount rate: an economic concept describing the relative weighting of present benefits or costs compared to future benefits or costs The choices we make are also influenced by our emotions. The conventional view is that emotions get in the way of good decision-making, as they tend to interfere with logical reasoning. But again, research from behavioral economics suggests a more nuanced reality. It does not seem to be true that decisions based on logical reasoning are always “better” than those based on emotion or intuition. Instead, studies suggest that reasoning is most effective when used for making relatively simple economic decisions, but for more complex decisions, we can become overwhelmed by too much information. In such cases, emotions or intuition can sometimes help us make better decisions.8 For example, an experiment with college students involved their tasting five brands of strawberry jam.9 In one case, students simply ranked the jams from best to worst. The student rankings were highly correlated with the results of independent testing by Consumer Reports, suggesting that the students’ rankings were reasonable. But in another case, students were asked to fill out a written questionnaire explaining their preferences. As a result of the additional deliberation, students’ rankings were no longer significantly correlated with the Consumer Report rankings. The researcher concluded that overthinking might cut individuals off from the wisdom of their emotions, which are sometimes much better at assessing actual preferences.10 Altruism, meaning a concern of the well-being of others without thought about oneself, can also motivate our behavior. Although it would be idealistic to assume that altruism is the prime mover in human behavior, it is reasonable to assert that some elements of altruism enter into most people’s decision-making—contrary to the neoclassical assumption of rational, self-interested individuals. Especially relevant to economics is the fact that much economic behavior may be motivated by a desire to advance the common good—the general good of society, of which one’s own interests are only a part. People are often willing to participate in the creation of social benefits, even if this involves some personal sacrifice, as long as they feel that others are also contributing. altruism: actions focused on the well-being of others, without thought about oneself common good: the general well-being of society, including one’s own well-being A well-functioning economy cannot rely only on self-interest. Without such values as honesty, for example, even the simplest transaction would require costly and elaborate safeguards or policing. Imagine if you were afraid to put down your money before having in your hands the merchandise that you wished to purchase—and the merchant was afraid that as soon as you had what you wanted, you would run out of the store without paying. Such a situation would require police in every store—but what if the police themselves were unethical? Without ethical values that promote trust, inefficiencies would overwhelm any economic system. Fortunately, behavioral economics experiments demonstrate that people really do pay attention to social norms, even when this has a cost in terms of their narrow self-interest, as discussed in Box 4.1. BOX 4.1 THE ULTIMATUM GAME The “Ultimatum Game” is a behavioral economics experiment in which two people are told that they will be given a sum of money, say $20, to share. The first person gets to propose a way of splitting the sum. This person may offer to give $10 to the second person, or only $8, or $1, and keep the rest. The second person cannot offer any input to this decision but has the power to decide whether to accept the offer or reject it. If the second person rejects the offer, both people will walk away empty-handed. If the offer is accepted, they get the money and split it as the first person indicated. If the two individuals act only from narrow financial self-interest, then the first person should offer the second person the smallest possible amount—say $1—in order to keep the most for himself or herself. The second person should accept this offer because, from the point of view of pure financial self-interest, $1 is better than nothing. Contrary to such predictions, researchers find that deals that vary too far from a 50–50 split tend to be rejected. Specifically, offers of around 40 percent or more are almost always accepted, while offers of 20 percent or less are almost always rejected. 11 People would rather walk away with nothing than be treated in a way that they perceive as unfair. Also, whether out of a sense of fairness or a fear of rejection, individuals who propose a split often offer something close to 50–50. Such behavior suggests we have cooperative inclinations along with our more self-interested inclinations. Other recent evidence suggests that pursuing pure self-interest does not lead to happiness. A 2017 journal article by economist Tom Lane reviewed dozens of studies that looked at the relationship between happiness levels and economic behavior and concluded that: “happiness tends to result from pro-social behavior,” including trust and generosity.12 Meanwhile, there “is clear evidence of a negative relationship between happiness and selfishness.” These results indicate that if one wants to be happy in life, being trustful and generous might be more “rational” than being selfish. Finally, our brains, physiology, and genetics also play a role in influencing our decisionmaking. Referred to as neuroeconomics, this relatively new interdisciplinary field is based on approaches, such as using brain imaging, or a functional magnetic resonance imaging (fMRI) machine, to study the brain and predict human behavior. For example, one research study that used an fMRI machine to study the brain confirms the findings discussed previously—that when people engage in cooperative behavior, regions of the brain associated with positive emotions are activated.13 On the other hand, when observing others being treated unfairly, our brains react as if we ourselves had been treated unfairly.14 neuroeconomics: the interdisciplinary field that studies the role our brains, physiology, and genetics play in how we make economic decisions Now that we have considered several factors influencing economic behavior, we can present a model based on behavioral economics using concepts that have been suggested as alternatives to self-interested and rational behavior. 