Chapter 8

Question 1

The choices that you make as a buyer of goods and services—your consumption choices—are influenced by many factors. We can summarize them under two broad headings:

Answer 1

Consumption possibilities

Preferences

Question 2

Your consumption possibilities are all the things that _____________.

Answer 2

Your consumption possibilities are all the things that you can afford to buy.

Question 3

You can afford many different combinations of goods and services, but they are all limited by your ______ and by the prices that you must pay.

Answer 3

You can afford many different combinations of goods and services, but they are all limited by your income and by the prices that you must pay.

For example, you might decide to spend a big part of your income on a gym membership and personal trainer and little on movies and music, or you might spend lots on movies and music and use the free gym at school.

Question 4

Budget line

Answer 4

The limit to a household’s consumption choices. It marks the boundary between those combinations of goods and services that a household can afford to buy and those that it cannot afford.

When Lisa spends all her income, she reaches the limits to her consumption possibilities. We describe this limit with a budget line

Question 5

Fig 8.1

Answer 5

Figure 8.1 illustrates Lisa’s consumption possibilities of movies and pop and her budget line. Lisa has an income of $40 a month, the price of a movie is $8, and the price of pop is $4 a case. Rows A through F in the table show six possible ways of allocating $40 to these two goods. For example, in row A Lisa buys 10 cases of pop and sees no movies; in row F she sees 5 movies and buys no pop; and in row C she sees 2 movies and buys 6 cases of pop.

Points A through F in the graph illustrate the possibilities presented in the table, and the line passing through these points is Lisa’s budget line.

Question 6

The budget line constrains choices: It marks the boundary between what is affordable and unaffordable. Lisa can afford all the points ____ the budget line and _____ it. Points ______ the line are unaffordable. Fig 8.1

Answer 6

The budget line constrains choices: It marks the boundary between what is affordable and unaffordable. Lisa can afford all the points on the budget line and inside it. Points outside the line are unaffordable.

Question 7

Consumption possibilities change when ______ or _______ change.

Answer 7

Consumption possibilities change when income or prices change.

Question 8

A rise in income shifts the budget line __________ but ____________

Answer 8

A rise in income shifts the budget line outward but leaves its slope unchanged

Question 9

A change in a price changes ________________

Answer 9

A change in a price changes the slope of the line

Question 10

Utility

Answer 10

The benefit or satisfaction that a person gets from the consumption of goods and services.

Question 11

Total utility

Answer 11

The total benefit that a person gets from the consumption of all the different goods and services.

Question 12

Total utility depends on the level of __________—more __________ generally gives more total utility.

Answer 12

Total utility depends on the level of consumption—more consumption generally gives more total utility.

Question 13

Total Utility Information

Answer 13

To illustrate the concept of total utility, think about Lisa’s choices. We tell Lisa that we want to measure her utility from movies and pop. We can use any scale that we wish to measure her total utility and we give her two starting points: (1) We will call the total utility from no movies and no pop zero utility; and (2) We will call the total utility she gets from seeing 1 movie a month 50 units.

We then ask Lisa to tell us, using the same scale, how much she would like 2 movies, and more, up to 10 movies a month. We also ask her to tell us, on the same scale, how much she would like 1 case of pop a month, 2 cases, and more, up to 10 cases a month.

In Table 8.1, the columns headed “Total utility” show Lisa’s answers. Looking at those numbers, you can say a lot about how much Lisa likes pop and movies. She says that 1 case of pop gives her 75 units of utility—50 percent more than the utility that she gets from seeing 1 movie. You can also see that her total utility from pop climbs more slowly than her total utility from movies. This difference turns on the second utility concept: marginal utility.

Question 14

Marginal utility

Answer 14

The change in total utility resulting from a one-unit increase in the quantity of a good consumed.

In Table 8.1, the columns headed “Marginal utility” show Lisa’s marginal utility from movies and pop. You can see that if Lisa increases the pop she buys from 1 to 2 cases a month, her total utility from pop increases from 75 units to 123 units. For Lisa, the marginal utility from the second case each month is 48 units (123−75).

