5.1Household 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

5.2Firms and Household Decisions

5.3Perfect Competition

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

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

5.4Household Choice in Output Markets

Every household must make three basic decisions:

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

2. How much labor to supply.

3. 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.

5.51. Determinants of Household Demand

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

prices.

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

5.6The 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.

5.7The Budget Constraint

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

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

I = PxX + PYY

Example:

5.8The Budget Constraint

XX

Y

4

8

4

6

2

2

5.9

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 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:

Budget Line

5.10The 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.

YI

P

P

PX

Y

X

Y

I

PY

P

PX

Y

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

5.11Effect of a Price Change on the Budget Constraint

XX4

8

4

6

2

2 8

• 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 consumer’s opportunity set,allowing him/her to buy more of both goods

Y

5.12The 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.

5.13Marginal 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”

5.14Diminishing 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.

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

5.15Using 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?

5.16The 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

y

y

x

x

P

MU

P

MU

5.17Allocating 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

5.18Allocating Expenditures to Maximize Utility

Don’t 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 isn’t affordable (it is outside the budget constraint)

Affordable Bundles:X Y0 81 62 43 24 0

5.19About the Utility-Maximizing Rule

Realistically, we cannot measure a consumer’s total or marginal utility, so how can we ever really apply the rule?

This ratio is unobservable

This ratio is observable

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.

y

x

y

x

y

y

x

x

P

P

MU

MU

P

MU

P

MU

5.20Diminishing 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.

5.21

X4

8

4

6

2

2

Y

6

Demand for X

Px

X

Px = $2

Px = $1

$2

$1

62

Demand for Y

$1

42

How to Derive a Demand Curve from Uitlity-Maximizing Behavior

Py

Y

Budget Constraint

5.22Income 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)

5.23

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.

Income and Substitution Effects of a Price Change

5.24Consumer 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.

5.25The Diamond/Water Paradox

The diamond/water paradox states that:1. the things with the greatest value in use frequently have

little or no value in exchange, and2. the things with the greatest value in exchange frequently

have little or no value in use.

5.26Household Choice in Input Markets

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

These decisions are affected by:

1. The availability of jobs

2. Market wage rates

3. The skill possessed by the household

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

5.27Leisure vs. Work Decision

• The wage rate can be thought of as the price—or 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.

5.28Income and Substitution Effects of a Wage Change

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

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.

5.29Income 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)

5.30Saving 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).