Introduction to Consumer Choices
|Course:||ECON101: Principles of Microeconomics|
|Book:||Introduction to Consumer Choices|
|Printed by:||Guest user|
|Date:||Thursday, October 28, 2021, 1:52 AM|
Read all the sections in this chapter for information on consumer choice, including utility, consumer equilibrium, consumer equilibrium demand, consumer surplus, budget constraint, and consumer equilibrium and indifference curves.
Table of contents
- 1. Introduction to Consumer Choices
- 2. Consumption Choices
- 3. How Changes in Income and Prices Affect Consumption Choices
- 4. Labor-Leisure Choices
- 5. Intertemporal Choices in Financial Capital Markets
- 6. Key Terms
- 7. Key Concepts and Summary
1. Introduction to Consumer Choices
Figure 6.1 Investment Choices Higher education is generally viewed as a good investment, if one can afford it, regardless of the state of the economy.
BRING IT HOME
"Eeny, Meeny, Miney, Moe" - Making Choices
The Great Recession of 2008–2009 touched families around the globe. In too many countries, workers found themselves out of a job. In developed countries, unemployment compensation provided a safety net, but families still saw a marked decrease in disposable income and had to make tough spending decisions. Of course, non-essential, discretionary spending was the first to go.
Even so, there was one particular category that saw a universal increase in spending world-wide during that time - an 18% uptick in the United States, specifically. You might guess that consumers began eating more meals at home, increasing spending at the grocery store. But the Bureau of Labor Statistics' Consumer Expenditure Survey, which tracks U.S. food spending over time, showed "real total food spending by U.S. households declined five percent between 2006 and 2009". So, it was not groceries. Just what product would people around the world demand more of during tough economic times, and more importantly, why? (Find out at chapter's end).
That question leads us to this chapter's topic - analyzing how consumers make choices. For most consumers, using "eeny, meeny, miney, moe" is not how they make decisions; their decision-making processes have been educated far beyond a children's rhyme.
INTRODUCTION TO CONSUMER CHOICES
In this chapter, you will learn about:
- Consumption Choices
- How Changes in Income and Prices Affect Consumption Choices
- Labor-Leisure Choices
- Intertemporal Choices in Financial Capital Markets
Microeconomics seeks to understand the behavior of individual economic agents such as individuals and businesses. Economists believe that individuals' decisions, such as what goods and services to buy, can be analyzed as choices made within certain budget constraints. Generally, consumers are trying to get the most for their limited budget. In economic terms they are trying to maximize total utility, or satisfaction, given their budget constraint.
Everyone has their own personal tastes and preferences. The French say: Chacun à son goût, or "Each to his own taste". An old Latin saying states, De gustibus non est disputandum or "There's no disputing about taste". If people's decisions are based on their own tastes and personal preferences, however, then how can economists hope to analyze the choices consumers make?
An economic explanation for why people make different choices begins with accepting the proverbial wisdom that tastes are a matter of personal preference. But economists also believe that the choices people make are influenced by their incomes, by the prices of goods and services they consume, and by factors like where they live. This chapter introduces the economic theory of how consumers make choices about what to buy, how much to work, and how much to save.
The analysis in this chapter will build on the three budget constraints introduced in the Choice in a World of Scarcity chapter. These were the consumption choice budget constraint, the labor-leisure budget constraint, and the intertemporal budget constraint. This chapter will also illustrate how economic theory provides a tool to systematically look at the full range of possible consumption choices to predict how consumption responds to changes in prices or incomes. After reading this chapter, consult the appendix Indifference Curves to learn more about representing utility and choice through indifference curves.
Source: Rice University, https://openstax.org/books/principles-microeconomics/pages/6-introduction-to-consumer-choices
This work is licensed under a Creative Commons Attribution 4.0 License.
2. Consumption Choices
By the end of this section, you will be able to:
- Calculate total utility
- Propose decisions that maximize utility
- Explain marginal utility and the significance of diminishing marginal utility
Information on the consumption choices of Americans is available from the Consumer Expenditure Survey carried out by the U.S. Bureau of Labor Statistics. Table 6.1 shows spending patterns for the average U.S. household. The first row shows income and, after taxes and personal savings are subtracted, it shows that, in 2015, the average U.S. household spent $48,109 on consumption. The table then breaks down consumption into various categories. The average U.S. household spent roughly one-third of its consumption on shelter and other housing expenses, another one-third on food and vehicle expenses, and the rest on a variety of items, as shown. Of course, these patterns will vary for specific households by differing levels of family income, by geography, and by preferences.
|Average Household Income before Taxes||$62,481|
|Average Annual Expenditures||$48.109|
|Food at home||$3,264|
|Food away from home||$2,505|
|Apparel and services||$1,700|
|Personal insurance and pensions||$5,357|
|All else: alcohol, tobacco, reading, personal care, cash contributions, miscellaneous||$3,356|
2.1. Total Utility and Diminishing Marginal Utility
To understand how a household will make its choices, economists look at what consumers can afford, as shown in a budget constraint line, and the total utility or satisfaction derived from those choices. In a budget constraint line, the quantity of one good is measured on the horizontal axis and the quantity of the other good is measured on the vertical axis. The budget constraint line shows the various combinations of two goods that are affordable given consumer income. Consider the situation of José, shown in Figure 6.2. José likes to collect T-shirts and watch movies.
In Figure 6.2, the quantity of T-shirts is shown on the horizontal axis, while the quantity of movies is shown on the vertical axis. If José had unlimited income or goods were free, then he could consume without limit. But José, like all of us, faces a budget constraint. José has a total of $56 to spend. The price of T-shirts is $14 and the price of movies is $7. Notice that the vertical intercept of the budget constraint line is at eight movies and zero T-shirts ($56/$7=8). The horizontal intercept of the budget constraint is four, where José spends of all of his money on T-shirts and no movies ($56/14=4). The slope of the budget constraint line is rise/run or –8/4=–2. The specific choices along the budget constraint line show the combinations of T-shirts and movies that are affordable.
The points on the graph show how a budget is affected by spending choices. Spending more money at the movies (y-axis) means that Jose' has less money to spend on T-shirts (x-axis).
Figure 6.2 A Choice between Consumption Goods José has income of $56. Movies cost $7 and T-shirts cost $14. The points on the budget constraint line show the combinations of movies and T-shirts that are affordable.
José wishes to choose the combination that will provide him with the greatest utility, which is the term economists use to describe a person's level of satisfaction or happiness with his or her choices.
Let's begin with an assumption, which will be discussed in more detail later, that José can measure his own utility with something called utils. (It is important to note that you cannot make comparisons between the utils of individuals; if one person gets 20 utils from a cup of coffee and another gets 10 utils, this does not mean than the first person gets more enjoyment from the coffee than the other or that they enjoy the coffee twice as much.) Table 6.2 shows how José's utility is connected with his consumption of T-shirts or movies. The first column of the table shows the quantity of T-shirts consumed. The second column shows the total utility, or total amount of satisfaction, that José receives from consuming that number of T-shirts. The most common pattern of total utility, as shown here, is that consuming additional goods leads to greater total utility, but at a decreasing rate. The third column shows marginal utility, which is the additional utility provided by one additional unit of consumption. This equation for marginal utility is:
Notice that marginal utility diminishes as additional units are consumed, which means that each subsequent unit of a good consumed provides less additional utility. For example, the first T-shirt José picks is his favorite and it gives him an addition of 22 utils. The fourth T-shirt is just to something to wear when all his other clothes are in the wash and yields only 18 additional utils. This is an example of the law of diminishing marginal utility, which holds that the additional utility decreases with each unit added.
