Understanding how consumers operate makes it easier for vendors to predict which of their products will sell more and enables economists to get a better grasp of the shape of the overall economy.
Consumer theory is the study of how people decide to spend their money based on their individual preferences and budget constraints. It is a branch of microeconomics. Consumer theory shows how individuals make choices, subject to how much income they have available to spend, and the prices of goods and services.
Individuals have the freedom to choose between different bundles of goods and services. Consumer theory seeks to predict their purchasing patterns by making the following three basic assumptions about human behavior:
The customer has to determine how to expend his or her earnings on different commodities. Usually, any customer would want to get a blend of commodities that gives him or her the utmost satisfaction. This relies upon the preferences of the customer and what the customer can manage to purchase. The ‘likes’ of the customers are also named preferences. And what the customer can manage to purchase, certainly relies on prices of the commodities and the earnings of the customer.
If the quantity demanded of a product increases with an increase in consumer income, the product is a normal good and if the quantity demanded decreases with an increase in income, it is an inferior good.
A normal good has positive and an inferior good has negative elasticity of demand.
An indifference curve is a graph that shows a combination of two goods that give a consumer equal satisfaction and utility, thereby making the consumer indifferent.
The indifference curve operates on a simple two-dimensional graph. Each axis represents one type of economic good. Along the curve or the line, the consumer has no preference for either combination of goods because both goods provide the same level of utility to the consumer. For example, a young boy might be indifferent between possessing two comic books and one toy car, or two toy cars and one comic book.
Properties of the indifference curves:
The income effect is the change in the consumption of goods based on income. This means consumers will generally spend more if they experience an increase in income, and they may spend less if their income drops. But this doesn’t dictate what kind of goods consumers will buy. In fact, they may opt to purchase more expensive goods in lesser quantities or cheaper goods in higher quantities, depending on their circumstances and preferences.
Substitution effect may occur when a consumer replaces cheaper or moderately priced items with ones that are more expensive when a change in finances occurs. For example, a good return on an investment or other monetary gains may prompt a consumer to replace the older model of an expensive item for a newer one. The inverse is true when income decreases.
A small reduction in price may make an expensive product more attractive to consumers, which can also lead to the substitution effect. For instance, if private college tuition is more expensive than public college tuition, a small decrease in private college tuition fees may be enough to motivate more students to begin attending private schools.
Building a better understanding of an individual’s tastes and incomes is important because it has a big bearing 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 overall economy.
Consumer spending drives a significant large chunk of gross domestic product (GDP) in countries. If people cut down on purchases, demand for goods and services will fall, squeezing company profits, the labor market, investment, and many other things that make the economy work.
People are not always rational and are occasionally indifferent to the choices available. Some decisions are particularly difficult to make because consumers are not familiar with the products. There could also be an emotional component involved in the decision-making process that isn’t able to be captured in an economic function.
The main assumption that consumer theory makes means it has come under heavy criticism. While its observations may be valid in a perfect world, in reality, there are numerous variables that can expose the process of simplifying spending habits as flawed.
