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This document summarizes key concepts from Chapter 5 of the textbook "Principles of Economics, 6th edition" by Karl Case and Ray Fair. It discusses how households make choices about consumption and labor supply given budget constraints. Households maximize utility subject to their budget. The budget constraint shows the combinations of goods that are affordable given prices and income. Utility is the satisfaction from consumption and marginal utility declines with additional units of a good. Households allocate spending to equalize marginal utility per dollar across goods.

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© 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
© 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 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
© 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 Firms and Household DecisionsFirms and Household Decisions
© 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 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.
© 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 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.
© 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 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.
© 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 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:
© 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 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.
© 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 The Budget ConstraintThe 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.
© 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 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.
© 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 The Budget ConstraintThe Budget Constraint • 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= +. .
© 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 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
© 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 The Budget LineThe 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.
© 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 The Budget LineThe Budget Line • 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.
© 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 The Budget LineThe Budget Line • PointPoint EE isis unattainable, andunattainable, and pointpoint DD does notdoes not exhaust the entireexhaust the entire income available.income available.
© 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 The Budget LineThe Budget Line • 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.
© 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 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.
© 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 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.
© 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 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
© 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 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
© 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 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
© 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 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.
© 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 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:
© 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 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. • When the price of a productWhen the price of a product risesrises, a consumer has, a consumer has lessless purchasing power with the samepurchasing power with the same amount of income.amount of income.
© 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 The Substitution Effect of a Price ChangeThe Substitution Effect of a Price Change • When the price of a productWhen the price of a product fallsfalls, that product becomes, that product becomes moremore attractive relative to potentialattractive relative to potential substitutes.substitutes. • When the price of a productWhen the price of a product risesrises, that product becomes, that product becomes lessless attractive relative to potentialattractive relative to potential substitutes.substitutes.
© 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 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 Household buysHousehold buys moremore Household isHousehold is worse offworse off IncomeIncome effecteffect Household buysHousehold buys lessless OpportunityOpportunity cost of thecost of the good risesgood rises SubstitutionSubstitution effecteffect Household buysHousehold buys lessless FALLSFALLS RISESRISES Price of a goodPrice of a good or serviceor service
© 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 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.
© 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 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.
© 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 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:
© 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 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.
© 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 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.
© 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 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.
© 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 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.
© 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 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).
© 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 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:

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Ch05

  • 1. © 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
  • 2. © 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 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
  • 3. © 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 Firms and Household DecisionsFirms and Household Decisions
  • 4. © 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 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.
  • 5. © 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 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.
  • 6. © 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 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.
  • 7. © 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 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:
  • 8. © 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 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.
  • 9. © 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 The Budget ConstraintThe 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.
  • 10. © 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 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.
  • 11. © 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 The Budget ConstraintThe Budget Constraint • 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= +. .
  • 12. © 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 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
  • 13. © 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 The Budget LineThe 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.
  • 14. © 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 The Budget LineThe Budget Line • 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.
  • 15. © 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 The Budget LineThe Budget Line • PointPoint EE isis unattainable, andunattainable, and pointpoint DD does notdoes not exhaust the entireexhaust the entire income available.income available.
  • 16. © 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 The Budget LineThe Budget Line • 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.
  • 17. © 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 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.
  • 18. © 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 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.
  • 19. © 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 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
  • 20. © 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 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
  • 21. © 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 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
  • 22. © 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 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.
  • 23. © 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 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:
  • 24. © 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 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. • When the price of a productWhen the price of a product risesrises, a consumer has, a consumer has lessless purchasing power with the samepurchasing power with the same amount of income.amount of income.
  • 25. © 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 The Substitution Effect of a Price ChangeThe Substitution Effect of a Price Change • When the price of a productWhen the price of a product fallsfalls, that product becomes, that product becomes moremore attractive relative to potentialattractive relative to potential substitutes.substitutes. • When the price of a productWhen the price of a product risesrises, that product becomes, that product becomes lessless attractive relative to potentialattractive relative to potential substitutes.substitutes.
  • 26. © 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 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 Household buysHousehold buys moremore Household isHousehold is worse offworse off IncomeIncome effecteffect Household buysHousehold buys lessless OpportunityOpportunity cost of thecost of the good risesgood rises SubstitutionSubstitution effecteffect Household buysHousehold buys lessless FALLSFALLS RISESRISES Price of a goodPrice of a good or serviceor service
  • 27. © 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 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.
  • 28. © 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 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.
  • 29. © 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 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:
  • 30. © 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 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.
  • 31. © 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 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.
  • 32. © 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 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.
  • 33. © 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 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.
  • 34. © 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 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).
  • 35. © 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 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:

Editor's Notes

  • #9: Information of household income and wealth, together with information on product prices, makes it possible to distinguish those combinations of goods and services that are affordable from those that are not.
  • #10: Information of household income and wealth, together with information on product prices, makes it possible to distinguish those combinations of goods and services that are affordable from those that are not.