To understand the different effects of the theory of consumer choice on various microeconomic functions such as demand curves, wages, and interest rates, it is important to know what the consumer choice is. Bordalo, Gennaioli, & Shleifer, (2013), defined consumer choice as the decision made by the consumer on what products and services given their income. It is known that the consumer would wish to buy all the goods and services that satisfy his or her needs but is constrained by income. Therefore, the consumer has to make a choice on what products and services to buy and which to forego. The theory of consumer choice behavior examines how the consumers arrive at these decisions and how they change over time.
How does this theory affect Demand Curves?
The demand curves show the relationship between the amount of goods or services purchased and prices. Evidently, at lower prices quantity of goods demanded is higher than quantity demanded at higher prices. This is because, at low prices, the consumer will choose to purchase more goods than when the prices are high. The demand curve indicates that there is an inverse relationship between the price of a commodity and the quantity demanded. All demand curves slope downward to show the mentioned relationship between price and quantity demanded. It is, however, possible that some demand curve slope upwards (Bordalo, Gennaioli, & Shleifer, 2013).
For instance, the graph below is a demand curve for ice cream. The price of ice cream ranges from $1 to $7. When the ice cream is sold at $7, no consumer will buy, but if the vendor sells the ice at $1, consumers will purchase nine ice creams.
Effect on Higher Wages
As pointed out earlier, the consumer choices are constrained by the income. The choice of consumption of goods and services by the consumer is determined by the budget constraint and the demand curve. In microeconomics, the consumer satisfaction does not depend on one commodity but a combination of two or more goods. An indifference curve is the combination of two commodities that yield same utility to the consumer. An increase in wages shifts the budget constraint outwards making it possible for the consumer to choose the combination of goods and services in a higher indifference curve. For example, if a consumer utility is determined by consumption of apples and bananas, the indifference curves will be as shown below. The straight line represents the budget constraint. If this consumer receives a wage increase, the budget constraint will shift outwards up to the indifference curve IC3.
However, it is important to note that the increase in wages has a different effect on consumption depending on the type of good. In this regard, when consumer purchases more of a good when his or her income increases, the good is called a normal good. Subsequently, if fewer quantities of a good are purchased as the consumers income increases, the good is called an inferior good. Generally, the more people earn, the more they spend. Higher wages will, therefore, increase consumer options leading to more purchases.
Effect on Higher Interest Rates
Consumer choice theory also affects the interest rates in an economy. In case of higher interest rates, the consumers are compelled to postpone their consumption to future periods. Consequently, the consumers have less money to spend in the current periods. Higher interest rates will, therefore, cause the demand for goods and services to decrease as consumers save bigger proportions of their income. According to the theory of consumer choice, higher interest rates encourage the households to save rather than spend. Asymmetric Information
Asymmetric information refers to a transaction where one party has more information than the second party. This often happens in transactions where the seller has more information about the product or market conditions than the buyer. In some instances, it is possible that the buyer has more information than the seller. In such transactions, the party with more or superior information takes advantage of the other party by charging more (if the seller has more information) or buying for less than the market price.
The economic effect of asymmetric information is desirable in a market economy. For instance, if workers specialize in their field of expertise, they create great value for workers in other fields. Problems arising from asymmetric information have serious implication on the economy. Moral hazards and adverse selection are the problems associated with asymmetric information. Moral hazard refers to a situation where one party is involved in a risky event because another party protects them from this event. The best example of moral hazard is the case of insurance. Adverse selection also applies in insurance where those living high-risk insurance or in dangerous jobs get life insurance.
The Condorcet Paradox and Arrows Impossibility Theorem in the Political Economy
When the majority rule in a society fails to produce transitive preferences for the people, the situation is known as Condorcet paradox. Dubas, & Strong, (2015), identified two lessons from the paradox. The first lesson is that in case of more than two options in society, the outcome of a democratic election is highly dependent on the decision of the order in which the items are voted for. The second lesson is that the outcome of a democratic process does not always indicate what the society wants. Arrows impossibility theorem is a mathematical expression that tries to show that even under certain assumptions, it is not possible to aggregate individual preferences into a valid set of social preferences for the whole society. While this theorem does not advice abandoning the democratic form of government, it points out that it is impossible for a society to aggregate the preferences of its members no matter what voting system is adopted as it will be flawed in some way.
People are not Rational in Behavior Economics
According to psychologists, real people are characterized by various imperfections such as impulsiveness, forgetfulness, confusion, and emotional. The proposers of behavioral economics have chosen to neglect them which makes it impossible to defend the notion that people are always rational. Additionally, studies have shown that human decision-making process usually has systematic mistakes including overconfidence, reluctant to change their minds, and giving too much weight to small but vivid observations (Altman, 2015)
Consumer choice theory is applicable in many instances in microeconomics. For instance, it describes why it is possible to have demand curves that slope upwards, the relationship between wages and labor supplied, and how savings are affected by the interest rates. The concept of indifference curves is also introduced by the theory of consumer choice. Asymmetric information can lead to exploitation of one party in a transaction. Though there are advantages associated with asymmetric information, the costs to the economy are much higher and more destructive.
Altman, M. (2015). Handbook of contemporary behavioral economics: foundations and developments. Routledge.
Bordalo, P., Gennaioli, N., & Shleifer, A. (2013). Salience and consumer choice. Journal of Political Economy, 121(5), 803-843.
Dubas, K. M., & Strong, J. T. (2015). Arrows general impossibility theorem and five collective choice rules: Pareto, Condorcet, Plurality, Approval Voting, and Borda. In Proceedings of the 1993 Academy of Marketing Science (AMS) Annual Conference (pp. 334-338). Springer, Cham.
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