Consumer choice

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The theory of consumer choice is the branch of microeconomics that relates preferences to consumption expenditures and to consumer demand curves. It analyzes how consumers maximize the desirability of their consumption as measured by their preferences subject to limitations on their expenditures, by maximizing utility subject to a consumer budget constraint. [1]

Microeconomics is a branch of economics that studies the behaviour of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms.

In economics and other social sciences, preference is the ordering of alternatives based on their relative utility, a process which results in an optimal "choice". The character of the individual preferences is determined purely by taste factors, independent of considerations of prices, income, or availability of goods. In addition to this, agents are expected to act in their best interest.

Supply and demand economic model of price determination in microeconomics

In microeconomics, supply and demand is an economic model of price determination in a market. It postulates that, holding all else equal, in a competitive market, the unit price for a particular good, or other traded item such as labor or liquid financial assets, will vary until it settles at a point where the quantity demanded will equal the quantity supplied, resulting in an economic equilibrium for price and quantity transacted.

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Consumption is separated from production, logically, because two different economic agents are involved. In the first case consumption is by the primary individual; in the second case, a producer might make something that he would not consume himself. Therefore, different motivations and abilities are involved. The models that make up consumer theory are used to represent prospectively observable demand patterns for an individual buyer on the hypothesis of constrained optimization. Prominent variables used to explain the rate at which the good is purchased (demanded) are the price per unit of that good, prices of related goods, and wealth of the consumer.

Mathematical problem problem that is amenable to being represented, analyzed, and possibly solved, with the methods of mathematics

A mathematical problem is a problem that is amenable to being represented, analyzed, and possibly solved, with the methods of mathematics. This can be a real-world problem, such as computing the orbits of the planets in the solar system, or a problem of a more abstract nature, such as Hilbert's problems.

Hypothesis Proposed explanation for an observation, phenomenon, or scientific problem

A hypothesis is a proposed explanation for a phenomenon. For a hypothesis to be a scientific hypothesis, the scientific method requires that one can test it. Scientists generally base scientific hypotheses on previous observations that cannot satisfactorily be explained with the available scientific theories. Even though the words "hypothesis" and "theory" are often used synonymously, a scientific hypothesis is not the same as a scientific theory. A working hypothesis is a provisionally accepted hypothesis proposed for further research, in a process beginning with an educated guess or thought.

In mathematical optimization, constrained optimization is the process of optimizing an objective function with respect to some variables in the presence of constraints on those variables. The objective function is either a cost function or energy function, which is to be minimized, or a reward function or utility function, which is to be maximized. Constraints can be either hard constraints, which set conditions for the variables that are required to be satisfied, or soft constraints, which have some variable values that are penalized in the objective function if, and based on the extent that, the conditions on the variables are not satisfied.

The law of demand states that the rate of consumption falls as the price of the good rises, even when the consumer is monetarily compensated for the effect of the higher price; this is called the substitution effect. As the price of a good rises, consumers will substitute away from that good, choosing more of other alternatives. If no compensation for the price rise occurs, as is usual, then the decline in overall purchasing power due to the price rise leads, for most goods, to a further decline in the quantity demanded; this is called the income effect.

Law of demand economics theorem

In microeconomics, the law of demand states that, "conditional on all else being equal, as the price of a good increases (↑), quantity demanded decreases (↓); conversely, as the price of a good decreases (↓), quantity demanded (↑)". In other words, the law of demand describes an inverse relationship between price and quantity demanded of a good. Alternatively, other things being constant, quantity demanded of a commodity is inversely related to the price of the commodity. For example, a consumer may demand 2 kilograms of apples at $70 per kg; he may, however, demand 1 kg if the price rises to $80 per kg. This has been the general human behaviour on relationship between the price of the commodity and the quantity demanded. The factors held constant refer to other determinants of demand, such as the prices of other goods and the consumer's income. There are, however, some possible exceptions to the law of demand, such as Giffen goods and Veblen goods.

In economics and particularly in consumer choice theory, the substitution effect is one component of the effect of a change in the price of a good upon the amount of that good demanded by a consumer, the other being the income effect.

In addition, as the wealth of the individual rises, demand for most products increases, shifting the demand curve higher at all possible prices.

The basic problem of consumer theory takes the following inputs:

In economics, an ordinal utility function is a function representing the preferences of an agent on an ordinal scale. The ordinal utility theory claims that it is only meaningful to ask which option is better than the other, but it is meaningless to ask how much better it is or how good it is. All of the theory of consumer decision-making under conditions of certainty can be, and typically is, expressed in terms of ordinal utility.

In economics, a price system is a component of any economic system that uses prices expressed in any form of money for the valuation and distribution of goods and services and the factors of production. Except for possible remote and primitive communities, all modern societies use price systems to allocate resources, although price systems are not used exclusively for all resource allocation decisions.

Example: homogeneous divisible goods

Consider an economy with two types of homogeneous divisible goods, traditionally called X and Y.

Budget constraint A budget constraint represents all the combinations of goods and services that a consumer may purchase given current prices within his or her given income.

In economics, a budget constraint represents all the combinations of goods and services that a consumer may purchase given current prices within his or her given income. Consumer theory uses the concepts of a budget constraint and a preference map to analyze consumer choices. Both concepts have a ready graphical representation in the two-good case.

The consumer will choose the indifference curve with the highest utility that is attainable within his budget constraint. Every point on indifference curve I3 is outside his budget constraint so the best that he can do is the single point on I2 where the latter is tangent to his budget constraint. He will purchase X* of good X and Y* of good Y.

Consumer constraint choice.svg

Indifference curve analysis begins with the utility function. The utility function is treated as an index of utility. [2] All that is necessary is that the utility index change as more preferred bundles are consumed.

Indifference curves are typically numbered with the number increasing as more preferred bundles are consumed. The numbers have no cardinal significance; for example if three indifference curves are labeled 1, 4, and 16 respectively that means nothing more than the bundles "on" indifference curve 4 are more preferred than the bundles "on" indifference curve 1.

Income effect and price effect deal with how the change in price of a commodity changes the consumption of the good. The theory of consumer choice examines the trade-offs and decisions people make in their role as consumers as prices and their income changes.

Example: land

As a second example, consider an economy which consists of a large land-estate L.

Effect of a price change

The indifference curves and budget constraint can be used to predict the effect of changes to the budget constraint. The graph below shows the effect of a price increase for good Y. If the price of Y increases, the budget constraint will pivot from BC2 to BC1. Notice that because the price of X does not change, the consumer can still buy the same amount of X if he or she chooses to buy only good X. On the other hand, if the consumer chooses to buy only good Y, he or she will be able to buy less of good Y because its price has increased.

To maximize the utility with the reduced budget constraint, BC1, the consumer will re-allocate consumption to reach the highest available indifference curve which BC1 is tangent to. As shown on the diagram below, that curve is I1, and therefore the amount of good Y bought will shift from Y2 to Y1, and the amount of good X bought to shift from X2 to X1. The opposite effect will occur if the price of Y decreases causing the shift from BC2 to BC3, and I2 to I3.

Consumer constraint choice price shift.svg

If these curves are plotted for many different prices of good Y, a demand curve for good Y can be constructed. The diagram below shows the demand curve for good Y as its price varies. Alternatively, if the price for good Y is fixed and the price for good X is varied, a demand curve for good X can be constructed.

Found demand.svg

Income effect

Another important item that can change is the money income of the consumer. The income effect is the phenomenon observed through changes in purchasing power. It reveals the change in quantity demanded brought by a change in real income. Graphically, as long as the prices remain constant, changing income will create a parallel shift of the budget constraint. Increasing the income will shift the budget constraint right since more of both can be bought, and decreasing income will shift it left.

Consumer constraint choice income shift.svg

Depending on the indifference curves, as income increases, the amount purchased of a good can either increase, decrease or stay the same. In the diagram below, good Y is a normal good since the amount purchased increased as the budget constraint shifted from BC1 to the higher income BC2. Good X is an inferior good since the amount bought decreased as the income increases.

Inferior good.svg

is the change in the demand for good 1 when we change income from to , holding the price of good 1 fixed at :

Price effect as sum of substitution and income effects

Every price change can be decomposed into an income effect and a substitution effect; the price effect is the sum of substitution and income effects.

