Household Behavior and Household Behavior and Consumer ChoiceConsumer Choice

Asst. Prof. Dr. Serdar AYANAsst. Prof. Dr. Serdar AYAN

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

• 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.

The Budget ConstraintThe 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 1,000Possible Budget Choices of a Person Earning 1,000TLTL Per Per Month After TaxesMonth After Taxes

MONTHLMONTHLY Y OTHEROTHER

OPTIONOPTION RENTRENT FOODFOOD EXPENSESEXPENSES TOTALTOTAL AVAILABLE?AVAILABLE?

AA TLTL 400400 250250 350350 1,0001,000 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 Budget ConstraintThe Budget Constraint

• 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 XPY = price of good Y

I X P Y PX Y . .

I X P Y PIP

X PP

Y

YIP

PP

X

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 Budget LineThe 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..

YIP

PP

XY

X

Y

IPY

PPX

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.

The Budget LineThe Budget Line

• This is the budget This is the budget constraint when constraint when income equals 200 income equals 200 TL TL per month, the price per month, the price of a jazz club visit is of a jazz club visit is 10 10 TL TL each, and the each, and the price of a Thai meal is price of a Thai meal is 2020 TL TL..

• 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.

The Budget LineThe Budget Line

• 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.

The Budget LineThe Budget Line

• 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

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.