Household behavior and consumer choice Chapter 5 Household behavior and consumer choice

Circular flow Figure 5.1

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 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 to supply How much money to spend today and how much to save for the future

Review -- 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 expectations about future income, wealth, and prices

Budget Constraint The limits imposed on household choices by income, wealth, and product prices

Choice or Opportunity Set The set of options that is defined and limited by a budget constraint

Struggling 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?

To graphically depict Ann and Tom’s budget constraint: Jazz club visits per month 20 If they purchase only jazz club visits, they can purchase $200/$10, or 20 of them. 10 If they purchase only Thai meals, they can purchase $200/$20, or 10 of them. 10 Thai meals per month

To graphically depict Ann and Tom’s budget constraint: Jazz club visits per month 20 Line 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. B Infeasible 10 Feasible A O 10 Thai meals per month

What if the price of Thai meals falls to $10 per couple? Jazz club visits per month Line A1B represents Ann and Tom’s new budget constraint. When the price of one good changes, the budget constraint pivots. 20 B 10 A A1 O 10 20 Thai meals per month

What if the income increases to $300? Jazz club visits per month B2 30 Line A2B2 represents Ann and Tom’s new budget constraint. When the income changes, the budget constraint shifts. 20 B 10 A A2 O 10 15 Thai meals per month

Chapter 6 Utility

The 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?

Utility Utility: The satisfaction, or reward, a product yields relative to its alternatives Impossible to measure Cannot be compared across people Helps us to better understand consumer choice...

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 by the consumption or use of one more unit of a good or service.

Law 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.

In other words Your order of nachos tastes great. Your ninth bag of nachos gives you indigestion.

An 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 5.2 Graphs of Frank’s total utility and marginal utility Figure 5.5

Allocating 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?

Key point -- Bang for the Buck We try to get the maximum BANG FOR THE BUCK or BANG FOR THE HOUR

An example Consider Frank. He is trying to determine the utility maximizing combination of trips to a jazz club and basketball games to take per week.

An example – total and marginal utility for both trip and game Club Total utility Marginal utility 1 12 2 22 10 3 28 6 4 32 5 34 Bball Total utility Marginal utility 1 21 2 33 12 3 42 9 4 48 6 5 51

Time is scarce Suppose Frank’s “friend” will buy tickets for either one, every night. Time is the scarce resource. Suppose he goes to 6 clubs, 1 game?

Time is scarce His totally utility is 34+21=55 Club Total utility Marginal utility 1 12 2 22 10 3 28 6 4 32 5 34 Bball Total utility Marginal utility 1 21 2 33 12 3 42 9 4 48 6 5 51 His totally utility is 34+21=55

Time is scarce Suppose he gives up one club, for another game. What happens to total utility? Club Total utility Marginal utility 1 12 2 22 10 3 28 6 4 32 5 34 Bball Total utility Marginal utility 1 21 2 33 12 3 42 9 4 48 6 5 51 His total utility now: 34+33=67

What allocation is best? Why? Club Total utility Marginal utility 1 12 2 22 10 3 28 6 4 32 5 34 Bball Total utility Marginal utility 1 21 2 33 12 3 42 9 4 48 6 5 51 His total utility now: 28+48=76

What allocation is best? Why? Not consider the price of club or basketball game, he got highest total utility when He equalized Marginal utility PER NIGHT!! What if we consider the problem of price?

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 $3.00 and games cost $6.00, what will he buy for a $21 budget? Club Marginal utility 1 12 4.0 2 10 3.3 3 6 2.0 4 1.3 5 0.7 Bball Marginal utility 1 21 3.5 2 12 2.0 3 9 1.5 4 6 1.0 5 0.5

Downward-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

Price changes affect households in two ways: Income effects: Consumption changes because purchasing power changes. 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.

Substitution 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.

Review questions Sketch budget constraints. Know how to calculate marginal utility. What is utility maximizing rule? Income and substitution effects.