Consumer choice


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, by maximizing utility subject to a consumer budget constraint.
Factors influencing consumers' evaluation of the utility of goods include: income level, cultural factors, product information and physio-psychological factors.
Consumption is separated from production, logically, because two different economic agents are involved. In the first case, consumption is determined by the individual. Their specific tastes or preferences determine the amount of utility they derive from goods and services they consume. In the second case, a producer has different motives to the consumer in that they are focussed on the profit they make. This is explained further by producer theory. 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 are the price per unit of that good, prices of related goods, and wealth of the consumer.
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. As the wealth of the individual rises, demand for most products increases, shifting the demand curve higher at all possible prices.
In addition, people's judgments and decisions are often influenced by systemic biases or heuristics and are strongly dependent on the context in which the decisions are made, small or even unexpected changes in the decision-making environment can greatly affect their decisions.
The basic problem of consumer theory takes the following inputs:
  • The consumption set ''C – the set of all bundles that the consumer could conceivably consume.
  • A preference relation over the bundles of C''. This preference relation can be described as an ordinal utility function, describing the utility that the consumer derives from each bundle.
  • A price system, which is a function assigning a price to each bundle.
  • An initial endowment, which is a bundle from C that the consumer initially holds. The consumer can sell all or some of his initial bundle in the given prices, and can buy another bundle in the given prices. He has to decide which bundle to buy, under the given prices and budget, in order to maximize their utility.

    Behavioral economics

has criticized neoclassical consumer choice theory because reality is more complex that what the theory can determine itself.
Firstly, consumers use heuristics, which means they do not scrutinize decisions too closely but rather make broad generalizations. Further, it is deemed not worthwhile to attempt to determine the value of specific behavior. Heuristics are techniques for simplifying the decision-making process by omitting or disregarding certain information and focusing exclusively on particular elements of alternatives. While some heuristics must be utilized purposefully and deliberately, others can be used relatively effortlessly, even without our conscious awareness. Consumption by individuals is typically impacted by advertising and consumer habits as well.
Secondly, consumers struggle to give standard utils and instead rank distinct options in order of preference, which is referred to as ordinal utility.
Thirdly, it is not always likely that a consumer would stay rational and make the choice which maximizes their utility. Sometimes, individuals are irrational. For example, a consumer making impulsive purchases is not a rational choice. The rise of the internet and social networks may cause changes in consumer behavior, resulting in more planned and sensible purchase processes.
Fourthly, individuals can be reluctant to spend cash on particular items because they have preconceived boundaries on how much they can afford to spend on 'luxuries,' according to their mental accounting.
Lastly, it is not easy to separate products in the market. Some items, such as an electronic car or a refrigerator, are only purchased occasionally and cannot be mathematically divided.

Example: homogeneous divisible goods

Consider an economy with two types of homogeneous divisible goods, traditionally called X and Y.
  • The consumption set is, i.e. the set of all pairs where and. Each bundle contains a non-negative quantity of good X and a non-negative quantity of good Y.
  • A typical preference relation can be represented by a set of indifference curves. Each curve represents a set of bundles that give the consumer the same utility. A typical utility function is the Cobb–Douglas function:, which is shown in the figure below.
  • A typical price system assigns a price to each type of good, such that the cost of bundle is.
  • A typical initial endowment for an individual is fixed income, which along with transparent prices of goods implies a budget constraint. The consumer can choose any point on or below the budget constraint line In the diagram. This line is downward sloped and linear since it represents the boundary of the inequality. 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 that is attainable within their budget constraint. Every point on indifference curve I3 is outside the budget constraint. As a result, the most optimal point for the individual is where the indifference curve I2 is tangent to the budget constraint. As a result, the individual will purchase of good X and 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.
The tangent point between the indifference curve and the budget line is the point at which consumer satisfaction is maximized.
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.
The income effect and price effect explain how the change in price of a good 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 change.

Characteristics of the indifference curve

Indifference curves are heuristic devices used in microeconomics to convey preferences of a consumer graphically along with the limitations of a consumer's budget.
An indifference curve shows the various combination of two goods that leave the consumer equally satisfied. For example, every point on the indifference curve I1, which represents a unique combination of good X and good Y, will give the consumer the same utility.
Indifference curves have a few assumptions that explain their nature.
Firstly, indifference curves are typically convex to the origin of the graph. This is because it is assumed that a given consumer will sacrifice consumption in one good for more consumption of the other good. Thus, the marginal rate of substitution, which is the slope of the indifference curve at any single point along the curve, will decrease when moving down a given indifference curve. Indifference curves can also take various other shapes depending on the preferences of the consumer.
Secondly, for a given consumer, their indifference curves cannot intersect each other. This is because the same set of consumption for a given individual cannot represent two different utility values.
Thirdly, it is assumed that individuals are more satisfied with a bundle of goods on an indifference curve that is further away from the origin. From the graph above, the indifference curve I3 would give the consumer the highest utility whereas I1 would give the lowest utility.
The indifference curves shown in the figure above adhere to the three assumptions outlined in that they are convex, do not intersect, and have a higher utility the further the indifference curve is away from the origin.

Example: land

As a second example, consider an economy that consists of a large land-estate L.
  • The consumption set is, i.e. the set of all subsets of L.
  • A typical preference relation can be represented by a utility function which assigns, to each land parcel, its total "fertility".
  • A typical price system assigns a price to each land parcel, based on its area.
  • A typical initial endowment is either a fixed income, or an initial parcel which the consumer can sell and buy another parcel.

    Sunk cost effect

According to the laws of economic logic, sunk costs and making decisions should be irrelevant. However, there is a widespread irrationality in people's actual investment activities, production and daily activities that takes sunk costs into account when making decisions.
Sunk costs for individuals may be represented by behaviour in which they make decisions based on the fact that they have paid for this good or service irrespective of current circumstances. An example of this is a consumer who has already purchased their ticket for a concert and may travel through a storm to be able to attend the concert in order to not waste their ticket.
Another example is different payment schedules for gym members may result in different levels of potential sunk costs and affect the frequency of gym visits by consumers. That is to say, the payment schedule with other less frequent, compared to a month pay the fee to the gym in a larger, these factors to reduce the cost and reduce the psychological sunk costs, more vivid sunk costs significantly increased people's gym visits. In summary, the behaviour of consumers in these two examples can be characterised by their ideal that losses loom larger than gains.