Consumer theory

Consumer theory

Overview
Consumer choice is a theory of microeconomics
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

 that relates preference
Preference
-Definitions in different disciplines:The term “preferences” is used in a variety of related, but not identical, ways in the scientific literature. This makes it necessary to make explicit the sense in which the term is used in different social sciences....

s for consumption goods and services to consumption expenditures and ultimately to consumer demand curves
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

. The link between personal preferences, consumption, and the demand curve is one of the most closely studied relations in economics. Consumer choice theory is a way of analyzing how consumers may achieve equilibrium between preferences and expenditures by maximizing utility
Utility
In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....

 as subject to consumer budget constraint
Budget constraint
A budget constraint represents the combinations of goods and services that a consumer can purchase given current prices with his or her income. Consumer theory uses the concepts of a budget constraint and a preference map to analyze consumer choices...

s.
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Encyclopedia
Consumer choice is a theory of microeconomics
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

 that relates preference
Preference
-Definitions in different disciplines:The term “preferences” is used in a variety of related, but not identical, ways in the scientific literature. This makes it necessary to make explicit the sense in which the term is used in different social sciences....

s for consumption goods and services to consumption expenditures and ultimately to consumer demand curves
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

. The link between personal preferences, consumption, and the demand curve is one of the most closely studied relations in economics. Consumer choice theory is a way of analyzing how consumers may achieve equilibrium between preferences and expenditures by maximizing utility
Utility
In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....

 as subject to consumer budget constraint
Budget constraint
A budget constraint represents the combinations of goods and services that a consumer can purchase given current prices with his or her income. Consumer theory uses the concepts of a budget constraint and a preference map to analyze consumer choices...

s.

Preferences are the desires by each individual for the consumption of goods and services that translate into choices based on income or wealth for purchases of goods and services to be combined with the consumer's time to define consumption activities.

Consumption is separated from production, logically, because two different consumers 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
Model (economics)
In economics, a model is a theoretical construct that represents economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified framework designed to illustrate complex processes, often but not always using...

 that make up consumer theory are used to represent
Mathematical problem
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...

 prospectively observable demand patterns for an individual buyer on the hypothesis
Hypothesis
A hypothesis is a proposed explanation for a phenomenon. The term derives from the Greek, ὑποτιθέναι – hypotithenai meaning "to put under" or "to suppose". For a hypothesis to be put forward as a scientific hypothesis, the scientific method requires that one can test it...

 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.

The fundamental theorem of demand states that the rate of consumption falls as the price of the good rises. This is called the substitution effect. Clearly if one does not have enough money to pay the price then they cannot buy any of that item. As prices rise, consumers will substitute away from higher priced goods and services, choosing less costly alternatives. Subsequently, as the wealth of the individual rises, demand increases, shifting the demand curve higher at all rates of consumption. This is called the income effect. As wealth rises, consumers will substitute away from less costly inferior goods and services, choosing higher priced alternatives.

Model setup


Economists' modern solution to the problem of mapping consumer choices is indifference curve
Indifference curve
In microeconomic theory, an indifference curve is a graph showing different bundles of goods between which a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for one bundle over another. One can equivalently refer to each point on the indifference curve...

 analysis. For an individual, indifference curves and an assumption of constant prices and a fixed income
Income
Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms. However, for households and individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings...

 in a two-good world will give the following diagram. The consumer can choose any point on or below the budget constraint
Budget constraint
A budget constraint represents the combinations of goods and services that a consumer can purchase given current prices with his or her income. Consumer theory uses the concepts of a budget constraint and a preference map to analyze consumer choices...

 line BC. This line is diagonal since it comes from the equation .
In other words, the amount spent on both goods together is less than or equal to the income of the consumer. The consumer will choose the indifference curve with the highest utility
Utility
In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....

 that is within his budget constraint. Every point on I3 is outside his budget constraint so the best that he can do is the single point on I2 that is tangent to his budget constraint. He will purchase X* of good X and Y* of good Y.



Indifference curve analysis begins with the utility function. The utility function is treated as an index of utility. 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. However, it is not necessary that numbers be used - any indexing system would suffice - colors for example. The advantage of numbers is that their use makes the math simpler. Numbers used to index indifference curves 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 I. The fact that the index number is a multiple of another is of no significance. For example, the bundles of good on 4 does not mean that they are four times more satisfying than those on 1. As noted they merely mean they are more satisfying.

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.

Substitution effect



The substitution effect is the effect observed with changes in relative price of goods. This effect basically affects the movement along the curve.

