Household Behavior

and Consumer Choice

A Presentation by

Anamitra Roy
 Goals of Economic Decision
Makers
Consumers
•Maximize their individual well-being, subject to their
choices being feasible.
Firms
•Maximize their profits, subject to being able to sell
what they produce at the price they charge.
Governments
•Maximize social welfare, subject to the responses
(consumption, labor supply, investment and production)
of individuals and firms.
Firms and Household Decisions
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?
Determinants of Household
Demand
Factors that influence the quantity of a given good or
service demanded by a single household include:
• The price of the product in question.
• The income available to the household.
• The household’s amount of accumulated wealth.
• The prices of related products available to the
household.
• The household’s tastes and preferences.
• The household’s expectations about future income,
wealth, and prices.
The Budget Constraint
• The budget constraint refers
to the limits imposed on
household choices by income,
wealth, and product prices.
• A choice set or opportunity set
is the set of options that is
defined by a budget constraint.
 Choice Set or Opportunity Set
Possible Budget Choices of a Person Earning $1,000 Per
Month After Taxes
MONTH
LY OTHER
EXPENSE AVAILABL
OPTION RENT FOOD S TOTAL E?
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
• The real cost of a good or service is its opportunity cost,
and opportunity cost is determined by relative prices.
 The Budget Constraint

• When a consumer’s income is allocated

entirely towards the purchase of only two
goods, X and Y, the consumer’s income
equals:
I  X . PX  Y . PY
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
 The 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 budget I  X . PX  Y . PY
line by rearranging the I  X . P X  Y . PY
terms in the income I X . PX
equation, as follows:  Y
PY PY
I PX
Budget Line Y   X
PY PY
 The Budget Line
I P X • The Y-intercept of the
Y   X budget line shows the
PY PY I
amount of good Y that can
be purchased when all PY
income is spent on good Y.

• The slope of the budget

PX
line equals the ratio of 
the goods’ prices. PY
The Budget Line
• This is the budget
constraint when
income equals $200
dollars per month, the
price of a jazz club
visit is $10 each, and
the price of a Thai
meal is $20.

• One of the possible

combinations is 5 Thai
meals and 10 Jazz club
visits per month.
The Budget Constraint

• A budget constraint
separates those
combinations of goods and
services that are available,
given limited income, from
those that are not. The
available combinations
make up the opportunity
set.
The Budget Line
• Point E is unattainable,
and point D does not
exhaust the entire
income available.
The Budget Line
• A decrease in the
price of Thai meals
shifts the budget
line outward along
the horizontal axis.
• The decrease in the
price of one good
expands the
consumer’s
opportunity set.
 What is Utility?

• Utility is the satisfaction, or reward, a product yields

relative to its alternatives. The basis of choice.

• unit of measuring utility ---- Util

 Cardinal Utility vs. Ordinal
Utility

• Cardinal Utility: Assigning numerical values to the

amount of satisfaction

• Ordinal Utility: Not assigning numerical values to

the amount of satisfaction but indicating the order of
preferences, that is, what is preferred to what
 Total Utility
•The amount of satisfaction obtained by consuming specified
amounts of a product per period of time.

•Example: TU(X) = U(X) = 16 X – X2

where X is the amount a good that is consumed in a given period
of time.

•5 units of the product per period of time yields 55 utils of

satisfaction
 Marginal Utility

•The change in total utility (TU) resulting from a

one unit change in consumption (X).
•MU = TU/ X
 Calculating MU from a TU Function
Example: TU(X) = 16 X – X2
• MU = dTU/dX = 16-2X

In general, the derivative of a total function is

the marginal function.

•The marginal function is the slope of the total

function.
Diminishing Marginal Utility

• The law of diminishing

marginal utility:
The more of one good
consumed in a given
period, the less satisfaction
(utility) generated by
consuming each additional
(marginal) unit of the same
good.
 Graphs of Total Utility
Total
TU
& Marginal Utility
Utility
X1 is where marginal utility reaches
its maximum.
This is where we encounter
diminishing marginal utility.
The slope of TU has reached its
maximum; TU has an inflection
X1 X2 X point here.
Marginal
Utility X2 is where total utility reaches its
maximum.
MU MU is zero.
This is the saturation point or
satiation point.
After that point, TU falls and MU
is negative.
X1 X2 X
The Utility-Maximizing Rule
• Utility-maximizing consumers spread out
their expenditures until the following
condition holds:
MU X MUY