The marginal utility numbers appear midway between the quantities of pop because it is the change in the quantity she buys from 1 to 2 cases that produces the marginal utility of 48 units.

Question 15

Marginal utility is _______, but it _______ as the quantity of a good consumed increases.

Answer 15

Marginal utility is positive, but it diminishes as the quantity of a good consumed increases.

Question 16

The things that people enjoy and want more of have a __________ marginal utility.

Answer 16

The things that people enjoy and want more of have a positive marginal utility.

Question 17

Diminishing Marginal Utility - Movie and Pop example Information, not definition

Answer 17

As Lisa sees more movies, her total utility from movies increases but her marginal utility from movies decreases. Similarly, as she consumes more pop, her total utility from pop increases but her marginal utility from pop decreases.

Question 18

Diminishing marginal utility (definition)

Answer 18

The tendency for marginal utility to decrease as the quantity consumed of a good increases

Question 19

Your Diminishing Marginal Utility

Answer 19

You’ve been studying all day and into the evening, and you’ve been too busy finishing an assignment to shop for pop. A friend drops by with a can of pop. The utility you get from that pop is the marginal utility from your first pop of the day—from one can. On another day you’ve been on a pop binge. You’ve been working on an assignment, but you’ve guzzled 10 cans of pop while doing so, and are now totally wired. You are happy enough to have one more can, but the thrill that you get from it is not very large. It is the marginal utility from the eleventh can in a day.

Question 20

Graphing Lisa’s Utility Schedules

Answer 20

Figure 8.2(a) illustrates Lisa’s total utility from pop. The more pop Lisa consumes in a month, the more total utility she gets. Her total utility curve slopes upward.

Figure 8.2(b) illustrates Lisa’s marginal utility from pop. It is a graph of the marginal utility numbers in Table 8.1. This graph shows Lisa’s diminishing marginal utility from pop. Her marginal utility curve slopes downward as she consumes more pop.

Question 21

Find the Just-Affordable Combinations - Table 8.2 and Fig 8.1

Answer 21

Table 8.2 shows the combinations of movies and pop that Lisa can afford and that exhaust her $40 income. For example, in row A, Lisa buys only pop and at $4 a case she can buy 10 cases. In row B, Lisa sees 1 movie and buys 8 cases of pop. She spends $8 on the movie. At $4 a case, she spends $32 on pop and can buy 8 cases. The combination in row B just exhausts her $40. The combinations shown in the table are the same as those plotted on her budget line in Fig. 8.1.

We noted that the budget line shows that Lisa can also afford any combination inside the budget line. The quantities in those combinations would be smaller than the ones shown in Table 8.2, and they do not exhaust her $40. But smaller quantities don’t maximize her utility. Why? The marginal utilities of movies and pop are positive, so the more of each that Lisa buys, the more total utility she gets.

Question 22

Find the Total Utility for Each Just-Affordable Combination - Table 8.2

Answer 22

Table 8.2 shows the total utility that Lisa gets from the just-affordable quantities of movies and pop. The second and third columns show the numbers for movies and the fourth and fifth columns show those for pop.

The centre column adds the total utility from movies to the total utility from pop. This number, the total utility from movies and pop, is what Lisa wants to maximize.

In row A of the table, Lisa sees no movies and buys 10 cases of pop. She gets no utility from movies and 260 units of utility from pop. Her total utility from movies and pop (the centre column) is 260 units.

In row C of the table, Lisa sees 2 movies and buys 6 cases of pop. She gets 90 units of utility from movies and 225 units of utility from pop. Her total utility from movies and pop is 315 units. This combination of movies and pop maximizes Lisa’s total utility. That is, given the prices of movies and pop, Lisa’s best choice when she has $40 to spend is to see 2 movies and buy 6 cases of pop.

