household behavior and consumer choice

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

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Prepared by: Fernando Prepared by: Fernando QuijanoQuijano

and Yvonn Quijanoand Yvonn Quijano

Household Behavior and Household Behavior and Consumer ChoiceConsumer Choice


Understanding the Microeconomy and the Understanding the Microeconomy and the Role of GovernmentRole of Government

Part TwoPart Two Part ThreePart Three

Chapter 5Chapter 5 Chapters 7-8Chapters 7-8 Chapters 12-15Chapters 12-15

Household BehaviorHousehold Behavior

• Demand in output Demand in output marketsmarkets

• Supply in input Supply in input marketsmarkets

EquilibriumEquilibriumin Competitivein CompetitiveOutput MarketsOutput Markets

• Short runShort run

• Long runLong run Chapter 11Chapter 11

Market Imperfections Market Imperfections and the Role of and the Role of GovernmentGovernment

• Imperfect market Imperfect market structuresstructures

• Externalities, public Externalities, public goods, imperfect goods, imperfect information, social information, social choicechoice

• Income distribution Income distribution and povertyand poverty

Chapters 6-7Chapters 6-7 Chapters 9-10Chapters 9-10

The Competitive The Competitive Market SystemMarket System

• General General equilibrium and equilibrium and efficiencyefficiency

Firm BehaviorFirm Behavior

• Choice of Choice of technologytechnology

• Supply in output Supply in output marketsmarkets

• Demand in input Demand in input marketsmarkets

Competitive Competitive Input MarketsInput Markets

• Labor/landLabor/land

• CapitalCapital


Firms and Household DecisionsFirms and Household Decisions


Perfect Competition Perfect Competition

• Perfect competitionPerfect competition is an industry is an industry structure in which there are many structure in which there are many firms, each small relative to the firms, each small relative to the industry, producing virtually identical industry, producing virtually identical (or homogeneous) products and in (or homogeneous) products and in which no firm is large enough to have which no firm is large enough to have any control over price.any control over price.

• A key assumption in the study of A key assumption in the study of household and firm behavior is that household and firm behavior is that all input and output markets are all input and output markets are perfectly competitive.perfectly competitive.


Perfect Knowledge Perfect Knowledge

• We also assume that households We also assume that households and firms possess all the information and firms possess all the information they need to make market choices.they need to make market choices.

• Perfect knowledgePerfect knowledge is the assumption is the assumption that households posses a knowledge of that households posses a knowledge of the qualities and prices of everything the qualities and prices of everything available in the market, and that firms available in the market, and that firms have all available information have all available information concerning wage rates, capital costs, concerning wage rates, capital costs, and output prices.and output prices.


Household Choice in Output MarketsHousehold Choice in Output Markets

• Every household must make Every household must make three basic decisions:three basic decisions:

1.1. How much of each product, or How much of each product, or output, to demand.output, to demand.

2.2. How much labor to supply.How much labor to supply.

3.3. How much to spend today and How much to spend today and how much to save for the how much to save for the future.future.


Determinants of Household Demand Determinants of Household Demand (review)(review)

• The The price of the productprice of the product in question. in question.

• The The incomeincome available to the household. available to the household.

• The household’s amount of The household’s amount of accumulated wealthaccumulated wealth..

• The The prices of related productsprices of related products available to the available to the household.household.

• The household’s The household’s tastes and preferencestastes and preferences..

• The household’s The household’s expectationsexpectations about future about future income, wealth, and prices.income, wealth, and prices.

Factors that influence the quantity of a given good or Factors that influence the quantity of a given good or service demanded by a single household include:service demanded by a single household include:


The Budget ConstraintThe Budget Constraint

• The The budget constraintbudget constraint refers to the limits imposed refers to the limits imposed on household choices by on household choices by income, wealth, and income, wealth, and product prices.product prices.

• A A choice setchoice set or or opportunity setopportunity set is the set is the set of options that is defined by of options that is defined by a budget constraint.a budget constraint.