3.3 CONSUMER BEHAVIOR IN CONTEXTUAL ECONOMICS Recent research has generally refuted the neoclassical view of self-interested people making economic decisions that maximize their utility (or profits, in the case of businesses). We now use the lessons from the previous discussion to develop a more modern and accurate model of consumer behavior. One important factor in an economic model of behavior is information. Consider the decision to purchase a new automobile. Numerous factors go into such a decision, such as the cost of the car, the importance of fuel economy, safety features, the resale value, and maintenance costs. Making a rational decision requires that you first obtain all this information. The neoclassical approach tends to assume that rational economic actors have “complete information” concerning each choice in front of them. A variation on this assumption is that people will optimize by collecting information until the perceived costs of acquiring additional information exceed the perceived benefits. However, there is a logical problem with this assumption, as Nobel Laureate Herbert Simon points out: one cannot know if that extra information was worth the cost of gathering it until it has been gathered! Maybe some additional searching will yield valuable information, or maybe it won’t. Simon showed that one first needs to have complete knowledge of all choices in order to identify the optimal point at which one should cease gathering additional information. Accordingly, Simon maintained, people rarely optimize. Instead they do what he called satisficing; they choose an outcome that would be satisfactory (rather than optimal) and then seek an option that reaches that standard. In other words, they identify an option that is “good enough” rather than continuing to search for the ideal. satisfice: to choose an outcome that would be satisfactory and then seek an option that at least reaches that standard Economic decisions are always made subject to constraints, including limits on income and other resources and on physical or intellectual capacities. A universal constraint, for example, is time—you only have 24 hours in a day to allocate among competing activities such as sleeping, studying, eating, or entertainment. Given such constraints, satisficing seems to be a reasonable behavior. If an individual finds that the “satisfactory” level was set too low, a search for options that meet that level will result in a “solution” rather quickly. In this case, the level may then be adjusted to a higher standard. Conversely, if the level is set too high, a long search will not yield an acceptable outcome, and the “satisficer” may lower his or her expectations for the outcome. Another deviation from maximizing behavior as traditionally defined has been called meliorating—defined as starting from the present level of well-being and finding opportunities to do better. A simple example is a line fisherwoman who has found a whole school of haddock but wants to keep only one for her supper. She first catches a fish. She doesn’t stop there but goes on to catch a second fish, which she compares to the first one—keeping the larger and releasing the other. Each subsequent catch is compared to the one she has retained as the largest so far. At the end of the day, the fish that she takes home will be the largest of all those caught. meliorating: starting from the present level of well-being and continuously attempting to do better One result of using melioration as the real-world substitute for optimization is its implication that history matters: people view each successive choice in relation to their previous experience. It is commonly observed that people are reluctant to accept a situation that they perceive as inferior to previous situations. For example, workers are likely to resist pay cuts or switch to jobs with lower wages. Satisficing and meliorating may both be included under the term bounded rationality. The general idea is that, instead of considering all possible options, people limit their attention to some more-or-less arbitrarily defined subset of the universe of possibilities. With satisficing or meliorating behavior, people may not choose the “best” choices available to them, but they at least make decisions that move them toward their goals. bounded rationality: the hypothesis that people make choices among a somewhat arbitrary subset of all possible options due to limits on information, time, or cognitive abilities Let us now summarize the current thinking about consumer behavior, in five core principles, based on two recent journal articles and contrast it to the neoclassical model presented in Section 2.15 1. People may try to engage in maximizing behavior, but they often aren’t successful due to insufficient or inaccurate information, poor judgment, limited resources, and other issues. We might think of economic decisions as being a somewhat “muddled” process rather than the maximizing process envisioned by the neoclassical model. 