econchap6

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2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

Prepared by:

Fernando & YvonnQuijano

6

Chapter

Household Behavior andConsumer Choice

PART II FOUNDATIONS OF MICROECONOMICS: CONSUMERS AND FIRMS

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Chapter Outline6Household Behaviorand Consumer Choice

Household Choice in Output MarketsThe Determinants of Household DemandThe Budget ConstraintThe Basis of Choice: Utility

Diminishing Marginal UtilityAllocating Income to Maximize UtilityThe Utility-Maximizing RuleDiminishing Marginal Utility andDownward-Sloping DemandIncome and Substitution EffectsThe Income EffectThe Substitution EffectConsumer SurplusHousehold Choice in Input MarketsThe Labor Supply DecisionThe Price of LeisureIncome and Substitution Effects of aWage ChangeSaving and Borrowing: Presentversus Future ConsumptionA Review: Households in Output and

Input MarketsAppendix: Indifference Curves

PART II FOUNDATIONS OF MICROECONOMICS: CONSUMERS AND FIRMS

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HOUSEHOLD BEHAVIOR ANDCONSUMER CHOICE

FIGURE 6.1Firm and Household Decisions

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FIGURE 6.2Understanding the Microeconomy and the Role of Government

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Assumptions

perfect competitionAn industrystructure in which there are many firms,

each small relative to the industry andproducing virtually identical products,and in which no firm is large enough tohave any control over prices.

homogeneous productsUndifferentiatedoutputs; products that are identical to, orindistinguishable from, one another.

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perfect knowledgeThe assumptionthat households possess a knowledge ofthe qualities and prices of everythingavailable in the market and that firms

have all available information concerningwage rates, capital costs, and outputprices.

Much of the economic analysis in the chapters that follow applies to all forms of market

structure. Indeed, much of the power of economic reasoning is that it is quite general. As

we continue in microeconomics, in Chapter 13 we will define and explore seeral different

kinds of market organi!ation and structure, including monopoly, oligopoly, and monopolistic

competition. "ecause monopolists, oligopolists, monopolistic competitors, and perfect

competitors share the o#$ectie of maximi!ing profits, it should not #e surprising that their

#ehaior is in many ways similar. %e focus here on perfect competition #ecause many of

these #asic principles are easier to learn in the simplest of cases first.

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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 howmuch to save for the future

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THE DETERMINANTS OF HOUSEHOLD DEMAND

Several factors influence the quantity of a given good orservice demanded by a single household:

The price of the product

The income available to the household

The households amount of accumulatedwealth

The prices of other products available to thehousehold

The households tastes and preferences

The households expectations about future

income, wealth, and prices

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THE BUDGET CONSTRAINT

Information on household income and wealth,together with information on product prices, makesit possible to distinguish those combinations ofgoods and services that are affordable from thosethat are not.

budget constraintThe limits imposedon household choices by income, wealth,and product prices.

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choice set or opportunity setThe setof options that is defined and limited by abudget constraint.

TABLE 6.1Possible Budget Choices of a Person Earning $1,000 Per Month After Taxes

OPTION

MONTHLY

RENT FOOD

OTHER

EXPENSES TOTAL AVAILABLE?

A $ 400 $250 $350 $1,000 Yes

B 600 200 200 1,000 Yes

C 700 150 150 1,000 Yes

D 1,000 100 100 1,200 No

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Preferences, Tastes, Trade-Offs, andOpportunity Cost

Preferences play a key role in

determining demand. Somepeople like the blues or jazz,some like classical, whileothers love country music.

As long as a household faces a limited #udget&and all households ultimately do&the real

cost of any good or serice is the alue of the other goods and serices that could hae #een

purchased with the same amount of money. 'he real cost of a good or serice is its

opportunity cost, and opportunity cost is determined #y relatie prices.

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FIGURE 6.3Budget Constraint and Opportunity Set for Ann and Tom

The Budget Constraint More Formally

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real incomeSet of opportunities topurchase real goods and services

available to a household as determinedby prices and money income.

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THE EQUATION OF THE BUDGET CONSTRAINT

In general, the budget constraint can bewritten:

PXX + PYY = I,

wherePX= the price ofX, X= the

quantity ofXconsumed,PY= the price of

Y, Y= the quantity ofYconsumed, andI= household income.

