Chapter 6: Household Behavior and Consumer Choice

ECON 110 Exam 1

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 concerning wage rates, capital costs, technology, and output prices.

Perfect Competition

An industry structure in which there are many firms, each being small relative to the industry and producing virtually identical products, and in which no firm is large enough to have any control over prices.

Homogeneous Products

Undifferentiated outputs; products that are identical to or indistinguishable from one another.

(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

What are the three basic decisions every household must make?

(1) The price of the product

(2) The income available to the household

(3) The household’s accumulated wealth

(4) The prices of other products available to the household

(5) The household’s tastes and preferences

(6) The household’s expectations about future income, wealth, and prices

What are the factors that influence the quantity of a given good or service demanded by a single household?

Budget Constraint

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

Choice Set or Opportunity Set

The set of options that is defined and limited by a budget constraint.

With a limited budget, the value of the other goods and services that could have been purchased with the same amount of money.

What’s the real cost of any good or service?

Real Income

.The set of opportunities to purchase real goods and services available to a household as determined by prices and money income.

When the price of a good decreases, the budget constraint swivels to the right, increasing the opportunities available and expanding choice.

What happens to the budget constraint when the price of a good decreases?

Utility

The satisfaction a product yields.

Marginal Utility

The additional satisfaction gained by the consumption of one more unit of a good or service.

Total Utility

The total satisfaction a product yields.

When marginal utility is zero, total utility stops rising.

What happens to total utility when marginal utility is zero?

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.

Utility-Maximizing Rule

Equating the ratio of the marginal utility of a good to its price for all goods.

Diamond/Water Paradox

A paradox stating 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.

The Income Effect

Assuming nothing else changes, a price decline in a product makes you better off because you have more income left over.

The change in consumption of X due to this improvement in well-being is called the income effect of a price change.

The Substitution Effect

When the price of a product falls, that product also becomes relatively cheaper.

A fall in the price of product X might cause a household to shift its purchasing pattern away from substitutes toward X.

This shift is called the substitution effect of a price change.

(1) Availability of jobs

(2) Market wage rates

(3) Skills they possess

(4) The limit of 168 hours in a week – The physical limit of time

What are the constrained choices made by households affected by?

The Price of Leisure

Wage rate is the price of leisure

Labor Supply Curve

A curve that shows the quantity of labor supplied at different wage rates. Its shape depends on how households react to changes in the wage rate.

When the substitution effect outweighs the income effect, the labor supply curve slopes upward.

What happens to the labor supply curve when the substitution effect outweighs the income effect?

When the income effect outweighs the substitution effect, the result is a “backward-bending” labor supply curve: The labor supply curve slopes downward.

What happens to the labor supply curve when the income effect outweighs the substitution effect?

Changes in interest rates affect household behavior in capital markets. Saving tends to increase as the interest rate rises.

How do changes in interest rates affect household behavior in capital markets specifically when interest rate rises?

Financial Capital Market

The complex set of institutions in which suppliers of capital (households that save) and the demand for capital (firms wanting to invest) interact.