The substitution effect is the change in demands resulting from a price change that alters the slope of the budget constraint but leaves the consumer on the same indifference curve. In other words, it illustrates the consumer's new consumption basket after the price change while being compensated as to allow the consumer to be as happy as he or she was previously. By this effect, the consumer is posited to substitute toward the good that becomes comparatively less expensive. In the illustration below this corresponds to an imaginary budget constraint denoted SC being tangent to the indifference curve I1. Then the income effect from the rise in purchasing power from a price fall reinforces the substitution effect. If the good is an inferior good, then the income effect will offset in some degree the substitution effect. If the income effect for an inferior good is sufficiently strong, the consumer will buy less of the good when it becomes less expensive, a Giffen good (commonly believed to be a rarity).

Hicks Substitution effect.svg

The substitution effect, , is the change in the amount demanded for when the price of good falls from to (represented by the budget constraint shifting from BC1 to BC2 and thus increasing purchasing power) and, at the same time, the money income falls from to to keep the consumer at the same level of utility on :

The substitution effect increases the amount demanded of good from to in the diagram. In the example shown, the income effect of the fall in partly offsets the substitution effect as the amount demanded of in the absence of an offsetting income change ends up at thus the income effect from the rise in purchasing power due to the price drop is that the quantity demanded of goes from to . The total effect of the price drop on quantity demanded is the sum of the substitution effect and the income effect.

Assumptions

The behavioral assumption of the consumer theory proposed herein is that all consumers seek to maximize utility. In the mainstream economics tradition, this activity of maximizing utility has been deemed as the "rational" behavior of decision makers. More specifically, in the eyes of economists, all consumers seek to maximize a utility function subject to a budgetary constraint. [4] In other words, economists assume that consumers will always choose the "best" bundle of goods they can afford. [5] Consumer theory is therefore based on generating refutable hypotheses about the nature of consumer demand from this behavioral postulate. [4]

In order to reason from the central postulate towards a useful model of consumer choice, it is necessary to make additional assumptions about the certain preferences that consumers employ when selecting their preferred "bundle" of goods. These are relatively strict, allowing for the model to generate more useful hypotheses with regard to consumer behaviour than weaker assumptions, which would allow any empirical data to be explained in terms of stupidity, ignorance, or some other factor, and hence would not be able to generate any predictions about future demand at all. [4] For the most part, however, they represent statements which would only be contradicted if a consumer was acting in (what was widely regarded as) a strange manner. [6] In this vein, the modern form of consumer choice theory assumes:

Preferences are complete
Consumer choice theory is based on the assumption that the consumer fully understands his or her own preferences, allowing for a simple but accurate comparison between any two bundles of good presented. [5] That is to say, it is assumed that if a consumer is presented with two consumption bundles A and B each containing different combinations of n goods, the consumer can unambiguously decide if (s)he prefers A to B, B to A, or is indifferent to both. [4] [5] The few scenarios where it is possible to imagine that decision-making would be very difficult are thus placed "outside the domain of economic analysis". [5] However, discoveries in behavioral economics has found that actual decision making is affected by various factors, such as whether choices are presented together or separately through the distinction bias.
Preferences are reflexive
Means that if A and B are in all respect identical the consumer will consider A to be at least as good as (i.e. weakly preferred to) B. [5] Alternatively, the axiom can be modified to read that the consumer is indifferent with regard to A and B. [7]
Preference are transitive
If A is preferred to B and B is preferred to C then A must be preferred to C.
This also means that if the consumer is indifferent between A and B and is indifferent between B and C she will be indifferent between A and C.
This is the consistency assumption. This assumption eliminates the possibility of intersecting indifference curves.
Preferences exhibit non-satiation
This is the "more is always better" assumption; that in general if a consumer is offered two almost identical bundles A and B, but where B includes more of one particular good, the consumer will choose B. [8]
Among other things this assumption precludes circular indifference curves. Non-satiation in this sense is not a necessary but a convenient assumption. It avoids unnecessary complications in the mathematical models.
Indifference curves exhibit diminishing marginal rates of substitution
This assumption assures that indifference curves are smooth and convex to the origin.
This assumption is implicit in the last assumption.
This assumption also set the stage for using techniques of constrained optimization. Because the shape of the curve assures that the first derivative is negative and the second is positive.
The MRS tells how much y a person is willing to sacrifice to get one more unit of x.
This assumption incorporates the theory of diminishing marginal utility.
Goods are available in all quantities
It is assumed that a consumer may choose to purchase any quantity of a good (s)he desires, for example, 2.6 eggs and 4.23 loaves of bread. Whilst this makes the model less precise, it is generally acknowledged to provide a useful simplification to the calculations involved in consumer choice theory, especially since consumer demand is often examined over a considerable period of time. The more spending rounds are offered, the better approximation the continuous, differentiable function is for its discrete counterpart. (Whilst the purchase of 2.6 eggs sounds impossible, an average consumption of 2.6 eggs per day over a month does not.) [8]

