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- Chapter 4
Household Finance
1
- Chapter Goals
Understand household finance and its economic and
financial underpinnings.
View the household as a functioning enterprise.
Recognize the many similarities between a household
and a business.
Start to apply business thinking to PFP.
Put into use in personal financial decision making cost of
time and life cycle theory principles.
Differentiate various types of household outlays.
Begin to understand personal financial planning theory
and Total Portfolio Management (TPM).
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- The Household Structure
Household: an organization of one or more people
who live in the same dwelling and share financial
and other resources intended for the well-being of its
members.
The household is the principal organization intended
to handle the financial and other personal activities
of one or more people and to foster achievement of
their goals.
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- The Household Structure, cont.
The household comes in many organizational forms,
which influence its financial, legal, and tax situation.
For example, financial efficiencies can result from a
multiperson household through:
– Reduction in income fluctuation,
– Specialization of task, and
– Economies of scale.
A breakdown of alternative household structures and
their effect on financial, legal, and tax matters is
shown on the next slide.
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- The Household Structure, cont.
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- The Household Structure, cont.
Household formation has changed since 1950:
6
- Theory: An Introduction
Theory underlies the personal financial planning
process.
However, theories don't usually give a complete
representation of how people act.
In many cases, the assumptions made seem
unrealistic. Theory leaves out parts of reality in order
to simplify key points that will help us understand
deeper aspects of behavior.
With theory, we can attempt to explain why people
do what they do.
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- The Theory of Consumer Choice
The theory of consumer choice describes the
method by which people select goods and services
to satisfy their needs.
People don’t have enough resources to purchase all
goods and services.
Each person has certain preferences.
Faced with a host of preferences and limited
resources, we make purchase decisions designed to
maximize utility.
Utility: The satisfaction an item presents.
Maximization: Getting the most possible from an
activity.
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- The Theory of Consumer Choice, cont.
People group goods and services into consumption
bundles and rank the bundles in order of
attractiveness.
Consumption bundle: The most attractive
combination of goods and services.
We naturally select the bundle that provides us with
the greatest enjoyment given our budget constraint.
Budget constraint: The limit on the amount we can
consume.
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- The Theory of Consumer Choice, cont.
Savings allow us to consider multi-year consumption
bundles.
Savings in the theory of choice represents future
spending.
Our choices in a more realistic multi-year time frame
are made by considering all current and future
consumption bundles as compared with current and
future wealth.
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- The Life Cycle Theory of Savings
The life cycle theory of savings shifts from the theory
of choice’s hard-to-measure utility to concrete money
terms.
The life cycle theory of savings assumes that utility
can be measured in money terms.
It says that our spending decisions are based on the
total amount we expect to earn over our life cycle.
Once we have established our lifetime resources, we
try to maintain a constant level of expenditures
throughout our life cycle.
The simple form of the theory assumes that risk and
inflation are not present and that people act logically
to pursue their goals.
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- The Life Cycle Theory of Savings, cont.
According to life cycle theory, borrowing generally
takes place early in the household’s life, when
income is low.
Then, as the income rises, people pay off their debt
and save for retirement.
In retirement, when work-related revenues have
stopped, savings would be liquidated steadily to
maintain their cost of living.
At death there would be no assets remaining.
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- The Life Cycle Theory of Savings, cont.
Demonstration of the life cycle theory:
13
- The Theory of the Firm
According to the economic theory of the firm, the firm
is an organization that produces goods or services.
The goods it offers are sold to households at a price
established in the marketplace.
The business concentrates on revenues (output
level) and costs (inputs) in order to find the optimum
level of production that maximizes profits.
Operating costs are split into those that are fixed and
the remainder that vary with the level of production.
Profits are revenues minus nondiscretionary (fixed)
and discretionary (variable) costs.
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- The Cost of Time
Gary Becker, an economics professor, employed a
money framework to develop a theory of the cost of
time.
Households and the people living and working in
them are limited in the amount of money they can
spend.
People are also limited in the time they have
available.
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- The Cost of Time, cont.
Our time can be viewed as being spent either in
work-related or leisure activities.
To decide how much time to devote to each, we:
– Compare the utility we receive from leisure time
with that from the money we receive from work
time.
– The fewer our leisure hours the greater its
pleasure.
– The higher the wage rate the more enticing is
further work.
The preference for work over leisure or vice versa at
any level will vary from one person to another.
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- The Cost of Time, cont.
We also perform other activities that can be viewed
as making us fit for work.
When we engage in any activities that don’t provide
us with money, we can say we have an opportunity
cost of time.
Opportunity cost of time: The amount of money we
could have made if we had worked instead.
Normally, this cost of time would be our hourly wage
or its equivalent.
By placing a money value on our non-earning time
we can better evaluate efficiencies in many areas.
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- The Household Enterprise
According to traditional economic theory, the
household is merely a supplier of labor to business
and a purchaser of its goods.
But in many ways the household resembles a small
business.
The household produces goods and services for its
own consumption by combining items purchased
with the time it takes to process it.
The cost is that of items purchased plus the
opportunity cost of the time.
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- The Household Enterprise, cont.
We combine business-related costs with capital
goods expenditures with our time at work.
The resulting product manufactured, our services, is
sold in the marketplace for a salary or hourly fee.
Some activities add directly to revenues.
Others support revenues by keeping us healthy and
ready to provide our best in the time we allocate to
work.
The rest of our time and money is devoted to
activities that we enjoy doing.
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- The Household Enterprise, cont.
Enterprise: An entity that engages in certain tasks for
an end result.
Household enterprise attempts to run the household
as efficiently as possible in order to provide as much
time and money as possible for pleasurable
activities.
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