Consumer Choice Theory
The following chapter will discuss consumer choice, considering theory behind utility maximisation, opportunity costs and consumer preferences. The theory of consumer choice is focused in microeconomics, relating to preferences for consumer expenditure, which in turn impacts on consumer demand curves. For instance, one use of consumer theory is to showcase why the demand curve for many goods slopes downward. However, moving on from these basic principles, consumer choice, and so consumer behaviour have far greater implications. In business, consumer behaviour theories are used by firms to consider why a consumer purchasing a car may place a greater value on safety over fuel mileage; it could be used by some businesses when it comes to determining their strategy. For example, Ryanair dominates the low-cost airline market with a focus on price, however other airlines, be it British Airways continue to offer the same product but at a higher price, using consumer choice theories to understand the added value which they can generate for their products from added services.
Observations will tell us that consumer choices differ widely, be it between countries/ demographics, or just between one consumer and another. Economists base their analysis on general propositions; making three general assumptions. The first assumption is that consumer preferences are complete, meaning that they can rank all market baskets in the order of their choice. So, considering Coca Cola and Pepsi, a consumer could either say that they prefer Coca Cola to Pepsi, Pepsi to Coca Cola, or are indifferent between the two.
The second assumption would be that preferences are transitive. This can be explained simple with the following example. Assume that a consumer prefers product A to B, and product B to C; then logically, the consumer must prefer product A to C.
Finally, the third assumption is that the consumer will prefer more goods to less. So, in the case of a holiday, the consumer will prefer two holidays to one. This assumption will later lead into a discussion on utility maximisation. However, the third assumption has always been up for discussion, with some arguing that this idea that a consumer prefers more goes against businesses which may seek to sell luxury products.
We can now consider ‘Indifference Curves’ (pictured below), the chart will plot all the combinations of the two goods which offer the consumer the same utility. In this case, they would be indifferent when it comes to choosing any one of them given that the utility received is the same.
Figure 1 - Example Indifference Curve for Apples vs. Banana’s
From analysing these curves, we can note several assumptions. The first is that the indifference curve must slope downward if the consumer views these goods as desirable. The main reason behind this is that all baskets of goods which are equally satisfactory to the consumer must contain less of one good, replaced in turn by more of another; creating this downward slope. The second assumption is that a consumer will always prefer a basket of goods towards the Northeast of the slope given the expectation of higher utility. On other hand, any basket of goods which lies below the indifference curve will be viewed as less desirable; we should always remember that a consumer will look to maximise their utility given the resources they have; i.e. income.
Three features of indifference curves have been mentioned: they slope downward, higher curves are preferred to lower ones, and they cannot intersect. Convexity can be seen as a fourth feature of indifference curves. The convexity brings into consideration the marginal rate of substitution, otherwise abbreviated as MRS. So, a consumer's MRS between chocolate, and apples is the maximum amount of chocolate that the consumer is willing to give up to obtain an additional apple. Essentially, it can be viewed as the willingness to trade one good for another. The complexity in this comes from that fact that the rate may differ depending on the actual quantity of the good already held. For instance, if a consumer has 10 chocolate bars, they may be more willing to trade a chocolate bar for an apple than say compared to their willingness to trade if they only had 2 chocolate bars.
We consider the diminishing MRS along the indifference curve, with the key word here being diminishing given the expectation that as the quantity of a good decreases, they are less willing to trade. This can be seen in the figure below:
Figure 3 - A visualisation of Marginal Rate of Substitution. As the consumer loses more of Good Y, they become more reluctant to give up further units for Good X.
When consumer choice is considered, the idea of consumer utility is also considered. Utility can be imagined as the satisfaction/ enjoyment that a consumer may receive from consuming a certain product. This leads to a decision as the consumer will look to maximise their utility based on purchasing a number of goods which allow them to reach the highest possible total utility. However, as mentioned before, the consumer will be constrained in their spending by their income; known as their budget constraint.
The law of ‘Diminishing Returns’ must also be considered here given that it could be expected that as a consumer demands more of a particular good; the utility received from that good decreases. This is mentioned above in our discussion on MRS. However, what needs to be added here is the idea of the budget constraint, and how this impacts on utility.
