The Theory of Consumer ChoiceEren BALABAN

Introduction

• The price of goods, relative to each other, is a very importantdetermining factor for our demand.

• As a consumer, our choice between different brands will be affectedby the change in relative price.

• Relative price helps us to measure the opportunity cost of ourbehaviour in the economic aspect of our daily lives.

• Consumer’s tastes or preferences may be the one of the mostimportant determinants of his/her choices.

Budget Constrains

• Consumption choices are limited by income and prices.

• Consumer always tries to get on the highest possible indifferencecurve. This statement assumes that, consumer makes rationaldecisions.

• To do so, consumer should not consider only his/her tastes andpreferences, but also prices of goods and level of his/her income. Prices and level of income can constrain the nature and size of themarket basket.

Budget Constrains

• Budget constrain is the combinations of quantities of X and Y that a consumer can purchase with certain amount of income orearning.

Budget Constrains

• If the income of a consumerincreases, amount of productsthat person can buy increasesalso. In case of decrease of income, the amount of goodsthat person can buy alsodecreases.

Budget Constrains

• Changes in prices of goods willresult in a parallel shift in thebudget constraint while changesin the prices of goods X and Y will affect the slope of thebudget constraint.

Consumer Preferences

• Consumer preferences or choices might change from time to time. Inorder to understand why these changes occur, several fundamentalprinciples should be outlined. These changes find their reflectionthrough an indifference curve that measures satisfaction of consumers via utility.

• As consumers have a goal in life, which is to maximize our utilitysubject to our budget constraint. We try to pick the basket we likemore which stays within our budget.

Utility

• Total Utility: The total satisfaction you derive from consumption

• Marginal Utility: The change in your total utility from a one-unitchange in your consumption of a good.

Consumer Preferences

• The maximizing market basket must satisfy two conditions.1. It must be located on the budget line.

2. Must give the consumer the most preferred combination of goods andservices.

• The basic assumptions that economists make about the nature of consumer’s tastes or preferences. These assumptions are providedbelow.

Consumer Preferences

1. Preferences are complete: Consumer is able to compare and rankall possible baskets.

2. Preferences are transitive: Consumer can change his preference fora specific type of good. Not every consumer shows transitivepreferences, but this assumption seems to be basis for a model of consumer behavior.

3. Consumers always prefer more of a commodity: More goods for thesame price are always preferred.

4. A diminishing marginal rate of substitution: Balanced market baskets are preferred to baskets that have a lot of one good andvery little of the other good.

Consumer Preferences

• There are also several fundamental principles underlying consumerbehaviour as follows.

1. Limited income necessitates choice: When more of one good or service is purchased, we must purchase less of some other good. This is the cost of purchasing something.

2. Consumers make their decisions purposefully: If two products have the same cost, a consumer is expected to choose the one with a higher benefit. If two productsyield equal benefits, the consumer would choose to purchase the cheaper one.

3. One good can be substituted for another: Consumers can achieve the same utilityfrom many different alternatives. What a person wants is not the same what a person needs.

4. Consumers must make decisions without perfect information: The likelihood that a consumer will spend the necessary time, effort and money to gather information is directly related to its value to the consumer. When making a bad decision has a low cost, consumers will rationally choose to be less informed. Being a goodconsumer is a process of learning through previous choices or preferences.

Consumer Preferences

5. The law of diminishing marginal utility applies: As the rate of consumptionincreases, the total utility will increase at decreasing rate or marginal utilityderived from consuming additional units of good will decline. It means that, you will have less satisfaction at each consumption level. This law explainswhy you would not spend the entire money in your budget on one type of products, goods or items even if you really like them.

Indifference Curves

• Point A is preferred to all points in mustardyellow area.

Indifference Curves

• An indifference curve can be derived when there are twoelements in every choice.

1. Preferences

2. Opportunities

• A person would be indifferent iffaced with choice between thecombinations of goodsrepresented by points B and D. Points that lie above and right of an indifference curve providehigher level of consumption of each good.

• Points that lie below and to theleft of the indifference curveprovide lower level of utility.

Properties of Indifference Curve

• Preferences of consumers exhibit certain properties or characteristics. These properties enable us to make statements about the general patternof indifference curves.

1. More goods are preferrable to fewer goods. An individual will always prefer a bundle with more of one good to the original bundle.

2. Goods are substitutable; therefore, indifference curves slope downward to theright. Since more of a good preferred to less, indifference curves have negativeslope.

3. Indifference curves cannot cross each other, if they did, the rational orderingamong preferences would be violated.

4. Indifference curves are everywhere. We can draw an indifference curve throughany point on the diagram. This means that any two bundles of goods can be compared by consumers.

5. The valuation of a good declines as it is consumed more intensively. Therefore, indifference curves are always convex.

Marginal Rate of Substitution (MRS)

• Marginal rate of substitution is defined as the number of units of good Y that must be given up if the consumer, after receiving an extraunit of good X, is to maintain a constant level of satisfaction or utility. This means that, cunsomer’s valuation of X relative to Y will decline orvice versa.

• This trade-off between good X and Y leaves consumer no better or noworse off maintaining a constant level of satisfaction or utility.

