In economics, one of the most important concepts is 'opportunity cost' - the idea that once you spend your money on something, you can't spend it again on something else.
Household Behavior and Consumer Choice
(Part A)
by
Charles Lamson
 |
Household Choice and Output Markets
Every household must make three basic decisions:
In the pages the following posts, we examine each of these decisions. As we begin our look at demand in output markets, you must keep in mind that the choices underlying the demand curve are only part of the larger household choice problem. Closely related decisions about how much to work and how much to save are equally important and must be made simultaneously with output demand decisions. The Determinants of Household Demand Several factors influence the quantity of a given good or service demanded by a single household:
Recall that demand schedules and demand curves express the relationship between quantity demanded and price, ceteris paribus. A change in price leads to a movement along a demand curve. Changes in income, and other prices, or in preferences shift demand curves to the left or right. We refer to these shifts as "changes in demand." However, the interrelationship among these variables is more complex.  The Budget Constraint Before we examine the household choice process, we need to discuss exactly what choices are open or not open to households. If you look carefully at the list of items that influence household demand, you will see that the first four actually define the set of options available: Information on 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. Income, wealth, and prices thus define what we call household budget constraint. The budget constraint facing any household results primarily from limits imposed externally by one or more markets. In competitive markets, for example, households cannot control prices; they must buy goods and services at market-determined prices. A household has some control over its income; its members can choose to work or not, and they can sometimes decide how many hours to work and how many jobs to hold. However, constraints exist in the labor market, too. The amount that household members are paid is limited by current market wage rates. Whether they can get a job is determined by the availability of jobs. While income does in fact depend, at least in part, on the choices that households make, we will treat it as a given for now. Later on in this analysis we will relax this assumption and explore labor supply choices in more detail. The income, wealth, and price constraints that surround choice are best Illustrated with an example. Consider Barbara, a recent graduate of a midwestern university, who takes a job as an account manager at a public relations firm. Let us assume that she receives a salary of $1,000 per month (after taxes), and that she has no wealth and no credit. Barbara's monthly expenditures are limited to her flow of income. Table 1 summarizes some of the choices open to her.   A careful search of the housing market reveals four vacant apartments. The least expensive is a one-room studio with a small kitchenette that rents for $400 per month, including utilities (option A). If she lived there, Barbara could afford to spend $250 per month on food and still have $350 left over for other things. About four blocks away is a one-bedroom apartment with wall-to-wall carpeting and a larger kitchen. It has much more space, but the rent is $600, including utilities. If Barbara took this apartment, she might cut her food expenditures by $50 per month and have only $200 per month left for everything else. In the same building as the one-bedroom apartment is an identical unit on the top floor of the building with a balcony facing west toward the sunset. The balcony and view add $100 to the monthly rent. To live there, Barbara would be left with only $300 to split between food and other expenses. Just because she was curious, Barbara took a look at a townhouse in the suburbs that was renting for $1,000 per month. Obviously, unless she could get along without eating or doing anything else that costs money, she could not afford it. The combination of the townhouse and any amount of food is outside her budget constraint. Notice that we have used the information that we have on income and prices to identify different combinations of housing, food, and other items that are available to a single person household with an income of $1,000 per month. We have said nothing about the process of choosing. Instead, we have carved out what is called a choice set or opportunity set, the set of options that is defined and limited by Barbara's budget constraint. Preferences, Tastes, Trade-Offs, and Opportunity Cost So far, we have identified only the combinations of goods and services that are available to Barbara and those that are not. Within the constraints imposed by limited incomes and fixed prices, however, households are free to choose what they will buy and what they will not buy. Their ultimate choices are governed by their individual preferences and tastes.  