Applications of Traditional vs. Behavioral Economics Explanations - Essay Example

Heading: Microeconomics Your name: Course name: Professors’ name: Date Introduction Consumer theory concerns preferences for goods and services for consumption, as well as consumption expenses and customer demand curves. Recently, there have been great housing bubbles in the world, especially among the US metropolitan areas. In part A, this paper seeks to analyze the concept of consumer theory regarding decision making of a dwelling residential for a better well-being. In part B, it attempts to analyze the connection between fundamentals and speculative house bubbles. Part 1 Applications of Traditional vs. Behavioral Economics Explanations Consumer choice entails a theory of microeconomics, which concerns preferences for services and consumption goods to consumption expenses and eventually to customer demand curves. The relationship between consumption, preferences, and the demand curve is among the most intimately surveyed connections in economics. Consumer choice theory refers to a means of examining how customers can attain equilibrium between expenditures and preferences through maximizing utility as subjected to budget constrictions (Mayumi and Gowdy2001). Preferences refer to desires by every person for the use for services and goods that turn into choices based on wealth or income for the combination of services and goods purchases with the customer’s time to explain consumption tasks. There is a difference between consumption and production, rationally, due to the involvement of two various consumers. Firstly, the primary individual is the consumer, and secondly, a producer may create something that he may not consumer himself. Therefore, there is an engagement of two distinct abilities and motivations. The models of consumer theory are useful in the representation prospectively noticeable demand patterns of a single purchaser on constrained optimization proposition. prominent factors used in explaining the rate of purchasing or demanding of goods are the price for each unit of the good, consumer’s wealth, and prices of associated goods (Mankiw 2012). Rich and Erb (2008) maintain that the basic demand theorem asserts that the consumption rate falls as the good’s price rises, which is the substitution effect. Explicitly, if an individual has inadequate money to pay for the good, he cannot purchase any of the goods. As the prices of goods increase, customers tend to substitute away from highly priced services and goods; hence, choosing less costly options. Consequently, the consumer’s wealth increases, demand rises, and thus moving the demand curve to a higher point at all consumption rates. This phenomenon entails the income effect. Here, as consumer wealth increases, consumers tend to move away from lowly priced inferior services and goods; hence, selecting highly priced options. In consumer theory, there is utility, which describes the enjoyment and satisfaction derived from the use of a service or a good. When consumers behave sensibly, they will select between the various services and goods in order to maximize total utility or satisfaction. Therefore, consumers tend to consider the amount of satisfaction derived from purchasing and consuming an additional unit of a service or a good. They think about the price that they should pay in order to buy the service or good. Besides, consumers also consider the satisfaction obtained from using optional products. Lastly, another consideration made by consumers before buying involves the prices of the substitute services or goods (Wells and Foxall 2012). Marginal utility is another concept in consumer theory, which refers to the change in total satisfaction and utility, which results from the use of one or more unit of a good. The supposition of decreasing marginal utility asserts that as the amount of a goods used increases, there is a decreased marginal utility attained from the good (Stibel, Dror, and Ben-Zeev 2008). With respect to the equi marginal returns’ law, a rational customer will use his money in a manner that capitalizes on the total utility obtained from all services and goods used. For instance, it happens in a case where a customer has a preference between two goods A and B whose prices are Pa and Pb respectively. The maximization of the total utility occurs when the utility from the final pound’s worth of item A equals to the utility attained form the final pound’s worth of item B. In order to derive a demand curve, it is important to consider the effect of law of equi-marginal returns by the fall of item A’s price. Here, the equality becomes an inequality, as the consumer gets more utility per pound’s worth of item A than in item B. to regain the equality and enhance total utility, a sensible consumer will use more of item A. As