Topic 6: Consumer Theory
“Eeny, Meeny, Miney, Moe”—Making Choices
The Great Recession of 2008–2009 touched families around the globe. In too many countries, workers found themselves out of a job. In developed countries, unemployment compensation provided a safety net, but families still saw a marked decrease in disposable income and had to make tough spending decisions. Of course, non-essential, discretionary spending was the first to go.
Even so, there was one particular category that saw a universal increase in spending world-wide during that time—an 18% uptick in the United States, specifically. You might guess that consumers began eating more meals at home, increasing spending at the grocery store. But the Bureau of Labor Statistics’ Consumer Expenditure Survey, which tracks U.S. food spending over time, showed “real total food spending by U.S. households declined five percent between 2006 and 2009.” So, it was not groceries. Just what product would people around the world demand more of during tough economic times, and more importantly, why? (Find out at chapter’s end.)
That question leads us to this chapter’s topic—analyzing how consumers make choices. For most consumers, using “eeny, meeny, miney, moe” is not how they make decisions; their decision-making processes have been educated far beyond a children’s rhyme.
Topic 6: Consumer Theory
In this topic, you will learn about:
- Budget Lines and the price ratio
- Indifference and the marginal rate of substitution
- Optimal consumer choice; changes in choice; substitution and income effects of price changes.
Microeconomics seeks to understand the behavior of individual economic agents, such as individuals and businesses. Economists believe that individuals’ decisions, such as which goods and services to buy, can be analyzed as choices made within certain budget constraints. Generally, consumers are trying to get the most for their limited budget. In economic terms, they are trying to maximize total utility, or satisfaction, given their budget constraint.
Everyone has their own personal tastes and preferences. The French say: à chacun son goût, or “Each to his own taste.” An old Latin saying goes, De gustibus non est disputandum or “There’s no disputing about taste.” If people’s decisions are based on their own tastes and personal preferences, however, then how can economists hope to analyze the choices consumers make?
An economic explanation for why people make different choices begins with accepting the proverbial wisdom that tastes are a matter of personal preference. But economists also believe that the choices people make are influenced by their incomes, by the prices of goods and services they consume, and by factors like where they live. This chapter introduces the economic theory of how consumers make choices about what to buy.
The analysis in this chapter will dive deeper into the demand side of our supply and demand model, which will help us develop a deeper understanding of all the impacts of a price change beyond a simple difference in quantity demanded.
Our Demand Model So Far
So far, we have learned the basics of demand. Our demand curve represents the marginal benefit to consumers. When our quantity increases, our marginal benefits fall. Why is that? We talked briefly about consumers preferring a bundle of goods, and referred back to our production possibility frontier where consumers had to make trade-offs relative to other goods. Essentially, marginal benefit reflects:
-how much we like a good in absolute sense, and
-how much we like a good relative to other goods.
This brings us to the two components of the demand model that we will explore in this chapter:
1. What goods can we afford?
This question will be answered with an analysis of the consumer’s budget line, which shows all the combinations of goods consumers can purchase using their full budget.
2. What goods do we like?
This question will be answered with an analysis of the consumer’s indifference curve, which shows all the bundles of goods that give the consumer the same amount of happiness, or utility.
By determining where these two curves are tangent to each other, we can determine where a consumer will consume at each price level.
Before we can use these tools, we need to understand all the components, we will start by exploring what goods consumers can afford, given their budget lines.