Household Behavior and Consumer Choice

1
Household Behavior and Consumer Choice

• We have studied the basics of markets how demand
  and supply determine prices and how changes in
  demand and supply will change prices
• Now we will study in depth the theory of
  consumers
• Consumers are buyers in the output markets and
  sellers in the input markets.
• We want to study consumer decision-making in more
  detail

2
Firms and Household Decisions
3
Perfect Competition
A key assumption in our study of household and
firm behavior is that all input and output
markets are perfectly competitive.

• Perfect competition is an industry structure in
  which
• There are many buyers and sellers, each small
  relative to the industry
• The product is identical (or homogeneous)
• There is easy entry and exit into and out of the
  market
• Buyers and Sellers have perfect knowledge
  (complete information) households posses
  knowledge of the qualities and prices of
  everything available in the market firms have
  all available information concerning wage rates,
  capital costs, and output prices.
• ? no one firm or consumer has any control over
  price

4
Household Choice in Output Markets

• Every household must make three basic decisions
• How much of each product, or output, to demand.
• How much labor to supply.
• How much to spend today and how much to save for
  the future.

These decisions are made with the objective of
maximizing satisfaction, happiness (a.k.a.
utility) subject to the constraints imposed by
prices, income, time.
5
1. Determinants of Household Demand
Factors that influence the quantity of a given
good or service demanded by a single household
include

• The price of the product in question.
• The income available to the household.
• The households amount of accumulated wealth.
• The prices of related products available to the
  household.
• The households tastes and preferences.
• The households expectations about future income,
  wealth, and prices.

6
The Budget Constraint

• The budget constraint refers to the limits
  imposed on household choices by income, wealth,
  and product prices.
• A choice set or opportunity set is the set of
  options that is defined by a budget constraint.
• A budget constraint separates those combinations
  of goods and services that are available, given
  limited income, from those that are not. The
  available combinations make up the opportunity
  set.

7
The Budget Constraint

• When a consumers income is allocated entirely
  towards the purchase of only two goods, X and Y,
  the consumers income equals
• where I consumers income X quantity of
  good X purchased Y quantity of good Y
  purchased PX price of good X PY price of
  good Y

I PxX PYY
Example
8
The Budget Constraint
Y
8
6
4
2
4
2
X
9
The 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 line by rearranging the
  terms in the income equation, as follows

10
The Budget Line

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

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

11
Effect of a Price Change on the Budget Constraint

• A decrease in the price of good X rotates the
  budget line outward along the horizontal axis.
• The decrease in the price of one good expands the
  consumers opportunity set,
• allowing him/her to buy more of both goods

Y
8
6
4
2
4
2
X
8
12
The Basis of Choice Utility

• The Budget Constraint tells us what combinations
  of goods the consumer can buy, but we now ask of
  the affordable bundles, which one does the
  consumer purchase?
• Utility is the satisfaction, or reward, a product
  yields relative to its alternatives. It is what
  consumers consider when making economic choices.
• The Consumer will purchase the bundle that
  provides the highest level of utility because we
  assume the objective is to maximize total
  utility.

13
Marginal Utility

• To understand how a consumer maximizes total
  utility, we need to understand marginal utility
• Marginal utility is the additional satisfaction
  gained by the consumption or use of one more unit
  of something.
• A fact of life the Law of Diminishing Marginal
  Utility
• The more of one good consumed in a given period,
  the less satisfaction (utility) generated by
  consuming each additional (marginal) unit of the
  same good within a given time period

14
Diminishing Marginal Utility

• Total utility increases at a decreasing rate.
• Marginal utility is the change in Total Utility.
• It is positive, but declining as more units are
  consumed.

