Consumption.pptx.ppt

8/11/2019 Consumption.pptx.ppt

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PA

RTIITheMarketSystem:C

hoicesMadebyHouseholdsa

ndFirms

2012 Pearson Education, Inc. Publishing as Prentice Hall

Household Behaviorand Consumer Choice I.


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Firm and HouseholdDecisions

Households demand in output markets and supply labor and capital in input markets.

To simplify our analysis, we have not included the government and international sectors in

this circular flow diagram.


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Every household must make three basicdecisionswith respect of consumption.:

1. How much of each product, or output,

to demand

2. How much laborto supply

3. How much to spend today and howmuch to save for the future

Household Choice in Output Markets


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Several factors influencethe quantity of a given good orservice demandedby a single household:

Thepriceof the product

The incomeavailable to the household

The households amount of accumulated wealth

Theprices of other products available to thehousehold

The households tastes and preferences

The households expectations about future income,

wealth, and prices


The Determinants of Household Demand


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budget constraint The limits imposed on householdchoices by income, wealth, and product prices.

choice set oropportunity set The set of options thatis defined and limited by a budget constraint.

Possible Budget Choices of a Person Earning $1,000 perMonth after Taxes

OptionMonthly

Rent FoodOther

Expenses Total Available?

A $ 400 $250 $350 $1,000 Yes

B 600 200 200 1,000 Yes

C 700 150 150 1,000 Yes

D 1,000 100 100 1,200 No


The Budget Constraint such a complex factor


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In general, the budget constraint can be written

PXX + P

YY = I,

where PX= the price ofX, X= the quantity ofXconsumed, PY= the price of Y, Y= the quantity of Yconsumed, and I= household income.

The Equation of the Budget Constraint



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Price changes affect households in two ways. First, if we

assume that households confine their choices to products

that improve their well-being, then a decline in the price of

any product, ceteris paribus, will make the householdunequivocally better off.

In other words, if a household continues to buy the same

amount of every good and service after the price decrease,

i t wi l l have income left over.That extra income may bespent on the product whose price has declined, hereafter

called goodX, or on other products.

The change in consumption ofXdue to this improvement in

well-being is called the incom e effect o f a pr ice change.

Income and Substitution Effects

The Income Effect


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When the pr ice of a product fal ls, that produc t

also becom es relat ively cheaper. That is, it

becomes more attractive relative to potential

substitutes. A fall in the price of productXmightcause a household to shift its purchasing pattern

away from substitutes towardX. This shift is called

the subst i tut ion effect o f a pr ice change.

Everything works in the opposite direction when a

price rises, ceteris paribus. When the price of a

product rises, that item becomes more expensive

relative to potential substitutes and the household is

likely to substitute other goods for it.


The Substitution Effect


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Income and Substitution Effects of a Price Change

Higher prices lead to a lower quantity demanded, and lower priceslead to a higher quantity demanded.



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Inflation and consumption

80

90

100

110

120

130

140

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Index of per capita

consumption Y(n)/Y(n-1)

Inflation Y(n)/Y(n-1)


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As in output markets, households faceconstrained choices in input markets. Theymust decide

1. Availability of jobs

2. Market wage rates

3. Skills they possess

In essence, household members must decide

how much labor to supply. The choices theymake are affected by:

Household Choice in Input Markets

The Labor Supply Decision

1. Whether to work

2. How much to work

3. What kind of a job to work at


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The Trade-Off FacingHouseholds

The decision to enter the workforce

involves a trade-off between wages

(and the goods and services that

wages will buy) on the one hand and

leisure and the value of nonmarket

production on the other hand.


The Labor Supply Decision


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Trading one good for another involves buying lessof one and more of another, so households simplyreallocate money from one good to the other.

Buying more leisure, however, means reallocatingtime between work and nonwork activities.

For each hour of leisurethat you decide to

consume, you give up one hours wages.

Thus, the wage rate is theprice of leisure.


The Price of Leisure


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Income and consumption

80

85

90

95

100

105

110

Index of per capita real income

Y(n)/Y(n-1)

Index of per capita



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Just as changes in wage rates affect householdbehavior in the labor market, changes in interest ratesaffect household behaviorin capital markets.

Most empirical evidence indicates that saving tends toincrease as the interest rate rises. In other words, thesubstitution effect is larger than the income effect.

financial capital market The complex set ofinstitutions in which suppliers of capital (householdsthat save) and the demand for capital (firms wanting toinvest) interact.


Saving and Borrowing: Present versus Future

Consumption


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Interest and consumption

50.0

70.0

90.0

110.0

130.0

150.0

170.0

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Index of base rate Y(n)/Y(n-1)

Index of per capita



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CONSUMPTION THEORIES II.