With this in mind, there is some link between the utility of the good and the price elasticity of the good. To provide a definition, the price elasticity of the good will showcase how customers will react with demand given a change in the price. So, for instance, how demand for a certain good will be impacted by an increase in the price?
When it comes to determining the elasticity, a result below 1 would suggest that the good is inelastic given that the change in demand is less than the change in price. On the other hand, a result above 1 would suggest elastic demand, being that the demand changes by more than the price.
When we talk about a budget constraint we consider a Linear function as shown below, with the consumer able to purchase any bundle of good on the line (shown below). In this example, we can see that the consumer can buy any bundle of goods behind the line, denoted as being feasible:
Figure 4 - Linear Budget Constraint.
Taking the example above, the consumer will thus look to maximise their utility given their current budget constraint, which in turn will create an optimal basket of goods, shown below in the diagram:
Figure 6 - The optimal basket of goods given the budget constraint.
The point at which the budget line and indifference curve intersect is the optimal point which maximises the consumer utility given their constraints. In this equilibrium, it could be mentioned that the MRS would thus equal the price ratio, denoted as MRSyx = px/ py.
When it comes to discussing utility, there is an element of opportunity cost to be considered. For instance, with a constrained budget, the consumer must make choices based on their own needs. Considering the lunch example once again, the opportunity cost there was that by buying a pastry and gaining the utility, the consumer was foregoing the utility which could be gained from spending that money on chocolate, or drink.
Opportunity Cost = Return of Most Lucrative Option - Return of Chosen Option
However, what must be mentioned when it comes to opportunity cost is that such is a forward looking equation, and so in this case the ‘Return’ may be hard to accurately calculate as it is not known.
Leading on from opportunity cost, Pareto Efficiency can be considered. The basic assumption under Pareto efficiency is that it is impossible to make one person better off without making someone else worse off. So, when it comes to allocating resources in an economy, helping one person improve their own preference criterion will lead to another being worse off. Usually, the Pareto Efficiency will be considered alongside the Production Possibility Frontier, hereafter PPF (see below), a graph which considers the combination of production available for two goods:
Figure 7 - Visual representation of the Production Possibility Frontier.
In the case above, the economy cannot increase the production of one good without decreasing production of the other; similar to what has been mentioned above when it comes to consumer choice and their budget constraint. However, what can also be mentioned in this case is that there is the potential to expand the PPF, in this case through improvements in productivity, or an expansion of the production capacity, and so the economy.
In all the discussions above, we have noted models which feature two goods. However, as most of us will know from being consumers ourselves, there are more than two goods to consider. So, to overcome this, there is the idea of a composite good, which is defined as several goods which are treated as the same. For instance, we may consider the outlay on clothing vs. all other goods. However, the main issue here is that denoting all other goods into a composite can be difficult given the many types of goods to consider.
Some may comment that of course people are selfish as the underling theory would suggest that a consumer will seek to maximise their own utility based on their budget. Ultimately, they only care for their own utility. However, the economic theory is vague in this respect given that the models above do not specify which goods/ services a consumer would see as desirable. For instance, we can consider that some individuals will seek to give more to charity, or donate their time to a ‘good cause’ as opposed to working and increasing their income. Essentially, while the person may still get a level of utility from this, the actual good would not be classed as selfish given that it is helping someone else. The consumer is viewing such as an economic good.
Finally, the main issue may be seen within behavioural theory, and consider how a consumer may not always be so informed to make the right choice to maximise their own utility. While this is another topic in itself, it is interesting to mention the concept of bounded rationality. This term refers to a situation whereby a consumer’s ability to make rational decisions could be restricted. Usually, there are three main reasons which are cited here. (1) is that the human mind has limited ability to process/ and evaluate the level of information which is available to them which may restrict their ability to consider all alternatives and substitutes. The (2) is that the information available could be incomplete and often unreliable; while the Internet has allowed for consumers to search for information quickly, the amount of information available has increased. Finally, the (3) concept would be that the time available to make decisions is limited and so a consumer may go with what they already know.
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