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FIGURE 6.4The Effect of a Decreasein Price on Ann and Toms

Budget Constraint

Budget Constraints Change When Prices Rise orFall

'he #udget constraint is defined #y income, wealth, and prices. %ithin those limits,

households are free to choose, and the household(s ultimate choice depends on its own

likes and dislikes.

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THE BASIS OF CHOICE: UTILITY

utilityThe satisfaction, or reward, aproduct yields relative to its alternatives.

The basis of choice.

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marginal utility (MU)The additionalsatisfaction gained by the consumption oruse of one more unit of something.

DIMINISHING MARGINAL UTILITY

total utilityThe total amount ofsatisfaction obtained from consumptionof a good or service.

law of diminishing marginal utilityThemore of any one good consumed in agiven period, the less satisfaction (utility)generated by consuming each additional(marginal) unit of the same good.

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TABLE 6.2Total Utility and Marginal

Utility of Trips to the Club

Per Week

TRIPS

TO CLUB

TOTAL

UTILITY

MARGINAL

UTILITY

1 12 12

2 22 10

3 28 6

4 32 4

5 34 2

6 34 0

FIGURE 6.5Graphs of Franks Total and

Marginal Utility

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ALLOCATING INCOME TO MAXIMIZE UTILITY

TABLE 6.3Allocation of Fixed Expenditure per Week Between Two Alternatives

(1)

TRIPS

TO CLUB

PER WEEK

(2)

TOTAL

UTILITY

(3)

MARGINAL

UTILITY

(MU)

(4)

PRICE

(P)

(5)

MARGINAL UTILITY

PER DOLLAR

(MU/P)1 12 12 $3.00 4.0

2 22 10 3.00 3.33 28 6 3.00 2.0

4 32 4 3.00 1.3

5 34 2 3.00 0.76 34 0 3.00 0

(1)

BASKETBALL

GAMESPER WEEK

(2)

TOTALUTILITY

(3)

MARGINAL

UTILITY(MU)

(4)

PRICE(P)

(5)

MARGINAL UTILITY

PER DOLLAR(MU/P)

1 21 21 $6.00 3.5

2 33 12 6.00 2.0

3 42 9 6.00 1.5

4 48 6 6.00 1.0

5 51 3 6.00 .5

6 51 0 6.00 0

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THE UTILITY-MAXIMIZING RULE

In general, utility-maximizing consumers spread out theirexpenditures until the following condition holds:

goodsofpairsallfor:rulemaximizing-utilityY

Y

X

X

P

MU

P

MU=

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DIMINISHING MARGINAL UTILITY ANDDOWNWARD-SLOPING DEMAND

FIGURE 6.6Diminishing Marginal Utility andDownward-Sloping Demand

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INCOME AND SUBSTITUTION EFFECTS

THE INCOME EFFECT

When the price of something

we buy falls, we arebetteroff. When the price ofsomething we buy rises, weareworse off.

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THE SUBSTITUTION EFFECT

"oth the income and the su#stitution effects imply a negatie

relationship #etween price and quantity demanded&in other

words, downward)sloping demand. %hen the price of somethingfalls, ceteris pari#us, we are #etter off, and we are likely to #uy

more of that good and other goods *income effect+. "ecause

lower price also means less expensie relatie to su#stitutes,-

we are likely to #uy more of the good *su#stitution effect+. %hen

the price of something rises, we are worse off, and we will #uy

less of it *income effect+. igher price also means moreexpensie relatie to su#stitutes,- and we are likely to #uy less of

it and more of other goods *su#stitution effect+.

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FIGURE 6.7Income and Substitution Effects of a Price Change

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CONSUMER SURPLUS

consumer surplusThe differencebetween the maximum amount a person iswilling to pay for a good and its currentmarket price.

diamond/water paradoxA paradoxstating that (1) the things with the greatestvalue in use frequently have little or no

value in exchange, and (2) the things withthe greatest value in exchange frequentlyhave little or no value in use.

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CONSUMER SURPLUS

cost-benefit analysisThe formal technique bywhich the benefits of a public project are weighedagainst its costs.