The rest of Table 6.2 shows the quantity of movies that José attends, and his total and marginal utility from seeing each movie. Total utility follows the expected pattern: it increases as the number of movies seen rises. Marginal utility also follows the expected pattern: each additional movie brings a smaller gain in utility than the previous one. The first movie José attends is the one he wanted to see the most, and thus provides him with the highest level of utility or satisfaction. The fifth movie he attends is just to kill time. Notice that total utility is also the sum of the marginal utilities. Read the next Work It Out feature for instructions on how to calculate total utility.
|T-Shirts (Quantity)||Total Utility||Marginal Utility||Movies (Quantity)||Total Utility||Marginal Utility|
Table 6.2 Total and Marginal Utility
Table 6.3 looks at each point on the budget constraint in Figure 6.2, and adds up José's total utility for five possible combinations of T-shirts and movies.
|P||4||0||81 + 0 = 81|
|Q||3||2||63 + 31 = 94|
|R||2||4||43 + 58 = 101|
|S||1||6||22 + 81 = 103|
|T||0||8||0 + 100 = 100|
Table 6.3 Finding the Choice with the Highest Utility
WORK IT OUT
Calculating Total Utility
Let's look at how José makes his decision in more detail.
Step 1. Observe that, at point Q (for example), José consumes three T-shirts and two movies.
Step 2. Look at Table 6.2. You can see from the fourth row/second column that three T-shirts are worth 63 utils. Similarly, the second row/fifth column shows that two movies are worth 31 utils.
Step 3. From this information, you can calculate that point Q has a total utility of 94 (63 + 31).
Step 4. You can repeat the same calculations for each point on Table 6.3, in which the total utility numbers are shown in the last column.For José, the highest total utility for all possible combinations of goods occurs at point S, with a total utility of 103 from consuming one T-shirt and six movies.
2.2. Choosing with Marginal Utility
Most people approach their utility-maximizing combination of choices in a step-by-step way. This step-by-step approach is based on looking at the tradeoffs, measured in terms of marginal utility, of consuming less of one good and more of another.
For example, say that José starts off thinking about spending all his money on T-shirts and choosing point P, which corresponds to four T-shirts and no movies, as illustrated in Figure 6.2. José chooses this starting point randomly; he has to start somewhere. Then he considers giving up the last T-shirt, the one that provides him the least marginal utility, and using the money he saves to buy two movies instead. Table 6.4 tracks the step-by-step series of decisions José needs to make (Key: T-shirts are $14, movies are $7, and income is $56). The following Work It Out feature explains how marginal utility can effect decision making.
|Try||Which Has||Total Utility||Marginal Gain and Loss of Utility, Compared with Previous Choice||Conclusion|
|Choice 1: P||4 T-shirts and 0 movies||81 from 4 T-shirts + 0 from 0 movies = 81||–||–|
|Choice 2: Q||3 T-shirts and 2 movies||63 from 3 T-shirts + 31 from 0 movies = 94||Loss of 18 from 1 less T-shirt, but gain of 31 from 2 more movies, for a net utility gain of 13||Q is preferred over P|
|Choice 3: R||2 T-shirts and 4 movies||43 from 2 T-shirts + 58 from 4 movies = 101||Loss of 20 from 1 less T-shirt, but gain of 27 from two more movies for a net utility gain of 7||R is preferred over Q|
|Choice 4: S||1 T-shirt and 6 movies||22 from 1 T-shirt + 81 from 6 movies = 103||Loss of 21 from 1 less T-shirt, but gain of 23 from two more movies, for a net utility gain of 2||S is preferred over R|
|Choice 5: T||0 T-shirts and 8 movies||0 from 0 T-shirts + 100 from 8 movies = 100||Loss of 22 from 1 less T-shirt, but gain of 19 from two more movies, for a net utility loss of 3||S is preferred over T|
Table 6.4 A Step-by-Step Approach to Maximizing Utility
WORK IT OUT
Decision Making by Comparing Marginal Utility
José could use the following thought process (if he thought in utils) to make his decision regarding how many T-shirts and movies to purchase:
Step 1. From Table 6.2, José can see that the marginal utility of the fourth T-shirt is 18. If José gives up the fourth T-shirt, then he loses 18 utils.
Step 2. Giving up the fourth T-shirt, however, frees up $14 (the price of a T-shirt), allowing José to buy the first two movies (at $7 each).
Step 3. José knows that the marginal utility of the first movie is 16 and the marginal utility of the second movie is 15. Thus, if José moves from point P to point Q, he gives up 18 utils (from the T-shirt), but gains 31 utils (from the movies).
Step 4. Gaining 31 utils and losing 18 utils is a net gain of 13. This is just another way of saying that the total utility at Q (94 according to the last column in Table 6.3) is 13 more than the total utility at P (81).
Step 5. So, for José, it makes sense to give up the fourth T-shirt in order to buy two movies.
José clearly prefers point Q to point P. Now repeat this step-by-step process of decision making with marginal utilities. José thinks about giving up the third T-shirt and surrendering a marginal utility of 20, in exchange for purchasing two more movies that promise a combined marginal utility of 27. José prefers point R to point Q. What if José thinks about going beyond R to point S? Giving up the second T-shirt means a marginal utility loss of 21, and the marginal utility gain from the fifth and sixth movies would combine to make a marginal utility gain of 23, so José prefers point S to R.
However, if José seeks to go beyond point S to point T, he finds that the loss of marginal utility from giving up the first T-shirt is 22, while the marginal utility gain from the last two movies is only a total of 19. If José were to choose point T, his utility would fall to 100. Through these stages of thinking about marginal tradeoffs, José again concludes that S, with one T-shirt and six movies, is the choice that will provide him with the highest level of total utility. This step-by-step approach will reach the same conclusion regardless of José's starting point.
Another way to look at this is by focusing on satisfaction per dollar. Marginal utility per dollar is the amount of additional utility José receives given the price of the product. For José's T-shirts and movies, the marginal utility per dollar is shown in Table 6.5.
José's first purchase will be a movie. Why? Because it gives him the highest marginal utility per dollar and it is affordable. José will continue to purchase the good which gives him the highest marginal utility per dollar until he exhausts the budget. José will keep purchasing movies because they give him a greater "bang or the buck" until the sixth movie is equivalent to a T-shirt purchase. José can afford to purchase that T-shirt. So José will choose to purchase six movies and one T-shirt.
|Quantity of T-Shirts||Total Utility||Marginal Utility||Marginal Utility per Dollar||Quantity of Movies||Total Utility||Marginal Utility||Marginal Utility per Dollar|
Table 6.5 Marginal Utility per Dollar
2.3. A Rule for Maximizing Utility
This process of decision making suggests a rule to follow when maximizing utility. Since the price of T-shirts is twice as high as the price of movies, to maximize utility the last T-shirt chosen needs to provide exactly twice the marginal utility (MU) of the last movie. If the last T-shirt provides less than twice the marginal utility of the last movie, then the T-shirt is providing less "bang for the buck" (i.e., marginal utility per dollar spent) than if the same money were spent on movies. If this is so, José should trade the T-shirt for more movies to increase his total utility. Marginal utility per dollar measures the additional utility that José will enjoy given what he has to pay for the good.
