CHAPTER

6: HOUSEHOLD BEHAVIOR AND CONSUMER CHOICE

Household behavior and consumer choice greatly influence the decisions made in the input and output markets. Household Choice in Output Markets Every household must make three basic decisions I How much of each product, or output, to demand II How much labor to supply III How much to spend today and how much to save for the future Determinants of Household Demand I The price of the product II The income available to the household III The households amount of accumulated wealth IV The price of other products available to the household V The households tastes and preferences VI The households expectations about future income, wealth, and prices Budget Constraint I The limits imposed on household choices by income, wealth, and product prices II The set of options that is defined and limited by a budget constraint is called the opportunity set The Equation of the Budget Constraint I The equation is simply defined as the price of good X times the quantity of X consumed, plus the price of good Y times the quantity of Y consumed, equals the household income; or + ! = The Basis of Choice: Utility Utility is the satisfaction that a certain product yields relative to its alternatives. Diminishing Marginal Utility I The additional satisfaction gained by the consumption or use of one more unit of a good or service is called marginal utility II Total utility is the total amount of satisfaction obtained from consumption of a good or service III The law of diminishing marginal utility states that the more of any one good consumed in a given period the less satisfaction generated by consuming each additional unit of the same good

Households tend to allocate income among goods and services to maximize utility, implying that they choose activities that yield the highest marginal utility per dollar The Utility-Maximizing Rule I

The diamond/water paradox states that the things with the greatest value in use frequently have little or no value in exchange and the things with the greatest value in exchange frequently have little or no value in use Every demand curve hits the quantity (horizontal) axis as a result of diminishing marginal utility.

Income and Substitution Effects The Income Effect I If a household continues to buy the same amount of every good and service after a price decrease, it will have income left over. That extra income may be spent on the product whose price has declined or on other products The Substitution Effect I When the price of a product falls, that product also becomes relatively cheaper, so that it becomes more attractive relative to potential substitutes. A fall in the price of a product might cause a household to shifts its purchasing pattern away from substitutes Both the income and substitution effects imply a negative relationship between price and quantity demanded in other words, a downward-sloping demand Household Choice in Input Markets The Labor Supply Decision I Household members must decide how much labor to supply; this is affected by: i Availability of jobs ii Market wage rates iii Skills they possess II Two alternatives to working for a wage i Not working ii Doing unpaid work The income and substitution effects of a change in the wage rate work in opposite directions

Higher wages mean that leisure is more expensive (substitution effect), and, since more income is earned, some time may be spent on leisure A household may decide to save or borrow, which either finances future spending with current income or finances current purchases with future income Interest rates have influential effects on saving I If interest rates increase; i There is a positive effect on saving if the substitution effect dominates the income effect ii There is negative effect on saving if the income effect dominates the substitution effect