Consumer Theory

Let’s introduce a prominent theory in microeconomics, known as consumer theory. We have already introduced key terminology and concepts from this theory, so please refer back to the first article, Understanding Microeconomics, if anything requires more explanation.

Consumer theory looks at individuals’ preferences and decision-making when faced with choices on a finite income. This is called the finite income budget. Microeconomists are interested in seeing how consumers use this budget to meet their needs and wants. By observing behaviour, economists can understand buying tendencies. This is instrumental for producers and vendors in setting prices and inducing spending. Simply put, microeconomists don’t just want to know what is in a consumer’s shopping basket, but why. Basically, if economists can establish demand and anticipate it, supply can be more efficiently produced. This reduces wastage and improves the economy as a whole. Additionally, producers can use consumer theory to maximise their profits. If they understand a consumer's response to a price increase, they can find the selling price that maximises income. Individuals are faced with many types of goods, so let’s recap a few of the basics:

Now to the theory. It is governed by five axioms. An axiom is essentially just an assumption we make which allows the theory to work. We will look at these five, identify their use and relevance, and discuss their shortcomings. As well as these 5 axioms, a key assumption is that consumers are rational, i.e. they will look to maximise their utility. This means they will aim to gain the most pleasure from their spending.

Axiom 1 - Completeness 

This axiom is essential to consumer theory and merely states that consumers can set preferences. An individual knows if they prefer apples to oranges or a new TV to a sofa. Although a TV and a sofa have different uses, an individual can deduce which they need, or want, more given their financial status and circumstances. This is a relatively easy axiom to accept as we do not need to assume that individuals act always with 100% information or in their best interest, but that they will know what they prefer when given two choices.

Axiom 2 - Transitivity

The notion that preferences are transitive states that given three choices, A, B, and C, if A is preferred to B (A > B) and B is preferred to C (B > C), then A will always be preferred to C (A > C). This is an interesting axiom because at first, it appears completely intuitive. However, there are instances where it falls apart. If we compare products across three criteria, we can see that A > B > C > A. For example, an individual may prefer car A to car B because it is faster, car B to car C because it is cheaper, and car C to car A because it is better for the environment. To assume individuals are faced with easy-to-make decisions is not always valid. For the sake of consumer theory, however, it is reasonable enough.

Axiom 3 - Continuity

This axiom suggests preferences are continuous and “well behaved”, as in preferences act as expected. If A > B, and a third option, C, lies on the utility function between A and B but is closer to B than A, A is preferred to C (A > C). For example, if a hotdog is strictly preferred to a hamburger, and a cheeseburger is marginally preferred to a hamburger, a hotdog will be preferred to a cheeseburger. 

These first three axioms allow for what we call well-behaved preferences. Were these to fail, we would not be able to predict a consumer's actions and their decision-making would be nearly enough random. The next two axioms are additional assumptions which allow utility to be plotted on a graph, although we won’t go into that in this introductory article.

Axiom 4 -  Monotonicity

Simply put, this axiom states more is better. If a consumer can buy more, they will buy more. There is no limit to their utility function but it does act differently as quantity increases, as we will see in axiom 5.

Axiom 5 - Convex preferences

Also known as diminishing marginal rate of substitution, this axiom simply means that averages are preferred to extremes. Given the choice of 9 apples and 1 orange, 9 oranges and 1 apple, and 5 apples and 5 oranges, the consumer will choose 5 of each. This assumption is not essential to creating well-behaved utility functions but allows for simplicity. Although generally an acceptable assumption, it is not always the case that consumers will pick averages. If a consumer goes out for a meal and budgets for two drinks, they will not necessarily have one glass of orange juice and one glass of apple juice, as this axiom suggests. They are much more likely to pick two of the same. 

Although this theory is not perfect, it is an integral part of microeconomic theory. It is right more often than it is wrong and allows producers to understand their pool of consumers much better. This is because it allows for a better understanding of demand. When we know how demand will change, i.e. due to a price increase of a product, supply can react much more efficiently and producers can either lose less money or enable their profits to surge.