If the last T-shirt provides more than twice the marginal utility of the last movie, then the T-shirt is providing more "bang for the buck" or marginal utility per dollar, than if the money were spent on movies. As a result, José should buy more T-shirts. Notice that at José's optimal choice of point S, the marginal utility from the first T-shirt, of 22 is exactly twice the marginal utility of the sixth movie, which is 11. At this choice, the marginal utility per dollar is the same for both goods. This is a tell-tale signal that José has found the point with highest total utility.
This argument can be written as a general rule: the utility-maximizing choice between consumption goods occurs where the marginal utility per dollar is the same for both goods.
A sensible economizer will pay twice as much for something only if, in the marginal comparison, the item confers twice as much utility. Notice that the formula for the table above is:
The following Work It Out feature provides step by step guidance for this concept of utility-maximizing choices.
WORK IT OUT
The general rule, , means that the last dollar spent on each good provides exactly the same marginal utility. So:
Step 1. If we traded a dollar more of movies for a dollar more of T-shirts, the marginal utility gained from T-shirts would exactly offset the marginal utility lost from fewer movies. In other words, the net gain would be zero.
Step 2. Products, however, usually cost more than a dollar, so we cannot trade a dollar's worth of movies. The best we can do is trade two movies for another T-shirt, since in this example T-shirts cost twice what a movie does.
Step 3. If we trade two movies for one T-shirt, we would end up at point R (two T-shirts and four movies).
Step 4. Choice 4 in Table 6.4 shows that if we move to point S, we would lose 21 utils from one less T-shirt, but gain 23 utils from two more movies, so we would end up with more total utility at point S.
In short, the general rule shows us the utility-maximizing choice.
There is another, equivalent way to think about this. The general rule can also be expressed as the ratio of the prices of the two goods should be equal to the ratio of the marginal utilities. When the price of good 1 is divided by the price of good 2, at the utility-maximizing point this will equal the marginal utility of good 1 divided by the marginal utility of good 2. This rule, known as the consumer equilibrium, can be written in algebraic form:
Along the budget constraint, the total price of the two goods remains the same, so the ratio of the prices does not change. However, the marginal utility of the two goods changes with the quantities consumed. At the optimal choice of one T-shirt and six movies, point S, the ratio of marginal utility to price for T-shirts (22:14) matches the ratio of marginal utility to price for movies (of 11:7).
2.4. Measuring Utility with Numbers
This discussion of utility started off with an assumption that it is possible to place numerical values on utility, an assumption that may seem questionable. You can buy a thermometer for measuring temperature at the hardware store, but what store sells an "utilimometer" for measuring utility? However, while measuring utility with numbers is a convenient assumption to clarify the explanation, the key assumption is not that utility can be measured by an outside party, but only that individuals can decide which of two alternatives they prefer.
To understand this point, think back to the step-by-step process of finding the choice with highest total utility by comparing the marginal utility that is gained and lost from different choices along the budget constraint. As José compares each choice along his budget constraint to the previous choice, what matters is not the specific numbers that he places on his utility - or whether he uses any numbers at all - but only that he personally can identify which choices he prefers.
In this way, the step-by-step process of choosing the highest level of utility resembles rather closely how many people make consumption decisions. We think about what will make us the happiest; we think about what things cost; we think about buying a little more of one item and giving up a little of something else; we choose what provides us with the greatest level of satisfaction. The vocabulary of comparing the points along a budget constraint and total and marginal utility is just a set of tools for discussing this everyday process in a clear and specific manner. It is welcome news that specific utility numbers are not central to the argument, since a good utilimometer is hard to find. Do not worry - while we cannot measure utils, by the end of the next module, we will have transformed our analysis into something we can measure - demand.
3. How Changes in Income and Prices Affect Consumption Choices
By the end of this section, you will be able to:
- Explain how income, prices, and preferences affect consumer choices
- Contrast the substitution effect and the income effect
- Utilize concepts of demand to analyze consumer choices
- Apply utility-maximizing choices to governments and businesses
Just as utility and marginal utility can be used to discuss making consumer choices along a budget constraint, these ideas can also be used to think about how consumer choices change when the budget constraint shifts in response to changes in income or price. Indeed, because the budget constraint framework can be used to analyze how quantities demanded change because of price movements, the budget constraint model can illustrate the underlying logic behind demand curves.
3.1. How Changes in Income Affect Consumer Choices
Let's begin with a concrete example illustrating how changes in income level affect consumer choices. Figure 6.3 shows a budget constraint that represents Kimberly's choice between concert tickets at $50 each and getting away overnight to a bed-and-breakfast for $200 per night. Kimberly has $1,000 per year to spend between these two choices. After thinking about her total utility and marginal utility and applying the decision rule that the ratio of the marginal utilities to the prices should be equal between the two products, Kimberly chooses point M, with eight concerts and three overnight getaways as her utility-maximizing choice.
The graph's various points represent which good is viewed as inferior. The first solid downward sloping line represents the original budget constraint. The second budget constraint represents a different set of options based on the consumer having more money to spend on both items.
Figure 6.3 How a Change in Income Affects Consumption Choices The utility-maximizing choice on the original budget constraint is M. The dashed horizontal and vertical lines extending through point M allow you to see at a glance whether the quantity consumed of goods on the new budget constraint is higher or lower than on the original budget constraint. On the new budget constraint, a choice like N will be made if both goods are normal goods. If overnight stays is an inferior good, a choice like P will be made. If concert tickets are an inferior good, a choice like Q will be made.
Now, assume that the income Kimberly has to spend on these two items rises to $2,000 per year, causing her budget constraint to shift out to the right. How does this rise in income alter her utility-maximizing choice? Kimberly will again consider the utility and marginal utility that she receives from concert tickets and overnight getaways and seek her utility-maximizing choice on the new budget line. But how will her new choice relate to her original choice?
The possible choices along the new budget constraint can be divided into three groups, which are divided up by the dashed horizontal and vertical lines that pass through the original choice M in the figure. All choices on the upper left of the new budget constraint that are to the left of the vertical dashed line, like choice P with two overnight stays and 32 concert tickets, involve less of the good on the horizontal axis but much more of the good on the vertical axis. All choices to the right of the vertical dashed line and above the horizontal dashed line - like choice N with five overnight getaways and 20 concert tickets - have more consumption of both goods. Finally, all choices that are to the right of the vertical dashed line but below the horizontal dashed line, like choice Q with four concerts and nine overnight getaways, involve less of the good on the vertical axis but much more of the good on the horizontal axis.
All of these choices are theoretically possible, depending on Kimberly's personal preferences as expressed through the total and marginal utility she would receive from consuming these two goods. When income rises, the most common reaction is to purchase more of both goods, like choice N, which is to the upper right relative to Kimberly's original choice M, although exactly how much more of each good will vary according to personal taste. Conversely, when income falls, the most typical reaction is to purchase less of both goods. As defined in the chapter on Demand and Supply and again in the chapter on Elasticity, goods and services are called normal goods when a rise in income leads to a rise in the quantity consumed of that good and a fall in income leads to a fall in quantity consumed.