FIGURE 6.8The Diamond/Water Paradox

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HOUSEHOLD CHOICE IN INPUT MARKETS

THE LABOR SUPPLY DECISION

1. Whether to work

2. How much to work

3. What kind of a job to work at

As in output markets, households face constrained choicesin input markets. They must decide

1. Availability of jobs

2. Market wage rates

3. Skills they possess

In essence, household members must decide how much

labor to supply. The choices they make are affected by

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'he wage rate can #e thought of as the price&or the opportunity cost&of the #enefits of

either unpaid work or leisure.

FIGURE 6.9The Trade-Off Facing Households

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THE PRICE OF LEISURE

Trading off one good for another involves buying less ofone and more of another, so households simply reallocatemoney from one good to the other. Buying more leisure,however, means reallocating time between work andnonwork activities. For each hour of leisure that I decideto consume, I give up one hours wages. Thus the wagerate is theprice of leisure.

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INCOME AND SUBSTITUTION EFFECTS OF AWAGE CHANGE

labor supply curveA diagram that

shows the quantity of labor supplied atdifferent wage rates. Its shape dependson how households react to changes inthe wage rate.

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%hen leisure is added to the choice set, the line #etween input and output market decisions

#ecomes #lurred. In fact, households decide simultaneously how much of each good to

consume and how much leisure to consume.

FIGURE 6.10Two Labor Supply Curves

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SAVING AND BORROWING: PRESENT VERSUSFUTURE CONSUMPTION

Most empirical eidence indicates that saing tends to increase as the interest rate rises.

In other words, the su#stitution effect is larger than the income effect.

financial capital marketThe complex

set of institutions in which suppliers ofcapital (households that save) and thedemand for capital (business firmswanting to invest) interact.

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budget constraint

choice set or opportunity

set

consumer surpluscost-benefit analysis

diamond/water paradox

financial capital market

homogeneous products

income effect of a pricechange

labor supply curve

law of diminishing marginalutility

marginal utility (MU)

perfect competitionperfect knowledge

real income

substitution effect of a price

change

total utility

utility

utility-maximizing rule

REVIEW TERMS AND CONCEPTS

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INDIFFERENCE CURVES

Appendix

We base the following analysis on four assumptions:

1.We assume that this analysis is restricted to goods thatyield positive marginal utility, or, more simply, that more isbetter.

2.Themarginal rate of substitutionis defined asMUX/MUY, or the ratio at which a household is willing to

substituteXforY. We assume a diminishing marginalrate of substitution.3.We assume that consumers have the ability to chooseamong the combinations of goods and services available.

4.We assume that consumer choices are consistent with asimple assumption of rationality.

ASSUMPTIONS

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Appendix

FIGURE 6A.1An Indifference Curve

DERIVING INDIFFERENCE CURVES

Anindifference curveis aset of points, each point

representing a combinationof goodsXandY, all ofwhich yield the same totalutility.

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Appendix

FIGURE 6A.2A Preference Map: A Familyof Indifference Curves

The shapes of theindifference curves depend

on the preferences of theconsumer, and the wholeset of indifference curves iscalled apreference map.

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Appendix

! YMUXMUYX

=

PROPERTIES OF INDIFFERENCE CURVES

'he slope of an indifference cure is the ratio of the marginal utility of Xto the marginal

utility ofY

, and it is negatie.

If we divide both sides byMUYand byX, we obtain

=

Y

X

MU

MU

X

Y

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FIGURE 6A.3Consumer Utility-Maximizing

Equilibrium

CONSUMER CHOICE

As long as indifference cures are conex to the origin, utility maximi!ation will take place at

the point at which the indifference cure is $ust tangent to the #udget constraint.

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Appendix

Where two curves are tangent, they have the same slope,which implies that the slope of the indifference curve isexactly equal to the slope of the budget constraint at thepoint of tangency:

By multiplying both sides of this equation byMUYand dividingboth sides byPX, we can rewrite this utility-maximizing rule as

Y

Y

X

X

P

MU

P

MU=

Y

X

Y

X

P

P

MU

MU =

slope of indifference curve = slope of budget constraint

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Appendix

FIGURE 6A.4Deriving a Demand Curve from Indifference Curves and Budget Constraint

DERIVING A DEMAND CURVE FROM INDIFFERENCE CURVES

AND BUDGET CONSTRAINTS

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