These curves can be used to predict the effect of changes to the budget constraint. The graphic 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.



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.


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 (utility
Utility
In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....

).
Graphically, as long as the prices remain constant, changing the income will create a parallel
Parallel (geometry)
Parallelism is a term in geometry and in everyday life that refers to a property in Euclidean space of two or more lines or planes, or a combination of these. The assumed existence and properties of parallel lines are the basis of Euclid's parallel postulate. Two lines in a plane that do not...

 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.



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
Inferior good
In consumer theory, an inferior good is a good that decreases in demand when consumer income rises, unlike normal goods, for which the opposite is observed. Normal goods are those for which consumers' demand increases when their income increases....

 since the amount bought decreased as the income increases.



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 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.

If the good in question is a normal good
Normal good
In economics, normal goods are any goods for which demand increases when income increases and falls when income decreases but price remains constant, i.e. with a positive income elasticity of demand...

, 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
Inferior good
In consumer theory, an inferior good is a good that decreases in demand when consumer income rises, unlike normal goods, for which the opposite is observed. Normal goods are those for which consumers' demand increases when their income increases....

, 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
Giffen good
In economics and consumer theory, a Giffen good is one which people paradoxically consume more of as the price rises, violating the law of demand. In normal situations, as the price of a good rises, the substitution effect causes consumers to purchase less of it and more of substitute goods...

 (commonly believed to be a rarity).



In the figure, the substitution effect, , is the change in the amount demanded for when the price of good falls from to (increasing purchasing power for ) 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 example, the income effect of the price fall in partly offsets the substitution effect as the amount demanded of goes from to . Thus, the price effect is the algebraic sum of the substitution effect and the income effect.

Assumptions


The behavioral assumption of consumer theory is that all consumers are rational decision makers who seek to maximize utility
Utility
In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....

. More specifically, in the eyes of economists, all consumers seek to maximize a utility function subject to a budgetary constraint. In other words, economists assume that consumers will always choose the "best" bundle of goods they can afford. Consumer theory is therefore based around the problem of generate refutable hypotheses about the nature of consumer demand from this behavioral postulate. 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. 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. 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. 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. 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".


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 (is weakly preferred) to B. Alternatively, the axiom can be modified to read that the consumer is indifferent with regard to A and B.

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. :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.
The primary reason to have these technical preferences is to replicate the properties of the real number system so the math will work.

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.)


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

Use Value


In Marx's
Karl Marx
Karl Heinrich Marx was a German philosopher, economist, sociologist, historian, journalist, and revolutionary socialist. His ideas played a significant role in the development of social science and the socialist political movement...

 critique of political economy, any labor-product has a value and a use value
Use value
Use value or value in use is the utility of consuming a good; the want-satisfying power of a good or service in classical political economy. 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...

, and if it is traded as a commodity in markets, it additionally has an exchange value, most often expressed as a money-price. 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


Consumer theory can also be used 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 and scarce 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 (l) is constrained by T such that:

or

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 and income effects of various changes in price caused by welfare benefits, labor taxation, or tax credits can be analyzed.

See also

  • Alpha consumer
    Alpha consumer
    An Alpha Consumer is someone that plays a key role in connecting with the concept behind a product, then adopting that product, and finally validating it for the rest of society...

  • Budget constraint
    Budget constraint
    A budget constraint represents the combinations of goods and services that a consumer can purchase given current prices with his or her income. Consumer theory uses the concepts of a budget constraint and a preference map to analyze consumer choices...

  • Convex preferences
    Convex preferences
    In economics, convex preferences refer to a property of an individual's ordering of various outcomes which roughly corresponds to the idea that "averages are better than the extremes"...

  • Cost the limit of price
    Cost the limit of price
    Cost the limit of price was a maxim coined by Josiah Warren, indicating a version of the labor theory of value. Warren maintained that the just compensation for labor could only be an equivalent amount of labor . Thus, profit, rent, and interest were considered unjust economic arrangements...

  • Endowment effect
    Endowment effect
    In behavioral economics, the endowment effect is a hypothesis that people value a good or service more once their property right to it has been established. In other words, people place a higher value on objects they own than objects that they do not...

  • Important publications in consumer theory
  • Indifference curves
  • Microeconomics
    Microeconomics
    Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

  • Price point
    Price point
    Price points are prices at which demand for a given product is supposed to stay relatively high.- Characteristics :Introductory microeconomics depicts a demand curve as downward-sloping to the right and either linear or gently convex to the origin...

  • Supply and demand
    Supply and demand
    Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

  • Utility maximization problem
    Utility maximization problem
    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.-Basic setup:...