However, depending on Kimberly's preferences, a rise in income could cause consumption of one good to increase while consumption of the other good declines. A choice like P means that a rise in income caused her quantity consumed of overnight stays to decline, while a choice like Q would mean that a rise in income caused her quantity of concerts to decline. Goods where demand declines as income rises (or conversely, where the demand rises as income falls) are called "inferior goods". An inferior good occurs when people trim back on a good as income rises, because they can now afford the more expensive choices that they prefer. For example, a higher-income household might eat fewer hamburgers or be less likely to buy a used car, and instead eat more steak and buy a new car.
3.2. How Price Changes Affect Consumer Choices
For analyzing the possible effect of a change in price on consumption, let's again use a concrete example. Figure 6.4 represents the consumer choice of Sergei, who chooses between purchasing baseball bats and cameras. A price increase for baseball bats would have no effect on the ability to purchase cameras, but it would reduce the number of bats Sergei could afford to buy. Thus a price increase for baseball bats, the good on the horizontal axis, causes the budget constraint to rotate inward, as if on a hinge, from the vertical axis. As in the previous section, the point labeled M represents the originally preferred point on the original budget constraint, which Sergei has chosen after contemplating his total utility and marginal utility and the tradeoffs involved along the budget constraint. In this example, the units along the horizontal and vertical axes are not numbered, so the discussion must focus on whether more or less of certain goods will be consumed, not on numerical amounts.
Figure 6.4 How a Change in Price Affects Consumption Choices The original utility-maximizing choice is M. When the price rises, the budget constraint shifts in to the left. The dashed lines make it possible to see at a glance whether the new consumption choice involves less of both goods, or less of one good and more of the other. The new possible choices would be fewer baseball bats and more cameras, like point H, or less of both goods, as at point J. Choice K would mean that the higher price of bats led to exactly the same quantity of bats being consumed, but fewer cameras. Choices like L are ruled out as theoretically possible but highly unlikely in the real world, because they would mean that a higher price for baseball bats means a greater quantity consumed of baseball bats.
After the price increase, Sergei will make a choice along the new budget constraint. Again, his choices can be divided into three segments by the dashed vertical and horizontal lines. In the upper left portion of the new budget constraint, at a choice like H, Sergei consumes more cameras and fewer bats. In the central portion of the new budget constraint, at a choice like J, he consumes less of both goods. At the right-hand end, at a choice like L, he consumes more bats but fewer cameras.
The typical response to higher prices is that a person chooses to consume less of the product with the higher price. This occurs for two reasons, and both effects can occur simultaneously. The substitution effect occurs when a price changes and consumers have an incentive to consume less of the good with a relatively higher price and more of the good with a relatively lower price. The income effect is that a higher price means, in effect, the buying power of income has been reduced (even though actual income has not changed), which leads to buying less of the good (when the good is normal). In this example, the higher price for baseball bats would cause Sergei to buy a fewer bats for both reasons. Exactly how much will a higher price for bats cause Sergei consumption of bats to fall? Figure 6.4 suggests a range of possibilities. Sergei might react to a higher price for baseball bats by purchasing the same quantity of bats, but cutting his consumption of cameras. This choice is the point K on the new budget constraint, straight below the original choice M. Alternatively, Sergei might react by dramatically reducing his purchases of bats and instead buy more cameras.
The key is that it would be imprudent to assume that a change in the price of baseball bats will only or primarily affect the good whose price is changed, while the quantity consumed of other goods remains the same. Since Sergei purchases all his products out of the same budget, a change in the price of one good can also have a range of effects, either positive or negative, on the quantity consumed of other goods.
In short, a higher price typically causes reduced consumption of the good in question, but it can affect the consumption of other goods as well.
3.3. The Foundations of Demand Curves
Changes in the price of a good lead the budget constraint to shift. A shift in the budget constraint means that when individuals are seeking their highest utility, the quantity that is demanded of that good will change. In this way, the logical foundations of demand curves - which show a connection between prices and quantity demanded - are based on the underlying idea of individuals seeking utility. Figure 6.5 (a) shows a budget constraint with a choice between housing and "everything else". (Putting "everything else" on the vertical axis can be a useful approach in some cases, especially when the focus of the analysis is on one particular good). The preferred choice on the original budget constraint that provides the highest possible utility is labeled M0. The other three budget constraints represent successively higher prices for housing of P1, P2, and P3. As the budget constraint rotates in, and in, and in again, the utility-maximizing choices are labeled M1, M2, and M3, and the quantity demanded of housing falls from Q0 to Q1 to Q2 to Q3.
Figure 6.5 The Foundations of a Demand Curve: An Example of Housing (a) As the price increases from P0 to P1 to P2 to P3, the budget constraint on the upper part of the diagram shifts to the left. The utility-maximizing choice changes from M0 to M1 to M2 to M3. As a result, the quantity demanded of housing shifts from Q0 to Q1 to Q2 to Q3, ceteris paribus. (b) The demand curve graphs each combination of the price of housing and the quantity of housing demanded, ceteris paribus. Indeed, the quantities of housing are the same at the points on both (a) and (b). Thus, the original price of housing (P0) and the original quantity of housing (Q0) appear on the demand curve as point E0. The higher price of housing (P1) and the corresponding lower quantity demanded of housing (Q1) appear on the demand curve as point E1.
So, as the price of housing rises, the budget constraint shifts to the left, and the quantity consumed of housing falls, ceteris paribus (meaning, with all other things being the same). This relationship - the price of housing rising from P0 to P1 to P2 to P3, while the quantity of housing demanded falls from Q0 to Q1 to Q2 to Q3 - is graphed on the demand curve in Figure 6.5 (b). Indeed, the vertical dashed lines stretching between the top and bottom of Figure 6.5 show that the quantity of housing demanded at each point is the same in both (a) and (b). The shape of a demand curve is ultimately determined by the underlying choices about maximizing utility subject to a budget constraint. And while economists may not be able to measure "utils," they can certainly measure price and quantity demanded.
3.4. Applications in Government and Business
The budget constraint framework for making utility-maximizing choices offers a reminder that people can react to a change in price or income in a range of different ways. For example, in the winter months of 2005, costs for heating homes increased significantly in many parts of the country as prices for natural gas and electricity soared, due in large part to the disruption caused by Hurricanes Katrina and Rita. Some people reacted by reducing the quantity demanded of energy; for example, by turning down the thermostats in their homes by a few degrees and wearing a heavier sweater inside. Even so, many home heating bills rose, so people adjusted their consumption in other ways, too. As you learned in the chapter on Elasticity, the short run demand for home heating is generally inelastic. Each household cut back on what it valued least on the margin; for some it might have been some dinners out, or a vacation, or postponing buying a new refrigerator or a new car. Indeed, sharply higher energy prices can have effects beyond the energy market, leading to a widespread reduction in purchasing throughout the rest of the economy.
A similar issue arises when the government imposes taxes on certain products, like it does on gasoline, cigarettes, and alcohol. Say that a tax on alcohol leads to a higher price at the liquor store, the higher price of alcohol causes the budget constraint to pivot left, and consumption of alcoholic beverages is likely to decrease. However, people may also react to the higher price of alcoholic beverages by cutting back on other purchases. For example, they might cut back on snacks at restaurants like chicken wings and nachos. It would be unwise to assume that the liquor industry is the only one affected by the tax on alcoholic beverages. Read the next Clear It Up to learn about how buying decisions are influenced by who controls the household income.