• A A budget constraintbudget constraint separates those separates those combinations of goods and combinations of goods and services that are available, services that are available, given limited income, from given limited income, from those that are not. The those that are not. The available combinations available combinations make up the opportunity make up the opportunity set.set.


Choice Set or Opportunity SetChoice Set or Opportunity Set

Possible Budget Choices of a Person Earning $1,000 Per Possible Budget Choices of a Person Earning $1,000 Per Month After TaxesMonth After Taxes

MONTHLY MONTHLY OTHEROTHER

OPTIONOPTION RENTRENT FOODFOOD EXPENSESEXPENSES TOTALTOTAL AVAILABLE?AVAILABLE?

AA $$ 400400 $250$250 $350$350 $1,000$1,000 YesYes

BB 600600 200200 200200 1,0001,000 YesYes

CC 700700 150150 150150 1,0001,000 YesYes

DD 1,0001,000 100100 100100 1,2001,200 NoNo

• The real cost of a good or service is its The real cost of a good or service is its opportunity opportunity costcost, and opportunity cost is determined by relative , and opportunity cost is determined by relative prices.prices.



• When a consumer’s income is allocated When a consumer’s income is allocated entirely towards the purchase of only two entirely towards the purchase of only two goods, goods, XX and and YY, the consumer’s income , the consumer’s income equals:equals:

where: I = consumer’s incomeX = quantity of good X purchasedY = quantity of good Y purchasedPX = price of good X

PY = price of good Y

I X P Y PX Y . .


I X P Y P

I

P

X P

PY

YI

P

P

PX

X Y

Y

X

Y

Y

X

Y

. .

.

I X P Y PX Y . .

The Budget LineThe Budget Line

• The budget line shows the maximum quantity of two goods, X and Y, that can be purchased with a fixed amount of income, expressed as Y= f(X).

• We can derive the budget We can derive the budget line by rearranging the line by rearranging the terms in the income terms in the income equation, as follows:equation, as follows:

Budget Line



• The The YY-intercept of the -intercept of the budget line shows the budget line shows the amount of good amount of good YY that that can be purchased when can be purchased when all income is spent on all income is spent on good good YY..

YI

P

P

PX

Y

X

Y

I

PY

P

PX

Y

• The slope of the The slope of the budget line equals the budget line equals the ratio of the goods’ ratio of the goods’ prices.prices.



• This is the budget This is the budget constraint when constraint when income equals $200 income equals $200 dollars per month, the dollars per month, the price of a jazz club price of a jazz club visit is $10 each, and visit is $10 each, and the price of a Thai the price of a Thai meal is $20.meal is $20.

• One of the possible One of the possible combinations is 5 Thai combinations is 5 Thai meals and 10 Jazz meals and 10 Jazz club visits per month.club visits per month.



• Point Point EE is is unattainable, and unattainable, and point point DD does not does not exhaust the entire exhaust the entire income available.income available.



• A decrease in the A decrease in the price of Thai meals price of Thai meals shifts the budget line shifts the budget line outward along the outward along the horizontal axis.horizontal axis.

• The decrease in the The decrease in the price of one good price of one good expands the expands the consumer’s consumer’s opportunity set.opportunity set.


The Basis of Choice: UtilityThe Basis of Choice: Utility

• UtilityUtility is the satisfaction, or is the satisfaction, or reward, a product yields relative reward, a product yields relative to its alternatives. The basis of to its alternatives. The basis of choice.choice.

• Marginal utilityMarginal utility is the additional is the additional satisfaction gained by the satisfaction gained by the consumption or use of one more consumption or use of one more unit of something.unit of something.


Diminishing Marginal UtilityDiminishing Marginal Utility

• The The law of diminishing law of diminishing marginal utility:marginal utility:

The more of one good The more of one good consumed in a given consumed in a given period, the less satisfaction period, the less satisfaction (utility) generated by (utility) generated by consuming each additional consuming each additional (marginal) unit of the same (marginal) unit of the same good.good.


Diminishing Marginal UtilityDiminishing Marginal Utility

• Total utility increases Total utility increases at a decreasing rate, at a decreasing rate, while marginal utility while marginal utility decreases.decreases.

