HOUSEHOLD BEHAVIOR & CONSUMER CHOICE HOUSEHOLD

CHOICE IN OUTPUTMARKETS
The Five Determinants of Demand

1. The price of the good or service.

2. Income of buyers.
3. Prices of related goods or services. These are either complementary, those purchased
along with a particular good or service, or substitutes, those purchased instead of a
certain good or service.
4. Tastes or preferences of consumers.
5. Expectations. These are usually about whether the price will go up.

The Budget Constraint

When consumers' income limits their consumption behaviors, this is known as a budget
constraint. In other words, it's all of the many combinations of goods/services that consumers
are able to purchase in light of their particular income as well as the current prices of these
particular goods/services.
The Equation of the Budget Constraint

The Basis of Choice: Utility

Utility refers to the satisfaction that each choice provides to the decision maker.
Thus, utility theory assumes that any decision is made on the basis of the utility maximization
principle, according to which the best choice is the one that provides the
highest utility (satisfaction) to the decision maker.

 Diminishing Marginal Utility- the Law of Diminishing Marginal Utility states that all
else equal as consumption increases the marginal utility derived from each additional unit
declines. Marginal utility is derived as the change in utility as an additional unit is
consumed. Utility is an economic term used to represent satisfaction or happiness.
Marginal utility is the incremental increase in utility that results from consumption of one
additional unit.

 Allocating Income to Maximize Utility- Every item has a price tag. Consumers must
choose among alternative goods with their limited money incomes. The Utility
Maximization rule states: consumers decide to allocate their money incomes so that the
last dollar spent on each product purchased yields the same amount of extra
marginal utility.

Income Effect vs. Substitution Effect: An Overview

The income effect expresses the impact of increased purchasing power on consumption, while
the substitution effect describes how consumption is impacted by changing relative income and
prices. These economics concepts express changes in the market and how they impact
consumption patterns for consumer goods and services.
Different goods and services experience these changes in different ways. Some products, called
inferior goods, generally decrease in consumption whenever incomes increase. Consumer
spending and consumption of normal goods typically increases with higher purchasing power,
which is in contrast with inferior goods.

Income Effect

The income effect is the change in consumption of goods based on income. This means
consumers will generally spend more if they experience an increase in income, and they may
spend less if their income drops. But the effect doesn't dictate what kind of goods consumers will
buy. In fact, they may opt to purchase more expensive goods in lesser quantities or cheaper
goods in higher quantities, depending on their circumstances and preferences.

The income effect can be both direct and indirect. When a consumer chooses to make changes to
the way he or she spends because of a change in income, the income effect is said to be direct.

EXAMPLE, a consumer may choose to spend less on clothing because his income has dropped.
An income effect becomes indirect when a consumer is faced with making buying choices
because of factors not related to her income. For instance, food prices may go up leaving the
consumer with less income to spend on other items. This may force her to cut back on dining out,
resulting in an indirect income effect.

Substitution Effect

The substitution may occur when a consumer replaces cheaper or moderately priced items with
ones that are more expensive when a change in finances occurs. For example, a good return on
an investment or other monetary gains may prompt a consumer to replace the older model of an
expensive item for a newer one.

The inverse is true when incomes decrease. Substitution in the direction of buying lower-priced
items has a generally negative consequence on retailers because it means lower profits. It also
means fewer options for the consumer.

Retailers who generally sell cheaper items typically benefit from the substitution effect.
While the substitution effect changes consumption patterns in favor of the more affordable
alternative, even a modest reduction in price may make a more expensive product more attractive
to consumers.

EXAMPLE For instance, if private college tuition is more expensive than public college
tuition—and money is a concern—consumers will naturally be attracted to public colleges. But a
small decrease in private tuition costs may be enough to motivate more students to begin
attending private schools.

Household Choice in Input Markets

Saving and Barrowing: Present versus Future Consumption.
Capital formation in a year depends on savings of the people. Now the savings of the people are
determined by choice between present consumption and future consumption. The indifference
curve analysis can be used to show how an individual will choose between present and future
consumption so as to maximize his total satisfaction over time. To make our analysis simple (we
consider only two time periods, working period and the retirement period). The exchange of
present consumption for future consumption is done through saving and lending these savings to
others or keeping them in bank deposits which yield interest.
There are two possible kinds of consumption choices.
A. First, he consumes his entire income in present period, that is, he consumes Y0 in the
present period and saves nothing for the future (i.e. next period).

B. The second possibility is that he chooses to consume less than his present income and
saves some for future consumption. That is, some present consumption is exchanged for
 more consumption in the future. How much more future consumption he will have for
sacrifice of some consumption in the present depends on the rate of interest.

The effect of rise in interest rate has income effect as well as substitution effect:
A rise in rate of interest increases income of the individual and therefore makes him better off.
This induces him to consume more in the present. This is the income effect which tends to
reduce savings. But the rise in interest rate also increases return on savings.
This induces him to postpone consumption because every sacrifice of consumption (i.e. savings)
will mean more consumption in the next period due to higher interest earned. This is substitution
effect which tends to increase savings. Thus the substitution effect and income effect of rise in
interest rate work in opposite direction. Therefore, net effect of rise in interest rate on saving is
quite uncertain.
Either of the two effects may dominate. As a result, higher interest rate may cause more or less
savings. Empirical evidence in the US shows that substitution effect slightly out weights the
income effect. As a result, there is a small net positive effect of higher interest rate on savings.

Factors Affecting Savings

1. Interest Rate:
The rise in interest rate generally brings about increase in supply of savings, though this effect is
not significant. This is because rise in interest rate gives rise to two effects- income effect and
substitution effect – which work in opposite direction. While income effect of rise in wage rate
tends to reduce savings and its substitution effect tends to increase it. Since substitution effect
generally dominates there is a net positive effect, though a small one, of rise in interest rate on
supply of savings.

2. Income:
Keynes emphasized that its level of disposable income that determines savings. As the income
rises, both consumption and saving increase. However, according to Keynes, average propensity
to consume declines as income increases and therefore saving rate rises at higher levels of
income.

3. Social Security Provisions:

Social security measures adopted by the government such as state pension, free health care lower
savings. Generous pension scheme reduces the need for saving for the retirement years.
Similarly, the provision of free health care through the National Health Service also reduces the
need for savings to meet the medical expenses. It has been pointed by some economists that low
saving rate of the UK and USA is mainly due to the comprehensive social security system in
these countries.

4. Taxation System:
Taxes also affect savings by individuals. In India and other countries income tax is the main
direct tax levied on individuals’ incomes including interest and dividend income. It has been
pointed that income tax discourages saving.
For people who keep their savings in bank deposits or use them for buying bonds and shares, tax
on interest and dividends reduce after-tax return from them.”The tax on interest income
substantially reduces the future payoff from current saving and as a result reduces the incentives
for people to save”. According to N.G Mankiw, “Low rate of saving in the United States is at
least partly attributable to tax laws that discourage savings”.