If Lisa sees 1 movie, she can buy 8 cases of pop, but she gets only 298 units of total utility—17 units less than the maximum attainable. If she sees 3 movies, she can buy only 4 cases of pop. She gets 305 units of total utility—10 units less than the maximum attainable.

Question 23

Consumer equilibrium

Answer 23

A situation in which a consumer has allocated all his or her available income in the way that, given the prices of goods and services, maximizes his or her total utility.

Lisa’s consumer equilibrium is 2 movies and 6 cases of pop. (Table 8.2)

Question 24

Marginal utility per dollar

Answer 24

The marginal utility from a good that results from spending one more dollar on it. It is calculated as the marginal utility from the good divided by its price.

Question 25

Marginal utility per dollar - information

Answer 25

The distinction between these two marginal concepts is clearest for a good that is infinitely divisible, such as gasoline. You can buy gasoline by the smallest fraction of a litre and literally choose to spend one more or one less dollar at the pump. The increase in total utility that results from spending one more dollar at the pump is the marginal utility per dollar from gasoline.

When you buy a movie ticket or a case of pop, you must spend your dollars in bigger lumps (you can’t divide $10 ticket into 5 small $2 dollar tickets, it’s “bigger lump” than having the choice to spending a dollar more, or even a penny more, or less at a gas station). To buy our marginal movie ticket or case of pop, you must spend the price of one unit and your total utility increases by the marginal utility from that item. So to calculate the marginal utility per dollar for movies (or pop), we must divide marginal utility from the good by its price.

Question 26

A consumer’s total utility is maximized by following the rule:

Answer 26

Spend all the available income.

Equalize the marginal utility per dollar for all goods.

Question 27

Spend All the Available Income - example information

Answer 27

Because more consumption brings more utility, only those choices that exhaust income can maximize utility. For Lisa, combinations of movies and pop that leave her with money to spend don’t give her as much total utility as those that exhaust her $40 per month income.

Question 28

Equalize the Marginal Utility per Dollar

Answer 28

The basic idea behind this rule is to move dollars from good B to good A if doing so increases the utility from good A by more than it decreases the utility from good B. Such a utility-increasing move is possible if the marginal utility per dollar from good A exceeds that from good B.

But buying more of good A decreases its marginal utility. And buying less of good B increases its marginal utility. So by moving dollars from good B to good A, total utility rises, and the gap between the marginal utilities per dollar gets smaller.

As long as the gap exists—as long as the marginal utility per dollar from good A exceeds that from good B—total utility can be increased by spending more on A and less on B. But when enough dollars have been moved from B to A to make the two marginal utilities per dollar equal, total utility cannot be increased further. Total utility is maximized.

Question 29

Too Much Pop and Too Few Movies - example info Fig. 8.3

Answer 29

In row B, Lisa sees 1 movie a month and consumes 8 cases of pop a month. Her marginal utility from seeing 1 movie a month is 50 units. Because the price of a movie is $8, Lisa’s marginal utility per dollar from movies is 50 units divided by $8, or 6.25 units of utility per dollar.

Lisa’s marginal utility from pop when she consumes 8 cases of pop a month is 10 units. Because the price of pop is $4 a case, Lisa’s marginal utility per dollar from pop is 10 units divided by $4, or 2.50 units of utility per dollar.

When Lisa sees 1 movie and consumes 8 cases of pop a month, her marginal utility per dollar from pop is less than her marginal utility per dollar from movies.

If Lisa spent an extra dollar on movies and a dollar less on pop, her total utility would increase. She would get 6.25 units from the extra dollar spent on movies and lose 2.50 units from the dollar less spent on pop. Her total utility would increase by 3.75 units (6.25−2.50)

Question 30

Too Little Pop and Too Many Movies - example info Fig. 8.3

Answer 30

In row D, Lisa sees 3 movies a month and consumes 4 cases of pop. Her marginal utility from seeing the third movie a month is 32 units. At a price of $8 a movie, Lisa’s marginal utility per dollar from movies is 32 units divided by $8, or 4 units of utility per dollar.

