5 © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Household Behavior and Consumer Choice

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 38 Understanding the Microeconomy and the Role of Government Part TwoPart Three Chapter 5Chapters 7-8Chapters Household Behavior Demand in output markets Supply in input markets Equilibrium in Competitive Output Markets Short run Long runChapter 11 Market Imperfections and the Role of Government Imperfect market structures Externalities, public goods, imperfect information, social choice Income distribution and poverty Chapters 6-7Chapters 9-10 The Competitive Market System General equilibrium and efficiency Firm Behavior Choice of technology Supply in output markets Demand in input markets Competitive Input Markets Labor/land Capital

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 38 Firm and Household Decisions Households demand in output markets and supply labor and capital in input markets.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 38 Assumptions A key assumption in the 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 firms, each small relative to the industry, producing virtually identical (or homogeneous) products and in which no firm is large enough to have any control over price.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 38 Assumptions We also assume that households and firms possess all the information they need to make market choices. Perfect knowledge is the assumption that households posses a knowledge of the qualities and prices of everything available in the market, and that firms have all available information concerning wage rates, capital costs, and output prices.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 38 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.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 38 The Determinants of Household Demand (as seen in Chapter 3) 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:

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 38 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.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 38 The 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.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 38 The Budget Constraint Possible Budget Choices of a Person Earning $1,000 Per Month After Taxes OPTIONRENTFOODOTHERTOTALAVAILABLE? A$ 400$250$350$1,000Yes B ,000Yes C ,000Yes D1, ,200No The real cost of a good or service is its opportunity cost, and opportunity cost is determined by relative prices.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 38 The Budget Constraint This is the budget constraint when income equals $200 dollars per month, the price of jazz club visits is $10 each, and the price of a Thai meal is $20. One of the possible combinations is 5 Thai meals and 10 Jazz club visits per month.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 38 The Budget Constraint Point E is unattainable given the current income prices. Point D does not exhaust the entire income available.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 38 The Budget Constraint A decrease in the price of Thai meals shifts the budget line outward along the horizontal axis. The decrease in the price of one good expands the consumer’s opportunity set.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 38 The Basis of Choice: Utility Utility is the satisfaction, or reward, a product yields relative to its alternatives. The basis of choice. Marginal utility is the additional satisfaction gained by the consumption or use of one more unit of something.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 38 Diminishing Marginal Utility 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.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 38 Diminishing Marginal Utility Total utility increases at a decreasing rate, while marginal utility decreases. Total Utility and Marginal Utility of Trips to the Club Per Week TRIPS TO CLUB TOTAL UTILITY MARGINAL UTILITY

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 38 Allocating Income to Maximize Utility Ice Cream P=$2 Pizza P=$1 QuantityTotal Util.Marginal Util.Total Util.Marginal Util.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 38 Allocating Income to Maximize Utility The pizza is $1 a slice and the Ice Cream is $2 a scoop. I have $7 in my pocket. I want to choose the combination of pizza and Ice Cream that gives me the greatest possible utility for my $7. I bought 3 slices of pizza which give a total utility of 56 and 2 scoops of ice cream which give a total utility of 44. My total utility from lunch is 56+44=100. There is no other combination of pizza and ice cream that give a greater utility for $7.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 38 Allocating Income to Maximize Utility In order to maximize utility, an individual is to choose the items lying within his budget constraint that gives him the most utility per dollar spent. The consumer should therefore purchase all goods up to the quantities at which the marginal utility per dollar is equal for all the goods. That is the utility maximizing rule.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 38 Income and Substitution Effects The income effect: Consumption changes because purchasing power changes. The substitution effect: Consumption changes because opportunity costs change. Price changes affect households in two ways:

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 38 Income and Substitution Effects of a Price Change (for normal goods) Income effect: 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. Substitution effect: 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.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 38 Income and Substitution Effects of a Price Change (for normal goods)

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 38 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. The demand curve is a representation of what people are willing to pay at a given quantity. Therefore, the difference between the price and the demand curve is the consumer surplus for a given quantity.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 38 Consumer Surplus S D Q P 0 $ $9 $7 Consumer Surplus for the first case of soda is $ 9 - $ 5 = $ 4, for the second case is $ 7 - $ 5 = $ 2, and For the third one is $ 5 - $ 5 = $ 0.

C H A P T E R 5: Household Behavior and Consumer Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 38 Consumer Surplus S D Q P 0 Q* P* The area of this triangle is the total Consumer Surplus This is the generally accepted method of finding the total Consumer Surplus in a market