Chapter 3: The Theory of Consumer Choice

Introduction

Rational or irrational behaviors of consumers affect consumer choice. It is assumed that consumers behave rationally because they have to decide how to allocate their income to possible goods and services. Their tastes and preferences play an important role in this decision making process.

Budget Constraint

Prices and income limit consumption choices. In other words, besides tastes and preferences, consumers need to consider prices of commodities and the level of the consumer’s income, which may limit or constrain the nature and size of the market basket that they can buy.

Therefore, a budget constraint can be defined as “the combinations of quantities of X and Y that a consumer can purchase with certain amount of income or earning”.

The budget line shifts outward if there is an increase in income. However, backward shifts will lead to less consumption of goods than the original consumption basket. As prices of goods change, the budget constraint alters as well. If the price of one good increases, the budget line shifts inward, pivoting from the other good’s intercept.

If the price of one good decreases, the budget line shifts outward, pivoting from the other good’s intercept.

Consumer Preferences

It is a fact that consumer preferences change from time to time depending on various factors. Therefore, fundamental principles underlying consumer behavior should be outlined.

Consumers intend to maximize their utility which is affected by budget constraints. In other words, consumers choose a combination of goods that will maximize the satisfaction they can achieve within the limited budget available to them.

It can be said that satisfaction is maximized when the marginal rate of substitution is equal to the ratio of the prices. Hence, there are two condition of maximizing the market basket: a) It must be located on the budget line; b) it must give the consumer the most preferred combination of goods and services.

Economists make some basic assumptions related to the nature of the consumers’ tastes and preferences. These assumptions are as follows:

• Preferences are complete: this means that the consumer is able to compare and rank all possible baskets.
• Consumer’s preferences are transitive.
• Consumers always prefer more of a commodity to less (i.e., non-satiation).
• A diminishing marginal rate of substitution (i.e., convexity).

A diminishing marginal rate of substitution is exhibited when indifference curves are convex, and the slope of the indifference curve increases (becomes less negative) as we move down along the curve

Consumers can be indifferent between two baskets if they both provide equal units of utility. Otherwise, consumers will choose the basket with the higher utility.

As a consumer moves down along his or her indifference curve, he or she is willing to give up fewer units of the good on the vertical axis in exchange for one more unit of the good on the horizontal axis. This also assumes that consumers prefer balanced market baskets to baskets that have a lot of one good and very few of the other good.

Similar to in everyday life, in economics, rationality requires cost and benefit comparisons during decisionmaking.

There are other fundamental principles that affect consumer behavior apart from the ones mentioned above. These are:

• Limited income necessitates choice.
• Consumers make their decisions purposefully.
• One good can be substituted for another
• Consumers must make decisions without perfect information, but knowledge and past experiences will help.
• The law of diminishing marginal utility applies.

The law of diminishing marginal utility means the marginal utility derived from consuming successive units of a product will eventually decline as the rate of consumption increases.

Bearing abovementioned assumptions and principles, the customer’s tastes and preferences can be represented with a set of indifference curve. On an indifference curve, the locus of points represent market baskets (or consumption bundles), in which among the bundles the consumer is indifferent.

An indifference curve can be derived when there are two elements in every choice: (1) preferences (the desirability of various goods) and (2) opportunities (the attainability of various goods). It is related to the former: preferences. It separates better (more preferred) bundles of goods from inferior (less preferred) bundles, providing a diagrammatic picture of how an individual ranks alternative consumption bundles.

The total satisfaction you derive from consumption is total utility, which may refer to either your total utility of consuming a particular good or your total utility from all consumption.

Marginal utility, on the other hand, is the change in your total utility from a one-unit change in your consumption of a good.

Considering the properties and characteristics of consumer preferences, economists make statements about the general pattern of indifference curves.

First, more goods are preferable to fewer goods; thus, bundles on indifference curves lying farthest to the northeast of a diagram are always preferred. In other words, it is assumed that individuals attempt to place themselves on the highest level of utility that they can achieve, given the constraints that they face. Any market basket lying above and to the right of an indifference curve is preferred to any market basket that lies on the indifference curve.

Goods are substitutable; therefore, indifference curves slope downward to the right. As every commodity is defined so that more of it is preferred to less, indifference curves slope downward to the right or it follows that indifference curves must have a negative slope.

Moreover, indifference curves cannot cross each other, if they did, the rational ordering among preferences would be violated.

Indifference curves are also everywhere dense. We can draw an indifference curve trough any point on the diagram, which means that any two bundles of goods (commodity bundle) can be compared by the consumers.

In addition, the valuation of a good declines as it is consumed more intensively; therefore, indifference curves are always convex.

