Chapter 6

Household Behavior and Consumer Choice

6.1 Household Choice in Output Markets

• Households make three basic decisions:

  • How much of each product/output to demand.

  • How much labor to supply.

  • How much to spend today and how much to save for the future.

Determinants of Household Demand

• Factors influencing the quantity of a good or service demanded by a household:

  • The price of the product

  • The income available to the household

  • The household’s 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

The Budget Constraint

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

• Choice Set/Opportunity Set: The set of options defined and limited by a budget constraint.

• Within limited incomes and fixed prices, households choose what to buy.

• A household weighs a good/service against other things that money could buy.

• With a limited budget, the real cost of a good/service is the value of other goods/services that could have been purchased with the same money.

• The budget constraint separates available combinations of goods/services from those not available, given limited income.

• Available combinations make up the opportunity set.

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

Equation of the Budget Constraint

• The budget constraint can be written as: PX * X + PY * Y = I

  • Where:

    • P_X = the price of X

    • X = the quantity of X consumed

    • P_Y = the price of Y

    • Y = the quantity of Y consumed

    • I = household income

Effect of Price Decrease on Budget Constraint

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

6.2 The Basis of Choice: Utility

• Utility: The satisfaction a product yields.

Diminishing Marginal Utility

• 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.

• Marginal Utility (MU): The additional satisfaction gained by the consumption of one more unit of a good or service.

• Total Utility: The total satisfaction a product yields.

• Marginal utility is the additional utility gained by consuming one additional unit of a commodity.

• When marginal utility is zero, total utility stops rising.

Allocating Income to Maximize Utility

• Utility-maximizing consumers spread their expenditures until the following condition holds:

The Utility-Maximizing Rule

• \frac{MUX}{PX} = \frac{MUY}{PY}

  • Where:

    • MU_X is the marginal utility derived from the last unit of X consumed

    • MU_Y is the marginal utility derived from the last unit of Y consumed

    • P_X is the price per unit of X

    • P_Y is the price per unit of Y

• Utility-Maximizing Rule: Equating the ratio of the marginal utility of a good to its price for all goods.

Diminishing Marginal Utility and Downward-Sloping Demand

• Diminishing marginal utility explains downward sloping demand.

• As price decreases, consumers are willing to consume more units until marginal utility falls to the level of the new price.

Household Choice in Input Markets: The Labor Supply Decision

• Households face constrained choices in input markets and must decide:

  • Whether to work

  • How much to work

  • What kind of a job to take

Deriving Indifference Curves

• Indifference Curve: A set of points, each representing a combination of some amount of good X and some amount of good Y, that all yield the same amount of total utility.

• The consumer is indifferent between bundles A and B, B and C, and A and C.

• Because “more is better,” our consumer is unequivocally worse off at A' than at A.

Preference Map

• Each consumer has a unique family of indifference curves called a preference map.

• Higher indifference curves represent higher levels of total utility.

Consumer Utility-Maximizing Equilibrium

• Consumers will choose the combination of X and Y that maximizes total utility.

• Graphically, the consumer will move along the budget constraint until the highest possible indifference curve is reached.

• At that point, the budget constraint and the indifference curve are tangent. This point of tangency occurs at X* and Y* (point B).