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 (as measured by their preferences subject to limitations on their expenditures), by maximizing utility subject to a consumer budget constraint.[1] 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 (demanded) 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.[2]
The basic problem of consumer theory takes the following inputs:
Behavioral economics[edit]
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.[3] Consumption by individuals is typically impacted by advertising and consumer habits as well.
Secondly,[4] 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.[5]
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.
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 . 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.
indifference curves
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 . 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.
budget constraint
Consider an economy with two types of homogeneous divisible goods, traditionally called X and Y.
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.[6] 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[edit]
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.[7] For example, every point on the indifference curve I1 (as shown in the figure above), 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 (MRS), which is the slope of the indifference curve at any single point along the curve, will decrease when moving down a given indifference curve.[8] 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.
The consumption set is , i.e. the set of all subsets of L (all land parcels).
As a second example, consider an economy that consists of a large land-estate L.
Sunk cost effect[edit]
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.[10] 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 (e.g., quarterly, semi-annual or annual payment schedule), 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.[11] In summary, the behaviour of consumers in these two examples can be characterised by their ideal that losses loom larger than gains.
Effect of online reviews[edit]
During the online shopping process, retailers encourage customers to share their product reviews on digital platforms such as e-commerce websites and social media, which in turn helps other shoppers to have a better understanding of the product.[15] Online consumer reviews play a crucial role in providing product information before consumers make a purchase decision.[16] These reviews, full of desires, preferences and behavioural insights, are a valuable source of data for both consumers and businesses.[17] By understanding consumer behaviour and preferences, businesses can develop strategic plans to improve the quality of their services and tailor their offerings to better meet the needs of their customers.
For example, when consumers do an online search for hotels, they can compare prices, locations, services and other aspects of various potential hotels on the site. The platform can also provide personalised recommendations based on a user's search history and preferences. Based on the attributes listed for each hotel, consumers can make an informed decision that is influenced by the consistency between their perceived hotel performance and their preferences – a classic multi-attribute decision making (MADM) problem. Vocabulary-based sentiment analysis is incorporated into online reviews to create product rankings that take into account the sentiment score of the review, the brand ranking of the product and the usefulness of the review.
In the context of travel, travellers' choices and behaviours when selecting restaurants are heavily influenced by their travel classification or purpose, such as leisure, business or adventure.[18] The study's modelling results suggest that travellers show diverse preferences in terms of dining behaviour, depending on factors such as environment, type of cuisine, price range and dietary restrictions. While the study provides valuable insights into restaurant decision-making, it also acknowledges limitations and suggests other directions for research to further explore consumer preferences in various contexts.
However, the sheer volume of online reviews and the need to consider various attributes when making decisions can be overwhelming for consumers. In many cases, it can be a challenge to discern genuine reviews from fake ones or marketing-driven content. Therefore, tools and methods must be developed to help consumers make informed choices by helping them rank product candidates based on other consumers' reviews and their preferences. The use of artificial intelligence and machine learning algorithms has the potential to help sift through large amounts of data, extract useful insights and provide personalised recommendations to consumers.
In short, online consumer reviews are an important resource for shoppers and businesses alike. Using this information can help businesses better understand consumer preferences, improve their offerings and ultimately increase customer satisfaction. For consumers, having access to aggregated, relevant and trustworthy information can greatly enhance their decision-making process and overall online shopping experience.
Effect of a price change[edit]
The indifference curves and budget constraint can be used to predict the effect of changes to the budget constraint. The graph below shows the effect of a price increase for good Y. If the price of Y increases, the budget constraint will pivot from to . Notice that because the price of X does not change, the consumer can still buy the same amount of X if he or she chooses to buy only good X. On the other hand, if the consumer chooses to buy only good Y, he or she will be able to buy less of good Y because its price has increased.
Now, the consumption of good X and Y will be re-allocated to account for the price change in good Y. To maximize their utility, the consumption bundle that is on the highest indifference curve that is tangent to . This consumption bundle is now (X1, Y1) as shown in the figure below. As a result, the amount of good Y bought has shifted from Y2 to Y1, and the amount of good X bought has shifted from X2 to X1. The opposite effect will occur if the price of Y decreases causing the budget constrain to shift from to , and the highest indifference curve that maximises the consumers utility shifts from I2 to I3.
If these curves are plotted for many different prices of good Y, a demand curve for good Y can be constructed. The diagram below shows the demand curve for good Y as its price varies. Alternatively, if the price for good Y is fixed and the price for good X is varied, a demand curve for good X can be constructed.
Income effect[edit]
The income effect is the phenomenon observed through changes in purchasing power. It reveals the change in quantity demanded brought by a change in real income. Graphically, as long as the prices remain constant, changing income will create a parallel shift of the budget constraint. Increasing income will shift the budget constraint right since more of both goods can be bought by the consumer. On the other hand, a decrease in income will shift the budget constraint to the left.
Depending on the indifference curves, as income increases, the quantity purchased of a good can either increase, decrease or stay the same. In the figure below, good Y is a normal good since the amount purchased increased as the budget constraint shifted from BC1 to the higher income budget constraint, BC2. However, good X is an inferior good since the quantity purchased by the consumer decreased as their income increased.
is the change in the demand for good 1 when we change income from to , holding the price of good 1 fixed at :
The equilibrium points at various levels of consumer's income builds the income consumption curve. This curve traces out the income consumption curve traces out the income effect on the quantity consumed of the goods.[19]
Utility[edit]
The usefulness of a good is a key factor when discussing consumer decision making. When a product both meets the needs of a consumer and has value it has utility.[20] Utility can be quatified through a set of numerical values that reflect the relative rankings of various bundles of goods measured by consumers preference in their consumption.
Utility function measures the preferences consumers apply to their consumption of goods and services. One of the most well known utility functions is the Cobb-Douglas utility function.
Marginal Utility
Marginal utility differs from utility as it refers to the additional benefit derived from consuming one more unit of a specific good or service.[21] Marginal utility result can be positive, neutral or negative depending on the outcomes for the consumer. Utility is not constant, and for every additional unit consumed, often the consumer experiences what economists refer to as the diminishing marginal utility or diminishing returns, where each additional unit adds less and less marginal utility.
It can be represented by the formula below:
MUz=△U/△Z
Where MUz represents the marginal utility of good Z; △U and△Z represent changes in utility and consumption of good Z respectively.
