Household Choices and Budget Constraints

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
CHAPTERCHAPTER 55
Prepared by: Fernando QuijanoPrepared by: Fernando Quijano
and Yvonn Quijanoand Yvonn Quijano
Household Behavior andHousehold Behavior and
Consumer ChoiceConsumer Choice

Understanding the Microeconomy and theUnderstanding the Microeconomy and the
Role of GovernmentRole of Government
Part TwoPart Two Part ThreePart Three
Chapter 5Chapter 5 Chapters 7-8Chapters 7-8 Chapters 12-15Chapters 12-15
Household BehaviorHousehold Behavior
• Demand in outputDemand in output
marketsmarkets
• Supply in inputSupply in input
marketsmarkets
EquilibriumEquilibrium
in Competitivein Competitive
Output MarketsOutput Markets
• Short runShort run
• Long runLong run Chapter 11Chapter 11
Market ImperfectionsMarket Imperfections
and the Role ofand the Role of
GovernmentGovernment
• Imperfect marketImperfect market
structuresstructures
• Externalities, publicExternalities, public
goods, imperfectgoods, imperfect
information, socialinformation, social
choicechoice
• Income distributionIncome distribution
and povertyand poverty
Chapters 6-7Chapters 6-7 Chapters 9-10Chapters 9-10
The CompetitiveThe Competitive
Market SystemMarket System
• GeneralGeneral
equilibrium andequilibrium and
efficiencyefficiency
Firm BehaviorFirm Behavior
• Choice ofChoice of
technologytechnology
• Supply in outputSupply in output
marketsmarkets
• Demand in inputDemand in input
marketsmarkets
CompetitiveCompetitive
Input MarketsInput Markets
• Labor/landLabor/land
• CapitalCapital

Firms and Household DecisionsFirms and Household Decisions

Perfect CompetitionPerfect Competition
• Perfect competitionPerfect competition is an industryis an industry
structure in which there are manystructure in which there are many
firms, each small relative to thefirms, each small relative to the
industry, producing virtually identicalindustry, producing virtually identical
(or homogeneous) products and in(or homogeneous) products and in
which no firm is large enough to havewhich no firm is large enough to have
any control over price.any control over price.
• A key assumption in the study ofA key assumption in the study of
household and firm behavior is thathousehold and firm behavior is that
all input and output markets areall input and output markets are
perfectly competitive.perfectly competitive.

Perfect KnowledgePerfect Knowledge
• We also assume that householdsWe also assume that households
and firms possess all the informationand firms possess all the information
they need to make market choices.they need to make market choices.
• Perfect knowledgePerfect knowledge is the assumptionis the assumption
that households posses a knowledge ofthat households posses a knowledge of
the qualities and prices of everythingthe qualities and prices of everything
available in the market, and that firmsavailable in the market, and that firms
have all available informationhave all available information
concerning wage rates, capital costs,concerning wage rates, capital costs,
and output prices.and output prices.

Household Choice in Output MarketsHousehold Choice in Output Markets
• Every household must makeEvery household must make
three basic decisions:three basic decisions:
1.1. How much of each product, orHow much of each product, or
output, to demand.output, to demand.
2.2. How much labor to supply.How much labor to supply.
3.3. How much to spend today andHow much to spend today and
how much to save for thehow much to save for the
future.future.

Determinants of Household DemandDeterminants of Household Demand (review)(review)
• TheThe price of the productprice of the product in question.in question.
• TheThe incomeincome available to the household.available to the household.
• The household’s amount ofThe household’s amount of accumulated wealthaccumulated wealth..
• TheThe prices of related productsprices of related products available to theavailable to the
household.household.
• The household’sThe household’s tastes and preferencestastes and preferences..
• The household’sThe household’s expectationsexpectations about futureabout future
income, wealth, and prices.income, wealth, and prices.
Factors that influence the quantity of a given good orFactors that influence the quantity of a given good or
service demanded by a single household include:service demanded by a single household include:

The Budget ConstraintThe Budget Constraint
• TheThe budget constraintbudget constraint
refers to the limits imposedrefers to the limits imposed
on household choices byon household choices by
income, wealth, andincome, wealth, and
product prices.product prices.
• AA choice setchoice set oror
opportunity setopportunity set is the setis the set
of options that is defined byof options that is defined by
a budget constraint.a budget constraint.