It will help you to think of the household choice process as a process of allocating income over a large number of available goods and services. Final demand of a household for any single product is just one of many outcomes that result from the decision-making process. Think, for example, of a demand curve that shows shows a household's reaction to a drop in the price of air travel. During certain periods when people travel less frequently, special fares flood the market and many people decide to take trips that they otherwise would not have taken. However, if I live in Florida and decide to spend $400 to visit my mother in Nashville, I can not spend that $400 on new clothes, dinners at a restaurant, or a new set of tires. A change in the price of a single good changes the constraints within which households choose, and this may change the entire allocation of income. Demand for some goods and services may rise while demand for others falls. A complicated set of trade-offs lies behind the shape and position of a household demand curve for a single good. Whenever a household makes a choice, it is really weighing the good or service it chooses against all the other things that the same money could buy. Consider again our young account manager and her options as listed in Table 1. If she likes to cook, likes to eat at restaurants, and goes out three nights a week, she will probably trade off some housing for dinners out and money to spend on clothes and other things. She will probably rent the studio for $400. She may, however, love to spend long evenings at home reading, listening to classical music, and sipping tea while watching the sunset. In that case, she will probably trade off some restaurant meals, evenings out, and travel expense for the added comfort of the larger apartment with the balcony and the view. As long as a household faces a limited budget---and all households ultimately do---the real cost of any good or service is the value of the other goods and services that could have been purchased with the same amount of money. The real cost of a good or service is its opportunity cost, and opportunity cost is determined by relative prices.  The Budget Constraint More Formally Ann and Tom are struggling graduate students in economics at the University of Virginia. Their tuition is completely paid by graduate fellowships. They live as resident advisors in a first-year dormitory, in return for which they receive an apartment and meals. Their fellowships also give them $200 each month to cover all their other expenses. To simplify things, let us assume that Ann and Tom spend their money on only two things: meals at the local Thai restaurant and nights at the local jazz club, The Hungry Ear. The meals go for a fixed price of $20 per couple. Two tickets to the jazz club, including espresso, are $10. As Figure 3 shows, we can graphically depict the choices that are available to our dynamic duo. The axes measure the quantities of the two goods that Ann and Tom buy. The horizontal axis measures the number of Thai meals consumed per month, and the vertical axis measures the number of trips to The Hungry Ear. (Note that price is not on the vertical axis here.) Every point in the space between the axes represents some combination of Thai meals and nights at the jazz club. The question is: which of these points can Ann and Tom purchase with a fixed budget of $200 per month? That is, which points are in the opportunity set and which are not?  One possibility is that the kids in the dorm are driving Ann and Tom crazy. The two grad students want to avoid the dining hall at all costs. Thus they might decide to spend all their money on Thai food and none of it on jazz. This decision would be represented by a point on the horizontal axis because all the points on that axis are points at which Ann and Tom make no jazz club visits. How many meals can Ann and Tom afford? The answer is simple: if income is $200 and the price of Thai meals is $20, they can afford $200/$20 = 10 meals. This point is labeled A on the budget constraint in Figure 3. Another possibility is that general exams are coming up and Ann and Tom decide to chill out at The Hungry Ear to relieve stress. Suppose that they choose to spend all their money on jazz and none of it on Thai food. This decision would be represented by a point on the vertical axis because all the points on this axis are points at which Ann and Tom eat no Thai meals. How many jazz club visits can they afford? Again, the answer is simple: with an income of $200 and with the price of jazz/espresso at $10, they can go to The Hungry Ear $200/$10 = 20 times. This is the point labeled B in Figure 3. The line connecting points A and B is Ann and Tom's budget constraint.  Budget Constraints Change When Prices Rise or Fall Now suppose that the Thai restaurant is offering 241 certificates good during the month of November. In effect, this means that the price of Thai meals drops to $10 for Ann and Tom. How would the budget constraint in Figure 3 change? First point B would not change. If Ann and Tom spend all their money on jazz, the price of Thai meals is irrelevant. Ann and Tom can still afford only 20 trips to the jazz club. What has changed is point A, which moves to point A' in Figure 4. At the new lower price of $10, if Ann and Tom spent all their money on Thai meals, they could buy twice as many, $200/$10 = 20. The budget constraint swivels, as shown in Figure 4.  The new, flatter budget constraint reflects the new trade-off between Thai meals and Hungry Ear visits. Now, after the price of Thai meals drops to $10, the opportunity cost of a Thai meal is only one jazz club visit. The opportunity set has expanded because at the lower price more combinations of Thai meals and Jazz are available.  *MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, PP. 104-108* end |
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