consumption rises, the marginal utility from item A will decrease until the aforementioned equi-marginal situation is back and maximization of total utility occurs. A reduction in the item A’s price causes an increase in the demanded quantity of the item (Mankiw 2012). In terms of a consumer’s choice for a residential dwelling to enhance well-being, consumers engage in rational decision-making. This involves a process of establishing what alternatives available and then selecting the most preferred one as per some constant standard. Rational consumers tend to opt for those alternatives that tend to enable them maximize their utility. In the case of a dwelling residential, consumers will consider price of the alternatives available before making a decision. Secondly, rational consumers will tend to opt for a house that gives them the desired satisfaction or enjoyment. Thirdly, consumers usually consider the price paid in order to use the preferred choice among other alternatives. Eventually, rational clients choose the alternatives that meet their needs and expectations, after successfully considering all the aforementioned factors (Wells and Foxall 2012). Part 2 Speculative Housing-Price Bubbles As per Hwang and Quigley (2006), housing markets entail local and housing market results reflect local economic situations. Housing prices increased due to enhanced employment chances and increased incomes that residents enjoy in a growing metropolitan market. Fluctuations in the income distribution are noticeable in the allocation of housing amenities and prices. Likewise, the rates of housing vacancy may decline when local economic gets better, and as house demand rises. Building activity and residential construction are reactive to housing vacancy rates, prices, and local economic health. As high incomes raises the housing demand, prices also increase; new construction gets more profitable; hence, inducing activity of the supplier. Dwellings, which would otherwise get vacant, are occupied, and those that would leave the housing reserve are renovated for sustained use. Most of the popular press ignore that the new increases in the house price observed across the globe is proof of a bubble in the housing market. For instance, McCarthy and Peach (2004), realized that the increased ration of home prices compared to household income and decreased ratio of home prices compared to market rents for the corresponding property were the greatest bubble evidence in the recent study. Nonetheless, house price bubbles are still a contentious subject in economics. For instance, Case and Shiller (2004) noticed that house prices in the majority of the US cities show fundamental values. According to McCarthy and Peach (2004), applying information from 1977-2003, assert that the proof based on ordinary fundamental value proportions is inconclusive, as these proportions overlook the dramatic decrease in mortgage interest rates in the 1990s, and the expansion in house demand due to demographic changes in the people. Upon regulating the current approaches in mortgage markets, McCarthy and Peach (2004) hold that the advantages of the reduction in mortgage rates in the 1990s counterbalance the rise in home prices. Additionally, Himmelberg, Mayer, and Sinai (2005) analyze the conventional metrics of fundamentals of housing market, such as, price-to-income ratio, growth rates, and rent-to-rent price ratio, and maintain that lack of interest rates in such examination may result in false judgments. The aforementioned authors commonly agreed that prices in many US housing markets seem to comply with market fundamentals. A study by Brunnermeier and Julliard (2008) analyze the connection between the interest rates, rent-price ratio, and inflation. Home purchasers might be suffering from money fantasy and overlook the fact that inflation reduces future costs of the real mortgage. They also realize that the small interest rates, unlike real estate, influence the ratio of the house-rent. Upon decomposing this ratio into mispricing and rational component is strongly motivated by inflation movements. As per the US data of 1970-2003, long-horizon regressions aid the application of the rent-price ratio as a symbol of housing market value (Gallin 2004). Therefore, the aforementioned studies indicate that prices can shift from fundamentals over a long period. With respect to the global crisis of 2008-2012, the US faced housing bubbles like other parts of the globe. The US real estate bubbles entails the economic bubble influencing various parts of the country’s housing market in more than half of the states. Here, housing prices increased in 2006 and reduced between 2006 and 2007, and hit new lows during 2012. In December 2008, there was a historical, biggest price decline as reported by Case-Shiller home price index. The