2. People make economic decisions using various reference points to help them. We saw previously how framing and anchoring can influence economic decisions. 3. Most people have a “present bias” when making decisions with long-term impacts. Running up large credit card debts and under-investing in education are examples of “present-bias.” 4. While people often engage in self-interested behavior, they also care about the welfare of others, even people they do not know. People may care about others in order to increase their own well-being or out of true altruism and concern for the common good. Any model that assumes only self-interested behavior is inadequate. 5. The fact that people’s preferences are often not fixed or even fully known to them means that their decisions can be influenced through framing, anchoring, or present bias. We have discussed how these techniques may be used by advertisers or politicians to influence people’s behavior. But such approaches may also be used to design policies that might encourage people to make healthier and wiser choices, as we will discuss in the final section of this chapter. The model just described is supported by many scientific studies, and it is also consistent with experience and common sense. We are all human beings, often far from perfect, normally with good intentions but subject to many influential factors. Discussion Questions 1. Can you think of any economic situations where people seem to make irrational decisions? For the most part, do you think people are rational or irrational? 2. Discuss how one or more conclusions reached by behavioral economists help you to understand an experience that you have had making an economic decision. 4. CONSUMPTION IN SOCIAL CONTEXT In modern societies, consumption is as much a social activity as an economic activity. Consumption is closely tied to personal identity, and it has become a means of communicating social messages. We are immersed in the culture of consumerism, where people’s sense of identity and meaning are often defined through their purchase of consumer goods and services. An increasing range of social interactions are influenced by consumerist values. consumerism: having one’s sense of identity and meaning significantly defined through the purchase and use of consumer goods and services The rise of consumerism is also deeply connected to capitalism, where the profit-driven nature of market competition imposes strong pressure on firms to increase their production and sales. As we will see, firms often devote an enormous amount of resources to advertising and other marketing strategies to encourage consumption. Consumption behavior has evolved over time, with influences from various cultural, religious, political, and social forces, as well as from the availability of environmental resources. Consumerism is often traced back to the Industrial Revolution, when technological advances in mass production made it possible to increase consumption levels. The rise of consumerism is also related to other historical developments such as the invention of department stores, the expansion of consumer credit (with the invention of credit cards), and changes in work ethics as workers came to see themselves as consumers and became more inclined to work full-time or even overtime (instead of advocating for a shorter work week) in order to increase their consumption. Despite these developments, consumerism has not become a global phenomenon even in the twenty-first century. Many people around the world are still simply too poor to be considered modern consumers. Over 700 million people, about 10 percent of humanity lives in “extreme” poverty, defined by the World Bank as living on less than $1.90 per day. 16 Poverty is about more than just low income. The United Nations defines absolute deprivation as “a condition characterized by severe deprivation of basic human needs, including food, safe drinking water, sanitation facilities, health, shelter, education and information.”17 The poorest of developing countries, particularly in sub-Saharan Africa and Southern Asia, often lack the resources needed to lift their populations out of absolute deprivation. absolute deprivation: severe deprivation of basic human needs Additionally, in numerous places around the world, cultural and religious values exist that seek to restrain the consumer society. For example, Buddhism teaches a “middle path” that emphasizes material simplicity, nonviolence, and inner peace. Even in the United States, some Americans are motivated to lower their consumption levels with the goal of reducing environmental impacts and focusing more on social connections. In this section, we discuss some social aspects that influence consumer behavior. 4.1 SOCIAL COMPARISONS As social beings, we compare ourselves to other people. In a consumer society, such comparison is commonly in terms of income and consumption levels. We are often motivated to maintain a material lifestyle that is comparable to a reference group, which includes people around us who influence our behavior because we compare ourselves to them. Most people have various reference groups, traditionally including our neighbors, our coworkers, and other members of our family. We are also influenced as consumers by aspirational groups, groups to which a consumer wishes he or she could belong. People often buy, dress, and behave like the group—corporate executives, rock stars, athletes, or whoever—with whom they would like to identify. reference group: the group to which an individual compares himself or herself aspirational group: the group to which an individual aspires to belong This tendency to compare ourselves with a reference group has evolved over time. Economist Juliet Schor