It is important to bear in mind that if two market baskets are to be equivalent, and if one market basket contains more of both commodities, it would mean that one or the other of the commodities is not defined so that more of it is preferred to less. If it sloped upward, it would violate the assumption that more of any commodity is preferred to less.

Consumers attach different importance to an extra unit of a particular good. While a consumer’s consumption of good X increases (and his or her consumption of good Y declines), his or her valuation of good X relative to good Y will decline. Hence, the marginal rate of substitution (MRS) can be defined as the number of units of good Y that must be given up if the consumer, after receiving an extra unit of good X, is to maintain a constant level of satisfaction or utility.

As utility is the level of happiness or satisfaction associated with alternative choices, it is assumed that when individuals are faced with a choice of feasible alternatives, they will always select the alternative that provides the highest level of utility. Such choices and tastes are represented on consumer’s indifference map, which gives economists ideas on how to attach a number, a utility, to each of the market baskets that might confront a consumer.

This law of diminishing marginal utility is believed to occur for virtually all commodities. A bit of introspection should confirm the general applicability of this principle.

In brief, there is a close relationship between marginal utility and consumer choice. Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good.

When the marginal rate of substitution of one good for the other is constant, these two goods are assumed to be perfect substitutes.

Complementary goods are items that go together, so if the price of one increases, the demand for the other will decrease. Two goods with right-angle indifference curves are perfect complements.

Optimization: Optimal Choices for Individual Consumers

Individuals maximizing utility subject to their budget constraint attain the highest possible level of utility at a point of tangency between their budget constraint and an indifference curve.

A consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent.

The consumer chooses between the consumption of the two goods so that the marginal rate of substitution equals the relative price. At the consumer’s optimum, the consumer’s valuation of the two goods equals the market’s valuation.

A utility maximizing consumer will select the bundle of goods (or commodity bundle) at which the following two conditions are satisfied:

1. MU _A /P _A = MU _B /P _B = ... = MU _Z /P _Z , for all commodities (A-Z), and
2. All income is spent.

A state of consumer equilibrium is said to occur when these conditions are satisfied. This is an equilibrium because the individual consumer has no reason to change the mix of goods and services consumed once this outcome is achieved unless there is a change in tastes, income, or relative prices.

A corner solution is available when the chooser is either unwilling or unable to make a tradeoff. It holds true if there is a higher preference vs. a lower preference and a perfect substitution between two goods.

Changes in Consumer Choices

Factors affecting consumer choices are as follows:

• Change in income,
• Changes in prices,
• Derivation of demand curve.

When the marginal utility decreases quickly as more of a good is consumed, a fall in the good’s price requires only a small change in consumption to equate the marginal utility per dollar spent on it with the marginal utility per dollar spent on other goods. As a result, the quantity demanded increases very little and so demand is inelastic. When the marginal utility decreases slowly as more of a good is consumed, a fall in the good’s price requires a large change in consumption to equate the marginal utility per dollar spent on it with the marginal utility per dollar spent on other goods. As a result, the quantity demanded increases significantly and so demand is elastic.

Conventional demand curve is that the lower the price, the higher the quantity demanded. This relationship follows the law of demand. It states that the quantity demanded will drop as the price rises, ceteris paribus, or “all other things being equal.” The relationship between quantity and price will follow the demand curve as long as the four determinants of demand don’t change These determinants are:

1. Price of related goods or services.
2. Income of the buyer.
3. Tastes or preferences of the buyer,
4. Expectation of the buyer, especially about future prices.

Positively Sloped Demand Curve

Even though the law of demand states that the demand curve has a negative slope, there is an exceptional situation for some goods which may indicate a positive demand curve opposite to the conventional demand curve.

Applications

In an economy, the real changes in the wages of individuals are crucial while they are thinking to decide whether to work or not. There is a threshold wage for some people that may cause changes in their decisions.

After the threshold wage level, the labor supply curve tends to move with a backward rotation that is a validity of indication of Engel Curve.

Engel curves, named after 19th Century German statistician Ernst Engel, illustrate the relationship between consumer demand and household income. Engel curves for normal goods slope upwards – the flatter the slope the more luxurious the good, and the greater the income elasticity. In contrast, Engel curves for inferior goods have a negative slope.

Another real life case to analyze the behavior of consumer is how increased or decreased real interest rates affect the decisions of individuals to save more or less, which also means to consume less and more, respectively.

If interest rates fall, the reward from saving falls. It becomes relatively more attractive to hold cash and / or spend. This is the substitution effect – with lower interest rates, consumers substitute saving for spending.

If interest rates fall, savers see a decline in income because they receive lower income payments. A pensioner relying on interest payments from savings may feel he needs to save more in order to maintain the income from savings. Usually, the substitution effect dominates. Lower interest rates make saving less attractive. But, for some, the income effect may dominate, and people may respond to lower interest rates by saving more in order to maintain their standard of living.