• AA budget constraintbudget constraint
separates thoseseparates those
combinations of goods andcombinations of goods and
services that are available,services that are available,
given limited income, fromgiven limited income, from
those that are not. Thethose that are not. The
available combinationsavailable combinations
make up the opportunitymake up the opportunity
set.set.

Choice Set or Opportunity SetChoice Set or Opportunity Set
Possible Budget Choices of a Person Earning $1,000 PerPossible Budget Choices of a Person Earning $1,000 Per
Month After TaxesMonth After Taxes
MONTHLYMONTHLY OTHEROTHER
OPTIONOPTION RENTRENT FOODFOOD EXPENSESEXPENSES TOTALTOTAL AVAILABLE?AVAILABLE?
AA $$ 400400 $250$250 $350$350 $1,000$1,000 YesYes
BB 600600 200200 200200 1,0001,000 YesYes
CC 700700 150150 150150 1,0001,000 YesYes
DD 1,0001,000 100100 100100 1,2001,200 NoNo
• The real cost of a good or service is itsThe real cost of a good or service is its opportunityopportunity
costcost, and opportunity cost is determined by relative, and opportunity cost is determined by relative
prices.prices.

• When a consumer’s income is allocatedWhen a consumer’s income is allocated
entirely towards the purchase of only twoentirely towards the purchase of only two
goods,goods, XX andand YY, the consumer’s income, the consumer’s income
equals:equals:
where: I = consumer’s income
X = quantity of good X purchased
Y = quantity of good Y purchased
PX = price of good X
PY = price of good Y
I X P Y PX Y= +. .

I X P Y P
I
P
X P
P
Y
Y
I
P
P
P
X
X Y
Y
X
Y
Y
X
Y
− =
− =
= −
. .
.
I X P Y PX Y= +. .
The Budget LineThe Budget Line
• The budget line shows the maximum
quantity of two goods, X and Y, that can be
purchased with a fixed amount of income,
expressed as Y= f(X).
• We can derive the budgetWe can derive the budget
line by rearranging theline by rearranging the
terms in the incometerms in the income
equation, as follows:equation, as follows:
Budget Line

• TheThe YY-intercept of the-intercept of the
budget line shows thebudget line shows the
amount of goodamount of good YY thatthat
can be purchased whencan be purchased when
all income is spent onall income is spent on
goodgood YY..
Y
I
P
P
P
X
Y
X
Y
= −
I
P Y
−
P
P
X
Y
• The slope of theThe slope of the
budget line equals thebudget line equals the
ratio of the goods’ratio of the goods’
prices.prices.

• This is the budgetThis is the budget
constraint whenconstraint when
income equals $200income equals $200
dollars per month, thedollars per month, the
price of a jazz clubprice of a jazz club
visit is $10 each, andvisit is $10 each, and
the price of a Thaithe price of a Thai
meal is $20.meal is $20.
• One of the possibleOne of the possible
combinations is 5 Thaicombinations is 5 Thai
meals and 10 Jazzmeals and 10 Jazz
club visits per month.club visits per month.

• PointPoint EE isis
unattainable, andunattainable, and
pointpoint DD does notdoes not
exhaust the entireexhaust the entire
income available.income available.

• A decrease in theA decrease in the
price of Thai mealsprice of Thai meals
shifts the budget lineshifts the budget line
outward along theoutward along the
horizontal axis.horizontal axis.
• The decrease in theThe decrease in the
price of one goodprice of one good
expands theexpands the
consumer’sconsumer’s
opportunity set.opportunity set.

The Basis of Choice: UtilityThe Basis of Choice: Utility
• UtilityUtility is the satisfaction, oris the satisfaction, or
reward, a product yields relativereward, a product yields relative
to its alternatives. The basis ofto its alternatives. The basis of
choice.choice.
• Marginal utilityMarginal utility is the additionalis the additional
satisfaction gained by thesatisfaction gained by the
consumption or use of one moreconsumption or use of one more
unit of something.unit of something.

Diminishing Marginal UtilityDiminishing Marginal Utility
• TheThe law of diminishinglaw of diminishing
marginal utility:marginal utility:
The more of one goodThe more of one good
consumed in a givenconsumed in a given
period, the less satisfactionperiod, the less satisfaction
(utility) generated by(utility) generated by
consuming each additionalconsuming each additional
(marginal) unit of the same(marginal) unit of the same
good.good.