Lisa’s marginal utility from pop when she buys 4 cases a month is 24 units. At a price of $4 a case, Lisa’s marginal utility per dollar from pop is 24 units divided by $4, or 6 units of utility per dollar.

When Lisa sees 3 movies and consumes 4 cases of pop a month, her marginal utility per dollar from pop exceeds her marginal utility per dollar from movies.

If Lisa spent an extra dollar on pop and a dollar less on movies, her total utility would increase. She would get 6 units from the extra dollar spent on pop and she would lose 4 units from the dollar less spent on movies. Her total utility would increase by 2 units (6−4).

Question 31

Utility-Maximizing Movies and Pop - example info Fig. 8.3

Answer 31

In Fig. 8.3, if Lisa moves from row B to row C, she increases the movies she sees from 1 to 2 a month and decreases the pop she consumes from 8 to 6 cases a month. Her marginal utility per dollar from movies falls to 5 and her marginal utility per dollar from pop rises to 5.

Similarly, if Lisa moves from row D to row C, she decreases the movies she sees from 3 to 2 a month and increases the pop she consumes from 4 to 6 cases a month. Her marginal utility per dollar from movies rises to 5 and her marginal utility per dollar from pop falls to 5.

When Lisa sees 2 movies and consumes 6 cases of pop a month, her marginal utility per dollar from pop equals her marginal utility per dollar from movies.

Lisa can’t move from this allocation of her budget without making herself worse off.

Question 32

If the marginal gain from an action ________ the marginal loss, take the action

Answer 32

If the marginal gain from an action exceeds the marginal loss, take the action

Question 33

Lisa’s Preferences

Answer 33

Check word document to see this section

Question 34

Units of Utility Don’t Matter

Answer 34

Lisa’s marginal utility from 6 cases of pop is one-half of her marginal utility from 2 movies. So if the marginal utility from the second movie is 40 units, then the marginal utility from the sixth case of pop is 20 units. But if we call the marginal utility from the second movie 50 units, then the marginal utility from the sixth case of pop is 25 units. The units of utility are arbitrary.

Question 35

Predictions of Marginal Utility Theory

Answer 35

You will see that marginal utility theory predicts the law of demand. The theory also predicts that a fall in the price of a substitute of a good decreases the demand for the good and that for a normal good, a rise in income increases demand.

Question 36

To derive these predictions, we will study the effects of three events: (Predictions of Marginal Utility Theory)

Answer 36

A fall in the price of a movie

A rise in the price of pop

A rise in income

Question 37

You can find the effect of a fall in the price of a movie on the quantities of movies and pop that Lisa buys in a three-step calculation:

Answer 37

Determine the just-affordable combinations of movies and pop at the new prices.

Calculate the new marginal utilities per dollar from the good whose price has changed.

Determine the quantities of movies and pop that make their marginal utilities per dollar equal.

Question 38

Affordable Combinations (table 8.3)

Answer 38

The lower price of a movie means that Lisa can afford more movies or more pop. Table 8.3 shows her new affordable combinations. In row A, if she continues to see 2 movies a month, she can now afford 8 cases of pop; and in row B, if she continues to buy 6 cases of pop, she can now afford 4 movies. Lisa can afford any of the combinations shown in the rows of Table 8.3.

Question 39

New Marginal Utilities per Dollar from Movies (table 8.3)

Answer 39

A person’s preferences don’t change just because a price has changed. With no change in her preferences, Lisa’s marginal utilities in Table 8.3 are the same as those in Table 8.1. But because the price of a movie has changed, the marginal utility per dollar from movies changes. In fact, with a halving of the price of a movie from $8 to $4, the marginal utility per dollar from movies has doubled.

The numbers in Table 8.3 show Lisa’s new marginal utility per dollar from movies for each quantity of movies. The table also shows Lisa’s marginal utility per dollar from pop for each quantity.