suggests that in the 1950s and 1960s, people usually compared themselves to individuals with similar incomes and backgrounds, but in recent decades, people have become “more likely to compare themselves with, or aspire to the lifestyle of, those far above them in the economic hierarchy.”18 One reason for this might be the transformation in media representation, which has over time become increasingly depicted by upper-class lifestyles. Schor’s research indicates that the more television one watches, the more he or she is likely to spend, holding other variables, such as income, constant. Schor concludes that identifying with unrealistic aspirational groups leads many people to consume well above their means, acquiring large debts and suffering frustration, as they attempt to join those groups through their consumption patterns but fail to achieve the income to sustain them. Because people tend to evaluate themselves relative to reference and aspirational groups, increasing inequality may result in people feeling as if they are falling behind even when their incomes are actually increasing. Schor goes on to note that: The problem is not just that more consumption doesn’t yield more satisfaction, but that it always has a cost. The extra hours we have to work to earn the money cut into personal and family time. Whatever we consume has an ecological impact. . . . We find ourselves skimping on invisibles such as insurance, college funds, and retirement savings as the visible commodities somehow become indispensable. . . . We are impoverishing ourselves in pursuit of a consumption goal that is inherently unattainable.19 Modern technology means that nearly everyone has some exposure to the “lifestyles of the rich and famous” engaging in conspicuous consumption. The result is the creation of widespread feelings of relative deprivation, that is, the sense that one’s own condition is inadequate because it is inferior to someone else’s circumstances. Such feelings can diminish individual well-being and one’s sense of self-respect and self-confidence. Relative deprivation is a condition that exists in all countries to some extent, but it is more extreme in countries where the gap between rich and poor is greatest. relative deprivation: the feeling of insufficiency that comes from comparing oneself with someone who has more 4.2 ADVERTISING Advertising is central to the rise of consumerism. As Christopher Lasch writes, The importance of advertising is not that it invariably succeeds in its immediate purpose, . . . but simply that it surrounds people with images of the good life in which happiness depends on consumption. The ubiquity of such images leaves little space for competing conceptions of the good life.20 Though advertising is often justified by economists as a source of information about the goods and services available in the market, a vast amount of advertising sells consumer culture and influences consumers’ values and their spending behavior. Recent research shows that advertising is associated with problems such as obesity, attention deficit disorder, heart disease, and other negative consequences. Furthermore, advertising commonly portrays unrealistic body images, traditionally for women but more recently for men as well. (See Box 4.2.) Global advertising expenditures were about $520 billion in 2016, equivalent to the national economy of Argentina or Sweden. About one-third of global advertising spending takes place in the United States. According to one estimate, Americans are exposed to around 5,000 commercial messages per day, up from around 2,000 per day in 1980s.21 China recently became the world’s second-largest advertising market. BOX 4.2 WOMEN AND ADVERTISING A 2007 report by the American Psychological Association concluded that advertising and other media images encourage girls to focus on physical appearance and sexuality, with harmful results for their emotional and physical well-being.22 The research project reviewed data from numerous media sources and found that 85 percent of the sexualized images of children were of girls. The lead author of the report, Dr. Eileen L. Zurbriggen, points out that the sexualization of girls in media is likely to have negative effects on girls in a variety of domains, including cognitive functioning, physical and mental health, and healthy sexual development. She concludes, “As a society, we need to replace all of these sexualized images with ones showing girls in positive settings—ones that show the uniqueness and competence of girls.” Three of the most common mental health problems associated with exposure to sexualized images and unrealistic body ideals are eating disorders, low self-esteem, and depression. It is estimated that 8 million Americans suffer from an eating disorder—7 million of them women.23 According to a 2012 article, most female models would be considered anorexic according to their body mass index. Twenty years ago, the average model weighed 8 percent less than the average woman; now it is 23 percent less.24 Jean Kilbourne, an author and filmmaker, has been lobbying for advertising reforms since the 1960s. She has produced four documentaries on the negative effects of advertising on women, most recently in 2010, under the title Killing Us Softly. Kilbourne notes that virtually all photos of models in advertisements have been touched up, eliminating wrinkles, blemishes, extra weight, and even skin pores. She believes that we need to change the environment of advertising through public policy.25 4.3 PRIVATE VERSUS PUBLIC CONSUMPTION The growth of consumerism has altered the balance between private and public consumption. Public infrastructure has been shaped by the drive to sell and consume new products, and the availability of