HOUSEHOLD BEHAVIOR AND CONSUMER CHOICE The two fundamental decision making units in our economy – Firms and HOUSEHOLDS
The two fundamental decision making units in our economy – Firms and HOUSEHOLDS • Households demand outputs (goods and services) and supply inputs (labor). • Firms supply outputs (outputs) and demand inputs (labor).
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
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
The Budget Constraint • The limits imposed on household choices by income, wealth, and product prices. Information on household income and wealth, together with information on product prices, makes it possible to distinguish those combinations of goods and services that are affordable from those that are not.
The Budget Constraint • In a competitive market, households have no control over price. They must pay a price determined by the market. • The household has some control over income – whether to work or not, # of jobs, etc. However limits are imposed by # of jobs and wages available in the market.
The Budget Constraint Choice set or Opportunity Set The set of options at is defined and limited by a budget constraint.
The Budget Constraint Preferences, Tastes, Trade-Offs, and Opportunity Cost Their ultimate decisions are governed by their individual preferences and tastes. Household is really weighing the good or service it chooses against all the other things that the same money could buy. The real cost of a good or service is its opportunity cost, and opportunity cost is determined by relative prices.
The Budget Constraints change when prices rise or fall When the price of a good decreases, the budget constraint swivels to the right, increasing the opportunities available and expanding choice.
The Basis of Choice: Utility • Utility – the satisfaction, or reward, a product yields relative to its alternatives. • Marginal Utility (MU) – The additional satisfaction gained by the consumption or use of one more unit of something. • Total Utility – The total amount of satisfaction obtained from consumption 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.
The Utility Maximizing Rule MUx = MUy Px Py For all pairs of goods
Income and Substitution Effect • The income effect – when the price of something we buy falls, we are better off. When the price of something we buy rises, we are worse off. • The substitution effect - when the price of a good falls, the relative cost, the opportunity cost becomes lower.
Consumer Surplus • The difference between the maximum amount a person is willing to pay for a good and its current market price.
HOUSEHOLDS CHOICE IN INPUT MARKETS The Labor Supply Decision Must decide: 1. Whether to work 2. How much to work 3. What kind of job to work at
HOUSEHOLDS CHOICE IN INPUT MARKETS Labor decision affected by: 1. Availability of jobs. 2. Market wage rates. 3. Skills they possess (The wage rate can be thought of as the price – or the opportunity cost – of the benefits of either unpaid work or leisure. )
THE PRICE OF LEISURE When we add leisure to the picture, we so so with one important distinction. Trading off one good for another involves buying less of one and more of another, so households reallocate money from one good to another. “Buying” more leisure, however, means reallocating time between work and nonwork activities. For each hour of leisure that I decide to consume, I give up one hour’s wages. Thus the ware rate is the price of leisure.
INCOME AND SUBSTITUTION EFECTS OF A WAGE CHANGE The income and substitution effects of a change in wage rates work in opposite directions. Higher Wages mean that (1) leisure is more expensive. – (likely repsonse, people work more – substitution effect). (2) More income is earned in a certain # of hours, so some time may be spent on leisure – (likely response, people work less – income effect).
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