Question 40

Equalizing the Marginal Utilities per Dollar (table 8.3)

Answer 40

You can see that if Lisa continues to see 2 movies a month and buy 6 cases of pop, her marginal utility per dollar from movies (row A) is 10 units and her marginal utility per dollar from pop (row B) is 5 units. Lisa is buying too much pop and too few movies. If she spends a dollar more on movies and a dollar less on pop, her total utility increases by 5 units (10−5).

If Lisa continues to buy 6 cases of pop and increases the number of movies to 4 (row B), her marginal utility per dollar from movies falls to 7 units, but her marginal utility per dollar from pop is 5 units. Lisa is still buying too much pop and seeing too few movies. If she spends a dollar more on movies and a dollar less on pop, her total utility increases by 2 units (7−5).

But if Lisa sees 6 movies and buys 4 cases of pop a month (row C), her marginal utility per dollar from movies (6 units) equals her marginal utility per dollar from pop and she is maximizing utility. If Lisa moves from this allocation of her budget in either direction, her total utility decreases.

Lisa’s increased purchases of movies results from a substitution effect—she substitutes the now lower-priced movies for pop—and an income effect—she can afford more movies.

Question 41

Lisa’s increase in the quantity of movies that she sees is a change in the quantity demanded. It is the change in the quantity of movies that she plans to see each month when the price of a movie changes and all other influences on buying plans remain the same. We illustrate a change in the quantity demanded by a _____________.

Answer 41

Lisa’s increase in the quantity of movies that she sees is a change in the quantity demanded. It is the change in the quantity of movies that she plans to see each month when the price of a movie changes and all other influences on buying plans remain the same. We illustrate a change in the quantity demanded by a movement along a demand curve.

Question 42

Figure 8.4(a)

Answer 42

Figure 8.4(a) shows Lisa’s demand curve for movies. When the price of a movie is $8, Lisa sees 2 movies a month. When the price of a movie falls to $4, she sees 6 movies a month. Lisa moves downward along her demand curve for movies.

Question 43

The decrease in the quantity of pop that Lisa buys is the change in the quantity of pop that she plans to buy at a given price of pop when the price of a movie changes. It is a change in her demand for pop. We illustrate a change in demand by ______________.

Answer 43

The decrease in the quantity of pop that Lisa buys is the change in the quantity of pop that she plans to buy at a given price of pop when the price of a movie changes. It is a change in her demand for pop. We illustrate a change in demand by a shift of a demand curve.

Question 44

Figure 8.4(b)

Answer 44

Figure 8.4(b) shows Lisa’s demand curve for pop. The price of pop is fixed at $4 a case. When the price of a movie is $8, Lisa buys 6 cases of pop on demand curve D0. When the price of a movie falls to $4, Lisa buys 4 cases of pop on demand curve D1. The fall in the price of a movie decreases Lisa’s demand for pop. Her demand curve for pop shifts leftward. For Lisa, pop and movies are substitutes.

Question 45

Table 8.4

Answer 45

Table 8.4 shows Lisa’s new affordable combinations. In row A, if she continues to buy 4 cases of pop a month she can afford to see only 2 movies; and in row B, if she continues to see 6 movies a month, she can afford only 2 cases of pop.

Table 8.4 show Lisa’s marginal utility per dollar from pop for each quantity of pop when the price is $8 a case. The table also shows Lisa’s marginal utility per dollar from movies for each quantity.

If Lisa continues to buy 4 cases of pop (row A), her marginal utility per dollar from pop is 3. But she must cut the movies she sees to 2, which increases her marginal utility per dollar from movies to 10. Lisa is buying too much pop and too few movies. If she spends a dollar less on pop and a dollar more on movies, her utility increases by 7 units (10−3).

But if Lisa sees 6 movies a month and cuts her pop to 2 cases (row B), her marginal utility per dollar from movies (6 units) equals her marginal utility per dollar from pop. She is maximizing utility.

Lisa’s decreased purchases of pop results from an income effect—she can afford fewer cases and she buys fewer cases. But she continues to buy the same quantity of movies.