15
Using Marginal Utility
IF a good were free, how much would a consumer
consume in a given time period? (Assume the good
is perishable and cannot not be stored or given
away.) BUT goods are not free. Consumers are
subject to their budget constraint. What bundle
will maximize utility?
16
The Utility-Maximizing Rule

• Assume a consumer buys only 2 goods, X and Y.
• A Utility-maximizing consumer spreads out his
  expenditures on the two goods until the following
  condition holds

MUX marginal utility derived from the last unit
of X consumed. MUY marginal utility derived
from the last unit of Y consumed. PX price of
good X PY price of good Y
17
Allocating Expenditures to Maximize Utility
Units of X Total Utility TUx Marginal Utility MUx MUx Px Units of Y Total Utility TUy Marginal Utility MUy MUy Py
0 0 0 0
1 18 1 11
2 34 2 21
3 48 3 30
4 61 4 38
5 73 5 45
6 83 6 51
7 91 7 56
8 97 8 60
18
Allocating Expenditures to Maximize Utility

• Dont forget about the budget constraint. If we
  ignore it, then we might suggest that this
  consumer consume 8 units of X and 8 units of Y
  because total utility would be largest! But this
  bundle isnt affordable (it is outside the budget
  constraint)
• Affordable
• Bundles
• X Y
• 0 8
• 6
• 4
• 2
• 4 0

19
About the Utility-Maximizing Rule
Realistically, we cannot measure a consumers
total or marginal utility, so how can we ever
really apply the rule?
This ratio is observable
This ratio is unobservable
Intuition All consumers face the same prices.
If Px/Py 2 ? all consumers will adjust their
consumption of X and Y such that the value they
attach to one more unit of X is twice the value
they attach to one more value of Y. Be careful
this does not mean that all consumers consume
twice as much X and Y, or half as much X as Y.
In fact the rule tells us nothing about the
actual quantities purchased.
20
Diminishing Marginal Utility and Downward-Sloping
Demand

• Diminishing marginal utility helps to explain why
  demand slopes down.
• Marginal utility falls with each additional unit
  consumed, so people are not willing to pay as
  much.

21
How to Derive a Demand Curve from
Uitlity-Maximizing Behavior
Demand for X
Budget Constraint
Y
Px
8
2
?
Px 2
6
1
?
4
Px 1
?
X
6
2
2
?
Demand for Y
Py
X
4
2
6
1
?
?
Y
4
2
22
Income and Substitution Effects

• Price changes affect households in two ways
• The income effect Consumption changes because
  purchasing power changes.
• The substitution effect Consumption changes
  because opportunity costs change
• We can use these two effects to explain why
  demand curves slope downward, without appealing
  to Utility Theory (some economists object to
  utility theory)

23
Income and Substitution Effects of a Price Change

• The Income Effect of a Price Change
• When the price of a product falls, a consumer has
  more purchasing power with the same amount of
  income.
• When the price of a product rises, a consumer has
  less purchasing power with the same amount of
  income.

• The Substitution Effect of a Price Change
• When the price of a product falls, that product
  becomes more attractive relative to potential
  substitutes.
• When the price of a product rises, that product
  becomes less attractive relative to potential
  substitutes.

24
Consumer Surplus

• Consumer surplus is the difference between the
  maximum amount a person is willing to pay for a
  good and its current market price.
• Consumer surplus measurement is a key element in
  cost-benefit analysis.

25
The Diamond/Water Paradox

• The diamond/water paradox states that
• the things with the greatest value in use
  frequently have little or no value in exchange,
  and
• the things with the greatest value in exchange
  frequently have little or no value in use.

26
Household Choice in Input Markets
As in output markets, households face constrained
choices in input markets. They must decide

• Whether to work
• How much to work
• What kind of a job to work at

• These decisions are affected by
• The availability of jobs
• Market wage rates
• The skill possessed by the household

27
Leisure vs. Work Decision

• The wage rate can be thought of as the priceor
  the opportunity cost of the benefits of either
  unpaid work or leisure.
• The decision to enter the workforce involves a
  trade-off between wages (and the goods and
  services that wages will buy) on the one hand,
  and leisure and the value of nonmarket production
  on the other.

28
Income and Substitution Effects of a Wage Change
The labor supply curve is a diagram that shows
the quantity of labor supplied at different wage
rates. Its shape depends on how households
react to changes in the wage rate.

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

• The substitution effect of a higher wage means
  the opportunity cost of leisure is now higher.
  Given the law of demand, the household will buy
  less leisure.
• The income effect of a higher wage means that
  households can now afford to buy more of all
  goods, including leisure

29
Income and Substitution Effects of a Wage Change

• When the substitution effect outweighs the income
  effect, the labor supply curve slopes upward
  (typical supply curve)
• When the income effect outweighs the substitution
  effect, the result is a backward-bending labor
  supply curve (backward bending supply curve)

30
Saving and Borrowing Present Versus Future
Consumption

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