Principles of Economics Chapter 6 PDF

Principles of Economics Thirteenth Edition Chapter 6 Household Behavior and Consumer Choice Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Right...

Principles of Economics Thirteenth Edition Chapter 6 Household Behavior and Consumer Choice Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Part II The Market System (1 of 2) Roman number two Assumptions for Chapters 6 through 12: – 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Part II The Market System (2 of 2) Roman number two Products in a perfectly competitive industry are homogeneous. homogeneous products Undifferentiated outputs; products that are identical to or indistinguishable from one another. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure II.1 Roman number two Firm and Household Decisions Households demand in output markets and supply labor and capital in input markets. To simplify our analysis, we have not included the government and international sectors in this circular flow diagram. These topics will be discussed in detail later. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure II.2 Roman number two Understanding the Microeconomy and the Role of Government To understand how the economy works, it helps to build from the ground up. We start in Chapters 6–8 with an overview of household and firm decision making in simple, perfectly competitive markets. In Chapters 9–11, we see how firms and households interact in output markets (product markets) and input markets (labor/land and capital) to determine prices, wages, and profits. Once we have a picture of how a simple, perfectly competitive economy works, we begin to relax assumptions. Chapter 12 is a pivotal chapter that links perfectly competitive markets with a discussion of market imperfections and the role of government. In Chapters 13–19, we cover the three noncompetitive market structures (monopoly, monopolistic competition, and oligopoly), externalities, public goods, uncertainty and asymmetric information, and income distribution, as well as taxation and government finance.. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Chapter 6 Household Behavior and Consumer Choice Every day people make different decisions. In this chapter, we will develop a set of principles that can be used to understand decisions in the product market and the labor market. A theme in this analysis is the idea of constrained choice. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Determinants of Household Demand Several factors influence the quantity of a given good or service demanded by a single 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 Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Budget Constraint (1 of 3) 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Table 6.1 Possible Budget Choices of a Person Earning $1,000 per Month after Taxes Monthly Rent Food Other Expenses Total Option $ $ $ $ Available? A 400 250 350 1,000 Yes B 600 200 200 1,000 Yes C 700 150 150 1,000 Yes D 1,000 100 100 1,200 No Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Budget Constraint (2 of 3) Preferences, Tastes, Trade-offs, and Opportunity Cost Within the constraints imposed by limited incomes and fixed prices, households are free to choose what they will and will not buy. A household makes a choice by weighing the good or service that it chooses against all the other things that the same money could buy. With a limited budget, the real cost of any good or service is the value of the other goods and services that could have been purchased with the same amount of money. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 6.1 Budget Constraint and Opportunity Set for Ann and Tom A budget constraint separates those combinations of goods and services (e.g., point C) that are available, given limited income, from those that are not (e.g., point E). The available combinations make up the opportunity set. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Budget Constraint (3 of 3) The Budget Constraint More Formally Both prices and income affect the size of a household’s 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Equation of the Budget Constraint In general, the budget constraint can be written as: PX X + PYY = I, where: PX = the price of X X = the quantity of X consumed PY = the price of Y Y = the quantity of Y consumed I = household income Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 6.2 The Effect of a Decrease in Price on Ann and Tom’s Budget Constraint When the price of a good decreases, the budget constraint swivels to the right, increasing the opportunities available and expanding choice. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Basis of Choice: Utility (1 of 2) 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Basis of Choice: Utility (2 of 2) 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Table 6.2 Total Utility and Marginal Utility of Trips to the Club per Week Trips to Club Total Utility Marginal Utility 1 12 12 2 22 10 3 28 6 4 32 4 5 34 2 6 34 0 Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 6.3 Graphs of Frank’s Total and Marginal Utility Marginal utility is the additional utility gained by consuming one additional unit of a commodity—in this case, trips to the club. When marginal utility is zero, total utility stops rising. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Allocating Income to Maximize Utility Table 6.3 Allocation of Fixed Expenditure per Week between Two Alternatives (1) Trips to Club per (2) Total (3) Marginal (4) $Price (P) (5) Marginal Utility per Week Utility Utility (MU) Dollar (MU/P) 1 12 12 3.00 3 point 00 4.0 4 point 0 2 22 10 3.00 3 point 00 3.3 3 28 6 3.00 3 point 00 2.0 2 point 0 4 32 4 3.00 3 point 00 1.3 5 34 2 3.00 3 point 00 0.7 6 34 0 3.00 3 point 00 0 (1) Basketball Games (2) Total (3) Marginal (4) Price (P) (5) Marginal Utility per Week Utility Utility (MU) $ per Dollar (MU/P) 1 21 21 6.00 6 point 00 3.5 2 33 12 6.00 6 point 00 2.0 2 point 0 3 42 9 6.00 6 point 00 1.5 4 48 6 6.00 6 point 00 1.0 1 point 0 5 51 3 6.00 6 point 00 0.5 6 51 0 6.00 6 point 00 0 Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Utility-Maximizing Rule (1 of 2) Utility-maximizing consumers spread out their expenditures until the following condition holds: MU X MUY utility - maximizing = for all goods, PX PY where MU x is the marginal utility derived from the last unit X consumed, MUY is the marginal utility derived from the last unit of Y consumed, Px is the price per unit of X, and PY is the price per unit of Y. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Utility-Maximizing Rule (2 of 2) 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Diminishing Marginal Utility and Downward-Sloping Demand Figure 6.4 Diminishing Marginal Utility and Downward-Sloping Demand At a price of $40, the utility gained from even the first Thai meal is not worth the price. However, a lower price of $25 lures Ann and Tom into the Thai restaurant five times a month. (The utility from the sixth meal is not worth $25.) If the price is $15, Ann and Tom will eat Thai meals 10 times a month—until the marginal utility of a Thai meal drops below the utility they could gain from spending $15 on other goods. At 25 meals a month, they cannot tolerate the thought of another Thai meal, even if it is free. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Income and Substitution Effects Another explanation for downward-sloping demand curves centers on income and substitution effects. 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 6.5 Income and Substitution Effects of a Price Change For normal goods, the income and substitution effects work in the same direction. Higher prices lead to a lower quantity demanded, and lower prices lead to a higher quantity demanded. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Household Choice in Input Markets The Labor Supply Decision As in output markets, households face constrained choices in input markets. They must decide: 1. Whether to work 2. How much to work 3. What kind of a job to take Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Labor Supply Decision Household members must decide how much labor to supply. The choices they make are affected by: – Availability of jobs – Market wage rates – Skills they possess – The limit of 168 hours in a week Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 6.6 The Trade-off Facing Households 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 hand. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Price of Leisure Trading one good for another involves buying less of one and more of another, so households simply reallocate income from one good to the other. “Buying” more leisure, however, means reallocating time between work and nonwork activities. For each hour of leisure that you decide to consume, you give up one hour’s wages. Thus, the wage rate is the price of leisure. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Income and Substitution Effects of a Wage Change 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 6.7 Two Labor Supply Curves When the substitution effect outweighs the income effect, the labor supply curve slopes upward (a). When the income effect outweighs the substitution effect, the result is a “backward-bending” labor supply curve: The labor supply curve slopes downward (b). Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Saving and Borrowing: Present versus Future Consumption Changes in interest rates affect household behavior in capital markets. Empirical evidence indicates that saving tends to increase as the interest rate rises (i.e., the substitution effect is larger than the income effect). 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Review Terms and Concepts budget constraint choice set or opportunity set diamond/water paradox financial capital market homogeneous products labor supply curve law of diminishing marginal utility marginal utility (MU) perfect competition perfect knowledge real income total utility utility utility-maximizing rule Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved