Household Behavior and Household Behavior and Consumer ChoiceConsumer Choice

Asst. Prof. Dr. Serdar AYANAsst. Prof. Dr. Serdar AYAN

Household Choice in Output Markets

• Every household must make Every household must make three basic three basic decisions:decisions:

1.1. How much of each product, or output, to How much of each product, or output, to demand.demand.

2.2. How much to spend today and how much to How much to spend today and how much to save for the future.save for the future.

3.3. How much labor to supply.How much labor to supply.

Determinants of Household Demand

• 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:

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.

The Budget Constraint

A A budget constraintbudget constraint separates those separates those combinations of goods and services that are combinations of goods and services that are available, given limited income, from those available, given limited income, from those that are not. The available combinations that are not. The available combinations make up the opportunity set.make up the opportunity set.

Choice Set or Opportunity Set

Possible Budget Choices of a Person Earning 1,000TL Per Month After Taxes

OTHEROTHER

OPTIONOPTION RENTRENT FOODFOOD EXPENSESEXPENSES TOTALTOTAL AVAILABLE?AVAILABLE?

AA TLTL 400400 250250 350350 1,0001,000 YesYes

BB 600600 200200 200200 1,0001,000 YesYes

CC 700700 150150 150150 1,0001,000 YesYes

DD 1,0001,000 100100 100100 1,2001,200 NoNo

The Budget Constraint

When a consumer’s income is allocated entirely towards the purchase of only two goods, X and Y, the consumer’s income equals:

where:

I = consumer’s incomeX = quantity of good X purchasedY = quantity of good Y purchasedPX = price of good X

PY = price of good Y

I X P Y PX Y . .

I X P Y P

I

P

X P

PY

YI

P

P

PX

X Y

Y

X

Y

Y

X

Y

. .

.

I X P Y PX Y . .

The Budget Line

The budget line shows the maximum quantity of two goods, X and Y, that can be purchased with a fixed amount of income, expressed as Y= f(X).

We can derive the budget line by rearranging the terms in the income equation, as follows:

Budget Line

The Budget Line

• The The YY-intercept of the -intercept of the budget line shows the budget line shows the amount of good amount of good YY that that can be purchased when can be purchased when all income is spent on all income is spent on good good YY..

YI

P

P

PX

Y

X

Y

I

PY

P

PX

Y

• The slope of the The slope of the budget line equals the budget line equals the ratio of the goods’ ratio of the goods’ prices.prices.

The Budget Line

• This is the budget This is the budget constraint when constraint when income equals 200 income equals 200 TL TL per month, the price per month, the price of a jazz club visit is of a jazz club visit is 10 10 TL TL each, and the each, and the price of a Thai meal is price of a Thai meal is 2020 TL TL..

• One of the possible One of the possible combinations is 5 Thai combinations is 5 Thai meals and 10 Jazz meals and 10 Jazz club visits per month.club visits per month.

The Budget Line

• Point Point EE is is unattainable, and unattainable, and point point DD does not does not exhaust the entire exhaust the entire income available.income available.

The Budget Line

• A decrease in the A decrease in the price of Thai meals price of Thai meals shifts the budget line shifts the budget line outward along the outward along the horizontal axis.horizontal axis.

• The decrease in the The decrease in the price of one good price of one good expands the expands the consumer’s consumer’s opportunity set.opportunity set.

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.

Diminishing Marginal Utility

The law of diminishing marginal utility

The more of one good consumed in a The more of one good consumed in a given period, the less satisfaction (utility) given period, the less satisfaction (utility) generated by consuming each additional generated by consuming each additional (marginal) unit of the same good.(marginal) unit of the same good.

Diminishing Marginal Utility

Total utility increases at a decreasing rate, while marginal utility decreases.

TRIPS TO CLUB TOTAL UTILITY

0 01 12 122 22 103 28 64 32 45 34 26 34 0

MARGINAL UTLITY

Total Utility and Marginal Utility of Trips to the Club Per Week

Diminishing Marginal Utility and Downward-Sloping Demand

• Diminishing marginal Diminishing marginal utility helps to explain utility helps to explain why demand slopes why demand slopes down.down.

• Marginal utility falls Marginal utility falls with each additional with each additional unit consumed, so unit consumed, so people are not willing people are not willing to pay as much.to pay as much.

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:

The 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.

The Substitution Effect 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.

Income and Substitution Effects of a Price Change

Household is better off

Income effect

Household buys more

Opportunity cost of the good falls

Substitution effect

Household buys more

Household is worse off

Income effect

Household buys less

Opportunity cost of the good rises

Substitution effect

Household buys less

FALLS

RISES

Price of a good or service

Consumer Surplus

• Consumer surplusConsumer surplus is the difference is the difference between the between the maximum amount a maximum amount a person is willing to person is willing to pay for a good and its pay for a good and its current market price.current market price.

• Consumer surplus Consumer surplus measurement is a key measurement is a key element in element in cost-cost-benefit analysis.benefit analysis.

The Diamond/Water Paradox

The diamond/water paradox states that:

1. The things with the greatest value in use frequently have little or no value in exchange, and

2. The things with the greatest value in exchange frequently have little or no value in use.