Clear It Up
Does who controls household income make a difference?
In the mid-1970s, the United Kingdom made an interesting policy change in its "child allowance" policy. This program provides a fixed amount of money per child to every family, regardless of family income. Traditionally, the child allowance had been distributed to families by withholding less in taxes from the paycheck of the family wage earner - typically the father in this time period. The new policy instead provided the child allowance as a cash payment to the mother. As a result of this change, households have the same level of income and face the same prices in the market, but the money is more likely to be in the purse of the mother than in the wallet of the father.
Should this change in policy alter household consumption patterns? Basic models of consumption decisions, of the sort examined in this chapter, assume that it does not matter whether the mother or the father receives the money, because both parents seek to maximize the utility of the family as a whole. In effect, this model assumes that everyone in the family has the same preferences.
In reality, the share of income controlled by the father or the mother does affect what the household consumes. When the mother controls a larger share of family income a number of studies, in the United Kingdom and in a wide variety of other countries, have found that the family tends to spend more on restaurant meals, child care, and women's clothing, and less on alcohol and tobacco. As the mother controls a larger share of household resources, children's health improves, too. These findings suggest that when providing assistance to poor families, in high-income countries and low-income countries alike, the monetary amount of assistance is not all that matters: it also matters which member of the family actually receives the money.
The budget constraint framework serves as a constant reminder to think about the full range of effects that can arise from changes in income or price, not just effects on the one product that might seem most immediately affected.
4. Labor-Leisure Choices
By the end of this section, you will be able to:
- Interpret labor-leisure budget constraint graphs
- Predict consumer choices based on wages and other compensation
- Explain the backward-bending supply curve of labor
People do not obtain utility just from products they purchase. They also obtain utility from leisure time. Leisure time is time not spent at work. The decision-making process of a utility-maximizing household applies to what quantity of hours to work in much the same way that it applies to purchases of goods and services. Choices made along the labor-leisure budget constraint, as wages shift, provide the logical underpinning for the labor supply curve. The discussion also offers some insights about the range of possible reactions when people receive higher wages, and specifically about the claim that if people are paid higher wages, they will work a greater quantity of hours - assuming that they have a say in the matter.
According to the Bureau of Labor Statistics, U.S. workers averaged 38.6 hours per week on the job in 2014. This average includes part-time workers; for full-time workers only, the average was 42.5 hours per week. Table 6.6 shows that more than half of all workers are on the job 35 to 48 hours per week, but significant proportions work more or less than this amount.
Table 6.7 breaks down the average hourly compensation received by private industry workers, including wages and benefits. Wages and salaries are about three-quarters of total compensation received by workers; the rest is in the form of health insurance, vacation pay, and other benefits. The compensation workers receive differs for many reasons, including experience, education, skill, talent, membership in a labor union, and the presence of discrimination against certain groups in the labor market. Issues surrounding the inequality of incomes in a market-oriented economy are explored in the chapters on Poverty and Economic Inequality and Issues in Labor Markets: Unions, Discrimination, Immigration.
|Hours Worked per Week||Number of Workers||Percentage of Workforce|
|1–14 hours||6.9 million||5.0%|
|15–34 hours||27.6 million||20.1%|
|35–40 hours||68.5 million||49.9%|
|41–48 hours||11.9 million||8.6%|
|49–59 hours||13.3 million||9.6%|
|60 hours and over||9.3 million||6.8%|
Table 6.6 Persons at Work, by Average Hours Worked per Week in 2013 (Total number of workers: 137.7 million)
|Compensation, Wage, Salary, and Benefits||$30.92 per hour|
|Wages and Salaries||$20.92|
|Retirement and Savings||$1.24|
Table 6.7 Hourly Compensation: Wages, Benefits, and Taxes in 2014
4.1. The Labor-Leisure Budget Constraint
How do workers make decisions about the number of hours to work? Again, let's proceed with a concrete example. The economic logic is precisely the same as in the case of a consumption choice budget constraint, but the labels are different on a labor-leisure budget constraint.
Vivian has 70 hours per week that she could devote either to work or to leisure, and her wage is $10/hour. The lower budget constraint in Figure 6.6 shows Vivian's possible choices. The horizontal axis of this diagram measures both leisure and labor, by showing how Vivian's time is divided between leisure and labor. Hours of leisure are measured from left to right on the horizontal axis, while hours of labor are measured from right to left. Vivian will compare choices along this budget constraint, ranging from 70 hours of leisure and no income at point S to zero hours of leisure and $700 of income at point L. She will choose the point that provides her with the highest total utility. For this example, let's assume that Vivian's utility-maximizing choice occurs at O, with 30 hours of leisure, 40 hours of work, and $400 in weekly income.
Figure 6.6 How a Rise in Wages Alters the Utility-Maximizing Choice Vivian's original choice is point O on the lower opportunity set. A rise in her wage causes her opportunity set to swing upward. In response to the increase in wages, Vivian can make a range of different choices available to her: a choice like D, which involves less work; and a choice like B, which involves the same amount of work but more income; or a choice like A, which involves more work and considerably more income. Vivian's personal preferences will determine which choice she makes.
For Vivian to discover the labor-leisure choice that will maximize her utility, she does not have to place numerical values on the total and marginal utility that she would receive from every level of income and leisure. All that really matters is that Vivian can compare, in her own mind, whether she would prefer more leisure or more income, given the tradeoffs she faces. If Vivian can say to herself: "I'd really rather work a little less and have more leisure, even if it means less income," or "I'd be willing to work more hours to make some extra income," then as she gradually moves in the direction of her preferences, she will seek out the utility-maximizing choice on her labor-leisure budget constraint.
Now imagine that Vivian's wage level increases to $12/hour. A higher wage will mean a new budget constraint that tilts up more steeply; conversely, a lower wage would have led to a new budget constraint that was flatter. How will a change in the wage and the corresponding shift in the budget constraint affect Vivian's decisions about how many hours to work?
Vivian's choices of quantity of hours to work and income along her new budget constraint can be divided into several categories, using the dashed horizontal and vertical lines in Figure 6.6 that go through her original choice (O). One set of choices in the upper-left portion of the new budget constraint involves more hours of work (that is, less leisure) and more income, at a point like A with 20 hours of leisure, 50 hours of work, and $600 of income (that is, 50 hours of work multiplied by the new wage of $12 per hour). A second choice would be to work exactly the same 40 hours, and to take the benefits of the higher wage in the form of income that would now be $480, at choice B. A third choice would involve more leisure and the same income at point C (that is, 33-1/3 hours of work multiplied by the new wage of $12 per hour equals $400 of total income). A fourth choice would involve less income and much more leisure at a point like D, with a choice like 50 hours of leisure, 20 hours of work, and $240 in income.
In effect, Vivian can choose whether to receive the benefits of her wage increase in the form of more income, or more leisure, or some mixture of these two. With this range of possibilities, it would be unwise to assume that Vivian (or anyone else) will necessarily react to a wage increase by working substantially more hours. Maybe they will; maybe they will not.
