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# Consumer Choice

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You are standing in a store and see a great winter jacket but it costs $200. You know you'd wear the jacket for several winters and it would keep you warm but the price is steep. If you buy the jacket, you will not be able to afford to go on the weekend road trip you and your friends were planning for the next weekend. You have to weigh the benefits of buying the jacket to prepare for winter versus spending quality time with your friends and making memories. What will you choose? How people make these choices is what consumer choice theory is all about. In this explanation, we will go over consumer choice, the assumptions that the model makes, and why it is important. You might even learn a little bit about yourself and your consumption choices, who knows? Let's find out together! ## Consumer Choice Definition The consumer choice definition that is widely accepted in economics is one that hypothesizes why people make the consumption choices that they do when they are faced with trade-offs. A trade-off is an option that you forgo if you make a different choice. The theory of consumer choice attempts to understand why consumers choose one good or experience over another, working versus leisure, or saving versus spending their money. Consumer choice examines why people make the economic choices they do when facing trade-offs, restrictions, and changes in their environment that affect their ability to consume. A trade-off is a choice that you forgo when you make a different choice. If you choose to spend more money on one good, then you cannot buy as much of another good. If you want to enjoy more leisure time, you give up the time you could be working and making more money for the future. If a consumer decides to spend more of their income now, they will have less money to spend in the future. If they receive a raise at work, their budget will change. The idea of consumer choice relies on the fact that people will make rational decisions to satisfy their wants. People want to make the choice that best fits their budget, their preferences, and optimizes the amount of pleasure they will get from their choices. Of course, to make these choices, consumers need some bits of information. The price of a good is an important factor in a consumer's decision-making about how they can gain the most satisfaction based on their budget and their preferences. If the price of a good is too high then the consumer will buy less of it, or they will buy another lower-priced good if they are unwilling to make the trade-off. Consumer choice theory helps us understand a consumer's behavior that results from the combination of their income and preferences. Having a clear understanding of this behavior is necessary to be able to construct the demand curve and set the price of a good appropriately. ## Consumer Choice Assumptions Let's examine some of the main consumer choice assumptions: • Consumers are faced with budget constraints. • Consumers have tastes and preferences that impact their choices. • Consumers will look to optimize their decisions based on their budget and preferences. These assumptions together operate under the traditional economic assumption that consumers will make rational choices in the hope of maximizing personal benefit. ### The Budget Constraint The budget constraint is an economist's way of saying what the consumer can afford. By assuming that there is a budget constraint we imply that people want to spend more than they have, but their budget constraint forces them to consume less than they want to. When a consumer is on a budget, they have a set amount of money to spend so they must choose between the goods they want to spend it on. Mindy has$30. She wants to buy fries and burgers. This is considered her bundle of goods. Each burger costs $6 and fries cost$3. There are several bundle combinations she can choose that fit her budget:

 Order of Fries Number of Burgers Spending on Fries Spending on Burgers Total Spending 10 0 $30$0 $30 8 1$24 $6$30 6 2 $18$12 $30 4 3$12 $18$30 2 4 $6$24 $30 0 5$0 $30$30
Table 1 - Budget Constraint ExampleTable 1 shows Mindy's options for buying burgers and fries. If Mindy wanted to buy 4 burgers and 4 orders of fries one day, she would be unable to do so due to her budget constraint.

Fig. 1 - Consumer's Budget Constraint

Figure 1 above shows the consumer's budget line. As in Table 1, the consumer has several options to choose from, so long as they fit the budget line. Points A and B on the graph are viable options, whereas point C is not since it is above the budget line.

Dive deeper into these topics with us:- Budget Constraint;- Budget Constraint Graph.

### Preferences and Marginal Utility

A consumer will not just buy whatever fits their budget, that would likely not be satisfactory. They will make a choice that satisfies their preferences. A consumer's preferences are what they will choose to spend their time and money on if given the choice. A consumer's choice relies on a combination of their budget and what they prefer. Sometimes, there are choices that the consumer equally prefers, that is, they are indifferent to the choice. Much like a budget constraint, the indifference curve shows the different combinations of goods that will be equally satisfying for the consumer.

Fig. 2 - Indifference Curves

Figure 2 above shows a consumer indifference curve for the choice between burgers and fries. Points A, B, and C are all located on the same curve, indicating that they are all equally satisfying choices. Point D is located on a higher indifference curve. On I3, the consumer can have more of both goods, which we assume is always preferred to less. I1 offers the least amount of both goods so it is always less preferable.

Another way to describe a consumer's preference is by how much utility they receive. Utility is used to measure the level of satisfaction, or happiness, that a good provides. All points on the same indifference curve provide equal utility. Marginal utility is the additional utility that each additional unit of a good provides the consumer. When marginal utility equals zero, we have reached the maximum amount of satisfaction a good can provide.

We've got you covered on these topics too,so why not check out:- Indifference Curve;

### Optimization

Once the consumer has reconciled their budget with their preferences, they will make the optimal choice. This is the choice where the budget is tangent to the highest indifference curve. In Figure 3 below, it is point A.

Fig. 3 - Optimal Consumer Choice

The highest indifference curve that the budget line is tangent to is I2 at point A, indicating that this is where the consumer gets the highest amount of satisfaction within their budget. It also intersects point E, but this point is located on a lower indifference curve, making it less preferable overall.

We only grazed the surface of consumers facing budget constraints, marginal utility, and indifference curves.

To dive further in, have a look at these explanations:

- Budget Constraint;

- Marginal Utility;

- Indifference Curves.

## Consumer Choice and Demand

Consumer choice and demand are related in that the consumer's indifference curves help to determine the demand curve for a good. If we observe how the consumer's choice changes as the price of the good rises or falls, we can figure out what the demand curve for the good itself will look like.

For example, if the price of a bag of M&Ms is $2 and the price of nachos is$6 per order, the consumer will buy six bags of M&Ms and two orders of nachos if their budget is $24. If the price of nachos is reduced to$4, the consumer will buy four bags of M&Ms and four orders of nachos.

This consumer choice is illustrated in Figure 4 below.

Fig. 4 - Consumer's Optimum Budget

Figure 4 above shows us what happens to the consumer's budget line when the price of nachos decreases. The purchasing power of the consumer's budget expands because the consumer can now buy more nachos and still buy M&Ms. If they had wanted to buy four orders of nachos at $6, they could not have bought any M&Ms, but with the reduced price they can buy four orders of nachos and four bags of M&Ms. Now, let's see what this says about the demand curve for nachos. Fig. 5 - Demand Curve for Nachos Figure 5 combines the two prices of nachos and the quantity demanded at each price to form the demand curve for nachos. ## Model of consumer choice: Consumer Choice Theory Importance The importance of consumer choice theory as a model of consumer choice lies in its ability to predict the consumption patterns the economy will face. Understanding what drives a consumer to make the choices that they do is important for explaining the overall shape of the economy. Consumer demand is a driving factor for an economy without which money would not flow. The demand curve represents the inverse relationship between the price of a good and the quantity a consumer demands at that price. Using the consumer choice theory to understand the consumer's demand allows businesses to decide how to maximize profits and best allocate their resources. Understanding consumer demand and how it relates to the individual's budget also helps businesses price their goods most advantageously. When calculating Gross Domestic Product (GDP), one of the largest sectors included is consumer spending. In 2021, consumer spending accounted for nearly$16 trillion of the $23 trillion of the US nominal GDP.1 It is important that businesses, policymakers, and economists have an understanding of why consumers make the choices that they do to have a chance at understanding the flow of the economy and how to make business and policy choices that benefit both consumers and producers. ## Consumer Choice Theory Implications Some consumer choice theory implications are that consumers make choices that will bring them the most satisfaction that their budget allows and that consumers will face trade-offs that impact their utility. If a consumer buys more of good A they must buy less of good B. If they choose to have more leisure time, they will work less and probably reduce their income. They can choose to either spend their money now and have less in the future or they can save it now to have more in the future. Of course, there is more that goes into these choices than just the consumer's whim. Before consumers make their choices, they typically take into account the level of risk they are willing to accept, how high their income is, what the current interest rate is, etc. The thoughts that drive a consumer's choices are really interesting! Dig deeper into it by checking out these explanations: Consumer choice theory is an economist's effort to perform an economic analysis using explicit values, to model human psychological and emotional choices with implicit values. Because consumer choice theory is a model representing human behavior, there are exceptions to its application in real life. In economics, we assume that people behave rationally, but we know that is not always the case, which is one prominent criticism of consumer choice theory. ## Consumer Choice Examples Let's look at a couple of consumer choice examples. Since there are so many choices and unique preferences that seem rational to one but not another, for the sake of explaining consumer choice theory, that's okay. Buddy has$60 in birthday money to spend. His bundle of goods includes comic books and high-end markers. Each comic book costs $6 and each marker costs$10. Buddy could spend all his money on ten comics or six markers. If he wants both he can spend $30 on five comics and$30 on three markers. Any other combinations would leave him with change. Maybe he saves his money instead or only spends some of it. Who knows?

Then there's Marge. Marge wants to go see a concert a few towns away. She would have to take the day off of work to go. The concert costs $100 per ticket and Marge would lose$75 by not going to work. If she skips the concert and goes to work, she will earn $75. If Marge has already bought the concert ticket, her total loss will be$25, which is her $75 wage earned minus the$100 spent on the ticket. What choice is Marge going to make?

Consumer choice can help economists predict how Buddy and Marge will respond to their individual situations given that they behave rationally.

## Consumer Choice - Key takeaways

• Consumer choice explains why consumers make the choices that they do, given their budget and preferences.
• Utility is the amount of satisfaction a choice provides and will influence the choice a consumer makes.
• Four assumptions that the consumer choice theory makes are that consumers will behave rationally, they are on a budget, their preferences impact their consumption, and they will look to optimize and gain maximum utility from their budget.
• Consumer choice helps us understand the demand curve since it is a product of the choices consumers make given the price of a good.
• A critique of consumer choice theory is that it attempts to use explicit values to form an economic analysis out of something implicit like human emotions.

## References

1. Bureau of Economic Analysis, Table 1.1.5. Gross Domestic Product, September 2022, https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=2&isuri=1&1921=survey

Consumer choice explains why people make the economic choices they do when facing trade-offs, restrictions, and changes in their environment that affect their ability to consume.

Key assumptions are that consumers will behave rationally, they are on a budget, their preferences impact their consumption, and they will look to optimize and gain maximum utility from their budget.

An example of consumer choice is when presented with a restricted budget, the consumer will optimize their consumption based on which combination provides the most satisfaction.

Consumer choice theory tells us why people make the choices they do and the cost of a good is part of that consideration. The consumer's budget, the price of the good, and the utility that the good provides determine the demand curve.

Consumer choice is important for understanding what drives a consumer to make the choices they do and is important for explaining the overall shape of the economy.

## Consumer Choice Quiz - Teste dein Wissen

Question

In financial markets, what is the definition of return?

In financial markets, the return is how much the value of an investment increases or decreases over time.

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Risk refers to the _____ of outcomes people face when making financial decisions.

uncertainty

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The risk-return trade-off is the acceptance of greater _____ for a higher expected _____ on an investment.

risk, return

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The expected value of an investment is the _____-weighted average of the possible outcomes.

probability

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If the probability of a stock return of 20% (Outcome A) is 30% (PA) and the probability of a stock return of 40% (Outcome B) is 70% (PB), then the expected return would be:

34%

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A less-risky stock should be priced _____ than a riskier stock.

higher

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Risk and return are _____ correlated.

positively

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What is the risk-return trade-off formula?

$$R_p = b \times R_m + (1 - b) \times R_f$$

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The _____ _____, which is a measure of variability, is used to determine the riskiness of an investment.

standard deviation

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Question

Complete the following equation used to determine the share of a portfolio that should be invested in stocks:

$$b = \frac{S_p} {?}$$

$$S_m$$

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The following equation is known as the investor's _____ line.

$$R_p = R_f + \frac{S_p} {S_m} \times (R_m - R_f)$$

budget

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What is the marginal rate of substitution?

The marginal rate of substitution is the maximum amount of a certain good an individual is willing to exchange for receiving an additional unit of another good.

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One of the critical assumptions of the marginal rate of substitution hypothesis is that trade-offs made between two items that an individual substitutes for one another does ________ their utility.

not affect

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What's the indifference curve?

An indifference curve is a kind of graph that is used to illustrate the many combinations of two distinct goods that provide consumers with the same level of utility and pleasure.

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What's the relationship between the MRS and the indifference curve?

The marginal rate of substitution is the slope of the indifference curve.

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Why is the indifference curve not a straight line?

That's because the marginal rate of substitution is not equal at all points of the indifference curve.

