Household Behavior and Consumer Choice 1. What roles do prices, income, and wealth play in constraining choice?

Given income and wealth, the prices of goods and services define the maximum amount that can be purchased. For instance, if income and wealth made up $10 and the price of a good was $2, the consumer is constrained to being able to buy no more than five units. There are two elements that make up demand: desire and ability to purchase goods. The ability to purchase goods is defined by how much one can afford to purchase at the given prices knowing one's income and wealth. 2. How does a budget constraint represent opportunity cost? The budget constraint is a graphic representation of the maximum combination of goods that can be bought with a given income. As one moves along the budget constraint, purchasing more of one good, the amount that can be purchased of the other good will fall. This is the definition of opportunity cost. By making the choice to buy good A, you will give up the ability to buy some amount of good B. The opportunity cost is represented by the slope of the budget constraint. 3. What is utility and how does it relate to household behavior? Utility is the pleasure or happiness that is received from making a particular choice. Households base their choices on the marginal utility they receive from their various options. When households choose one option over another, that choice is based on which option yields the greatest marginal utility per dollar. By examining which is the better "deal" for the money, the household makes the best possible choice. 4. What is the rule for maximizing utility? Utility is maximized when the marginal utility per dollar is equal across all goods. This is because if the marginal utility per dollar is higher for one good than another, one consumes more of that good, lowering the marginal utility per dollar. One also is then consuming less of the other good, raising the marginal utility per dollar, until both marginal utilities per dollar are equal. 5. How can the income and substitution effects be used to derive the law of demand? The income effect says that when prices fall, a given income can afford to buy more of everything. People then buy more of a normal good. This relationship implies that when prices fall, the quantity demanded will rise and visa versa. Likewise, the substitution effect says that when prices fall, the marginal utility per dollar rises. A higher marginal utility per dollar means that one will buy more of that good and less of the good with the lower marginal utility per dollar. This substitution will result in lower prices that increase the quantity demanded and visa versa. 6. How do changes in wages affect peoples decisions about how much they should work? A change in wages has two (opposite) effects on the decision of how much labor to supply. A decrease in wages, for instance, means that less income is being earned. If you are earning less income, then you will choose to "purchase" less leisureobecause leisure is a normal goodothus working more. But the decrease in wages also has a substitution effect. Since the opportunity cost of leisure or non-wage activities is the wage that you could have received, then when the wage decreases, the cost of leisure has fallen. When the cost falls, people demand more. So the substitution effect implies that lower wages lead to less work and more leisure and non-wage activities. How household behavior and consumer choice that includes a discussion on the effects of household demand, allocating income to maximize utility, the income and substitution effects, wage and interest rates, and the price of leisure eff Generally household consumption is a function budget, preferences, interest rates, leisure, and expected tax rates. If the housholds face high interest rates then typically they will consume less and save more (sub effects). If wage increases and all other things constant we have a income effect and consumption patterns for different goods will change (normal goods, inferior goods, luxury goods). Also the higher a wage the high the cost of leisure. The household will not consumer leisure as much. The sub effect between leisure and work is effected by wage. Also households typically have rational expectations of tax rates. This may be observed through the sub effect between consumption-savings.