4.2. Applications of Utility Maximizing with the Labor-Leisure Budget Constraint
The theoretical insight that higher wages will sometimes cause an increase in hours worked, sometimes cause hours worked not to change by much, and sometimes cause hours worked to decline, has led to labor supply curves that look like the one in Figure 6.7. The bottom-left portion of the labor supply curve slopes upward, which reflects the situation of a person who reacts to a higher wage by supplying a greater quantity of labor. The middle, close-to-vertical portion of the labor supply curve reflects the situation of a person who reacts to a higher wage by supplying about the same quantity of labor. The very top portion of the labor supply curve is called a backward-bending supply curve for labor, which is the situation of high-wage people who can earn so much that they respond to a still-higher wage by working fewer hours. Read the following Clear It Up feature for more on the number of hours the average person works each year.
Figure 6.7 A Backward-Bending Supply Curve of Labor The bottom upward-sloping portion of the labor supply curve shows that as wages increase over this range, the quantity of hours worked also increases. The middle, nearly vertical portion of the labor supply curve shows that as wages increase over this range, the quantity of hours worked changes very little. The backward-bending portion of the labor supply curve at the top shows that as wages increase over this range, the quantity of hours worked actually decreases. All three of these possibilities can be derived from how a change in wages causes movement in the labor-leisure budget constraint, and thus different choices by individuals.
Clear It Up
Is America a nation of workaholics?
Americans work a lot. Table 6.8 shows average hours worked per year in the United States, Canada, Japan, and several European countries, with data from 2013. To get a perspective on these numbers, someone who works 40 hours per week for 50 weeks per year, with two weeks off, would work 2,000 hours per year. The gap in hours worked is a little astonishing; the 250 to 300 hour gap between how much Americans work and how much Germans or the French work amounts to roughly six to seven weeks less of work per year. Economists who study these international patterns debate the extent to which average Americans and Japanese have a preference for working more than, say, Germans, or whether German workers and employers face particular kinds of taxes and regulations that lead to fewer hours worked. Many countries have laws that regulate the work week and dictate holidays and the standards of "normal" vacation time vary from country to country. It is also interesting to take the amount of time spent working in context; it is estimated that in the late nineteenth century in the United States, the average work week was over 60 hours per week - leaving little to no time for leisure.
|Country||Average Annual Hours Actually Worked per Employed Person|
Table 6.8 Average Hours Worked Per Year in Select Countries
The different responses to a rise in wages - more hours worked, the same hours worked, or fewer hours worked - are patterns exhibited by different groups of workers in the U.S. economy. Many full-time workers have jobs where the number of hours is held relatively fixed, partly by their own choice and partly by their employer's practices. These workers do not much change their hours worked as wages rise or fall, so their supply curve of labor is inelastic. However, part-time workers and younger workers tend to be more flexible in their hours, and more ready to increase hours worked when wages are high or cut back when wages fall.
The backward-bending supply curve for labor, when workers react to higher wages by working fewer hours and having more income, is not observed often in the short run. However, some well-paid professionals, like dentists or accountants, may react to higher wages by choosing to limit the number of hours, perhaps by taking especially long vacations, or taking every other Friday off. Over a long-term perspective, the backward-bending supply curve for labor is common. Over the last century, Americans have reacted to gradually rising wages by working fewer hours; for example, the length of the average work-week has fallen from about 60 hours per week in 1900 to the present average of less than 40 hours per week.
Recognizing that workers have a range of possible reactions to a change in wages casts some fresh insight on a perennial political debate: the claim that a reduction in income taxes - which would, in effect, allow people to earn more per hour - will encourage people to work more. The leisure-income budget set points out that this connection will not hold true for all workers. Some people, especially part-timers, may react to higher wages by working more. Many will work the same number of hours. Some people, especially those whose incomes are already high, may react to the tax cut by working fewer hours. Of course, cutting taxes may be a good or a bad idea for a variety of reasons, not just because of its impact on work incentives, but the specific claim that tax cuts will lead people to work more hours is only likely to hold for specific groups of workers and will depend on how and for whom taxes are cut.
5. Intertemporal Choices in Financial Capital Markets
By the end of this section, you will be able to:
- Evaluate the reasons for making intertemporal choices
- Interpret an intertemporal budget constraint
- Analyze why people in America tend to save such a small percentage of their income
Rates of saving in America have never been especially high, but they seem to have dipped even lower in recent years, as the data from the Bureau of Economic Analysis in Figure 6.8 show. A decision about how much to save can be represented using an intertemporal budget constraint. Household decisions about the quantity of financial savings show the same underlying pattern of logic as the consumption choice decision and the labor-leisure decision.
Figure 6.8 Personal Savings as a Percentage of Personal Income Personal savings were about 7 to 11% of personal income for most of the years from the late 1950s up to the early 1990s. Since then, the rate of personal savings has fallen substantially, although it seems to have bounced back a bit since 2008.
The discussion of financial saving here will not focus on the specific financial investment choices, like bank accounts, stocks, bonds, mutual funds, or owning a house or gold coins. The characteristics of these specific financial investments, along with the risks and tradeoffs they pose, are detailed in the Labor and Financial Markets chapter. Here, the focus is saving in total - that is, on how a household determines how much to consume in the present and how much to save, given the expected rate of return (or interest rate), and how the quantity of saving alters when the rate of return changes.
5.1. Using Marginal Utility to Make Intertemporal Choices
Savings behavior varies considerably across households. One factor is that households with higher incomes tend to save a larger percentage of their income. This pattern makes intuitive sense; a well-to-do family has the flexibility in its budget to save 20–25% of income, while a poor family struggling to keep food on the table will find it harder to put money aside.
Another factor that causes personal saving to vary is personal preferences. Some people may prefer to consume more now, and let the future look after itself. Others may wish to enjoy a lavish retirement, complete with expensive vacations, or to pile up money that they can pass along to their grandchildren. There are savers and spendthrifts among the young, middle-aged, and old, and among those with high, middle, and low income levels.
Consider this example: Yelberton is a young man starting off at his first job. He thinks of the "present" as his working life and the "future" as after retirement. Yelberton's plan is to save money from ages 30 to 60, retire at age 60, and then live off his retirement money from ages 60 to 85. On average, therefore, he will be saving for 30 years. If the rate of return that he can receive is 6% per year, then $1 saved in the present would build up to $5.74 after 30 years (using the formula for compound interest, $1(1 + 0.06)30 = $5.74). Say that Yelberton will earn $1,000,000 over the 30 years from age 30 to age 60 (this amount is approximately an annual salary of $33,333 multiplied by 30 years). The question for Yelberton is how much of those lifetime earnings to consume during his working life, and how much to put aside until after retirement. This example is obviously built on simplifying assumptions, but it does convey the basic life-cycle choice of saving during working life for future consumption after retirement.
Figure 6.9 and Table 6.9 show Yelberton's intertemporal budget constraint. Yelberton's choice involves comparing the utility of present consumption during his working life and future consumption after retirement. The rate of return that determines the slope of the intertemporal budget line between present consumption and future consumption in this example is the annual interest rate that he would earn on his savings, compounded over the 30 years of his working life. (For simplicity, we are assuming that any savings from current income will compound for 30 years). Thus, in the lower budget constraint line on the figure, future consumption grows by increments of $574,000, because each time $100,000 is saved in the present, it compounds to $574,000 after 30 years at a 6% interest rate. If some of the numbers on the future consumption axis look bizarrely large, remember that this occurs because of the power of compound interest over substantial periods of time, and because the figure is grouping together all of Yelberton's saving for retirement over his lifetime.