TRIPS TO CLUB TOTAL UTILITY

0 01 12 122 22 103 28 64 32 45 34 26 34 0

MARGINAL UTLITY

Total Utility and Marginal Utility of Trips to the Club Per Week


The Utility-Maximizing RuleThe Utility-Maximizing Rule

• Utility-maximizing consumers spread out Utility-maximizing consumers spread out their expenditures until the following their expenditures until the following condition holds:condition holds:

MU

P

MU

PX

X

Y

Y

where: MUX = marginal utility derived from the last unit

of X consumed.MUY = marginal utility derived from the last unit

of Y consumed.Y = quantity of Y purchasedPX = price of good X

PY = price of good Y


Allocation of Fixed Expenditure Per Week Allocation of Fixed Expenditure Per Week Between Two AlternativesBetween Two Alternatives

(1)(1)TRIPS TO CLUB PER TRIPS TO CLUB PER

WEEKWEEK

(2)(2)TOTAL TOTAL UTILITYUTILITY

(3)(3)MARGINAL MARGINAL

UTILITY (MU)UTILITY (MU)

(4)(4)PRICEPRICE

(P)(P)

(5)(5)MARGINAL MARGINAL

UTILITY PER UTILITY PER DOLLAR (MU/P)DOLLAR (MU/P)

11 1212 1212 $$ 3.003.00 4.04.0

22 2222 1010 3.003.00 3.33.3

33 2828 66 3.003.00 2.02.0

44 3232 44 3.003.00 1.31.3

55 3434 22 3.003.00 0.70.7

66 3434 00 3.003.00 00

(1)(1)BASKETBALL BASKETBALL

GAMES PER WEEKGAMES PER WEEK

(2)(2)TOTAL TOTAL UTILITYUTILITY

(3)(3) (MU) (MU)

(4)(4) (P) (P)

(5)(5) (MU/P) (MU/P)

11 2121 2121 $$ 6.006.00 3.53.5

22 3333 1212 6.006.00 2.02.0

33 4242 99 6.006.00 1.51.5

44 4848 66 6.006.00 1.01.0

55 5151 33 6.006.00 .5.5

66 5151 00 6.006.00 00


Diminishing Marginal Utility and Downward-Diminishing Marginal Utility and Downward-Sloping DemandSloping Demand

• Diminishing marginal Diminishing marginal utility helps to explain utility helps to explain why demand slopes why demand slopes down.down.

• Marginal utility falls Marginal utility falls with each additional with each additional unit consumed, so unit consumed, so people are not willing people are not willing to pay as much.to pay as much.


Income and Substitution EffectsIncome and Substitution Effects

• The The income effectincome effect: : Consumption changes Consumption changes because purchasing power because purchasing power changes.changes.

• The The substitution effectsubstitution effect: : Consumption changes Consumption changes because opportunity costs because opportunity costs changechange..

Price changes affect households Price changes affect households in two ways:in two ways:


The Income Effect of a Price ChangeThe Income Effect of a Price Change

• When the price of a product When the price of a product fallsfalls, a consumer has , a consumer has moremore purchasing power with the same purchasing power with the same amount of income.amount of income.

• When the price of a product When the price of a product risesrises, a consumer has , a consumer has lessless purchasing power with the same purchasing power with the same amount of income.amount of income.


The Substitution Effect of a Price ChangeThe Substitution Effect of a Price Change

• When the price of a product When the price of a product fallsfalls, that product becomes , that product becomes moremore attractive relative to potential attractive relative to potential substitutes.substitutes.

• When the price of a product When the price of a product risesrises, that product becomes , that product becomes lessless attractive relative to potential attractive relative to potential substitutes.substitutes.


