Copyright 2002, Pearson Education Canada1 Household Behavior and Consumer Choice Chapter 6

Copyright 2002, Pearson Education Canada2 The Circular Flow (Figure 6.1)

Copyright 2002, Pearson Education Canada3 Assumptions Underlying the Household Choice Model zHouseholds make demand decisions in output markets, and supply decisions in input markets. zAll input and output markets are perfectly competitive. zHouseholds possess all the information they need to make market choices.

Copyright 2002, Pearson Education Canada4 Perfect Knowledge zPerfect knowledge is 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.

Copyright 2002, Pearson Education Canada5 Every household must make three basic decisions: zHow much of each product to demand zHow much labour to supply zHow much money to spend today and how much to save for the future

Copyright 2002, Pearson Education Canada6 The Determinants of Household Demand zThe price of the product zThe income available to the household zThe household’s amount of accumulated wealth zThe prices of other products available to the household zThe household’s tastes and preferences zThe household’s expectations about future income, wealth, and prices

Copyright 2002, Pearson Education Canada7 Budget Constraint zThe budget constraint refers to the limits imposed on household choices by income, wealth, and product prices

Copyright 2002, Pearson Education Canada8 Choice Set or Opportunity Set zThe choice set or opportunity set refers to the set of options that is defined and limited by a budget constraint.

Copyright 2002, Pearson Education Canada9 Choice Sets: An Example

Copyright 2002, Pearson Education Canada10 Example of a Choice Problem zTrudee and Mark have $200 a month in spending money. zThey spend all their money on two goods; meals at the local Thai restaurant, and trips to the local jazz club - The Hungry Ear. zThai meals are $20 per couple, and The Hungry Ear costs $10 per couple.

Copyright 2002, Pearson Education Canada11 Budget Constraint and Opportunity Set for Trudee and Mark (Figure 6.3) zPoints A, B, and C are each on the budget constraint, meaning that Trudee and Mark have spent their income. zPoint D does not spend the entire $200 and point E is unattainable as it would cost more than $200.

Copyright 2002, Pearson Education Canada12 The Effect of a Decrease in Price on Trudee and Mark’s Budget Constraint (Figure 6.4) zWhen the price of a good decreases, in this case Thai meals fall from $20 to $10, the budget constraint swivels to the right, increasing the opportunities available and expanding choice.

Copyright 2002, Pearson Education Canada13 The Basis of Choice: Utility zUtility is the satisfaction, or reward, a product yields relative to its alternative. It is the basis for choice. zMarginal utility is the additional satisfaction gained by the consumption or use of one more unit of something. zTotal utility is the total amount of satisfaction obtained from consumption of a good or service.

Copyright 2002, Pearson Education Canada14 Law of Diminishing Marginal Utility zThe more of any one good consumed in a given period, the less satisfaction (utility) is generated by consuming each additional (marginal) unit of the same good.

Copyright 2002, Pearson Education Canada15 Allocation of Fixed Expenditures per Week Between Two Alternatives (Table 6.3) Frank’s utility maximizing decision between basketball games and trips to the club.

Copyright 2002, Pearson Education Canada16 Frank’s Total and Marginal Utility of Trips to the Club (Figure 6.5)

Copyright 2002, Pearson Education Canada17 Utility-Maximizing Rule zA utility maximizing consumer allocates his or her expenditures such that the marginal utility per dollar spent on each activity is equal: MU x = MU y P x P y

Copyright 2002, Pearson Education Canada18 Solving Frank’s Utility Maximizing Problem (Table 6.3) Frank chooses to attend 2 games and 3 trips to the club where the marginal utility per dollar for each choice is equal (2 utils per $).

Copyright 2002, Pearson Education Canada19 Diminishing Marginal Utility and Downward-Sloping Demand zDiminishing 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 as they were for previous units.

Copyright 2002, Pearson Education Canada20 Income Effect of a Price Change zThe income effect of a price change is a change in consumption of a good or service that results from a change in well-being, other things being equal. zWhen the price of a product falls, a consumer has more purchasing power with the same amount of income and is better off. zWhen the price of a product rises, a consumer has less purchasing power with the same amount of income and is worse off.

Copyright 2002, Pearson Education Canada21 Substitution Effect of a Price Change zThe substitution effect of a price change is a change in consumption of a good or service that results from holding well-being unchanged. zWhen the price of a product falls, that product becomes more attractive relative to potential substitutes. zWhen the price of a product rises, that product becomes less attractive relative to potential substitutes.

Copyright 2002, Pearson Education Canada22 Income and Substitution Effects: Summary (Figure 6.7)

Copyright 2002, Pearson Education Canada23 Consumer Surplus zConsumer surplus or net benefit refers to the difference between the maximum amount a person is willing to pay for a good and its current market price.

Copyright 2002, Pearson Education Canada24 Market Demand, Revealed Preference and Consumer Surplus (Figure 6.8)

Copyright 2002, Pearson Education Canada25 Diamond/Water Paradox: zA paradox stating that: yThe things with the greatest value in use frequently have little or no value in exchange. yThe things with the greatest value in exchange frequently have little or no value in use.

Copyright 2002, Pearson Education Canada26 Cost-Benefit Analysis zCost-benefit analysis is the formal technique by which the benefits of a public project are weighed against its costs.

Copyright 2002, Pearson Education Canada27 The Labour Supply Decision zHouseholds must decide: yWhether to work yHow much to work yWhat kind of job to work at zTheir choices are affected by: yThe availability of jobs yMarket wage rates yThe skills they possess

Copyright 2002, Pearson Education Canada28 The Price of Leisure (Figure 6.9) zThe wage rate can be thought of as the price - or the opportunity cost - of either the benefits of unpaid work or leisure.

Copyright 2002, Pearson Education Canada29 The Labour-Leisure Choice (Figure 6.10) zBy plotting income on the y-axis and hours of leisure on the x-axis, the graph shows all the combinations of daily income and leisure available to someone who can choose how many hours to work at a given wage of $10.

Copyright 2002, Pearson Education Canada30 Labour Supply Curve zThe labour supply curve is a diagram that shows the quantity of labor supplied as a function of the wage rate. zIts shape depends on how households react to changes in the wage rate (on the income and substitution effects).

Copyright 2002, Pearson Education Canada31 Two Labour Supply Curves (Figure 6.11) zIf the wage rate increases two things happen: zThe income affect says that the household can afford more leisure. zThe substitution effect says that the opportunity cost of leisure is now higher. zThe shape of the labour supply curve depends on which effect dominates.

Copyright 2002, Pearson Education Canada32 Saving and Borrowing: Present vs. Future Consumption zWhen a household decides to save part of its current income, it is using current income to finance future consumption. zWhen a household decides to borrow, it finances current spending with future income. zA change in interest rates has a positive effect on saving if the substitution effect dominates the income effect. Empirical evidence shows this to be the case.

Copyright 2002, Pearson Education Canada33 Financial Capital Market zThe financial capital market refers to the complex set of institutions in which suppliers of capital (households that save) and the demanders of capital (business firms wanting to invest) interact.

Copyright 2002, Pearson Education Canada34 Review Terms & Concepts zbudget constraint zchoice set or opportunity set zconsumer surplus or net benefit zcost-benefit analysis zdiamond/water paradox zfinancial capital market zincome effect of a price change zlabour supply curve zlaw of diminishing marginal utility zmarginal utility (MU) zperfect knowledge zsubstitution effect of a price change ztotal utility zutility