Figure 6.9 Yelberton's Choice: The Intertemporal Budget Set Yelberton will make a choice between present and future consumption. With an annual rate of return of 6%, he decides that his utility will be highest at point B, which represents a choice of $800,000 in present consumption and $1,148,000 in future consumption. When the annual rate of return rises to 9%, the intertemporal budget constraint pivots up. Yelberton could choose to take the gains from this higher rate of return in several forms: more present saving and much higher future consumption (J), the same present saving and higher future consumption (K), more present consumption and more future consumption (L), or more present consumption and the same future consumption (M).
|Present Consumption||Present Savings||Future Consumption (6% annual return)||Future Consumption (9% annual return)|
Table 6.9 Yelburton's Intertemporal Budget Constraint
Yelberton will compare the different choices along the budget constraint and choose the one that provides him with the highest utility. For example, he will compare the utility he would receive from a choice like point A, with consumption of $1 million in the present, zero savings, and zero future consumption; point B, with present consumption of $800,000, savings of $200,000, and future consumption of $1,148,000; point C, with present consumption of $600,000, savings of $400,000, and future consumption of $2,296,000; or even choice D, with present consumption of zero, savings of $1,000,000, and future consumption of $5,740,000. Yelberton will also ask himself questions like these: "Would I prefer to consume a little less in the present, save more, and have more future consumption?" or "Would I prefer to consume a little more in the present, save less, and have less future consumption?" By considering marginal changes toward more or less consumption, he can seek out the choice that will provide him with the highest level of utility.
Let us say that Yelberton's preferred choice is B. Imagine that Yelberton's annual rate of return raises from 6% to 9%. In this case, each time he saves $100,000 in the present, it will be worth $1,327,000 in 30 years from now (using the formula for compound interest that $100,000 (1 + 0.09)30 = $1,327,000). A change in rate of return alters the slope of the intertemporal budget constraint: a higher rate of return or interest rate will cause the budget line to pivot upward, while a lower rate of return will cause it to pivot downward. If Yelberton were to consume nothing in the present and save all $1,000,000, with a 9% rate of return, his future consumption would be $13,270,000, as shown on Figure 6.9.
As the rate of return rises, Yelberton considers a range of choices on the new intertemporal budget constraint. The dashed vertical and horizontal lines running through the original choice B help to illustrate his range of options. One choice is to reduce present consumption (that is, to save more) and to have considerably higher future consumption at a point like J above and to the left of his original choice B. A second choice would be to keep the level of present consumption and savings the same, and to receive the benefits of the higher rate of return entirely in the form of higher future consumption, which would be choice K.
As a third choice Yelberton could have both more present consumption - that is, less savings - but still have higher future consumption because of the higher interest rate, which would be choice like L, above and to the right of his original choice B. Thus, the higher rate of return might cause Yelberton to save more, or less, or the same amount, depending on his own preferences. A fourth choice would be that Yelberton could react to the higher rate of return by increasing his current consumption and leaving his future consumption unchanged, as at point M directly to the right of his original choice B. The actual choice of what quantity to save and how saving will respond to changes in the rate of return will vary from person to person, according to the choice that will maximize each person's utility.
5.2. Applications of the Model of Intertemporal Choice
The theoretical model of the intertemporal budget constraint suggests that when the rate of return rises, the quantity of saving may rise, fall, or remain the same, depending on the preferences of individuals. For the U.S. economy as a whole, the most common pattern seems to be that the quantity of savings does not adjust much to changes in the rate of return. As a practical matter, many households either save at a fairly steady pace, by putting regular contributions into a retirement account or by making regular payments as they buy a house, or they do not save much at all. Of course, some people will have preferences that cause them to react to a higher rate of return by increasing their quantity of saving; others will react to a higher rate of return by noticing that with a higher rate of return, they can save less in the present and still have higher future consumption.
One prominent example in which a higher rate of return leads to a lower savings rate occurs when firms save money because they have promised to pay workers a certain fixed level of pension benefits after retirement. When rates of return rise, those companies can save less money in the present in their pension fund and still have enough to pay the promised retirement benefits in the future.
This insight suggests some skepticism about political proposals to encourage higher savings by providing savers with a higher rate of return. For example, Individual Retirement Accounts (IRAs) and 401(k) accounts are special savings accounts where the money going into the account is not taxed until it is taken out many years later, after retirement. The main difference between these accounts is that an IRA is usually set up by an individual, while a 401(k) needs to be set up through an employer. By not taxing savings in the present, the effect of an IRA or a 401(k) is to increase the return to saving in these accounts.
IRA and 401(k) accounts have attracted a large quantity of savings since they became common in the late 1980s and early 1990s. In fact, the amount of IRAs rose from $239 billion in 1992 to $3.7 trillion in 2005, then to over $5 trillion in 2012, as per the Investment Company Institute, a national association of U.S. investment companies. However, overall U.S. personal savings, as discussed earlier, actually dropped from low to lower in the late 1990s and into the 2000s. Evidently, the larger amounts in these retirement accounts are being offset, in the economy as a whole, either by less savings in other kinds of accounts, or by a larger amount of borrowing (that is, negative savings). The following Clear It Up further explores America's saving rates.
A rise in interest rates makes it easier for people to enjoy higher future consumption. But it also allows them to enjoy higher present consumption, if that is what these individuals desire. Again, a change in prices - in this case, in interest rates - leads to a range of possible outcomes.
Clear It Up
How does America's saving rates compare to other countries?
By international standards, Americans do not save a high proportion of their income, as Table 6.10 shows. The rate of gross national saving includes saving by individuals, businesses, and government. By this measure, U.S. national savings amount to 17% of the size of the U.S. GDP, which measures the size of the U.S. economy. The comparable world average rate of savings is 22%.
|Country||Gross Domestic Savings as a Percentage of GDP|
Table 6.10 National Savings in Select Countries
5.3. The Unifying Power of the Utility-Maximizing Budget Set Framework
The choices of households are determined by an interaction between prices, budget constraints, and personal preferences. The flexible and powerful terminology of utility-maximizing gives economists a vocabulary for bringing these elements together.
Not even economists believe that people walk around mumbling about their marginal utilities before they walk into a shopping mall, accept a job, or make a deposit in a savings account. However, economists do believe that individuals seek their own satisfaction or utility and that people often decide to try a little less of one thing and a little more of another. If these assumptions are accepted, then the idea of utility-maximizing households facing budget constraints becomes highly plausible.
5.4. Behavioral Economics: An Alternative Viewpoint
As we know, people sometimes make decisions that seem "irrational" and not in their own best interest. People's decisions can seem inconsistent from one day to the next and they even deliberately ignore ways to save money or time. The traditional economic models assume rationality, which means that people take all available information and make consistent and informed decisions that are in their best interest. (In fact, economics professors often delight in pointing out so-called "irrational behavior" each semester to their new students, and present economics as a way to become more rational).
But a new group of economists, known as behavioral economists, argue that the traditional method leaves out something important: people's state of mind. For example, one can think differently about money if one is feeling revenge, optimism, or loss. These are not necessarily irrational states of mind, but part of a range of emotions that can affect anyone on a given day. And what's more, actions under these conditions are indeed predictable, if the underlying environment is better understood. So, behavioral economics seeks to enrich the understanding of decision-making by integrating the insights of psychology into economics. It does this by investigating how given dollar amounts can mean different things to individuals depending on the situation. This can lead to decisions that appear outwardly inconsistent, or irrational, to the outside observer.
