1. Household behavior and consumer choice
Chapter 5
Household behavior and consumer choice

2. Circular flow
Figure 5.1

3. 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.

4. 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

5. 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

6. 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

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

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

9. 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?

10. 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

11. 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

12. 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

13. 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

14. Chapter 6
Utility

15. 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?

16. 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...

17. 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.

18. 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.

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

20. 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

21. 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?

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

23. 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.

24. 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

25. 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?

26. 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

27. 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

28. 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

29. 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?

30. 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.

31. 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

32. 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

33. Price changes affect households in two ways:
Income effects: Consumption changes because purchasing power changes.
Substitution effects: Consumption changes because opportunity costs change.

34. 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.

35. 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.

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