Note the assumptions do not guarantee that the demand curve will be negatively sloped. A positively sloped curve is not inconsistent with the assumptions. [9]

Use value

In Marx's critique of political economy, any labor-product has a value and a use value, and if it is traded as a commodity in markets, it additionally has an exchange value, most often expressed as a money-price. [10] Marx acknowledges that commodities being traded also have a general utility, implied by the fact that people want them, but he argues that this by itself tells us nothing about the specific character of the economy in which they are produced and sold.

Labor-leisure tradeoff

One can also use consumer theory to analyze a consumer's choice between leisure and labor. Leisure is considered one good (often put on the horizontal axis) and consumption is considered the other good. Since a consumer has a finite amount of time, he must make a choice between leisure (which earns no income for consumption) and labor (which does earn income for consumption).

The previous model of consumer choice theory is applicable with only slight modifications. First, the total amount of time that an individual has to allocate is known as his "time endowment", and is often denoted as T. The amount an individual allocates to labor (denoted L) and leisure () is constrained by T such that

A person's consumption is the amount of labor they choose multiplied by the amount they are paid per hour of labor (their wage, often denoted w). Thus, the amount that a person consumes is:

When a consumer chooses no leisure then and .

From this labor-leisure tradeoff model, the substitution effect and income effect from various changes caused by welfare benefits, labor taxation, or tax credits can be analyzed.

See also

Related Research Articles

Within economics the concept of utility is used to model worth or value, but its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or satisfaction within the theory of utilitarianism by moral philosophers such as Jeremy Bentham and John Stuart Mill. But the term has been adapted and reapplied within neoclassical economics, which dominates modern economic theory, as a utility function that represents a consumer's preference ordering over a choice set. As such, it is devoid of its original interpretation as a measurement of the pleasure or satisfaction obtained by the consumer from that choice.

Indifference curve microeconomic graph; connects points representing different quantities of 2 goods, points between which a consumer is indifferent: i.e. the consumer doesnt prefer one combination or bundle of goods over another combination on the same curve

In economics, an indifference curve connects points on a graph representing different quantities of two goods, points between which a consumer is indifferent/curve that shows all combinations of two products that will provide the consumer with equal levels of utility. That is, the consumer has no preference for one combination or bundle of goods over a different combination on the same curve. One can also refer to each point on the indifference curve as rendering the same level of utility (satisfaction) for the consumer. In other words, an indifference curve is the locus of various points showing different combinations of two goods providing equal utility to the consumer. Utility is then a device to represent preferences rather than something from which preferences come. The main use of indifference curves is in the representation of potentially observable demand patterns for individual consumers over commodity bundles.

In economics, elasticity is the measurement of the proportional change of an economic variable in response to a change in another. It shows how easy it is for the supplier and consumer to change their behavior and substitute another good, the strength of an incentive over choices per the relative opportunity cost.

Intertemporal choice is the process by which people make decisions about what and how much to do at various points in time, when choices at one time influence the possibilities available at other points in time. These choices are influenced by the relative value people assign to two or more payoffs at different points in time. Most choices require decision-makers to trade off costs and benefits at different points in time. These decisions may be about saving, work effort, education, nutrition, exercise, health care and so forth.

In economics and consumer theory, a Giffen good is a product that people consume more of as the price rises and vice versa—violating the basic law of demand in microeconomics. For any other sort of good, as the price of the good rises, the substitution effect makes consumers purchase less of it, and more of substitute goods; for most goods, the income effect reinforces this decline in demand for the good. But a Giffen good is so strongly an inferior good in the minds of consumers that this contrary income effect more than offsets the substitution effect, and the net effect of the good's price rise is to increase demand for it.

