Section 1. Microfoundations: Section 1. Microfoundations: Concepts for Making Consumer Concepts for Making Consumer

DecisionsDecisions

What is the difference between What is the difference between microeconomics and macroeconomics?microeconomics and macroeconomics?

Microeconomics: focuses on the Microeconomics: focuses on the behavior of individual behavior of individual consumers, households, & consumers, households, & businesses.businesses.

Examples:Examples:

1. Why do some couples choose to have 1. Why do some couples choose to have three children while others elect to have three children while others elect to have none?none?

2. Why do some families carry life 2. Why do some families carry life insurance while others do not?insurance while others do not?

3. Why do some families save to 3. Why do some families save to purchase major appliances while others purchase major appliances while others buy them on credit?buy them on credit?

Microeconomic Principles (i.e., Microeconomic Principles (i.e., proverbs) We’ll Coverproverbs) We’ll Cover

the basic principles of cost-benefit analysis or CBAthe basic principles of cost-benefit analysis or CBA why prices matterwhy prices matter what should be included in a “price”what should be included in a “price” valuing timevaluing time imputing costs and benefits that do not involve imputing costs and benefits that do not involve

actual money paymentsactual money payments dealing with inflationdealing with inflation the role of interest ratesthe role of interest rates incorporating risk and uncertainty into the analysisincorporating risk and uncertainty into the analysis present value and future value calculationspresent value and future value calculations

Proverb #1: Families are a bit like Proverb #1: Families are a bit like firmsfirms

What’s involved in cost-benefit What’s involved in cost-benefit analyses?analyses?

CBA-CBA-• The process of assessing the most The process of assessing the most

efficient alternative resource allocation. efficient alternative resource allocation. • The most efficient option is determined The most efficient option is determined

by looking at the “costs” of each by looking at the “costs” of each resource allocation option weighed resource allocation option weighed against the “benefits” of each allocation against the “benefits” of each allocation option. option.

• Typically, both costs and benefits are Typically, both costs and benefits are measured in dollar terms.measured in dollar terms.

The central question is…The central question is…

How do families appropriately How do families appropriately measure the benefits and costs of measure the benefits and costs of each alternative? each alternative?

Application of the cost-benefit Application of the cost-benefit framework to household decision-framework to household decision-making presumes that each making presumes that each household’s goal is to maximize its household’s goal is to maximize its welfare given its existing economic welfare given its existing economic resource. These resources include:resource. These resources include:• financial capitalfinancial capital• physical capitalphysical capital• human capitalhuman capital

For family economic scholars, For family economic scholars, application of the cost-benefit application of the cost-benefit analysis implies that we are able to analysis implies that we are able to • articulate all of the viable resource articulate all of the viable resource

allocation options available to the allocation options available to the householdhousehold

• quantify the benefits & costs quantify the benefits & costs associated with each optionassociated with each option

Proverb #2: Make Sure “The Price Proverb #2: Make Sure “The Price is Right”is Right”

Why do prices matter?Why do prices matter?•With limited financial resources, With limited financial resources,

prices affect a household’s prices affect a household’s ability to acquire goods and ability to acquire goods and services -- that is, they affect a services -- that is, they affect a household’s decisions regarding household’s decisions regarding their consumption.their consumption.

Nominal Price Nominal Price

Price paid for a product or service Price paid for a product or service at the time of the transaction.at the time of the transaction.

Nominal prices are those that have Nominal prices are those that have not been adjusted to remove the not been adjusted to remove the effect of changes in the purchasing effect of changes in the purchasing power of the dollar.power of the dollar.

Nominal prices reflect buying Nominal prices reflect buying power in the year in which the power in the year in which the transaction occurred. transaction occurred.

What should be included in the What should be included in the price of a product?price of a product?• Look beyond the nominal price:Look beyond the nominal price:

– example: tuition and fees “price” of 15 example: tuition and fees “price” of 15 credit hours at the U fall semester: credit hours at the U fall semester:

$2,386.48$2,386.48 . But, is that the full price of . But, is that the full price of attending school?attending school?

• Incorporate time costs into the full Incorporate time costs into the full price of a product/service...price of a product/service...

ExampleExample: Why has commercial plane travel : Why has commercial plane travel continued to grow despite the fact that the continued to grow despite the fact that the real prices of airline tickets have risen?real prices of airline tickets have risen?

Proverb #3: Time is Proverb #3: Time is moneymoney

Year # Passenger-Miles* Real Price

1985 346 1.04

1990 362 1.14

1993 403 1.24

* In billions. Source: Statistical Abstract of the U.S. 1997.

The Time Costs of Preparing The Time Costs of Preparing DinnerDinner

Cooking at home: $50 (ingredients) + 6 hours of your time Cooking at home: $50 (ingredients) + 6 hours of your time preparing the meal and dealing with clean-up.preparing the meal and dealing with clean-up.