Question 46

Figure 8.5

Answer 46

Figure 8.5 shows these points on Lisa’s demand curve for pop. It also shows the change in the quantity of pop demanded when the price of pop rises and all other influences on Lisa’s buying plans remain the same.

In this example, Lisa continues to buy the same quantity of movies, but this outcome does not always occur. It is a consequence of Lisa’s preferences. With different marginal utilities, she might have decreased or increased the quantity of movies that she sees when the price of pop changes.

Question 47

Table 8.5 - A Rise In Income

Answer 47

Table 8.5 shows the calculations needed to answer this question. If Lisa continues to see 6 movies a month, she can now afford to buy 8 cases of pop (row A); if she continues to buy 4 cases of pop, she can now afford to see 10 movies (row C).

In row A, Lisa’s marginal utility per dollar from movies is greater than her marginal utility per dollar from pop. She is buying too much pop and too few movies. In row C, Lisa’s marginal utility per dollar from movies is less than her marginal utility per dollar from pop. She is buying too little pop and too many movies. But in row B, when Lisa sees 8 movies a month and buys 6 cases of pop, her marginal utility per dollar from movies equals that from pop. She is maximizing utility.

Question 48

Figure 8.6

Answer 48

Figure 8.6 shows the effects of the rise in Lisa’s income on her demand curves for movies and pop. The price of each good is $4. When Lisa’s income rises to $56 a month, she sees 2 more movies and buys 2 more cases of pop. Her demand curves for both movies and pop shift rightward—her demand for both movies and pop increases. With a larger income, the consumer always buys more of a normal good. For Lisa, movies and pop are normal goods.

Question 49

The paradox is resolved by distinguishing between _________ and _______.

Answer 49

The paradox is resolved by distinguishing between total utility and marginal utility

The total utility that we get from water is enormous. But remember, the more we consume of something, the smaller is its marginal utility.

Question 50

The Paradox of Value - The Paradox Resolved (water and diamonds)

Answer 50

We use so much water that its marginal utility—the benefit we get from one more glass of water or another 30 seconds in the shower—diminishes to a small value.

Diamonds, on the other hand, have a small total utility relative to water, but because we buy few diamonds, they have a high marginal utility.

When a household has maximized its total utility, it has allocated its income in the way that makes the marginal utility per dollar equal for all goods. That is, the marginal utility from a good divided by the price of the good is equal for all goods.

This equality of marginal utilities per dollar holds true for diamonds and water: Diamonds have a high price and a high marginal utility. Water has a low price and a low marginal utility. When the high marginal utility from diamonds is divided by the high price of a diamond, the result is a number that equals the low marginal utility from water divided by the low price of water. The marginal utility per dollar is the same for diamonds and water.

Question 51

Value and Consumer Surplus - Figure 8.7

Answer 51

Figure 8.7 explains the paradox of value by using this idea. The supply of water in part (a) is perfectly elastic at price PW, so the quantity of water consumed is QW and the large green area shows the consumer surplus from water.

The supply of diamonds in part (b) is perfectly inelastic at the quantity QD, so the price of a diamond is PD and the small green area shows the consumer surplus from diamonds.

Water is cheap, but brings a large consumer surplus; diamonds are expensive, but bring a small consumer surplus.

Question 52

Temperature: An Analogy

Answer 52

Utility is similar to temperature—both are abstract concepts. You can’t observe temperature. You can observe water turning to steam if it is hot enough or turning to ice if it is cold enough. You can also construct an instrument—a thermometer—that can help you to predict when such changes will occur. We call the scale on the thermometer temperature and we call the units of temperature degrees. But like the units of utility, these degree units are arbitrary. We can use Celsius units or Fahrenheit units or some other units.

The concept of utility helps us to make predictions about consumption choices in much the same way that the concept of temperature helps us to make predictions about physical phenomena.