Income and Substitution Effects of a Price Income and Substitution Effects of a Price ChangeChange

Household is Household is better offbetter off

Income Income effecteffect

Household buys Household buys moremore

Opportunity Opportunity cost of the cost of the good fallsgood falls

Substitution Substitution effecteffect

Household buys Household buys moremore

Household is Household is worse offworse off

Income Income effecteffect

Household buys Household buys lessless

Opportunity Opportunity cost of the cost of the good risesgood rises

Substitution Substitution effecteffect

Household buys Household buys lessless

FALLSFALLS

RISESRISES

Price of a good Price of a good or serviceor service


Consumer SurplusConsumer Surplus

• Consumer surplusConsumer surplus is the difference is the difference between the between the maximum amount a maximum amount a person is willing to person is willing to pay for a good and its pay for a good and its current market price.current market price.

• Consumer surplus Consumer surplus measurement is a key measurement is a key element in element in cost-cost-benefit analysis.benefit analysis.


The Diamond/Water ParadoxThe Diamond/Water Paradox

The The diamond/water paradoxdiamond/water paradox states that: states that:

1.1. the things with the greatest value in the things with the greatest value in use frequently have little or no value in use frequently have little or no value in exchange, andexchange, and

2.2. the things with the greatest value in the things with the greatest value in exchange frequently have little or no exchange frequently have little or no value in use.value in use.


Household Choice in Input MarketsHousehold Choice in Input Markets

1.1. Whether to workWhether to work

2.2. How much to workHow much to work

3.3. What kind of a job to work atWhat kind of a job to work at

These decisions are affected by:These decisions are affected by:

1.1. The availability of jobsThe availability of jobs

2.2. Market wage ratesMarket wage rates

3.3. The skill possessed by the The skill possessed by the householdhousehold

As in output markets, households face As in output markets, households face constrained choices in input markets. constrained choices in input markets. They must decide:They must decide:


The Price of LeisureThe Price of Leisure

• The wage rate can be thought of as the The wage rate can be thought of as the price—or the opportunity cost– of the price—or the opportunity cost– of the benefits of either unpaid work or leisure.benefits of either unpaid work or leisure.

• The decision to enter the workforce The decision to enter the workforce involves a trade-off between wages (and involves a trade-off between wages (and the goods and services that wages will the goods and services that wages will buy) on the one hand, and leisure and the buy) on the one hand, and leisure and the value of nonmarket production on the value of nonmarket production on the other.other.


The Labor Supply CurveThe Labor Supply Curve

• The The labor supply curvelabor supply curve is is a diagram that shows the a diagram that shows the quantity of labor supplied at quantity of labor supplied at different wage rates. Its different wage rates. Its shape depends on how shape depends on how households react to households react to changes in the wage rate.changes in the wage rate.


Income and SubstitutionIncome and SubstitutionEffects of a Wage ChangeEffects of a Wage Change

• An increase in the wage rate affects households in An increase in the wage rate affects households in two ways, known as the substitution and income two ways, known as the substitution and income effects.effects.

• The substitution effect of a higher wage means that the opportunity cost of leisure is now higher. Given the law of demand, the household will buy less leisure.

• When the substitution effect outweighs the income effect, the labor supply curve slopes upward.


Income and SubstitutionIncome and SubstitutionEffects of a Wage ChangeEffects of a Wage Change

• An increase in the wage rate affects households in two An increase in the wage rate affects households in two ways, known as the substitution and income effects.ways, known as the substitution and income effects.

• The The income effectincome effect of a of a higher wage means that higher wage means that households households can now afford can now afford to buy to buy more leisure.more leisure.

• When the income effect outweighs the substitution effect, the result is a “backward-bending” labor supply curve.


Saving and Borrowing: Present Versus Saving and Borrowing: Present Versus Future ConsumptionFuture Consumption

• Households can use Households can use present income to present income to finance future spending finance future spending (i.e., save), or they can (i.e., save), or they can use future funds to use future funds to finance present spending finance present spending (i.e., borrow).(i.e., borrow).


Saving and Borrowing: Present Versus Saving and Borrowing: Present Versus Future ConsumptionFuture Consumption

• Income effect: Households will now earn more on all previous savings, so they will save less

• Substitution effect: The opportunity cost of present consumption is now higher; given the law of demand, the household will save more.

An increase in the interest rate also has An increase in the interest rate also has substitution and income effects, as follows:substitution and income effects, as follows: