Consumer Choice Theory
Within this chapter we will cover the topics that relate to how consumers choose to allocate their consumption.
The first step to understanding this is the concept of utility, this is the description and calculation of the value that a consumer receives from their consumption of a good/service.
By combining the concept of utility with the budget constraints that consumers face we can generate a curve to show how the consumer feels about selecting between two goods.
These indifference curves show the different combinations of two different goods that offer the same overall level of utility to the customer that can be achieved from their given budget.
Indifference curves are helpful to us in understanding the underlying consumer motives and decisions.
An important concept is behind the curved appearance of the indifference curves - and why they are not a straight line. This is due to the changing marginal utility from consuming a good. A key assumption is that utility gain decreases for each extra of a certain good that is consumed. For example, owning one car produces significant utility, owning 100 cars and then purchasing another one will give less utility. This means that consumers will tend toward consuming a mixture of goods, rather than just consuming one high utility good in extreme quantities. This
Related to utility and indifference curves we can look at the effect of expanding budgets or changing values of utility from different goods. These will shift the curves and thus we can create charts comparing the possible curves.
Applying consumer choice to wider economic matters allows us to discuss two other issues: Pareto efficiency and the Edgeworth Box.
Pareto efficiency is the concept of reaching a point of resource allocation where no person can be made better off without someone else losing out. This relates to indifference curves as they show a similar issue, where a consumer must decide their individual resource allocation. Utility is valuable for understanding how Pareto efficiency occurs and can be managed effectively, especially given the productive limits of an economy. Resources must be distributed in a balanced way, so an economy cannot focus on just one good/service at the expense of others and expect this to maximise welfare.
A related issue is described in the Edgeworth Box, which represents the interaction between two individuals endowed with a certain level of goods. This diagram shows how market general equilibrium is achieved through the interaction of the two individuals and their indifference curves. Where the curves meet there is the possibility for market clearing, and there is efficiency when the rate of substitution of the different goods is equal - thus they are produced/consumed with equal efficiency.
Understanding these underlying factors of consumer choice ensures that we have the basis to understand microeconomic decisions, which then play their role in determining macroeconomic factors. Hence, this chapter gives an important foundation of understanding for the wider school of economics.