Households & Consumer Preferences

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.

Role of Households in an Economy

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. 

Enlarged image:
What is a Budget Constraint?

A budget constraint occurs when a consumer is limited in consumption patterns by a certain income.

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.

Understanding Budget Constraints

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.
Budget Line

A line showing the various combinations of two goods that a consumer can purchase by spending all income.

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

Decisions within a Budget Constraint

Most consumers have a limited amount of income to spend on the things they need and want.

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!

Enlarged version:
Each point on the budget constraint represents a combination of burgers and bus tickets whose total cost adds up to Steve’s budget of $10.

The slope of the budget constraint is determined by the relative price of burgers and bus tickets.

If Steve is like most people, he will choose some combination that includes both bus tickets and burgers. That is, he will choose some combination on the budget constraint that connects points A and F.

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.

Optimal Choice with a Budget Constraint

One of the basic premises of ‘normal’ preferences in microeconomics is that we assume that more is better.

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.

[Optional] Budget Constraint – Example Problem
Watch this 7-minute video to see an example of a budget constraint problem.
Link to the video:
Consumer’s taste & preferences
In this section, we define indifference curves and examine their characteristics.

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:

* Ordinal Utility: The rankings of the utility received from consuming various amounts of a good.
First, we assume that when faced with any two baskets of goods, the consumer can determine whether he/she prefers basket A to basket B, B to A, or whether he/she is indifferent between the two.
Second, we assume that the tastes of the consumer are consistent or transitive.

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.

Third, we assume that more of a commodity is preferred to less.

That is, we assume that the commodity is a good* rather than a bad**, and the consumer is never satiated with the commodity.

* Good: a commodity of which more is preferred to less.
** Bad: an item of which less is preferred to more.
These three assumptions can be used to represent an individual’s tastes with indifference curves.

In order to conduct the analysis, we will assume throughout that there are only two goods, X and Y.

What is an Indifference Curve?

An indifference curve shows the various combinations of two goods that give the consumer equal utility or satisfaction.

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.

Enlarged version:
Indifference Schedule

For example, the table below is an indifference schedule showing the various combinations of hamburgers (good X) and soft drinks (good Y) that give the consumer equal satisfaction.

Understanding Indifference Curves
Indifference curve U1 shows that one hamburger and ten soft drinks per unit of time (combination A) give the consumer the same level of satisfaction as two hamburgers and six soft drinks (combination B), four hamburgers and three soft drinks (combination C), or seven hamburgers and one soft drink (combination F).

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:

An individual is indifferent between combinations A, B, C, and F since they all lie on indifference curve U1. U1 refers to a higher level of satisfaction than U0, but to a lower level than U2.
Marginal Rate of Substitution

The slope of the indifference curve at a particular point shows us the rate at which the consumer is willing to substitute one good for another in order to retain the same level of utility. This is the marginal rate of substitution.

Marginal Rate of Substitution (MRS) = MUx / MUy

[Optional] Indifference Curves
Watch this 3-minute video to learn more.
Link to the video:
What is a Giffen Good?

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 concept of a giffen good is limited to poor communities with a very limited choice of goods.

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.

[Optional] Notes on Indifference Curves
Jim Rohn Sứ mệnh khởi nghiệp