Admittedly, marginal utility theory does not enable us to predict how buying plans change with the same precision that a thermometer enables us to predict when water will turn to ice or steam. But the theory provides important insights into buying plans and has some powerful implications. It helps us to understand why people buy more of a good or service when its price falls and why people buy more of most goods when their incomes increase. It also resolves the paradox of value.

Question 53

For Jevons, and for most economists today, the purpose of marginal utility theory is to explain our _______, not __________

Answer 53

For Jevons, and for most economists today, the purpose of marginal utility theory is to explain our actions, not what goes on inside our brains.

Question 54

Behavioural economics

Answer 54

A study of the ways in which limits on the human brain’s ability to compute and implement rational decisions influences economic behaviour—both the decisions that people make and the consequences of those decisions for the way markets work.

Question 55

Behavioural economics starts with observed behaviour. It looks for ______________

Answer 55

Behavioural economics starts with observed behaviour. It looks for anomalies—choices that do not seem to be rational.

Question 56

In behavioural economics, instead of being rational utility maximizers, people are assumed to have three impediments that prevent rational choice:

Answer 56

bounded rationality, bounded willpower, and bounded self-interest.

Question 57

Bounded rationality

Answer 57

rationality that is limited by the computing power of the human brain.

We can’t always work out the rational choice.

For Lisa, choosing between movies and pop, it seems unlikely that she would have much trouble figuring out what to buy. But toss Lisa some uncertainty and the task becomes harder. She’s read the reviews of Iron Man 3 on Fandango, but does she really want to see that movie? How much marginal utility will it give her? Faced with uncertainty, people might use rules of thumb, listen to the views of others, and make decisions based on gut instinct rather than on rational calculation.

Question 58

Bounded willpower

Answer 58

the less-than-perfect willpower that prevents us from making a decision that we know, at the time of implementing the decision, we will later regret.

Lisa might be feeling particularly thirsty when she passes a pop vending machine. Under Lisa’s rational utility-maximizing plan, she buys her pop at the discount store, where she gets it for the lowest possible price. Lisa has already bought her pop for this month, but it is at home. Spending $1 on a can now means giving up a movie later this month.

Lisa’s rational choice is to ignore the temporary thirst and stick to her plan. But she might not possess the willpower to do so—sometimes she will and sometimes she won’t.

Question 59

Bounded Self-Interest

Answer 59

the limited self-interest that results in sometimes suppressing our own interests to help others.

A hurricane hits the Florida coast and Lisa, feeling sorry for the victims, donates $10 to a fundraiser. She now has only $30 to spend on movies and pop this month. The quantities that she buys are not, according to her utility schedule, the ones that maximize her utility.

Question 60

The main applications of behavioural economics are in two areas:

Answer 60

finance, where uncertainty is a key factor in decision making

savings, where the future
is a key factor.

Question 61

The Endowment Effect

Answer 61

the tendency for people to value something more highly simply because they own it.

If you have allocated your income to maximize utility, then the price you would be willing to accept to give up something that you own (for example, your coffee mug) should be the same as the price you are willing to pay for an identical one.

In experiments, students seem to display the endowment effect: The price they are willing to pay for a coffee mug that is identical to the one they own is less than the price they would be willing to accept to give up the coffee mug that they own. Behavioural economists say that this behaviour contradicts marginal utility theory.

Question 62

Neuroeconomics

Answer 62

The study of the activity of the human brain when a person makes an economic decision.

Question 63

Observations show that some economic decisions generate activity in the area of the brain called the ___________, where we store memories, analyze data, and anticipate the consequences of our actions.

Answer 63

Observations show that some economic decisions generate activity in the area of the brain called the prefrontal cortex, where we store memories, analyze data, and anticipate the consequences of our actions.

Question 64

Observations also show that some economic decisions generate activity in the region of the brain called the ___________, where we store memories of anxiety and fear.

Answer 64

Observations also show that some economic decisions generate activity in the region of the brain called the hippocampus, where we store memories of anxiety and fear.

Decisions that are influenced by activity in this part of the brain might not be rational and be driven by fear or panic.