Explanation of Household Economics

Households affect the economy in two ways. They use consumer goods and supply labor. Households make choices in what goods to buy and how much labor to supply. These choices greatly impact our economy. Economics explains how these choices are made and how they may be predicted.

Households have a limited amount of income. Each month they choose how and on what to spend this money. Some decisions are made for them. They must have a place to live, food to eat, and clothes to wear. Any money left over may be allocated to consumer goods. Money left after purchasing basic necessities is called disposable income.

Personal preferences influence the allocation of disposable income. We will use a hypothetical family named the Smiths. Smiths have one thousand dollars per month in disposable income. They enjoy eating out. Their two favorite restaurants are the Indian House and China Hut. Each meal at the Indian House costs $10. While meals at the Chinese Hut costs $20. Smith family has to choose how to allocate their disposable income.

Indian House is the Smith family's preference. Cheaper cost per meal would allow them to buy more dinners. However, personal preference is not the only factor. We must also consider the law of diminishing marginal utility. Law of Diminishing Marginal Utility states "a person increases consumption of a product - while keeping consumption of other products constant - there is a decline in the marginal utility that person derives from consuming each additional unit of that product" (investopedia.com, 2008).

Let us apply this to the Smiths. They could spend their entire disposable income at the Indian Hut. One thousand dollars would buy one hundred meals. Yet, they choose to go to the China Hut twice per week. Their chose is being driven by marginal utility. Marginal Utility is "the additional satisfaction or benefit (utility) that a consumer derives from buying an additional unit of a commodity or service" (economyprofessor.com, 2008). For the Smiths, their first Indian House meal tastes heavenly. They thoroughly enjoy every bite. Their next meal is a little less enjoyable. Each successive meal becomes a little less enjoyable. Eventually no additional benefit (utility) is gained from Indian food. Their marginal utility has reached zero.

Smiths still highly value eating out. But, they will allocate disposable income to maximize utility. The first night they go to the Indian Hut. This visit gains them 18 utils. The next night, they have a choice. Should they eat Indian or Chinese? Indian food has lost some marginal utility. Eating Indian food would only gain 16 utils. They have not eaten any Chinese meals yet. Smith would gain 16 utils by eating Chinese. Marginal Utility gained from each meal is the same. In this case, the Smiths fall back on personal preference. They choose to eat at the Indian House. The next night Indian food offers less marginal utility (14 utils). Chinese food is still worth 16 utils. Smiths choose to eat Chinese.

Let us say that each consecutive meal costs two utils of marginal utility. After nine Indian meals and eight Chinese meals neither would offer any additional marginal utility. Yet, the Smiths have only spent $250 of their disposable income. They may choose to find another restaurant or spend money on an entirely different product.

Economics can be used to predict how the Smiths will allocate their additional money. This prediction is done using the Utility Maximizing Rule. Utility Maximizing Rule explains "how consumers allocate their money incomes so that the last dollar spent on each product purchased yields the same amount of extra (marginal) utility" (Muryn, 2008, pg. 1). Utility Maximizing Rule is calculated using the equation MUx/Px = MUy/Py. MUx is the maximum utility gained from product X. Px is the price of product X. MUy is the maximum utility gained from product Y. Py is the price of product Y.

By applying this rule to the Smiths, we can see this rule in action. Smith buys one Indian meal. The marginal utility gain (18 utils) is higher than the gain from Chinese food (16 utils). The Smiths gain more utility from Indian food than Chinese food. This is true until they run into the law of Diminishing Marginal Utility. At this point, more utility is gained by spending more money on Chinese food than Indian food. Smiths will then choose to buy more Chinese meals. This trend continues until MUx/Px=MUy/Py. When the marginal utility, from both products, is equal no additional marginal utility is gained.

Household's choice of consumer goods is just one piece of the puzzle. They also choose how to supply labor. Households choose whether to work, how much to work, and what kind of job to work at. These choices are affected by availability of jobs, market wage rates, and skills possessed. Leisure time must also be considered.

Up to this point choices were between goods and services. Choices must now be made between goods, services, and leisure. Leisure is purchased like any other product. Like any other product leisure has a cost. One hour of leisure costs one hour of wages. Thus, the price of leisure is one hour of wages.

Let us say Mrs. Smith decides to return to work. She wants to have another baby. This will cost hospital bills, diapers, formulas, and supplies. Her marginal utility for these products is very high. This is due to these products being linked to having a child. She must decide what job to pursue. She previously worked as a paralegal (skills). Several paralegal jobs are available (availability of jobs). Paralegals are paid enough to achieve her goals (market wage rates).

Working as a paralegal would fulfill Mrs. Smith's needs. However, she would be required to work forty hours per week. She thoroughly enjoys bowling. Presently, she bowls ten hours per week. She does not want to give this up. For Mrs. Smith the price of leisure is too high. Mrs. Smith chooses to only work part time and put off having a child.

Mrs. Smith negotiates with her potential employer. They will allow her to work twenty hours per week. Mrs. Smith is a very productive worker. Her employer offers her a significant wage increase. Mrs. Smith could afford more leisure time. The higher wage allows her to work less and still achieve her goals. This higher demand for leisure, due to the wage increase, is known as the income effect of a wage increase.

Mrs. Smith does not work less. Although each leisure hour still only costs one hour of wages, the cost per hour has increased. Mrs. Smith decides she can afford a child sooner by working more. This decrease in demand for leisure, in response to higher wages, is called the substitution effect of a wage increase.

Household choices are also effected by outside forces. News stories reporting job cuts may make a family save more money. Saving more money causes fewer goods to be sold. Decreasing sales may make companies lay off workers. Economics is a cycle. Knowledge of these cycles can be used to predict and even influence this cycle.

References

Investopedia.com (2008), Law of Diminishing Marginal Utility. Retrieved November 8, 2008 from http://www.investopedia.com/terms/l/lawofdiminishingutility.asp

Economyprofessor.com, (2008), Marginal Utility Theory. Retrieved November 8, 2008 from http://www.economyprofessor.com/economictheories/marginal-utility-theory.php

Muryn, Jack, (2008), ECON 204 Syllabus. Retrieved November 8, 2008 from http://www.google.com/search?hl=en&q=utility+maximizing+rule&btnG=Search