The way the mind works, according to this view, may seem inconsistent to traditional economists but is actually far more complex than an unemotional cost-benefit adding machine. For example, a traditional economist would say that if you lost a $10 bill today, and also got an extra $10 in your paycheck, you should feel perfectly neutral. After all, –$10 + $10 = $0. You are the same financially as you were before. However, behavioral economists have done research that shows many people will feel some negative emotion - anger, frustration, and so forth - after those two things happen. We tend to focus more on the loss than the gain. This is known as loss aversion, where a $1 loss pains us 2.25 times more than a $1 gain helps us, according to the economists Daniel Kahneman and Amos Tversky in a famous 1979 article in the journal Econometrica. This insight has implications for investing, as people tend to "overplay" the stock market by reacting more to losses than to gains. Indeed, this behavior looks irrational to traditional economists, but is consistent once we understand better how the mind works, these economists argue.
Traditional economists also assume human beings have complete self-control. But, for instance, people will buy cigarettes by the pack instead of the carton even though the carton saves them money, to keep usage down. They purchase locks for their refrigerators and overpay on taxes to force themselves to save. In other words, we protect ourselves from our worst temptations but pay a price to do so. One way behavioral economists are responding to this is by setting up ways for people to keep themselves free of these temptations. This includes what are called "nudges" toward more rational behavior rather than mandatory regulations from government. For example, up to 20 percent of new employees do not enroll in retirement savings plans immediately, because of procrastination or feeling overwhelmed by the different choices. Some companies are now moving to a new system, where employees are automatically enrolled unless they "opt out". Almost no-one opts out in this program and employees begin saving at the early years, which are most critical for retirement.
Another area that seems illogical is the idea of mental accounting, or putting dollars in different mental categories where they take different values. Economists typically consider dollars to be fungible, or having equal value to the individual, regardless of the situation.
You might, for instance, think of the $25 you found in the street differently from the $25 you earned from three hours working in a fast food restaurant. The street money might well be treated as "mad money" with little rational regard to getting the best value. This is in one sense strange, since it is still equivalent to three hours of hard work in the restaurant. Yet the "easy come-easy go" mentality replaces the rational economizer because of the situation, or context, in which the money was attained.
In another example of mental accounting that seems inconsistent to a traditional economist, a person could carry a credit card debt of $1,000 that has a 15% yearly interest cost, and simultaneously have a $2,000 savings account that pays only 2% per year. That means she pays $150 a year to the credit card company, while collecting only $40 annually in bank interest, so she loses $130 a year. That doesn't seem wise.
The "rational" decision would be to pay off the debt, since a $1,000 savings account with $0 in debt is the equivalent net worth, and she would now net $20 per year. But curiously, it is not uncommon for people to ignore this advice, since they will treat a loss to their savings account as higher than the benefit of paying off their credit card. The dollars are not being treated as fungible so it looks irrational to traditional economists.
Which view is right, the behavioral economists' or the traditional view? Both have their advantages, but behavioral economists have at least shed a light on trying to describe and explain behavior that has historically been dismissed as irrational. If most of us are engaged in some "irrational behavior," perhaps there are deeper underlying reasons for this behavior in the first place.
5.5. Bring It Home
"Eeny, Meeny, Miney, Moe" - Making Choices
In what category did consumers worldwide increase their spending during the recession? Higher education. According to the United Nations Educational, Scientific, and Cultural Organization (UNESCO), enrollment in colleges and universities rose one-third in China and almost two-thirds in Saudi Arabia, nearly doubled in Pakistan, tripled in Uganda, and surged by three million - 18 percent - in the United States. Why were consumers willing to spend on education during lean times? Both individuals and countries view higher education as the way to prosperity. Many feel that increased earnings are a significant benefit of attending college.
Bureau of Labor Statistics data from May 2012 supports this view, as shown in Figure 6.10. They show a positive correlation between earnings and education. The data also indicate that unemployment rates fall with higher levels of education and training.
Figure 6.10 The Impact of Education on Earnings and Unemployment Rates, 2012 Those with the highest degrees in 2012 had substantially lower unemployment rates whereas those with the least formal education suffered from the highest unemployment rates. The national median average weekly income was $815, and the nation unemployment average in 2012 was 6.8%.
6. Key Terms
backward-bending supply curve for labor
the situation when high-wage people can earn so much that they respond to a still-higher wage by working fewer hours
a branch of economics that seeks to enrich the understanding of decision-making by integrating the insights of psychology and by investigating how given dollar amounts can mean different things to individuals depending on the situation.
budget constraint line
shows the possible combinations of two goods that are affordable given a consumer's limited income
when the ratio of the prices of goods is equal to the ratio of the marginal utilities (point at which the consumer can get the most satisfaction)
diminishing marginal utility
the common pattern that each marginal unit of a good consumed provides less of an addition to utility than the previous unit
the idea that units of a good, such as dollars, ounces of gold, or barrels of oil are capable of mutual substitution with each other and carry equal value to the individual.
a higher price means that, in effect, the buying power of income has been reduced, even though actual income has not changed; always happens simultaneously with a substitution effect
the additional utility provided by one additional unit of consumption
marginal utility per dollar
the additional satisfaction gained from purchasing a good given the price of the product; MU/Price
when a price changes, consumers have an incentive to consume less of the good with a relatively higher price and more of the good with a relatively lower price; always happens simultaneously with an income effect
satisfaction derived from consumer choices
7. Key Concepts and Summary
Economic analysis of household behavior is based on the assumption that people seek the highest level of utility or satisfaction. Individuals are the only judge of their own utility. In general, greater consumption of a good brings higher total utility. However, the additional utility received from each unit of greater consumption tends to decline in a pattern of diminishing marginal utility.
The utility-maximizing choice on a consumption budget constraint can be found in several ways. You can add up total utility of each choice on the budget line and choose the highest total. You can choose a starting point at random and compare the marginal utility gains and losses of moving to neighboring points - and thus eventually seek out the preferred choice. Alternatively, you can compare the ratio of the marginal utility to price of good 1 with the marginal utility to price of good 2 and apply the rule that at the optimal choice, the two ratios should be equal:
How Changes in Income and Prices Affect Consumption Choices
The budget constraint framework suggest that when income or price changes, a range of responses are possible. When income rises, households will demand a higher quantity of normal goods, but a lower quantity of inferior goods. When the price of a good rises, households will typically demand less of that good - but whether they will demand a much lower quantity or only a slightly lower quantity will depend on personal preferences. Also, a higher price for one good can lead to more or less of the other good being demanded.
When making a choice along the labor-leisure budget constraint, a household will choose the combination of labor, leisure, and income that provides the most utility. The result of a change in wage levels can be higher work hours, the same work hours, or lower work hours.
Intertemporal Choices in Financial Capital Markets
When making a choice along the intertemporal budget constraint, a household will choose the combination of present consumption, savings, and future consumption that provides the most utility. The result of a higher rate of return (or higher interest rates) can be a higher quantity of saving, the same quantity of saving, or a lower quantity of saving, depending on preferences about present and future consumption. Behavioral economics is a branch of economics that seeks to understand and explain the "human" factors that drive what traditional economists see as people's irrational spending decisions.