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Keyness Conjectures1. 0 < MPC< 1

2. Average propensity to consume(APC) fallsas income rises.(APC = C/Y )

3. Income is the main determinant ofconsumption.

4. Constant C + marginal propensity toconsume= Consumption

slide 22


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The Keynesian Consumption Function

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C

Y

slope =APC

As income rises, the APC (average propensity to

consume) falls (consumers save a bigger fractionof their income).

C Cc

Y Y APC

Very strong correlation between income and consumption

income seemed to be the maindeterminant of consumption


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Irving Fisher and Intertemporal Choice

The basis for much subsequent work onconsumption.

Assumes consumer is forward-looking and

chooses consumption for the present andfuture to maximize lifetime satisfaction.

Consumers choices are subject to an

intertemporal budget constraint,a measure of the total resources available forpresent and future consumption

slide 24


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The basic two-period model Period 1: the present

Period 2: the future

Notation

Y1is income in period 1

Y2is income in period 2

C1is consumption in period 1

C2is consumption in period 2

S= Y1-C1is saving in period 1

(S< 0 if the consumer borrows in period 1)

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In their earlyworking years,people consume

more than theyearn.This is also truein the retirementyears.In between,people save

(consume lessthan they earn) topay off debtsfrom borrowingand toaccumulatesavings forretirement.

Life-CycleTheory ofConsumption

Households: Consumption and Labor Supply Decisions

The Life-Cycle Theory of Consumption


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The intertemporal budget constraint

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2 2

1 11 1

C YC Y

r r

present value oflifetime consumption

present value oflifetime income


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Consumer preferences

An indifferencecurveshows all

combinations of

C1and C2that

make theconsumer equally

happy.

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C1

C2

IC1

IC2

Higherindifferencecurvesrepresent

higher levelsof happiness.


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Keynes vs. Fisher

Keynes:current consumption depends only oncurrent income

Fisher:current consumption depends only onthe present value of lifetime income;the timing of income is irrelevant

because the consumer can borrow orlend between periods.

slide 29


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The Life-Cycle Hypothesis

due to Franco Modigliani (1950s) Fishers model says

that consumption depends on lifetime income, and

people try to achieve smooth consumption.

The LCH says that income varies systematically over thephases of the consumers life cycle,

and saving allows the consumer to achieve smooth

consumption.

slide 30


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Implications of the Life-Cycle Hypothesis

The LCH

implies that

saving varies

systematically

over a persons

lifetime.

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Saving

Dissaving

Retirementbegins

Endof life

Consumption

Income

$

Wealth


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THE MULTIPLIER EFFECT OFCONSUMPTION


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Multipliers

Direct effects represent direct or initial spending

Type I- Direct and indirect effects include the direct

spending plus the indirect spending or businessesbuying and selling to each other

Type II- Direct, indirect and induced effects includedirect and indirect plus household spending earned

from direct and indirect effects


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The econometric model

income

tax

disposable income

saveconsumption1

company value added I.

dividend corporate tax interest wages

Personal tax

disposable

incomesave

consumption2

company value added II.


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Consumption

C=Co+c'Y=Y (c'=dC/dY)

C/Y=Co/Y+c'Y/Y=Y/Y

Co/Y+c'=1

Y=Co/(1-c') // with tax: Y=Co/((1-c') *(1-t))

Co= independent consumption

c'= marginal propensity to consume

C=consumption

Y=income


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Example

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

Net Income

Consumption

Net Income Consumption

2002 573 247 494 273

2003 656 610 557 875

2004 730 103 607 870

2005 804 104 643 535

2006 840 891 673 381

2007 875 837 706 310

2008 874 504 750 309

2009 867 658 747 827

2010 939 396 759 608

2011 988 927 790 8832012 994 876 815 907


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Consumption

Consumption multiplicator c'=0,8

plus autonomous

consumption

plus producing

and income

plus demand

propensity

^Co ^Y

1000 1000 800800 800 640

640 640 512

512 512 410

410 410 328

5 000 5 000 4 000

Multiplicator= 1/ (1-0,8)=5


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GDP and consumption

80

85

90

95

100

105

110

Gross domestic product

(GDP) total Y(n)/Y(n-1)

Actual final consumption of

which actual final

consumption of

households Y(n)/Y(n-1)


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Summing up Keynes suggested that consumption depends

primarily on current income.

Recent work suggests instead that consumption

depends on

current income expected future income

wealth

interest rates

Economists disagree over the relative importance of

these factors and of borrowing constraints and

psychological factors.

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