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Question

When an individual moves from consuming 10 units of coffee and 1 unit of pepsi, to consuming 5 units of coffee and 2 units of pepsi, the MRS equals ______ .

5

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When an individual moves from consuming 5 units of coffee and 2 unit of pepsi, to consuming 3 units of coffee and 3 units of pepsi, the MRS equals ______ .

2

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Question

Diminishing marginal utility means that the MRS throughout the indifference curve declines.

True

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Question

The diminishing marginal rate of substitution is why the indifference curve is ______

Convex

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What is the formula for MRS?

$$MRS = -\frac{\Delta\hbox{Good 1}}{\Delta\hbox{Good 2}}$$

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Why is the MRS important?

The importance of the marginal rate of substitution comes from its ability to reveal and measure whether a consumer would exchange one product or service for another one.

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Why is it the minus sign added to the MRS formula?

To make the MRS a positive number as the change in good 1 is always negative.

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Question

As the consumption of one good in terms of another increase, the magnitude of the slope of the indifference curve _______

Decreases

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What is consumer choice theory?

Consumer Choice Theory examines why people make the economic choices they do when facing trade-offs, restrictions, and changes in their environment that affect their ability to consume.

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Question

A trade-off is an option that you forgo if you make a different choice.

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What do indifference curves show?

The indifference curve shows the different combinations of goods that will be equally satisfying for the consumer.

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Question

_______ is used to measure the level of satisfaction or happiness that a good provides.

Utility.

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Question

What does the budget constraint imply?

It implies that people want to spend more than they have, but the budget constraint forces them to consume less than they want to.

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Question

When economists use consumer choice theory, they assume that consumers will behave _________.

Rationally.

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What are the three key assumptions of the consumer choice theory?

1. Consumers are faced with budget constraints.

2. Consumers have tastes and preferences that impact their choices.

3. Consumers will look to optimize their decisions based on their budget and preferences.

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Question

True/False: The intersection of the budget line and the lowest indifference curve is the optimal choice.

False. The intersection of the budget line and the highest indifference curve is the optimal choice.

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True/False: Consumer spending makes up the largest percentage of GDP.

True.

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True/False: Consumer choice theory only applies to the consumption of goods.

False. Consumer choice theory also looks at why consumers choose one good over another, working versus leisure, or saving versus spending their money.

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What is a point of criticism for consumer choice theory?

A criticism is that it attempts to use explicit values to form an economic analysis out of something implicit like human emotions.

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What does consumer choice theory have to do with the demand curve?

Consumer choice theory helps us understand the demand curve since it shows the choices consumers make given the price of a good.

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Why is consumer choice theory important for a business?

It can help a business understand its consumers so that it can optimize its resource allocation and maximize profits.

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Which two pieces of information are necessary for an economist to predict a consumer's behavior using consumer choice theory?

They need to know the consumer's budget and preferences.

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Define risk.

Risk is the uncertainty about future outcomes.

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Define risk preference.

Risk preference is defined as how much risk a person is willing to take based on the expected utility, or satisfaction, of the outcome.

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What is expected utility?

Expected utility is the probability-weighted average of total utility (satisfaction) given uncertain outcomes.

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What is the expected utility formula?

$$E(U) = P_A \times U_A + P_B \times U_B$$

$$\hbox{Where:}$$
$$E(U) = \hbox{Expected Utility}$$
$$P_A = \hbox{Probability of Outcome A}$$
$$U_A = \hbox{Utility of Outcome A}$$
$$P_B = \hbox{Probability of Outcome B}$$
$$U_B = \hbox{Utility of Outcome B}$$

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Question

Someone who exhibits diminishing marginal utility has what risk preference type?

Risk-averse

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Someone who exhibits constant marginal utility has what risk preference type?

Risk-neutral

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Someone who exhibits increasing marginal utility has what risk preference type?

Risk-loving

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A risk-_____ person needs a larger increase in income or expected utility for a given increase in risk compared to a risk-_____ person.

averse, neutral

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Diminishing marginal utility means that, as income grows, the additional utility gained from a given increase in income becomes _____.

smaller

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What are the three risk preference types?

Risk-averse

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Which of the following is not a way to measure risk preference?

Investing in a stock and measuring how you feel if it goes up or down.

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What does the term “utility” represent in economics?

Utility is an abstract value that an agent gets from a preference. It may also be defined as satisfaction gained from a selection.

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