Chapter 6 Summary HOUSEHOLD CHOICE IN OUTPUT MARKETS p 121 1 Every household must make three basic decisions a How much of each product or output to demand b How much labor to supply c How much to save for the future 2 Income wealth and prices define a household budget constraint The budget constraint separates those combos of goods services that are available from those that are NOT All the points below to the left of the graph of a household budget constraint make up the choice set or opportunity set choice opportunity set budget constraint 3 It is best to think of the household choice problem as one of allocating income over a large number of goods services A change in the price of one good may change the entire allocation Demand from some goods may rise while demand for others may fall 4 As long as a household faced limited income the real cost of any single good or service is the value of the next preferred other goods services that could have been purchased w the same amount of spending 5 Within the constraints of prices wealth and income household decisions ultimately depend on preferences likes dislikes and tastes THE BASIS OF CHOICE UTILITY p 126 6 Whether one item is preferable to another depends on how much utility SATIFCATION it yields relative to its alternatives 7 Law of Diminishing Marginal Utility says that the more of any good we consume in a given period of time the less utility SATIFCATION we get out of each additional MARGINAL unit of that good 8 Households allocate income among goods services to maximize utility This implies choosing activities that yield the highest marginal utility MU per dollar In a two good world households will choose to equate the marginal utility MU per dollar spent on X w the MU per dollar spent on Y This is the utility maximizing rule INCOME AND SUBSTITUTION EFFECTS p 131 9 The fact that demand curves have a negative slope can be explained in two ways a MU for all goods diminishes b For most normal goods both the income and the substitution effects of a price decline lead to more consumption of the good HOUSEHOLD CHOICE IN INPUT MARKETS p 133 10 In labor market a trade off exists between the value of the goods and services that can be bought in the market or produced at home the value that one places on leisure The opportunity cost of paid work is leisure unpaid work The wage rate is the price or opportunity cost of the benefits of unpaid work or leisure 11 The income substitution effects of a change in the wage rate work in opposite directions Higher wages mean that 1 leisure is more expensive likely response people work more substitution effect 2 more income is earned in a given number of hours so time may be spent on leisure likely response people work less income effect 12 In addition to deciding how to allocate its present income among goods services a household may also decide to save or borrow When a household decides to save part of its current income it is using current income to finance future spending When a household borrows it finances current purchases with future income 13 An increase in interest rates has a positive effect on saving if the substitution effect dominates the income effect a negative effect if the income effect dominates the substitution effect Most empirical evidence shows that the substitution effect dominates here