Economics - Analysis of Choice: The Individual

There is no question individuals (households) play a key role in the economic system - they provide the workers in the labor market, the consumers in the output market, and the borrowers and lenders in the capital market. In this unit we are going to look more carefully at households to get a better handle on the demographic breakdown of the population - a sort of statistical profile of the world's and nation's people. If you ever intend to sell something, and most of you will be in this position, you will want to read this section carefully. As you read the newspaper or watch the news you will note how often discussions center around generations - the baby boomers, generation X, the elderly - or around the racial, ethnic, or regional patterns of population growth. We will start with a brief description of some of the basic trends.

But what makes individuals do what they do? To answer this question economists have developed an elaborate theory of individual choice - an analysis that provides a framework for explaining households' decisions regarding spending, working, and saving. As it turns out, there are some choices that seem to defy the simple model and we will explore some of those in a later section on extensions of the model.

The unit will close with a discussion of elasticity. To move from qualitative relationships - an increase in price will reduce demand - to quantitative relationships - a 4 percent increase in income will increase demand by 6 percent - requires the introduction of a new concept - elasticity.

Economists traditionally start with the premise that people's choices are the end result of a careful weighing of costs and benefits, what we would call rational behavior. In this sense people are viewed as calculators. It is an admittedly narrow view of behavior, and one that has been challenged on a number of fronts, but it remains a powerful guide to decision-making. In this unit we will look first at this decision-making framework. It has proved to be a very flexible framework, one that allows us to explain decisions regarding demand for goods and services, supply of labor, and savings. Here we will focus our attention on the output market and the demand for goods and services, but a more detailed treatment of individual choice is available for the labor supply and savings decisions for those who would like to explore the material.

Before examining the models in more detail, we can begin with a brief description of the nature of the analysis. The basic premise is individuals enter into choice situations with a well defined set of preferences. You know what you like, and you are consistent. If I asked you if you liked gift A or B, you could tell me. And if you told me you liked A better than B, and B better than C, then you would also like A better than C. We also assume there is a positive relationship between the level of consumption of some good and the sense of well being derived from the consumption - what economists call utility. As you consume more, you feel better. We could show this with three possible utility curves. What's the difference between them? They are all positively sloped so all are possible candidates since each shows us an increase in consumption of X increases the sense of satisfaction (Utility).

Where these curves differ is in their shape - the slope. What happens to you as you consume more. We can see this with the help of a table based on the graphs. In the table we have the consumption levels of X and the utility received for each of the three lines.

	Utility
X	Blue	Red	Green
1	2	2	2
2	4	8	3
...	...	...	...
10	20	22.2	16.8
11	22	23.2	24.9

The blue line, with the constant slope, indicates every time you buy one more unit of X, you get the same amount of additional satisfaction from it. If you have one unit of X and then get the second unit of X, your satisfaction increases from 2 to 4. If you had ten units of X and you get the eleventh, then your satisfaction increases from 20 to 22. In both cases the increase in utility was two. This would be the situation if you never got tired of X, another X would mean the same to you if you had one or if you had 10. The red line, meanwhile, indicates the second unit of X increases your satisfaction from 2 to 8 - an increase of 6. If you had ten units of X and you get the eleventh, then your satisfaction increases from 22.2 to 23.2 - an increase of 1. This would be the situation if you got tired of X, another X would mean more to you if you had one than if you had 10. Finally, the green line would be the picture of a situation where X became increasingly valuable as you bought more of it.

Which of these do you think best reflects your preferences? What economists assume is the red line best represents your situation, as consumption of a good increases, you value additional units less highly than earlier one. The name given to this feature of preferences is diminishing marginal utility. How much would you value one ice cream cone on a hot afternoon? How much would you value the fourth ice cream cone? Economists assert you would value the first more than the fourth - and if you agree, then you have indicated you believe in the concept of diminishing marginal utility.

If you accept the concept of diminishing marginal utility, is there any 'rule' that should guide you in your efforts to maximize your satisfaction (total utility), in the choices you make? To answer this we need to bring into the picture the second feature of all choice situations - the constraint. Scarcity means we cannot have it all and now we need to introduce the constraint on our behavior- the budget constraint. You can only spend what you have as income and how much X you can buy depends upon the price of X, the price of other things, and your income.

As an example, consider the situation faced by Chris who values another ice cream at $3.00 (Marginal Utility) and the price (P) is $2.00. What should Chris do? It would seem as though Chris would buy the cone since the increase in value is greater than the cost. Following this logic, Chris would continue to buy extra cones as long as Marginal Utility (MU) > P. As Chris bought more cones, though, the value of each cone would decrease due to diminishing marginal utility. The next cone might be worth only $2.50 and the next one only $2.00. Diminishing marginal utility is demonstrated in the diagram below.

Eventually we would reach a point where MU = P, where the value added to an individual's sense of satisfaction (Utility) by consuming another cone just equals the price. If we went further and MU < P, we would cut back on our consumption since the additional value created would be less than the price. The optimal rule is then:

What does this mean for our analysis of demand? First, it highlights the significance of preferences and constraints in the choices of individuals. An individual's choice could be altered by a change in the price (P) that would alter the constraint, or by altering preferences that would be reflected in the marginal utility (MU) derived from consumption of X. This idea has not been lost on the advertising agencies that routinely attempt to use advertising to alter individual's preferences by convincing them good things will happen if they buy a specific car or deodorant. It is also not lost on the government that routinely attempts to alter behavior by altering prices. Two examples of the latter would be the interest rate deduction on federal income taxes that induces individuals to buy homes and the proposed tax increase on cigarettes designed to lower smoking.

It also means we should expect an inverse relationship between price and demand. If we assume an individual is consuming the optimal level of a good, then MU = P. As the price falls, however, consumers will find MU > P and now the individual consumer will get more enjoyment from consumption than she is paying for it. To restore equality, MU will need to fall. Because of diminishing marginal utility, this will be achieved if there is an increase in consumption that will drive down MU and reestablish a balance between P and MU. As the price of the cone falls you will consume more ice cream and the marginal utility of the cone will decrease.

The relationship between utility and demand allows us to introduce the concept of consumer surplus which allows us to examine the rationale behind some important pricing decisions. For example, many of you have been to amusement parks such as Disney in Florida and some of your parents may belong to country clubs. One of the things you notice is pricing structures have two parts - a flat entry and price per ride at the amusement parks and a membership fee and a price per round of golf. The reasoning is based on the analysis of demand. Looking at the diagram below, we know Mary is willing to pay a price of $16 to get 4 units of X. If she is able to buy it at $10, then she has a surplus value of $6. In fact, it is true at all prices above $10 so that if the good's price is $10, then Mary has a Consumer Surplus equal to the area of the yellow triangle [1/2H*L = .5*10*10 = 50]. In this case Mary could be charged a maximum membership fee of $50 and a rate of $10 per unit of X.

Now we are ready to move to a more detailed treatment of the choice situation in the output market. We will look no further than the output market, but you are encouraged to see how the analysis could be expanded to explain choices regarding how much to work and how much to save.

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Economics: It's not just whats' in your wallet