PX PY
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
Between Two Alternatives
(5)
(1) (2) (3) (4) MARGINAL
TRIPS TO CLUB PER TOTAL MARGINAL PRICE UTILITY PER
WEEK UTILITY UTILITY (MU) (P) DOLLAR (MU/P)
1 12 12 $ 3.00 4.0
2 22 10 3.00 3.3
3 28 6 3.00 2.0
4 32 4 3.00 1.3
5 34 2 3.00 0.7
6 34 0 3.00 0
(1) (2)
BASKETBALL TOTAL (3) (4) (5)
GAMES PER WEEK UTILITY (MU) (P) (MU/P)
1 21 21 $ 6.00 3.5
2 33 12 6.00 2.0
3 42 9 6.00 1.5
4 48 6 6.00 1.0
5 51 3 6.00 .5
6 51 0 6.00 0
Diminishing Marginal Utility and
Downward-Sloping Demand
• Diminishing marginal
utility helps to explain
why demand slopes
down.
• Marginal utility falls
with each additional
unit consumed, so
people are not willing
to pay as much.
 Indifference curve

 Locus of combinations of two goods giving equal

level of utility to the consumer

Good
Indifference
Y
curve

Good
X
 Properties of Indifference curve

i.IC will be downward sloping

ii.IC is convex to the origin

iii. Two IC can not cut or touch each other

iv.Higher IC represents higher level of utility

 Indifference Map
 Map consisting several
ICs each representing
unique level of utility
derived from different
Units of good Y

combinations of the two

goods consumed.

I5
I4
I3
I2
I1
O
Units of good X 27
 Optimum consumption

r
Points r, s, u and v
s
give a lower level of
utility than point t.
Units of good Y

Y1 t Point t gives
the maximum
level of utility

u I5
I4
v I3
I2
I1
O X1 Units of good X 28
 Consumers Equilibrium

 Objective: Maximization of utility subject to budget

constraint.
 Equilibrium condition:
i.Necessary condition:MRSXY =Price Ratio
ii.Sufficient condition: IC is convex at the point of
tangency
 Price Effect

Qy
A

U”
U’
Qx
Qx’ B Qx” C

Change in the optimum level of consumption arising out

of the change in the price of the of one commodity( other
things remaining constant).
Income and Substitution Effects
Price changes affect households in two
ways:
• The income effect: Consumption
changes because purchasing power
changes.
• The substitution effect:
Consumption changes because
opportunity costs change.
 Income Effect

INCOME EFFECT: Change in the optimum

level of consumption arising out of the
change in the real income of the consumer
(other things remaining constant).
 The Income Effect of a Price Change

• When the price of a product falls, a

consumer has more purchasing power
with the same amount of income.
• When the price of a product rises, a
consumer has less purchasing power
with the same amount of income.
The Substitution Effect of a Price
Change
• When the price of a product
falls, that product becomes
more attractive relative to
potential substitutes.
• When the price of a product
rises, that product becomes less
attractive relative to potential
substitutes.
 Income and Substitution Effects of a Price
Change
Price of a good
or service
Household is Income Household buys
better off effect more
FALLS
Opportunity
Substitution Household buys
cost of the
effect more
good falls

Household is Income Household buys

RISES worse off effect less

Opportunity
Substitution Household buys
cost of the
effect less
good rises
Consumer Surplus
• Consumer surplus is
the difference between
the maximum amount
a person is willing to
pay for a good and its
current market price.

• Consumer surplus
measurement is a key
element in cost-benefit
analysis.
Consumer’s surplus
Buyer’s willingness to pay = maximum price he is willing to pay
A point on a demand curve reflects the willingness to pay of some
buyers.
Demand curve is downward sloping because as you are lowering the
market price, more people whose willingness to pay is lower, enters
the market.
Consumer’s surplus = willingness to pay – actual price buyer
pays in a market, measures the benefits to buyers of participating in
a market.
Consumer surplus is measured as the area below the demand curve
above the market price.
 Market Demand Curve, Price and
Consumer Surplus
Price If quantity demanded
A
is perfectly divisible
we have this smooth linear
demand curve.
Initial
consumer
surplus Consumer
P1 C surplus to new
B consumers

P2 F
D E
Additional
consumer
surplus to Demand
initial
consumers
0 Q1 Q2 Quantity
The Diamond/Water Paradox
The diamond/water paradox states 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.
Thank You