Substitute good good with a positive cross elasticity of demand

A substitute good is a good that can be used in place of another. In consumer theory, substitute goods or substitutes are products that a consumer perceives as similar or comparable, so that having more of one product makes them desire less of the other product. Formally, X and Y are substitutes if, when the price of X rises, the demand for Y rises.

In economics, the marginal rate of substitution (MRS) is the rate at which a consumer can give up some amount of one good in exchange for another good while maintaining the same level of utility. At equilibrium consumption levels, marginal rates of substitution are identical. The marginal rate of substitution is one of the three factors from marginal productivity, the others being marginal rates of transformation and marginal productivity of a factor.

In economics and particularly in consumer choice theory, the income-consumption curve is a curve in a graph in which the quantities of two goods are plotted on the two axes; the curve is the locus of points showing the consumption bundles chosen at each of various levels of income.

In microeconomics, the utility maximization problem is the problem consumers face: "how should I spend my money in order to maximize my utility?" It is a type of optimal decision problem. It consists of choosing how much of each available good or service to consume, taking into account a constraint on total spending as well as the prices of the goods.

Revealed preference theory, pioneered by economist Paul Samuelson, is a method of analyzing choices made by individuals, mostly used for comparing the influence of policies on consumer behavior. Revealed preference models assume that the preferences of consumers can be revealed by their purchasing habits.

In microeconomics, a consumer's Hicksian demand correspondence is the demand of a consumer over a bundle of goods that minimizes their expenditure while delivering a fixed level of utility. If the correspondence is actually a function, it is referred to as the Hicksian demand function, or compensated demand function. The function is named after John Hicks.

A corner solution is a special solution to an agent's maximization problem in which the quantity of one of the arguments in the maximized function is zero. In non-technical terms, a corner solution is when the chooser is either unwilling or unable to make a tradeoff.

Gorman polar form is a functional form for indirect utility functions in economics. Imposing this form on utility allows the researcher to treat a society of utility-maximizers as if it consisted of a single 'representative' individual. Gorman showed that having the function take Gorman polar form is both necessary and sufficient for this condition to hold.

In economics and consumer theory, quasilinear utility functions are linear in one argument, generally the numeraire. Quasilinear preferences can be represented by the utility function where is strictly concave. A nice property of the quasilinear utility function is that, the Marshallian/Walrasian demand for does not depend on wealth and therefore is not subject to a wealth effect. The absence of a wealth effect simplifies analysis and makes quasilinear utility functions a common choice for modelling. Furthermore, when utility is quasilinear, compensating variation (CV), equivalent variation (EV), and consumer surplus are algebraically equivalent. In mechanism design, quasilinear utility ensures that agents can compensate each other with side payments.

In consumer theory, a consumer's preferences are called homothetic if they can be represented by a utility function which is homogeneous of degree 1. For example, in an economy with two goods , homothetic preferences can be represented by a utility function that has the following property: for every :

A Robinson Crusoe economy is a simple framework used to study some fundamental issues in economics. It assumes an economy with one consumer, one producer and two goods. The title "Robinson Crusoe" is a reference to the novel of the same name authored by Daniel Defoe in 1719.

In economics and consumer theory, a linear utility function is a function of the form:

References

  1. "What is 'consumer choice theory'? — Economy". Economy. Retrieved 2017-05-31.
  2. Silberberg & Suen 2001 , p. 255
  3. Berliant, M.; Raa, T. T. (1988). "A foundation of location theory: Consumer preferences and demand". Journal of Economic Theory. 44 (2): 336. doi:10.1016/0022-0531(88)90008-7.
  4. 1 2 3 4 Silberberg & Suen 2001 , pp. 252–254
  5. 1 2 3 4 5 Varian 2006 , p. 20
  6. Silberberg & Suen 2001 , p. 260
  7. Binger & Hoffman 1998 , pp. 109–17
  8. 1 2 Silberberg & Suen 2001 , pp. 256–257
  9. Binger & Hoffman 1998 , pp. 141–143
  10. "Glossary of Terms: Us". Marxists.org. Retrieved 2013-11-07.