increased foreclosure rates of 2006 and 2007 in the US real estate owners caused a crisis in 2008 for the mortgage, hedge fund, credit, Alt-A, and international bank markets. In fact, in 2007, the US Treasury Secretary referred to the increasing house bubble the greatest risk to the country’s economy. Any reduction in the US housing bubble constitutes a direct effect on home valuations, as well as country’s home builders, mortgage markets, real estate, foreign banks among others; hence, enhancing the risk of countrywide recession. The increased housing prices resulted from the land prices as compared to the structure prices. An approximation of land value for real estate is attainable through the subtraction of replacement worth of the structure, changed for depreciation, from the house price. Housing bubbles can take place in global or local real estate markets. In these phenomena’s final stages, they are features of fast rise in real property valuations until the attainment of unsustainable degrees comparative to price-to-rent ratios, incomes, and other economic signs of affordability. Next, there are decreases in house prices, which place many homeowners in a negative equity position; a mortgage debt that is greater than the property’s value (Hwang and Quigley 2006). The fundamental reasons for house bubbles, especially in the US are complex. Some of the causal factors include tax policy, which entail the exception of real state from capital gain, lax lending measures, historically decreased interest rates, speculative fever, and lack of intervention by regulators. Some of the metropolitan areas affected in the US include Miami, San Diego, Los Angeles, Tampa, Phoenix, Las Vegas, and Washington DC. Nevertheless, these bubbles did not occur in each area at the same period. Paradoxically, as housing bubbles deflate, certain metropolitan area slime Atlanta and Denver experience great foreclosure rates, although they did not face much house appreciation initially, and thus did not seem to be causing national bubble (Calverley 2009). Conclusion In microeconomics, consumer choice theory entails preferences for goods and services for consumption, as well as consumption expenses and customer demand curves. This implies that consumers decide on a certain service or good based on various factors, such as, price or associated goods, satisfaction obtained from the service or good, and the price of the good or price. As the demand rise, prices of goods and services also increased. During the global crisis of 2008 and 2012, US and other parts of the globe experienced great real estate bubbles. Various studies show that prices can shift from fundamentals over a long period. Moreover, some of the causes of the bubbles include tax policy, which entail the exception of real state from capital gain, lax lending measures, historically decreased interest rates, speculative fever, and lack of intervention by regulators. References Brunnermeier, Markus K., and Christian Julliard. “Money Illusion and Housing Frenzies.” The Review of Financial Studies 21, no.1 (2008): 135-180. Case, Karl E., and Robert J. Shiller. “Is There a Bubble in the Housing Market?” Brookings Papers on Economic Activity 2, no. 2 (2003): 299-342. DOI 10.1007/s11238-007-9094-7 Calverley, John. When bubbles burst surviving the financial fallout. London Boston: Nicholas Brealey Pub, 2009. Gallin, Joshua H. “The Long-Run Relationship between House Prices and Rents.” Federal Reserve Board Finance and Economics Discussion Series, 2004. Himmelberg, Charles, Christopher Mayer, and Todd Sinai. 2005. “Assessing High House Prices: Bubbles, Fundamentals, and Misperceptions”. Journal of Economic Perspectives, 19, no.4 (2005): 67-92. Hwang, Min and Quigley, John M.“Economic Fundamentals in Local Housing Markets: Evidence from U.S. Metropolitan regions.” Journal of Regional Science 46, no. 3, (2006): 425–453 Kemmer, Michael and Herfurth, Dirk.The Economics of the US House Price Bubble in the early 21st century. John Wiley & Sons. Hoboken, 2012. Mankiw, N. Gregory. Principles of economics. Mason, OH: South-Western Cengage Learning, 2012. Mayumi, Kozo, and Gowdy, John M. “Analysis Reformulating the foundations of consumer choice theory and environmental valuation”. Ecological Economics 39, no.1 (2001): 223–237 McCarthy, Jonathan, and Richard W. Peach. “Are Home Prices the Next ‘Bubble’?” FRBNY Economic Policy Review 3, no. 1 (2004): 1-17. Rich, Robert F., and Erb, Christopher T. Consumer choice: social welfare & health policy. New Brunswick: Transaction Publishers, 2005. Stibel, Jeffrey M., Dror, Itiel E., and Ben-Zeev, Talia. The Collapsing Choice Theory: Dissociating Choice and Judgment in Decision Making. Springer, 2008. Wells, Victoria, and Foxall, Gordon. Handbook of developments in consumer behavior. Cheltenham: Edward Elgar, 2012. Read More