Microfoundations: Concepts for Making Consumer Decisions

1. Microfoundations: Concepts for Making Consumer Decisions What is the difference between microeconomics and macroeconomics?

2. Microeconomics: focuses on the behavior of individual consumers, households, & businesses. Examples: 1. Why do some couples choose to have three children while others elect to have none? 2. Why do some families carry life insurance while others do not? 3. Why do some families save to purchase major appliances while others buy them on credit?

3. Microeconomic Principles (i.e., proverbs) We’ll Cover • the basic principles of cost-benefit analysis • why prices matter and what should be included in a “price” • looking beyond the list price • valuing time • imputing costs and benefits that do not involve actual money payments • dealing with inflation • the role of interest rates • incorporating risk and uncertainty into the analysis • present value and future value calculations • a.k.a. time value of money calculations

4. Proverb #1: Families are a bit like firms

5. What’s involved in cost-benefit analyses? • Cost-Benefit Analysis- • Definition: the process of assessing the most efficient alternative resource allocation. • The most efficient option is determined by looking at the “costs” of each resource allocation option weighed against the “benefits” of each allocation option. • Typically, both costs and benefits are measured in dollar terms. • The central question is: how do families appropriately measure the benefits and costs of each alternative?

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

7. For family economic scholars, application of the cost-benefit analysis implies that we are able to • articulate all of the viable resource allocation options available to the household • quantify the benefits & costs associated with each option • make rational decisions

8. REVIEW: • With your neighbor, review CBA and make sure you understand the theory • We will apply this concept throughout the semester

9. Proverb #2: Make Sure “The Price is Right” • Why do prices matter? • With limited financial resources, prices affect a household’s ability to acquire goods and services -- that is, they affect a household’s decisions regarding their consumption.

10. Nominal PriceReading – “What’s the Difference btw Nom & Real?” • Price paid for a product or service at the time of the transaction. • Nominal prices are those that have not been adjusted to remove the effect of changes in the purchasing power of the dollar. • Nominal prices reflect buying power in the year in which the transaction occurred.

11. What should be included in the price of a product? • Look beyond the nominal price (i.e., the price that is listed in a store): • example: tuition and fees “price” of 15 credit hours at the U for an upper division undergraduate resident for 2009-2010 = $2,902.02. • But, is that the full price of attending school? • Incorporate time costs into the full price of a product/service...

12. Proverb #3: Time is money • Americans make more money now than ever before in the history of this country – even accounting for inflation • Does it feel like it? • Why or why not? • http://www.youtube.com/watch?v=_nk2_rk0FLw

13. The Time Costs of Preparing Dinner

14. Example: Housework tradeoffs - Friends are coming to town for the weekend. Should you take them out to dinner or cook for them at home? • Assumption: the quality of meals is equal, you get no enjoyment from cooking, and you don’t mind doing dishes • Cooking at home: $50 (ingredients) + 6 hours of your time preparing the meal and dealing with clean-up. • Eating at a restaurant: $120 (including tax and tip), 15 minute drive to the restaurant, 30 minute wait for your table, 15 minute drive back home but no time spent in meal preparation. • The economic answer depends on the rate at which you value your time: • $20/hr time costs: $50 + ($20/hr * 6 hrs) = $170 > $140 ==> eat out! • $10/hr time costs: $50 + ($10/hr * 6 hrs) = $110 < $130 ==> eat in!

15. So, how can do we measure the value of time? 1. Opportunity Cost • the value of time spent in any activity is measured by the value of the next best opportunity that would be foregone . • offered wage rate (wage someone offers) • asked wage rate (wage asked to be paid)

16. Opportunity Cost of Getting an ‘A’ in This Class • Attend class- 48 hours • Study 3 hours weekly- 48 hours • If your job paid $10/ hour • (48+48)*10= $960 • If your job paid $20/ hour • (48+48)*20= $1920

17. 2. Replacement Cost • the value of time spent in an activity is measured by what it would cost to replace your time (that is, to hire someone to do the task). • Applies to home production activities

18. So, what are the costs of your time (i.e. time costs)? Weekly median earnings for in 1st quarter of 2009 Total 20-24 $455 Men 471 Women 435 Source: Bureau of Labor Statistics, 1st Quarter Earnings 2009 http://www.bls.gov/news.release/wkyeng.t02.htm

19. Always ask: so what? • Families are often willing to spend money to save time. • It pays to “shop around” -- but only up to a point! • The rising value of time over the past 30 years may help us understand why families are… • buying more “fast foods” • having fewer children • using more air transportation • shopping by internet more • Bottom Line – The value of one’s time needs to be included in price comparisons when assessing resource allocation alternatives