Diminishing Marginal UtilityDiminishing Marginal Utility
• Total utility increasesTotal utility increases
at a decreasing rate,at a decreasing rate,
while marginal utilitywhile marginal utility
decreases.decreases.
TRIPS TO
CLUB TOTAL UTILITY
0 0
1 12 12
2 22 10
3 28 6
4 32 4
5 34 2
6 34 0
MARGINAL
UTLITY
Total Utility and Marginal Utility of
Trips to the Club Per Week

The Utility-Maximizing RuleThe Utility-Maximizing Rule
• Utility-maximizing consumers spread outUtility-maximizing consumers spread out
their expenditures until the followingtheir expenditures until the following
condition holds:condition holds:
M U
P
M U
P
X
X
Y
Y
=
where: MUX = marginal utility derived from the last unit
of X consumed.
MUY = marginal utility derived from the last unit
of Y consumed.
Y = quantity of Y purchased
PX = price of good X
PY = price of good Y

Allocation of Fixed Expenditure Per Week BetweenAllocation of Fixed Expenditure Per Week Between
Two AlternativesTwo Alternatives
(1)(1)
TRIPS TO CLUB PERTRIPS TO CLUB PER
WEEKWEEK
(2)(2)
TOTALTOTAL
UTILITYUTILITY
(3)(3)
MARGINALMARGINAL
UTILITY (MU)UTILITY (MU)
(4)(4)
PRICEPRICE
(P)(P)
(5)(5)
MARGINALMARGINAL
UTILITY PERUTILITY PER
DOLLAR (MU/P)DOLLAR (MU/P)
11 1212 1212 $$ 3.003.00 4.04.0
22 2222 1010 3.003.00 3.33.3
33 2828 66 3.003.00 2.02.0
44 3232 44 3.003.00 1.31.3
55 3434 22 3.003.00 0.70.7
66 3434 00 3.003.00 00
(1)(1)
BASKETBALLBASKETBALL
GAMES PER WEEKGAMES PER WEEK
(2)(2)
TOTALTOTAL
UTILITYUTILITY
(3)(3)
(MU)(MU)
(4)(4)
(P)(P)
(5)(5)
(MU/P)(MU/P)
11 2121 2121 $$ 6.006.00 3.53.5
22 3333 1212 6.006.00 2.02.0
33 4242 99 6.006.00 1.51.5
44 4848 66 6.006.00 1.01.0
55 5151 33 6.006.00 .5.5
66 5151 00 6.006.00 00

Diminishing Marginal Utility and Downward-Diminishing Marginal Utility and Downward-
Sloping DemandSloping Demand
• Diminishing marginalDiminishing marginal
utility helps to explainutility helps to explain
why demand slopeswhy demand slopes
down.down.
• Marginal utility fallsMarginal utility falls
with each additionalwith each additional
unit consumed, sounit consumed, so
people are not willingpeople are not willing
to pay as much.to pay as much.

Income and Substitution EffectsIncome and Substitution Effects
• TheThe income effectincome effect::
Consumption changesConsumption changes
because purchasing powerbecause purchasing power
changes.changes.
• TheThe substitution effectsubstitution effect::
Consumption changesConsumption changes
because opportunity costsbecause opportunity costs
changechange..
Price changes affect householdsPrice changes affect households
in two ways:in two ways:

The Income Effect of a Price ChangeThe Income Effect of a Price Change
• When the price of a productWhen the price of a product
fallsfalls, a consumer has, a consumer has moremore
purchasing power with the samepurchasing power with the same
amount of income.amount of income.
risesrises, a consumer has, a consumer has lessless
purchasing power with the samepurchasing power with the same
amount of income.amount of income.

The Substitution Effect of a Price ChangeThe Substitution Effect of a Price Change
fallsfalls, that product becomes, that product becomes moremore
attractive relative to potentialattractive relative to potential
substitutes.substitutes.
risesrises, that product becomes, that product becomes lessless
attractive relative to potentialattractive relative to potential
substitutes.substitutes.

