1. 5.1 Household Behavior and Consumer Choice We have studied the basics of markets: how demand and supply determine prices and how changes in demand and supply will change prices Now we will study in depth the theory of consumers Consumers are buyers in the output markets and sellers in the input markets. We want to study consumer decision-making in more detail

2. 5.2 Firms and Household Decisions

3. 5.3 Perfect Competition Perfect competition is an industry structure in which There are many buyers and sellers, each small relative to the industry The product is identical (or homogeneous) There is easy entry and exit into and out of the market Buyers and Sellers have perfect knowledge (complete information): households posses knowledge of the qualities and prices of everything available in the market; firms have all available information concerning wage rates, capital costs, and output prices.  no one firm or consumer has any control over price A key assumption in our study of household and firm behavior is that all input and output markets are perfectly competitive.

4. 5.4 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. These decisions are made with the objective of maximizing satisfaction, happiness (a.k.a. utility) subject to the constraints imposed by prices, income, time.

5. 5.5 1. 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:

6. 5.6 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. A budget constraint separates those combinations of goods and services that are available, given limited income, from those that are not. The available combinations make up the opportunity set.

7. 5.7 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 income X = quantity of good X purchased Y = quantity of good Y purchased P X = price of good X P Y = price of good Y I = P x X + P Y Y Example:

8. 5.8 The Budget Constraint X Y 4 8 4 6 2 2

9. 5.9 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

10. 5.10 The Budget Line The Y-intercept of the budget line shows the amount of good Y that can be purchased when all income is spent on good Y. The slope of the budget line equals the ratio of the goods’ prices.

11. 5.11 Effect of a Price Change on the Budget Constraint X 4 8 4 6 2 2 8 A decrease in the price of good X rotates the budget line outward along the horizontal axis. The decrease in the price of one good expands the consumer’s opportunity set, allowing him/her to buy more of both goods Y

12. 5.12 The Basis of Choice: Utility The Budget Constraint tells us what combinations of goods the consumer can buy, but we now ask: of the affordable bundles, which one does the consumer purchase? Utility is the satisfaction, or reward, a product yields relative to its alternatives. It is what consumers consider when making economic choices. The Consumer will purchase the bundle that provides the highest level of utility because we assume the objective is to maximize total utility.

13. 5.13 Marginal Utility To understand how a consumer maximizes total utility, we need to understand marginal utility: Marginal utility is the additional satisfaction gained by the consumption or use of one more unit of something. A fact of life: the Law of Diminishing Marginal Utility: “The more of one good consumed in a given period, the less satisfaction (utility) generated by consuming each additional (marginal) unit of the same good within a given time period”

14. 5.14 Diminishing Marginal Utility Total utility increases at a decreasing rate. Marginal utility is the change in Total Utility. It is positive, but declining as more units are consumed.

15. 5.15 Using Marginal Utility “IF” a good were free, how much would a consumer consume in a given time period? (Assume the good is perishable and cannot not be stored or given away.) BUT goods are not free. Consumers are subject to their budget constraint. What bundle will maximize utility?

16. 5.16 The Utility-Maximizing Rule Assume a consumer buys only 2 goods, X and Y. A Utility-maximizing consumer spreads out his expenditures on the two goods until the following condition holds: MU X = marginal utility derived from the last unit of X consumed. MU Y = marginal utility derived from the last unit of Y consumed. P X = price of good X P Y = price of good Y

17. 5.17 Allocating Expenditures to Maximize Utility Units of X Total Utility TU x Marginal Utility MU x MU x P x Units of Y Total Utility TU y Marginal Utility MU y MU y P y 0000 118111 234221 348330 461438 573545 683651 791756 897860

18. 5.18 Allocating Expenditures to Maximize Utility Don’t forget about the budget constraint. If we ignore it, then we might suggest that this consumer consume 8 units of X and 8 units of Y because total utility would be largest! But this bundle isn’t affordable (it is outside the budget constraint) Affordable Bundles: XY 08 16 24 32 40

19. 5.19 About the Utility-Maximizing Rule Realistically, we cannot measure a consumer’s total or marginal utility, so how can we ever really apply the rule? This ratio is unobservable This ratio is observable Intuition: All consumers face the same prices. If P x /P y = 2  all consumers will adjust their consumption of X and Y such that the value they attach to one more unit of X is twice the value they attach to one more value of Y. Be careful: this does not mean that all consumers consume twice as much X and Y, or half as much X as Y. In fact the rule tells us nothing about the actual quantities purchased.

20. 5.20 Diminishing Marginal Utility and Downward-Sloping Demand 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.

21. 5.21 X4 8 4 6 2 2 Y  6  Demand for X PxPx X P x = $2 P x = $1 $2 $1 62   Demand for Y $1 42   How to Derive a Demand Curve from Uitlity- Maximizing Behavior PyPy Y Budget Constraint

22. 5.22 Income and Substitution Effects Price changes affect households in two ways: The income effect: Consumption changes because purchasing power changes. The substitution effect: Consumption changes because opportunity costs change We can use these two effects to explain why demand curves slope downward, without appealing to Utility Theory (some economists object to utility theory)

23. 5.23 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

24. 5.24 Consumer Surplus Consumer surplus is the difference between the maximum amount a person is willing to pay for a good and its current market price. Consumer surplus measurement is a key element in cost-benefit analysis.

25. 5.25 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.

26. 5.26 Household Choice in Input Markets Whether to work How much to work What kind of a job to work at These decisions are affected by: 1. The availability of jobs 2. Market wage rates 3. The skill possessed by the household As in output markets, households face constrained choices in input markets. They must decide:

27. 5.27 Leisure vs. Work Decision The wage rate can be thought of as the price—or the opportunity cost– of the benefits of either unpaid work or leisure. The decision to enter the workforce involves a trade-off between wages (and the goods and services that wages will buy) on the one hand, and leisure and the value of nonmarket production on the other.

28. 5.28 Income and Substitution Effects of a Wage Change An increase in the wage rate affects households in two ways, known as the substitution and income effects: The substitution effect of a higher wage means the opportunity cost of leisure is now higher. Given the law of demand, the household will buy less leisure. The income effect of a higher wage means that households can now afford to buy more of all goods, including leisure The labor supply curve is a diagram that shows the quantity of labor supplied at different wage rates. Its shape depends on how households react to changes in the wage rate.

29. 5.29 Income and Substitution Effects of a Wage Change When the substitution effect outweighs the income effect, the labor supply curve slopes upward (typical supply curve) When the income effect outweighs the substitution effect, the result is a “backward-bending” labor supply curve (backward bending supply curve)

30. 5.30 Saving and Borrowing: Present Versus Future Consumption Households can use present income to finance future spending (i.e., save), or they can use future funds to finance present spending (i.e., borrow).