Households & Consumer Preferences
In this lesson, you’re expected to learn:
– the role of households in an economy
– how consumers are limited in their consumption by price and income constraints
– how indifference curves depict a consumer’s tastes and preferences
Consumer Behavior & Consumption Decisions
Economists are always making assumptions about people’s behavior. One assumption that seems to make sense is that people try to make themselves as happy as possible. In economics-speak, this is called utility maximization.
When consumers buy goods and services, they are doing so to maximize their utility. The ability of consumers to maximize utility is constrained by the amount they have to spend; this is called a budget constraint.
When it comes to consumer behavior, economists argue that consumers seek to maximize their utility subject to their budget constraint.
In a market economy, households provide resources and labor, and purchase goods and services.
On the other hand, firms provide goods and services and purchase resources and labor.
The budget constraint is the first piece of the utility maximization framework, and it describes all of the combinations of goods and services that the consumer can afford.
The budget constraint is the boundary of the opportunity set — all possible combinations of consumption that someone can afford given the prices of goods and the individual’s income.
One way for us to better understand budget constraints is to build an equation. Let’s make P and Q the price and quantity of items purchased and Y the amount of income one has to spend.
By assuming that a consumer spends all of his/her income on two goods, we can express the budget constraint as:
I = (P1 x Q1) + (P2 x Q2)
where P1 = price of good 1
Q1 = quantity of good 1
P2 = price of good 2
Q2 = quantity of good 2
I = consumer’s income
Let’s use an example to demonstrate this:
Steve has $10 in spending money each week that he can use to buy bus tickets for getting to work and the burgers that he eats for lunch. Burgers cost $2 each, and bus tickets are 50 cents ($0.50) each. There are a lot of combinations of burgers and bus tickets that Steve could buy. So many, in fact, that it might be easier for us to describe the situation using a graph!
The slope of the budget constraint is determined by the relative price of burgers and bus tickets.
Every point on or inside the constraint shows a combination of burgers and bus tickets that Steve can afford. Any point outside the constraint is not affordable because it would cost more money than he has in his budget.
In other words, if we are considering two goods, X and Y, and we have a choice between a bundle of 3X and 4Y, or 10X and 25Y, we are going to prefer the second because we get more of both goods.
However, we don’t have unlimited resources. The more we spend on good X, the less we can spend on good Y. So we will have a budget constraint depending on the resources available to us. We could either spend all our budget on good X, all on good Y, or on some combination of the two.
Link to the video: https://www.youtube.com/watch?v=nZ-tVwlwhxA
Indifference curves are a crucial tool of analysis because they are used to represent an ordinal measure of the tastes and preferences of the consumer and to show how the consumer maximizes utility in spending income.
What do Indifference Curves portray?
Consumers’ tastes can be examined with ordinal utility*. An ordinal measure of utility is based on three assumptions:
That is, if the consumer states that he/she prefers basket A to basket B and also that he/she prefers basket B to basket C, then that consumer will prefer A to C.
That is, we assume that the commodity is a good* rather than a bad**, and the consumer is never satiated with the commodity.
** Bad: an item of which less is preferred to more.
In order to conduct the analysis, we will assume throughout that there are only two goods, X and Y.
A higher indifference curve refers to a higher level of satisfaction, and a lower indifference curve refers to less satisfaction.
However, we have no indication as to how much additional satisfaction or utility a higher indifference curve indicates. That is, different indifference curves simply provide an ordering or ranking of the individual’s preference.
On the other hand, combination R (four hamburgers and seven soft drinks) has both more hamburgers and more soft drinks than combination B (see the right panel), and so it refers to a higher level of satisfaction. Thus, combination R and all the other combinations that give the same level of satisfaction as combination R define higher indifference curve U2.
See enlarged image: http://bit.ly/2l3d729
Marginal Rate of Substitution (MRS) = MUx / MUy
Link to the video: https://www.youtube.com/watch?v=JVadAl9qifM
A giffen good is an inferior good for which a higher price causes an increase in demand (reversing the usual law of demand).
This provides the unusual result of an upward-sloping demand curve.
The increase in demand is due to the income effect of the higher price outweighing the substitution effect.
The idea is that if you are very poor and the price of your basic foodstuff (e.g bread) increases, then you can’t afford the more expensive alternative food (meat).
Therefore, you end up buying more bread because it is the only thing you can afford.