Definition of consumer theory
What is consumer theory?
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, depending on income level they have to spend and the prices of goods and services.
Understanding how consumers operate makes it easier for sellers to predict which of their products will sell the most and allows economists to better understand the shape of the overall economy.
Key points to remember
- Consumer theory is the study of how people decide to spend their money based on their individual preferences and budget constraints.
- It is important to better understand the tastes and incomes of individuals, as these factors have an impact on the shape of the overall economy.
- Consumer theory is not flawless, however, as it relies on a number of assumptions about human behavior.
Understanding consumer theory
Individuals have the freedom to choose between different sets of goods and services. Consumer theory seeks to predict their purchasing habits by making the following three basic assumptions about human behavior:
- Maximization of utility: People are said to make calculated decisions when shopping, buying products that bring them the most benefit, also known as maximum utility in economic terms.
- Non-satiety: People are rarely happy with just one trip to the store 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 typically requires the following inputs:
- A full set of consumption options
- What is the usefulness that a consumer derives from each bundle of the set of options
- A set of prizes assigned to each package
- Any initial plan that the consumer currently has
Benefits of consumer theory
Building a better understanding of people’s tastes and incomes is important because it has a big impact on the demand curve, the relationship between the price of a good or service and the quantity demanded for a given period of time, and the shape of the global economy.
Consumer spending drives a significantly large share of gross domestic product (GDP) in the United States and other countries. If people cut back on their purchases, demand for goods and services will fall, reducing company profits, the labor market, investments and many other factors that make the economy check.
Consumer choice theory is taken very seriously, influencing everything from government policy to corporate advertising.
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 merchandise). If a pizza costs $ 10 and a video game costs $ 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 a stranger predict how Kyle is most likely to spend his money? Consumer theory can help answer this question.
Limits of consumer theory
The challenges in developing a practical formula for this situation are many. For example, as behavioral economics points out, people are not always rational and are sometimes indifferent to the choices available. Some decisions are particularly difficult to make because consumers are unfamiliar with the products. There might 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 mean that it has come under heavy criticism. While his observations may be valid in a perfect world, in reality there are many variables that can expose the process of simplifying spending habits as imperfect.
Going back to Kyle’s example, figuring out how he’ll spend his $ 200 isn’t as clear as it might first appear. Economics assumes that he understands his preferences for pizza and video games, and can decide how much each one wants to buy. It also assumes that there are enough video games and pizza available for Kyle to choose how much of each he wants.