Income and Substitution Effects of a PriceIncome and Substitution Effects of a Price
ChangeChange
Household isHousehold is
better offbetter off
IncomeIncome
effecteffect
Household buysHousehold buys
moremore
OpportunityOpportunity
cost of thecost of the
good fallsgood falls
SubstitutionSubstitution
effecteffect
moremore
Household isHousehold is
worse offworse off
IncomeIncome
effecteffect
lessless
OpportunityOpportunity
cost of thecost of the
good risesgood rises
SubstitutionSubstitution
effecteffect
lessless
FALLSFALLS
RISESRISES
Price of a goodPrice of a good
or serviceor service

Consumer SurplusConsumer Surplus
• Consumer surplusConsumer surplus
is the differenceis the difference
between thebetween the
maximum amount amaximum amount a
person is willing toperson is willing to
pay for a good and itspay for a good and its
current market price.current market price.
• Consumer surplusConsumer surplus
measurement is a keymeasurement is a key
element inelement in cost-cost-
benefit analysis.benefit analysis.

The Diamond/Water ParadoxThe Diamond/Water Paradox
TheThe diamond/water paradoxdiamond/water paradox states that:states that:
1.1. the things with the greatest value inthe things with the greatest value in
use frequently have little or no value inuse frequently have little or no value in
exchange, andexchange, and
2.2. the things with the greatest value inthe things with the greatest value in
exchange frequently have little or noexchange frequently have little or no
value in use.value in use.

Household Choice in Input MarketsHousehold Choice in Input Markets
1.1. Whether to workWhether to work
2.2. How much to workHow much to work
3.3. What kind of a job to work atWhat kind of a job to work at
These decisions are affected by:These decisions are affected by:
1.1. The availability of jobsThe availability of jobs
2.2. Market wage ratesMarket wage rates
3.3. The skill possessed by theThe skill possessed by the
householdhousehold
As in output markets, households faceAs in output markets, households face
constrained choices in input markets.constrained choices in input markets.
They must decide:They must decide:

The Price of LeisureThe Price of Leisure
• The wage rate can be thought of as theThe wage rate can be thought of as the
price—or the opportunity cost– of theprice—or the opportunity cost– of the
benefits of either unpaid work or leisure.benefits of either unpaid work or leisure.
• The decision to enter the workforceThe decision to enter the workforce
involves a trade-off between wages (andinvolves a trade-off between wages (and
the goods and services that wages willthe goods and services that wages will
buy) on the one hand, and leisure and thebuy) on the one hand, and leisure and the
value of nonmarket production on thevalue of nonmarket production on the
other.other.

The Labor Supply CurveThe Labor Supply Curve
• TheThe labor supply curvelabor supply curve isis
a diagram that shows thea diagram that shows the
quantity of labor supplied atquantity of labor supplied at
different wage rates. Itsdifferent wage rates. Its
shape depends on howshape depends on how
households react tohouseholds react to
changes in the wage rate.changes in the wage rate.

Income and SubstitutionIncome and Substitution
Effects of a Wage ChangeEffects of a Wage Change
• An increase in the wage rate affects households inAn increase in the wage rate affects households in
two ways, known as the substitution and incometwo ways, known as the substitution and income
effects.effects.
• The substitution effect of a
higher wage means that the
opportunity cost of leisure is
now higher. Given the law of
demand, the household will
buy less leisure.
• When the substitution effect
outweighs the income effect,
the labor supply curve slopes
upward.

Income and SubstitutionIncome and Substitution
Effects of a Wage ChangeEffects of a Wage Change
• An increase in the wage rate affects households inAn increase in the wage rate affects households in
two ways, known as the substitution and incometwo ways, known as the substitution and income
effects.effects.
• TheThe income effectincome effect of aof a
higher wage means thathigher wage means that
householdshouseholds can now afford tocan now afford to
buybuy more leisure.more leisure.
• When the income effect
outweighs the substitution
effect, the result is a
“backward-bending” labor
supply curve.

Saving and Borrowing: Present VersusSaving and Borrowing: Present Versus
Future ConsumptionFuture Consumption
• Households can useHouseholds can use
present income topresent income to
finance future spendingfinance future spending
(i.e., save), or they can(i.e., save), or they can
use future funds touse future funds to
finance present spendingfinance present spending
(i.e., borrow).(i.e., borrow).

Saving and Borrowing: Present VersusSaving and Borrowing: Present Versus
Future ConsumptionFuture Consumption
• Income effect: Households will now
earn more on all previous savings, so
they will save less
• Substitution effect: The opportunity
cost of present consumption is now
higher; given the law of demand, the
household will save more.
An increase in the interest rate also hasAn increase in the interest rate also has
substitution and income effects, as follows:substitution and income effects, as follows:

Household Choices and Budget Constraints

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