Marginal Rate of Substitution (MRS)

• Even though the marginal utility from pizza consumption declines, the total utility still increases at decreasing rate as long as the marginal utility is positive.

• The law of diminishing marginal utility is believed to ocur for virtually allcommodities.

The Marginal Utility Theory

• The marginal utility theory examines the increase in the satisfaction a consumer gains from consuming an extra unit of a good in a market or a consumption basket.

• Marginal utility measures the additional satisfaction obtained fromconsuming one additional unit of a good.

Perfect Substitute

• Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant. This means that a perfect substitute is a good that functions just the same as the good it is being compared to.

Perfect Complements

• Complementary goods are items that go together, so if the price of one increases the demand for the other one will decrease.

Optimization: Optimal Choices for IndividualConsumers• Individuals maximizing utility subject to

their budget constraint attain the highestpossible level of utility at a point of tangency between their budget constraintand an indifference curve.

• Tangent point indicates optimal choices foran individual consumer.

Consumer Equilibrium

• When two conditions below are satified, a state of consumerequilibrium is said to occur.

1. Marginal utility per dollar spent be equal for all goods.

2. All income should be spent. This assumption is made to simplify the model where there is no possibility of saving or borrowing.

• This is called an equilibrium because the individual consumer has noreason to change the mix of goods and services.

Changes in Consumer Choices – Changes in Income• An increase in income shifts the budget

constraint outward. The consumer is able tochoose a better combination of goods on a higher indifference curve.

• Prices of the goods and consumer’s tastesand preferences remain unchanged.

• Q1, Q2 and Q3 represent morecomsumption of both goods that are normal goods. When we connect all of pointsrepresenting the equilibrium market basketscorresponding to all possible levels of money income, the resulting curve is calledthe income-consumption curve.

Changes in Consumer Choices – Changes in Prices

• The substitution effect is the change in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution.

• If the price of a good decreases, purchasing power of the same level increases, thus consumer buy more of that good.

Derivation of Demand Curve

• When the price of a good rises, the marginal utility per dollar spent on thegood falls, so to maximize the utility, the consumer buys less of the good.

• 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 themarginal utility per dollar spent on other goods. As a result, the quantitydemanded increases very little and so demand is inelastic.

• When 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 equatethe marginal utility per dollar spent on it with the marginal utility per dollarspent on other goods. As a result, the quantity demanded increasessignificantly and so demand is elastic.

Derivation of Demand Curve – Price Consumption Curve

• Price Consumption Curve assumes following1. The Money to be spent by consumer is given and

constant

2. The price of good X falls

3. Prices of other related goods do not change

4. Consumer’s tastes and preferences remainconstant.

Positively Sloped Demand Curve – Giffen Good

• R. Giffen observed that, especially, during the famine periods of the economies, some of the certain goods are not line with the law of demand.

• This paradox is referred to Irish potato famine. The potato were in an upward trend in Ireland and the demand for it increased.

How Real Wage Changes Afffect Labor Supply

• Some people does not want to work aftersome threshold value of wages. Real wagechanges help individuals make their decisionto work or have free time. Therefore, we can have a demand and labor supply curves in the end.

• The substitution effect dominates the laborsupply, and the quantity of labor supply willcontinue to increase due to the substitutioneffect. Substitution effect means that, an increase in real wages cause in substitutionfor employed workers to work more but tohave less leisure time. Until the thresholdwage line, the substitution effect is largerthan the income effect.

How Real Wage Changes Afffect Labor Supply

• After threshold wage, curve willfollow the income effect whichmeans that, individuals will workless and have more leisure time since individual will have higherstandard of living due to higherwage level. Therefore, there will be a negative relationship betweenthe supply of labor and wage rate.

• SL curve has a negative slope, which means that the incomeeffect of a real wage increase is greater than the substitution effectof a real wage increase.

Engel Curves

• Engel curves illustrate the relationshipbetween consumer demand and householdincome.

How Real Interest Rate Changes AffectIndividual Savings• Real interest is the subtraction of the price level from the nominal

interest rate.

• When the real interest rate starts to decline, individuals become morewilling to spend Money for goods and services, instead of savings. This behaviour is attributed to lower level of opportunity cost of holding money. This negative effect of the real interest rate on thesaving rate is called the substitution effect.

• There are some studies showing a counter tendency by some peoplein the society in case of low real interest rate. Those people would liketo compansate their income loss by saving more. This is called as Income Effect.

How Real Interest Rate Changes AffectIndividual Savings• However, income effect is relatively smaller than substitution effect.

Therefore, spending money increases in general.

• When interest rates higher, income from interest is higher. Therefore, society tends to save more money in order to maximize their income. In other words, higher interest rates make saving more attractive thanspending.

How Real Interest Rate Changes AffectIndividual Savings• Interest rate will also have different effects

on a person depending on he is a net saveror net borrower. Increase in interest rate willrotate income curve in clockwise direction. This movement makes savers better off, borrowers worse.

• Increase in income of a net saver will inducehim to buy more goods while, borrower is induced to buy less.

• Increase in interest rate will decreasecurrent consumption of borrower because, it is more expensive to borrow from thefuture.