Eating at a restaurant: $120 (including tax and tip) but no time Eating at a restaurant: $120 (including tax and tip) but no time spent in meal preparation.spent in meal preparation.

The economic answer depends on the rate at which you value The economic answer depends on the rate at which you value your time:your time:• $20/hr time costs: $50 + ($20/hr * 6 hrs) = $170 > $120 $20/hr time costs: $50 + ($20/hr * 6 hrs) = $170 > $120

==> eat out!==> eat out!• $10/hr time costs: $50 + ($10/hr * 6 hrs) = $110 > $120 $10/hr time costs: $50 + ($10/hr * 6 hrs) = $110 > $120

==> eat in==> eat in!! NOTE: ALL OF THIS ASSUMES THAT THE QUALITY OF NOTE: ALL OF THIS ASSUMES THAT THE QUALITY OF

THE TWO MEALS IS EQUAL AND THAT YOU GET NO THE TWO MEALS IS EQUAL AND THAT YOU GET NO ENJOYMENT FROM COOKING!!!!ENJOYMENT FROM COOKING!!!!

Example: Time Costs of Preparing Dinner - Friends are coming to town for the weekend. Should you take them out to dinner or cook for them at home?

Flying to Denver costs $159/person round trip Flying to Denver costs $159/person round trip plus 4 hrs of time.plus 4 hrs of time.

Driving to and from Denver costs $200 in gas Driving to and from Denver costs $200 in gas and car depreciation plus 20 hrs of time.and car depreciation plus 20 hrs of time.

If value of time is $20/hr...If value of time is $20/hr...• ($159*3) + (4hrs * $20/hr) = $557($159*3) + (4hrs * $20/hr) = $557• $200 + (20 hrs * $20/hr) = $600 ==> fly!$200 + (20 hrs * $20/hr) = $600 ==> fly!

If value of time is $10/hr…If value of time is $10/hr…• ($159*3) + (4hrs * $10/hr) = $517($159*3) + (4hrs * $10/hr) = $517• $200 + (20 hrs * $10/hr) = $400 ==> drive!$200 + (20 hrs * $10/hr) = $400 ==> drive!

Example: Travel Trade-Offs - Should you and your two children fly or drive to Denver for your sister’s wedding?

So, how can do we measure the So, how can do we measure the value of time?value of time?

• Opportunity Cost Opportunity Cost – the value of time spent in any the value of time spent in any

activity is measured by the value of activity is measured by the value of the next best opportunity that the next best opportunity that would be foregone .would be foregone .–offered wage rate (wage offered wage rate (wage

someone offers)someone offers)–asked wage rate (wage asked to asked wage rate (wage asked to

be paid)be paid)

Opportunity Cost of Coming Opportunity Cost of Coming to Classto Class

3 hours a week for 15 weeks= 45 3 hours a week for 15 weeks= 45 hourshours

If your job paid $10/hourIf your job paid $10/hour• 45 *10= $45045 *10= $450

If your job paid $20/hourIf your job paid $20/hour• 45*20= $90045*20= $900

Opportunity Cost of Getting Opportunity Cost of Getting an ‘A’ in This Classan ‘A’ in This Class

Attend class- 45 hoursAttend class- 45 hours Study 3 hours weekly- 45 hoursStudy 3 hours weekly- 45 hours If your job paid $10/ hourIf your job paid $10/ hour

• (45+45)*10= $900(45+45)*10= $900 If your job paid $20/ hourIf your job paid $20/ hour

• (45+45)*20= $1800(45+45)*20= $1800

•Replacement CostReplacement Cost–the value of time spent in an the value of time spent in an activity is measured by what activity is measured by what it would cost to replace your it would cost to replace your time (that is, to hire time (that is, to hire someone to do the task).someone to do the task).

So, what are the costs of your time (I.e. time costs)?

Weekly earnings in 2009Total $738Men

16-24 $44824+ $870

Women16-24 $41524+ $691Source: Bureau of Labor Statistics,

First Quarter Earning 2006

Families are often willing to spend money to save Families are often willing to spend money to save time.time.

It pays to “shop around” -- but only up to a point!It pays to “shop around” -- but only up to a point! The rising value of time over the past 30 years may The rising value of time over the past 30 years may

help us understand why families are…help us understand why families are…• buying more “fast foods”buying more “fast foods”• having fewer childrenhaving fewer children• using more air transportationusing more air transportation• shopping by internet more shopping by internet more

Bottom Line – The value of one’s time needs to be Bottom Line – The value of one’s time needs to be included in price comparisons when assessing included in price comparisons when assessing resource allocation alternatives resource allocation alternatives

So What????