copyright 2002, pearson education canada1 household behavior and consumer choice chapter 6

Copyright 2002, Pearson Education Canada1

Household Behavior and Consumer Choice

Chapter 6


The Circular Flow (Figure 6.1)


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.


Perfect Knowledge

Perfect 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.


Every household must make three basic decisions:

How much of each product to demandHow much labour to supplyHow much money to spend today and how

much to save for the future


The Determinants of Household Demand

The price of the productThe income available to the householdThe household’s amount of accumulated

wealthThe prices of other products available to the

householdThe household’s tastes and preferencesThe household’s expectations about future

income, wealth, and prices


Budget Constraint

The budget constraint refers to the limits imposed on household choices by income, wealth, and product prices


Choice Set or Opportunity Set

The choice set or opportunity set refers to the set of options that is defined and limited by a budget constraint.


Table 6.1Possible Budget Choices of a Person Earning $1000 per Month After Taxes

Option Monthly Rent

Food OtherExpenses

Total Available?

A $400 $250 $350 $1000 Yes

B 600 200 200 1000 Yes

C 700 150 150 1000 Yes

D 1000 100 100 1200 No

Choice Sets: An Example


Example of a Choice Problem

Trudee and Mark have $200 a month in spending money.

They spend all their money on two goods; meals at the local Thai restaurant, and trips to the local jazz club - The Hungry Ear.

Thai meals are $20 per couple, and The Hungry Ear costs $10 per couple.


Budget Constraint and Opportunity Set for Trudee and Mark (Figure 6.3)

Points A, B, and C are each on the budget constraint, meaning that Trudee and Mark have spent their income.

Point D does not spend the entire $200 and point E is unattainable as it would cost more than $200.


The Effect of a Decrease in Price on Trudee and Mark’s Budget Constraint (Figure 6.4)

When 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.


The Basis of Choice: Utility

Utility is the satisfaction, or reward, a product yields relative to its alternative. It is the basis for choice.

Marginal utility is the additional satisfaction gained by the consumption or use of one more unit of something.

Total utility is 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) is generated by consuming each additional (marginal) unit of the same good.


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.


Frank’s Total and Marginal Utility of Trips to the Club (Figure 6.5)


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:

MUx = MUy

Px Py


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 $).


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 as they were for previous units.


Income Effect of a Price Change

The 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.

When the price of a product falls, a consumer has more purchasing power with the same amount of income and is better off.

When the price of a product rises, a consumer has less purchasing power with the same amount of income and is worse off.


Substitution Effect of a Price Change

The substitution effect of a price change is a change in consumption of a good or service that results from holding well-being unchanged.

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: Summary (Figure 6.7)


Consumer Surplus

Consumer 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.


Market Demand, Revealed Preference and Consumer Surplus (Figure 6.8)


Diamond/Water Paradox:

A paradox stating that: The things with the greatest value in use

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

frequently have little or no value in use.


Cost-Benefit Analysis

Cost-benefit analysis is the formal technique by which the benefits of a public project are weighed against its costs.


The Labour Supply Decision

Households must decide: Whether to work How much to work What kind of job to work at

Their choices are affected by: The availability of jobs Market wage rates The skills they possess


The Price of Leisure (Figure 6.9)

The wage rate can be thought of as the price - or the opportunity cost - of either the benefits of unpaid work or leisure.


The Labour-Leisure Choice (Figure 6.10)

By 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.


Labour Supply Curve

The labour supply curve is a diagram that shows the quantity of labor supplied as a function of the wage rate.

Its shape depends on how households react to changes in the wage rate (on the income and substitution effects).


Two Labour Supply Curves (Figure 6.11)

If the wage rate increases two things happen:

The income affect says that the household can afford more leisure.

The substitution effect says that the opportunity cost of leisure is now higher.

The shape of the labour supply curve depends on which effect dominates.


Saving and Borrowing: Present vs. Future Consumption

When a household decides to save part of its current income, it is using current income to finance future consumption.

When a household decides to borrow, it finances current spending with future income.

A 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.


Financial Capital Market

The 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.


Review Terms & Concepts

budget constraint choice set or

opportunity set consumer surplus or

net benefit cost-benefit analysis diamond/water paradox financial capital market income effect of a price

change

labour supply curve law of diminishing

marginal utility marginal utility (MU) perfect knowledge substitution effect of a

price change total utility utility

copyright 2002, pearson education canada1 household behavior and consumer choice chapter 6

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