Download Household Behavior and Consumer Choice (Utility Theory) The

Household Behavior and Consumer Choice
(Utility Theory)
The Circular Flow
Table 6.1Possible Budget Choices of a Person
Earning $1000 per Month After Taxes
Option
Monthly
Rent
Food
Other
Expenses
Total
Available?
A
$400
$250
$350
$1000
Yes
B
600
200
200
1000
Yes
C
700
150
150
1000
Yes
D
1000
100
100
1200
No
Figure
Assumptions underlying the household choice model:

Households make demand decisions in
output markets, and supply decisions in
input markets.

All input and output markets are perfectly
competitive

Households possess all the information they
need to make market choices
Perfect knowledge

Perfect knowledge is the assumption that
households possess a knowledge of the
qualities and prices of everything available in
the market and that firms have all available
information regarding wage rates, capital
costs, and output prices
Every household must make three basic decisions:

How much of each product to demand

How much labor supply

How much money to spend today and how
much to save for the future
An example of a Choice Problem:

Ann and Tom have $200 to spend each
month

They purchase meals to the local Thai
restaurant and trips to the local jazz club,
The Hungry Ear.

Thai meals cost $20 per couple, and The
Hungry Ear costs $10 per couple.

What can Ann and Tom buy with their
monthly budget?
A graphical description of Tom and Ann’s Budget
Budget Constraint and Opportunity Set for Ann
and Tom
Once again, the determinants of household demand:

The price of the product

The income available to the household

The household’s amount of accumulated
wealth

The prices of other products available to the
household

The household’s tastes and preferences
The household’s expectation about future
income, wealth and prices
Budget constraints

The budget constraint refers to the limits
imposed on household choices by income,
wealth and product prices
Choice or Opportunity set

The choice set refers to the set of options
that is defined and limited by a budget
constraint
Choice Sets: An example


Points A, B, and C are each on the budget
constraint, meaning that Ann and Tom have
spent their income
Point D does not spend the entire $200 and
point E is unattainable as it would cost more
than $200
What if the price of Thai meals falls to $10 per
couple?

The more of any one good consumed in a
given period, the less satisfaction (utility)
generated by consuming each additional
(marginal) unit of the same good.
Example: Frank is trying to determine the utility
maximizing combination of trips to a jazz club and
basketball games to take per week

When the price of a good decreases, in this
case Thai meals fall from $20 to $10, the
budget constraint swivels to the right,
increasing the opportunities available and
expanding choice
QuickTime™ and a
decompressor
are needed to see this picture.
The Basis of Choice: Utility


Utility

The budget constraint shows us the
combination of what the household can
buy…
What will they buy…
The satisfaction, or reward, a product yields
relative to its alternatives
o Impossible to measure
o Cannot be compared across people
o Helps us to better understand
consumer choice
QuickTime™ and a
decompressor
are needed to see this picture.
Total Utility vs. Marginal Utility

Total utility is the Total amount of
satisfaction obtained from consumption of a
good or service

Marginal utility is the additional
satisfaction gained is the additional
satisfaction gained by the consumption or
use of one or more unit of something
Law of Diminishing Marginal utility
Utility-Maximizing Rule

A utility maximizing consumer allocates his
or her expenditures such that the marginal
utility per dollar spent on each activity is
equal:
Returning to Frank’s problem….If club trips cost #300
and games cost $6.00, what will he buy for a $21
budget?
Diminishing Marginal utility and Downward-Sloping
Demand
Substitution effects of a Price change

When the price of a product falls, the
product becomes more attractive relative to
potential substitutes.

When the price of a product rises, the
product becomes less attractive relative to
potential substitutes
Summary: Income and Substitution Effects:
Consumer surplus

Consumer surplus refers to the difference
between the maximum amount a person is
willing to pay for a good and its current
market price
Market demand, Revealed Preference, and Consumer
Surplus:

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 as
they were for previous units
Income and substitution Effects

Price changes affect households in two
ways:
o Income effects: consumption
changes because purchasing power
changes
o Substitution effects: consumption
changes because opportunity costs
change
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 and is worse off
Diamond/Water Paradox:
A paradox stating 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
Cost-Benefit Analysis

Cost-benefit analysis is the formal technique
by which the benefits of a public project are
weighed against its costs
Labour Supply Decision
Household Choice in Input Markets

Households must sell land, labor, and…
In labor markets, households must decide:

Whether to work

How much to work

What kind of a job to take
These decisions are affected by:

The availability of jobs

Market wage rates

The skill possessed by the household
The labor supply decision involves a choice between
consuming “labor” or “leisure”:

Labor is defined as working in exchange for
a wage

Leisure…
Consider Alex. He has 24 hours per day to allocate
between labor and leisure:
Since either of these effects can dominate, the labor
supply curve can have several different c=shapes:
Financial Capital market

The financial capital market refers to the
complex set of institutions in which suppliers
of capital (households that save) and the
demanders of capital (business firms
wanting to invest) interact.
Saving and borrowing: Present vs. 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)
Change in interest rates have income and substitution
effects:
Suppose interest rates rise:

income effect: Housholds 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.
Labor Supply Curve

Diagram that shows the quantity of labor
supplied as a function of the wage rate

Its shape depends on how households react
to changes in the wage rate (on the income
and substitution effects)
Consider the household’s response to an increase in
wages:

The income effect says that the household
can now afford to buy more leisure.
However,
The substitution effects says that the
opportunity cost of leisure is now higher;
given the law of demand, the household will
buy less leisure.
Review














Terms:
Budget constraint
Choice set or opportunity set
Consumer surplus or net benefit
Cost-benefit analysis
Diamond/water paradox
Financial capital market
Income effect of a price change
Labour supply curve
Law of diminishing marginal utility
Marginal utility (MU)
Perfect knowledge
Substitution effect of a price change
Total utility
Utility