Transcript Household Behavior and Consumer Choice

5.1
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
5.2
Firms and Household Decisions
5.3
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
5.4
Household 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.
5.5
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 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.
5.6
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.
5.7
The 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:
I = PxX + PYY
where: I = consumer’s income
X = quantity of good X purchased
Y = quantity of good Y purchased
PX = price of good X
PY = price of good Y
Example:
5.8
The Budget Constraint
Y
8
6
4
2
2
4
X
5.9
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:
Budget Line
I  X . PX  Y. PY
I  X . PX  Y . PY
I
X . PX

Y
PY
PY
I PX
Y

X
PY PY
5.10
The Budget Line
• The Y-intercept of the
budget line shows the
I
PX
Y

X amount of good Y that can
PY PY
be purchased when all
income is spent on good Y.
• The slope of the budget
line equals the ratio of the
goods’ prices.
I
PY
PX

PY
5.11
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.
Y
8
6
• The decrease in the price of
one good expands the
consumer’s opportunity set,
allowing him/her to buy
more of both goods
4
2
2
4
8
X
5.12
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.
5.13
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”
5.14
Diminishing Marginal Utility
Total Utility and Marginal Utility of
Trips to the Club Per Week
TRIPS TO
CLUB
TOTAL UTILITY
0
0
1
12
2
22
3
28
4
32
5
34
6
34
MARGINAL
UTLITY
12
10
6
4
2
0
• 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.
5.15
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?
5.16
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:
MU x MU y

Px
Py
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
5.17
Allocating Expenditures to Maximize Utility
Units
of X
Total
Utility
TUx
0
Marginal MUx
Utility
Px
MUx
Units
of Y
Total
Utility
TUy
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
Marginal MUy
Utility
Py
MUy
5.18
Allocating 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 Y
0 8
1 6
2 4
3 2
4 0
5.19
About 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 observable
MU x MU y
MU x Px



Px
Py
MU y Py
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.
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.
5.20
5.21
How to Derive a Demand Curve from UitlityMaximizing Behavior
Demand for X
Budget Constraint
Y
8
Px
$2
Px = $2
6
4


$1
Px = $1

2
2

2
4
6
6
X
Demand for Y
X
Py
$1

2

4
Y
5.22
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)
5.23
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.
5.24
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.
5.25
The 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, and
2. the things with the greatest value in exchange frequently
have little or no value in use.
5.26
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:
1. The availability of jobs
2. Market wage rates
3. The skill possessed by the household
5.27
Leisure 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.
5.28
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
5.29
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)
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).
5.30