3Assumptions 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.
4Perfect KnowledgeThe 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
5Every household must make three basic decisions: How much of each product to demandHow much labor to supplyHow much money to spend today and how much to save for the future
6Review -- the determinants of household demand: The price of the productThe income available to the householdThe household’s amount of accumulated wealthThe prices of other products available to the householdThe household’s tastes and preferencesThe household’s expectations about future income, wealth, and prices
7Budget ConstraintThe limits imposed on household choices by income, wealth, and product prices
8Choice or Opportunity Set The set of options that is defined and limited by a budget constraint
9Struggling graduate students, Ann and Tom, solving the household choice problem: Ann and Tom have $200 to spend each month.They purchase meals at 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.QUESTION: WHAT CAN ANN AND TOM BUY WITH THEIR $200 MONTHLY BUDGET?
10To graphically depict Ann and Tom’s budget constraint: Jazz club visits per month20If they purchase only jazz club visits, they can purchase $200/$10, or 20 of them.10If they purchaseonly Thai meals, theycan purchase $200/$20,or 10 of them.10Thai meals per month
11To graphically depict Ann and Tom’s budget constraint: Jazz club visits per month20Line AB represents Ann and Tom’s budget constraint.The budget constraint is linear.The slope of the budget constraint represents the price ratio of the two goods.The budget constraint is NOT a demand curve.BInfeasible10FeasibleAO10Thai meals per month
12What if the price of Thai meals falls to $10 per couple? Jazz club visits per monthLine A1B represents Ann and Tom’s new budget constraint.When the price of one good changes, the budget constraint pivots.20B10AA1O1020Thai meals per month
13What if the income increases to $300? Jazz club visits per monthB230Line A2B2 represents Ann and Tom’s new budget constraint.When the income changes, the budget constraint shifts.20B10AA2O1015Thai meals per month
15The basis of choice: Utility The budget constraint shows us the combinations of two goods that a household CAN buy...What else do we need to know to determine what the household WILL buy?
16UtilityUtility: The satisfaction, or reward, a product yields relative to its alternativesImpossible to measureCannot be compared across peopleHelps us to better understand consumer choice...
17Total 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 by the consumption or use of one more unit of a good or service.
18Law of Diminishing Marginal Utility 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.
19In other words Your order of nachos tastes great. Your ninth bag of nachos gives you indigestion.
20An example - Frank’s total utility and marginal utility of trips to jazz club Frank’s total utility and marginal utility of trips to club.Table 5.2Graphs of Frank’s total utility and marginal utilityFigure 5.5
21Allocating Income to Maximize Utility How can we use the information on the budget set and utility theory to determine the utility maximizing bundle of goods and services?
22Key point -- Bang for the Buck We try to get the maximumBANG FOR THE BUCKorBANG FOR THE HOUR
23An exampleConsider Frank. He is trying to determine the utility maximizing combination of trips to a jazz club and basketball games to take per week.
24An example – total and marginal utility for both trip and game ClubTotal utilityMarginal utility112222103286432534BballTotal utilityMarginal utility1212331234294486551
25Time is scarceSuppose Frank’s “friend” will buy tickets for either one, every night. Time is the scarce resource. Suppose he goes to 6 clubs, 1 game?
26Time is scarce His totally utility is 34+21=55 Club Total utility Marginal utility112222103286432534BballTotal utilityMarginal utility1212331234294486551His totally utility is 34+21=55
27Time is scarceSuppose he gives up one club, for another game. What happens to total utility?ClubTotal utilityMarginal utility112222103286432534BballTotal utilityMarginal utility1212331234294486551His total utility now: 34+33=67
28What allocation is best? Why? ClubTotal utilityMarginal utility112222103286432534BballTotal utilityMarginal utility1212331234294486551His total utility now: 28+48=76
29What allocation is best? Why? Not consider the price of club or basketball game, he got highest total utility whenHe equalized Marginal utility PER NIGHT!!What if we consider the problem of price?
30Utility-Maximizing Rule A utility maximizing consumer allocates his or her expenditures such that the marginal utility per dollar spent on each activity is equal.
31Returning to Frank’s problem... If club trips cost $3.00 and games cost $6.00, what will he buy for a $21 budget?ClubMarginal utility1124.02103.3362.041.350.7BballMarginal utility1213.52122.0391.5461.050.5
32Downward-Sloping Demand Revisited 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.D
33Price changes affect households in two ways: Income effects: Consumption changes because purchasing power changes.Substitution effects: Consumption changes because opportunity costs change.
34Income 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.
35Substitution Effects 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.
36Review questions Sketch budget constraints. Know how to calculate marginal utility.What is utility maximizing rule?Income and substitution effects.