Consumer theory is the study of how people decide to spend their money based on their individual preferences and budget constraints. A branch of microeconomics, consumer theory shows how individuals make choices subject to how much income they have available to spend and the prices of goods and services.1
Understanding how consumers operate makes it easier for vendors to predict which of their products will sell more and enables economists to get a better grasp of the invisible hand, the unseen forces that shape the economy.
KEY TAKEAWAYS
- Consumer theory is the study of how people decide to spend their money based on their individual preferences and budget constraints.
- Building a better understanding of individuals’ tastes and incomes is important, because these factors impact the shape of the overall economy.
- Consumer theory is useful but is not flawless, as it is based on a number of assumptions about human behavior.
Understanding Consumer Theory
Individuals have the freedom to choose between different bundles of goods and services. Consumer theory seeks to predict their purchasing patterns by making the following three basic assumptions about human behavior:2
- Utility maximization—Individuals are said to make calculated decisions when shopping, purchasing products that bring them the greatest benefit, otherwise known in economic terms as maximum utility.
- Non-satiation—People are seldom satisfied with one trip to the shops and always want to consume more.
- Decreasing marginal utility—Consumers lose satisfaction in a product the more they consume it.
Working through examples and/or cases, consumer theory usually requires the following inputs:
- A full set of consumption options
- How much utility a consumer derives from each bundle in the set of options
- A set of prices assigned to each bundle
- Any initial bundle that the consumer currently holds
Advantages of Consumer Theory
Building a better understanding of individuals’ tastes and incomes is important, because it has a big bearing on the demand curve, which is the relationship between the price of a good or service and the quantity demanded for a given period of time, and on the shape of the overall economy.
Consumer spending drives a significantly large chunk of gross domestic product (GDP) in the United States.3 If people cut down on purchases, then demand for goods and services will fall, squeezing company profits, the labor market, investment, and many other things that make the economy tick.
Example of Consumer Theory
Let’s look at an example. Kyle is a consumer with a budget of $200 who must choose how to allocate his funds between pizza and video games (the bundle of goods). If a pizza costs $10 and a video game cost $50, Kyle could buy 20 pizzas, or four video games, or five pizzas and three video games. Alternatively, he could keep all $200 in his pocket.
How can an outsider predict how Kyle is most likely to spend his money? Consumer theory can help give an answer to this question.
Limitations of Consumer Theory
Challenges to developing a practical formula for this situation are numerous. For instance, as behavioral economics points out, people are not always rational and are occasionally indifferent to the choices available.
4 Some decisions are particularly difficult to make because consumers are not familiar with the products. There could also be an emotional component involved in the decision-making process that cannot be captured in an economic function.
The many assumptions made by consumer theory have caused it to come under criticism. While its observations may be valid in a perfect world, in reality, there are numerous variables that can expose as flawed the process of simplifying spending habits.
4Going back to the example of Kyle, figuring out how he will spend his $200 is not as clear-cut as it might seem at first. Economics assumes that he understands his preferences for pizza and video games and can decide how much of each he wants to purchase. It also presumes that there are enough video games and pizzas available to satisfy Kyle’s choices. Of course, none of these assumptions may be correct, even if generally they are.
What does consumer theory tell us?
Consumer theory attempts to predict how people will spend their money by looking at their budget constraints and individual preferences. Its weakness is that it assumes that people will always make rational choices.
Why is consumer theory important?
Because consumer spending is the engine of the U.S. economy, understanding how consumers may spend their hard-earned money helps businesses decide where to allocate their resources.
What is the demand curve?
The demand curve looks at the relationship between the cost of a good or service and the amount needed to satisfy consumer consumption over a stated period of time. It helps determine the shape of the economy.
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