public and private options, in turn, shapes individual consumer choices. In the early 1930s, for example, many major U.S. cities—including Los Angeles—had extensive and nonpolluting electric streetcar systems. However, due to a range of factors, including unsupportive policies, poor city planning, and the actions of companies such as General Motors in buying up streetcar systems and then converting many of them to buslines, the presence of streetcars declined in many U.S. cities.26 The ongoing viability of streetcar systems elsewhere in the United States, and across the world, suggests that many of the streetcar systems could have continued had the playing field been more level. U.S. government support for highway construction in the 1950s further hastened the decline of rail transportation, made possible the spread of suburbs far removed from workplaces, and encouraged the purchase of automobiles. These examples illustrate that many of the choices that you have, as an individual, depend on decisions made for you by businesses and governments. Living in Los Angeles today would be significantly different if it had better maintained and supported its streetcar system rather than cars and buses. As more people carry cell phones and bottled water, pay telephones and drinking fountains either cease to exist or become less well maintained, leading more people to carry cell phones and bottled water. The tradeoffs between public infrastructure and private consumption are significant. As economist Robert Frank notes, “at a time when our spending on luxury goods is growing four times as fast as overall spending, our highways, bridges, water supply systems, and other parts of our public infrastructure are deteriorating, placing lives in danger.”27 4.4 AFFLUENZA AND VOLUNTARY SIMPLICITY One of the main lessons of economics is that we should always weigh the marginal benefits of something against its marginal costs. In the case of consumerism, these costs include less time for leisure, friends, and family; greater environmental impacts; and negative psychological and physical effects. In short, there can be such a thing as too much consumption—when the marginal benefits of additional consumption are exceeded by the associated marginal costs. Two public television specials, as well as a book,28 refer to the problem of “affluenza”—a “disease” with symptoms of “overload, debt, anxiety and waste resulting from the dogged pursuit of more.” Some people see the solution to affluenza as rejecting consumerism as a primary goal in life. The term voluntary simplicity refers to a conscious decision to live with a limited or reduced level of consumption in order to increase one’s quality of life. voluntary simplicity: a conscious decision to live with a limited or reduced level of consumption in order to increase one’s quality of life The motivations for voluntary simplicity vary, including environmental concerns, a desire to have more free time to travel or raise a family, and to focus on non-consumer goals. Voluntary simplicity does not necessarily mean rejecting progress or living a life of poverty. Some people ascribing to voluntary simplicity have left high-paying jobs after many years, while others are young people content to live on less. Perhaps the unifying theme for those practicing voluntary simplicity is that they seek to determine what is “enough”—a point beyond which further accumulation of consumer goods is either not worth the personal, ecological, and social costs or simply not desirable. Unlike traditional economics, which has assumed that people always want more goods and services, voluntary simplicity sees these as only intermediate goals toward more meaningful final goals. (See Box 4.3.) BOX 4.3 VOLUNTARY SIMPLICITY Greg Foyster had a good job in advertising in Australia. But in 2012, he and his partner Sophie Chishkovsky decided to give up their consumer lifestyles and bicycle along the coast of Australia, interviewing people who have decided to embrace voluntary simplicity and eventually write a book about their experience. Voluntary simplicity is a growing movement in Australia, with several popular websites and a regular column on the topic in the Australian Women’s Weekly. Foyster explains: The overall idea is that you should step out of the consumer economy that we’re all plugged into and start doing things for yourself because that is how you’ll find happiness. The best way to think of it is as an exchange. In our society people trade their time for money, and then they spend that money on consumer items. . . . It’s really about stepping back and deciding what’s important to you in your life. Foyster found that his career in advertising conflicted with his personal sense of ethics. His “eureka” moment came during an advertising awards event when he saw colleagues being praised for their efforts to sell people products they didn’t need or even want. He realized that most of the world’s environmental problems stem from overconsumption, not overpopulation. He says: When I worked in advertising, I had a decent income, I had a prestigious job, and I was miserable. I chose to leave the industry because it wasn’t making me happy; it wasn’t my purpose in life. And now I have a much lower income; I work as a freelance writer, which isn’t the most prestigious job. But I am so much more happy because I know what is important to me and I’m doing what I love and I have everything I need.29 Discussion Questions 1. What are your reference groups? Describe why you consider these your reference groups. What are your aspirational groups? Why do you aspire to be a member of these groups? 