As with all economic models, the theory of consumer behavior employs some simplifying assumptions that allow us to focus on the fundamental determinants of consumer behavior and to abstract away from the less important aspects of the consumer’s decision process. Consumer behavior is modeled directly from the theory of constrained maximization described in Chapter 3. We begin this section with a short discussion of the specific form of the consumer’s optimizing decision.
Then we will explore the nature of consumer preferences for goods or services.
The Consumer’s Optimization Problem
As a basic premise for analyzing consumer behavior, we will assume that all individuals make consumption decisions with the goal of maximizing their total satisfaction from consuming various goods and services, subject to the constraint that their spending on goods exactly equals their incomes. Few, if any, people have incomes sufficient to buy as much as they desire of every good or service, so choices must be made about how to spend their limited incomes. To keep the income constraint as simple as possible, we will not allow consumers either to spend less than their incomes (i.e., no saving is allowed) or to spend more than their incomes (i.e., no borrowing is allowed). While it is not particularly difficult to allow saving and borrowing in our model, doing so would not change any of the conclusions that we will reach.
The basic model of consumer theory seeks to explain how consumers make their purchasing decisions when they are completely informed about all things that matter. Specifically, buyers are assumed to know the full range of products and services available, as well as the capacity of each product to provide utility. We also assume they know the price of each good and their incomes during the time period in question. Admittedly, to assume perfect knowledge is an abstraction from reality, but assuming complete information does not distort the relevant aspects of real-world consumer decisions.
Properties of Consumer Preferences
Consumer theory requires that consumers be able to rank (or to order) various combinations of goods and services according to the level of satisfaction associated with each combination. Such combinations of goods or services are called consumption bundles. Figure 5.1 shows a number of typical consumption bundles for two goods, X and Y. Bundle A consists of 10 units of good X and 60 units of good Y, bundle B consists of 20X and 40Y, bundle C consists of 40X and
consumption bundle A particular combination of specific quantities of goods or services.
20Y, and so on. Two important assumptions must be made about how people rank bundles of goods: consumer preferences must be complete and transitive.
Complete preference ordering For any given pair of consumption bundles, consumers must be able to rank the bundles according to the level of satisfaction they would enjoy from consuming the bundles. A consumption bundle would be ranked higher (i.e., preferred) to another bundle if the preferred bundle yields more satisfaction than the other, less-preferred bundle. Or, if the two bundles yield exactly the same level of satisfaction, the consumer would be indifferent between the two bundles and would give the two bundles the same ranking. When a con- sumer can rank all conceivable bundles of commodities, the consumer’s prefer- ences are said to be complete.
For example, a consumer who is confronted with bundles A and B in Figure 5.1 must be able to make one of the following three possible responses:
1. I prefer bundle A to bundle B (denoted as A s B).
2. I prefer bundle B to bundle A (denoted as B s A).
3. I am indifferent between bundles A and B (denoted as A ~ B).
The consumer’s preferences are complete if the consumer can do this for every possible pair of consumption bundles. Completeness of the preference ordering is essential for our model, because consumers would not be able to identify the most satisfying bundle without a complete ranking of all possible consumption bundles.
complete
Consumers are able to rank all conceivable bundles of commodities.
Quantity of good Y
C 70
60 50 40 30
10
0 10 30 50 70
D F
Quantity of good X
20 40 60
A
B E
20
15
F I G U R E 5.1 Typical Consumption Bundles for Two Goods, X and Y
Transitive preference ordering Consumer preferences are transitive when they are consistent in the following way. If bundle A is preferred to bundle B, and bundle B is preferred to bundle C, then bundle A must be preferred to bundle C.
Using the symbols presented above: If A s B, and B s C, then it follows that A s C. Consumer preferences must be transitive, otherwise inconsistent preferences would undermine the ability of consumer theory to explain or predict the bundles consumers will choose.
To see why transitivity is necessary, let’s suppose a Walmart shopper can purchase any one of three bundles of goods, A, B, or C, each of which costs exactly the same amount. Furthermore, suppose the consumer’s preferences violate the transitivity property in the following way: A s B, B s C, but, in violation of transitivity, C s A. Under this preference ranking, the shopper will be unable to make up his mind about which of these three bundles he would prefer to buy. Suppose, for some reason, he places bundle A in his basket and heads for the checkout line. On his way to check out, he realizes that bundle C should be in his basket, not bundle A because he believes C is more satisfying than A. After putting bundle A back on the shelf and placing bundle C in his basket, he heads back to the checkout line. But, once again, he decides along the way that he has the wrong bundle, because bundle B is more satisfying than bundle C. So, he grabs bundle B to replace bundle C. Of course, as you clearly see, he will now want to switch back to the original bundle A because bundle A is more satisfying than bundle B. This process would go on forever—or at least until Walmart closes or store security cameras detect his odd behavior!
More is preferred to less (nonsatiation) Completeness and transitivity are the only absolutely necessary assumptions for consumer theory. However, we are going to adopt one more assumption that will keep matters as simple as possible.
We are going to assume that consumers always prefer to have more of a good rather than less of the good. We do recognize that people may consume so much of something that they become satiated with it and do not want any more. However, no one would intentionally purchase so much of a good that they would be happier to have less of it.
The Utility Function
Utility is the name economists give to the benefits consumers obtain from the goods and services they consume. While utility implies usefulness, many of the products most of us consume may not be particularly useful. Nonetheless, we will follow tradition and refer to the benefits obtained from goods and services as utility.
Settling on a name for the benefits does not solve the problem of how to measure these benefits from consumption. Who could say how many units of benefit, or how much utility, they receive from consuming an ice cream cone or a pizza or from going to the dentist? After all, it is not possible to plug a “utility meter” into a consumer’s ear and measure the amount of utility generated by
transitive
Consumer preferences are transitive if A s B, and B s C, then it follows that A s C.
utility
Benefits consumers obtain from the goods and services they consume.
Now try Technical Problems 1–2.
consuming some good or service. And even if we could measure utility, what units or denomination would we use? In class, we have used terms such as
“utils,” which is too serious; “globs,” which is too frivolous; “bushels,” which is too precise; and others we need not mention. Over time, we have settled on the phrase “units of utility,” which is certainly pedestrian and dull, but it seems as good a name as any.
Consumer preferences can be represented as a utility function. A utility function shows an individual’s perception of the level of utility that would be attained from consuming each conceivable bundle or combination of goods and services. A simple form of a utility function for a person who consumes only two goods, X and Y, might be
U 5 f (X, Y)
where X and Y are, respectively, the amounts of goods X and Y consumed, f means “a function of” or “depends on,” and U is the amount of utility the person receives from each combination of X and Y. Thus, utility depends on the quantities consumed of X and Y.
The actual numbers assigned to the levels of utility are arbitrary. We need only say that if a consumer prefers one combination of goods, say, 20X and 30Y, to some other combination, say, 15X and 32Y, the amount of utility derived from the first bundle is greater than the amount from the second
U 5 f (20,30) . U 5 f (15,32)