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 may, but need not be, an individual person. Families and households also make collective consumption choices on behalf of their members. The theory takes the consumer unit as given. It therefore presents us with an important instance of how 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. The individual supplying labor can be thought of as simultaneously choosing an amount of leisure time, 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 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.
In order to derive the model of choice-making we need to describe first of all the logical structure of the choice problem which faces any consumer. We will find it helpful to think of that structure as being made up of three components. First, we must consider the items which the consumer finds desirable, the object of choice. Secondly, 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 choice. Finally, because choice necessarily involves the process of selection among alternatives, we must consider the way in which the consumer ranks the alternatives available, the consumer’s tastes or preferences.
The objects of consumer’s choice are goods and services, yielding utility, which may be ordered and (in principal) measured. The consumer’s budget constraint shows how the upper limit on consumption (usually present disposable income) may be allocated among consumption patterns or goods at given prices. The position of the budget line is determined by income and price alone. Its slope reflects only relative prices.
Consumer tastes can be represented by a map of non-intersecting indifference curves. Along each indifference curve, utility is constant. Higher indifference curves are preferred to lower indifference curves. Since the consumer prefers more to less, indifference curves must slope downwards. To preserve a given level of utility, increases in the quantity of one good must be offset by reductions in the quantity of the good.
Indifference curves reflect the principle of a diminishing marginal rate of substitution. Their slope becomes flatter as we move along them to the right. To preserve utility, consumers will sacrifice ever smaller amounts of one good to obtain successive unit increases in the amount of the other good.
Maximizing consumer utility generates an equilibrium where the budget constraint and the highest possible indifference curve are tangential. At any point other that equilibrium, the consumer can substitute one good for another and increase utility. In equilibrium the marginal rate of substitution between goods is equal to their ratio of prices.
Income-consumption and price-consumption curves describe how the quantity demanded of a good alters with variations in income and price.
At constant prices, an increase in income leads to a parallel outward shift in the budget line. If goods are normal the quantity demanded will increase.
A change in the price of one good rotates the budget line around the point at which none of that good is purchased. Such a price change has an income effect and a substitution effect. The income effect of a price increase is to reduce the quantity demanded for all normal goods. The substitution effect, induced by relative price movements alone, leads consumers to substitute away from the good whose relative price has increased.
In a two-good world, a good whose quantity purchased moves together with the changes in the price of the other good is called substitute. That, whose quantity moves in opposite directions to the other good’s price change is a complement.
The Engel curve maps quantity demanded of one good against changes in income. The ratio of the marginal propensity to consume (slope of the Engel curve) to the average propensity to consume (ratio of quantity demanded to income) is known as the income elasticity of demand.
The demand curve relates quantity demanded of one good to its own price. The own price elasticity of demand is given by the slope of the demand curve (treating quantity as the dependent variable) divided by the ratio of quantity demanded to price. The cross elasticity of demand measures the proportional change in the quantity demanded of one good to a proportional price of another.
Transfers in cash and kind. Cash transfers allow consumers to spend the extra income in any way that they desire. Transfers in kind may limit the consumer’s option. Where they do, The increase in consumer utility will be less than under a cash transfer of the same monetary value. Yet transfers in kind are politically popular. The electorate wants to know that money raised in taxation is being wisely spent. Some who favor transfers in kind will argue that the poor really do not know how to spend their money wisely. One view says that people can best choose for themselves, whereas the other says that people may not act in their own best interests. This issue is not merely one of economics but also of philosophy, involving wider questions such as liberty and paternalism. In so far as people are capable of judging their own self-interest, economic analysis is clear: people will be better off, or at least no worse off, if they are given transfers in cash rather than in kind.