2. Think about at least one fashion item you own, such as an item of clothing, jewelry, or accessory, that you think says a lot about who you are. What do you think it says about you? Do you think others interpret the item in the same way that you do? How much do you think that you were influenced by advertising or other media in your views about the item? 5. CONSUMPTION IN AN ENVIRONMENTAL CONTEXT The production process that creates every consumer product requires natural resources and generates some waste and pollution. However, we are normally only vaguely aware of the ecological impact of the processes that supply us with consumer goods. Most of us are unaware that, for example, it requires about 600 gallons of water to make a quarter-pound hamburger or that making a computer chip generates 4,500 times its weight in waste.30 (See Box 4.4.) BOX 4.4 THE ENVIRONMENTAL STORY OF A T-SHIRT T-shirts are perhaps the most ubiquitous article of clothing. What are the environmental impacts of one T-shirt?31 Consider a cotton/polyester blend T-shirt, weighing about 4 ounces. Polyester is made from petroleum—a few tablespoons are required to make a T-shirt. During the extraction and refining of the petroleum, one-fourth of the polyester’s weight is released in air pollution, including nitrogen oxides, particulates, carbon monoxide, and heavy metals. About ten times the polyester’s weight is released in carbon dioxide, contributing to global climate change. Cotton grown with nonorganic methods relies heavily on chemical inputs. Cotton accounts for 10 percent of the world’s use of pesticides. A typical cotton crop requires six applications of pesticides, commonly organophosphates that can damage the central nervous system. Cotton is also one of the most intensely irrigated crops in the world, contributing to water shortages for other uses. T-shirt fabric is bleached and dyed with chemicals including chlorine, chromium, and formaldehyde. Cotton resists coloring, so about one-third of the dye may be carried off in the waste stream. Most T-shirts are manufactured in Asia and then shipped by boat to their destination, with further transportation by train and truck. Each transportation step involves the release of additional air pollution and carbon dioxide. Despite the impacts of T-shirt production and distribution, most of the environmental impact associated with T-shirts occurs after purchase. Washing and drying a T-shirt just ten times requires about as much energy as was needed to manufacture the shirt. Laundering will also generate more solid waste than the production of the shirt, mainly from sewage sludge and detergent packaging. How can one reduce the environmental impacts of T-shirts? One obvious step is to avoid buying too many shirts in the first place. Buy shirts made of organic cotton or recycled polyester, or consider buying used clothing. Wash clothes only when they need washing, not necessarily every time you wear something. Make sure that you wash only full loads of laundry, and wash using cold water whenever possible. Finally, avoid using a clothes dryer— clothes dry naturally for free by hanging on a clothesline or a drying rack. 5.1 THE LINK BETWEEN CONSUMPTION AND THE ENVIRONMENT One measure used to quantify the ecological impacts of consumerism is the amount of “trash” generated by an economy. In 2014, the U.S. economy generated over 250 million tons of municipal solid waste, which consisted mostly of paper, food waste, and yard waste.32 But most of the waste generation in a consumer society occurs during the extraction, processing, or manufacturing stages—these impacts are normally hidden from consumers. According to a 2012 analysis, the U.S. economy requires about 8 billion tons of material inputs annually, which is equivalent to more than 25 tons per person.33 The vast majority of this material is discarded as mining waste, crop residue, logging waste, chemical runoff, and other waste prior to the consumption stage. Perhaps the most comprehensive attempt to quantify the overall ecological impact of consumption is the ecological footprint measure. This approach estimates how much land area a human society requires, both to provide all that it takes from nature and to absorb the society’s waste and pollution. Although the details of ecological footprint calculations are subject to debate, it does provide a useful way to compare the overall ecological impact of consumption in different countries. ecological footprint: a measure of the human impact on the environment, measured as the land area required to supply a society’s resources and assimilate its waste and pollution We see in Figure 4.5 below that the ecological footprint per capita varies significantly across countries. The United States has one of the highest per-capita ecological footprints (the percapita footprints of only six countries are higher, the highest being Qatar).34 The average European has a footprint about 40 percent lower than the average American, while the average Chinese has a footprint that is only one-quarter of that of a U.S. citizen. Perhaps the most significant implication of the ecological footprint research is that the world is now in a situation of “overshoot”—our global use of resources and generation of waste exceeds the global capacity to supply resources and assimilate waste, by about 60 percent. As seen in Figure 4.5, the total amount of productive area available on earth (the average “biocapacity”) is only 1.63 hectares per person. In other words, for humans to live in an ecologically sustainable manner, the average person’s ecological impacts could only be about that of the average Indonesian. However, an increasing number of people in the world seek to consume at a level equivalent to a typical American. We would require five earths to provide the resources needed and assimilate the waste to meet such a demand.