Consumer Choice / Behavioral Economics

Consumer Choice / Behavioral Economics

Economics is about scarcity. The word 'scarcity' is used here in a special sense: it refers to a state of affairs in which, given the wants of a society at any particular moment, the means available to satisfy them are not sufficient. If all desires cannot be totally satisfied, then choices have to be made as to which of them are going to be satisfied, and to what extent. To say that economics is about scarcity then is also to say that it is about choice. There is no suggestion here that the scope of the subject is confined to purely material matters, such as the production and distribution of those goods and services that happen to make up such statistical magnitudes as the gross national product. Economics is relevant here to be sure, but its scope is potentially much wider. Any social or private situation which involves a choice of some sort has an economic aspect.

As we saw in the introduction, economics is about scarcity, about social situations which require that choices be made. The theory of consumer behavior deals with the way in which scarcity impinges upon the individual consumer and hence deals with the way in which such an individual makes choices. This consumer need not, of course, be a biological individual. He may be, but the theory is of potentially broader application (Skurski, 1983). Families and households also make collective consumption choices on behalf of their members. The theory as we shall present it takes the consumer unit as given. It therefore presents us with an important instance of how other social sciences, such as sociology and social psychology which deal, in part, with the way in which people organize themselves into household and other units, could complement economics.

The theory of consumer choice has many applications. It enables us to deal with the selection of consumption patterns at a particular time and the allocation of consumption over time, and hence with saving (Hicks, 1946). The individual supplying labor can be thought of as choosing the amount of leisure time available to him, so the same theory is relevant there as it is when we come to consider behavior in the face of risk. Moreover, in constructing a theory to deal with problems such as these we are forced to think carefully about and to define precisely such much abused terms as 'real income' and the 'cost of living', so that our theory gives us many valuable insights into matters of potentially considerable practical importance.

Three factors are involved in constructing the elementary theory of consumer choice. First, we must consider the items which the consumer finds desirable, the objects of choice. Second, since the desirability of an object does not necessarily imply that it is available to be chosen, we must consider any limitations that might be placed on the alternatives available to the consumer, the constraints upon his choice (Stevens, 1993). Finally, because choice necessarily involves a process of selection among alternatives, we must consider the way in which the consumer ranks the alternatives available to him, his tastes or preferences.

The objects of the consumer's choice are goods and services. In the most general case we may consider patterns of consumption at each particular moment in time and over time (Bailey, 1994). To keep things simple we will for now confine ourselves to the choice facing an individual at a particular time, ignoring for the moment the problem of allocating consumption over time. We will also simplify the world by assuming that it contains only two goods, X and Y. This abstraction from a world with many goods to one with two is not quite so restrictive as might appear at first sight, for it is always possible to think of X as being one particular good and Y as being a composite bundle of all other goods.

Now consider figure 1. On the horizontal axis we measure quantities of X per unit of time, let us say per week, and on the vertical axis quantities of Y per week. Any point in the area bounded by these two axes may be interpreted as a pattern of consumption involving a particular mixture of X and Y per week. Thus the point on the X -axis at 5 X represents a consumption pattern of 5 X and no Y per week, the point D. represents consumption of 5 X, 10 Y per week, and so on. In short, the objects of choice in this particular simplification of the theory of consumer choice are consumption patterns measured in terms of bundles of goods per week and each such bundle is represented by a particular point on a diagram such as figure 1.

Now, in principle we may extend the axes of figure 1 indefinitely and hence encompass any conceivable bundle of X and Y, but this does not mean that the consumer is in fact able to select any bundle of X and Y which he finds desirable.

Each point on the diagram represents a bundle of goods. The point D. represents a bundle made up of 5X and 10 Y. The line bb is a budget constraint drawn on the assumption that a consumer has an income of $50 and faces prices for X and Y of $2 and $1 respectively. The budget constraint divides those bundles of goods that the consumer can obtain, given his income and their prices, from those that he cannot. The services are generally not free and what a consumer can get at a particular moment is limited by the purchasing power then at his disposal. Suppose, for simplicity, that his only source of purchasing power was his present income. This may be expressed as a certain sum of money per week and it puts an upper limit on his consumption. We may represent this in figure 1 in the following way.

A and Y are goods that have prices and it is reasonable enough to suppose that these prices may be taken as constant as far as the individual consumer is concerned. Suppose that the price of X is $2 per unit and that of Y $1 per unit. Suppose also that the consumer's income is $50 per week. Then it is obvious that, if he devotes all of his income to the consumption of X, he may consume not more than 25 units of X per week; alternatively he may consume 50 units of Y per week. However, there is nothing to stop him mixing X and Y in his consumption pattern. We can calculate how much he spends on any particular quantity (less than 25) of X, and this sum subtracted from income gives the amount left over to be spent on Y. This amount divided by the price of Y tells us the maximum amount of Y that can be bought, given the quantity of X. If we carry out this calculation for every quantity of X between 0 and 25 and link up the resulting bundles of goods we derive the line bb in figure 1 which represents the consumer's so-called budget constraint. This line separates all those consumption bundles that our consumer can afford to buy from those that he cannot afford. Given the prices we have assumed, it is clear that for every unit of X given up, two units of Y may be substituted. Hence the slope of this constraint is obviously the inverse of the ratio of the prices we have assumed. If X costs $2 and Y $1, then the ratio of the price of Y to the price of X is 1/2 and the rate at which Y may be substituted for X is 2/1.

We make two basic assumptions about our consumer's tastes. First, we assume he is able to compare any two bundles of goods (Marshall, 1936). He can decide whether he prefers bundle 1 or 2 or is indifferent between them. Second, we assume that he makes these comparisons in a consistent fashion. By that we mean that if in comparing bundles 1 and 2 he finds 1 to be preferable, and if in comparing 2 with a third bundle he prefers 2, then on comparing 1 and 3 he will decide that he prefers 1.

It follows from this that if D. is one of a set of bundles of goods between which the consumer is indifferent; such bundles must lie in the areas below and to the right of D. And above and to the left. It is usual to go further than this and argue that all such points must lie on a continuous negatively sloped line, an indifference curve such as the line I-I in figure 2, a curve that is convex.