Consumer Theory

The theory of consumer choice is the branch of microeconomics that relates preferences to consumption expenditures and to consumer demand curves. It analyzes how consumers maximize the desirability of their consumption as measured by their preferences subject to limitations on their expenditures, by maximizing utility subject to a consumer budget constraint.

Consumption is separated from production, logically, because two different economic agents are involved. In the first case consumption is by the primary individual; in the second case, a producer might make something that he would not consume himself. Therefore, different motivations and abilities are involved. The models that make up consumer theory are used to represent prospectively observable demand patterns for an individual buyer on the hypothesis of constrained optimization. Prominent variables used to explain the rate at which the good is purchased (demanded) are the price per unit of that good, prices of related goods, and wealth of the consumer.

The law of demand states that the rate of consumption falls as the price of the good rises, even when the consumer is monetarily compensated for the effect of the higher price; this is called the substitution effect. As the price of a good rises, consumers will substitute away from that good, choosing more of other alternatives. If no compensation for the price rise occurs, as is usual, then the decline in overall purchasing power due to the price rise leads, for most goods, to a further decline in the quantity demanded; this is called the income effect.

In addition, as the wealth of the individual rises, demand for most products increases, shifting the demand curve higher at all possible prices.

The basic problem of consumer theory takes the following inputs:

Consider an economy with two types of homogeneous divisible goods, traditionally called X and Y.

The consumer will choose the indifference curve with the highest utility that is attainable within his budget constraint. Every point on indifference curve I3 is outside his budget constraint so the best that he can do is the single point on I2 where the latter is tangent to his budget constraint. He will purchase X* of good X and Y* of good Y.

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