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Household Behavior and Consumer Choice

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We have studied the basics of markets: how demand and supply determine prices ... When the substitution effect outweighs the income effect, the labor supply curve ... – PowerPoint PPT presentation

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Title: 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
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).
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