Consumer Theory and Decision Theory - Essay Example

? Consumer theory primarily relates to consumer choice, where consumer choice is a microeconomics theory that links the preferences over consumption of goods and services to the expenditure entitled to these and hence, to consumer demand curves. Given the law ‘ceterus paribus’ of economics, a typical consumer demand curve shows, with all other factors constant an individual will consume more of a good or a service when its price falls and lesser of it if the price rises. Consumer choice is a basic way of analyzing how equilibrium between preferences and expenditures can be achieved by consumers by maximizing utility in regard to their budget constraints. Two important terms to understand here are utility and budget constraints. In raw economic terms, utility is a measure of consumer satisfaction, that is, how much satisfaction a consumer derives from the consumption of a good or a service. Budget constraint on the other hand represents the combination of goods or services an individual can consume or purchase in consideration to given prices with his or her limited income. Combining the two concepts forms the foundation of consumer theory. The utility theory provides a methodological framework whereby usually, all individuals, organizations and firms evaluate given options. Utility is a term used to describe the satisfaction that each of the given options provide to the one making the decision. Hence, the basis of the utility theory is that each individual will choose that option which tends to maximize utility, working on what is called the ‘maximization principle’. This principle states that the most desirable choice is the one with the highest level of satisfaction. However, while making these decisions, the individual must also consider his income earned along with the respective prices of the goods and services in question. Every rational consumer would want more of a product as its price falls to maximize the utility derived from the consumption of the product. It is assumed that Utility can be quantified fully when analyzing consumer behavior. Utility can be of two different types; total utility and marginal utility. Total utility measures the total consumption benefit derived from the consumption of a given number of units of a product. Total utility continuously rises as consumption increases. This rise becomes smaller as more units of a product are consumed, it can also decline after a certain level of consumption. On the other hand, marginal utility measures the change in consumption benefit as a result of consuming one more or one less unit of a product. In other words, marginal utility tracks the change in total utility as the number of units consumed changes. The behavior of marginal utility is such that it tends to fall continuously as consumption of a product increases. This is because the first few units consumed of a product provide a higher level of satisfaction than the later few. For example, the first drink of water is worth a lot more to a thirsty individual than his seventh one. For a consumer to be in equilibrium certain conditions need to be met. The consumers are assumed to be rational in their decision whereby they aim to maximize the utility derived from the consumption of any product. It is also assumed that consumers have limited incomes and that the value of utility can be quantified in monetary terms. The equi-marginal principle states that a consumer will be in equilibrium if it is not possible to switch expenditure from good X in favour of good Y to achieve an increase in total utility. In other word this principle is satisfied when the marginal utility of every dollar spent on a good is equal to the price paid for that good. If a basket of goods is in question, an individual will continue to alter the mix of consumption of the products until the marginal utility of a dollar spent on each of the goods is equal. Therefore, the equilibrium principle can be expressed as MUx/Px=MUy/Py, where MU is the marginal utility and P is the price of the good. Consumer behavior is affected by changes in price. Bringing about a change in price is beyond the control of an individual consumer. Therefore, a rational consumer will again alter his purchases of any two goods or basket of goods until such a time that the marginal utility of a dollar spent on each good is the same (Fishburn, P. C. ,1970). The law of demand states that a consumer buys more of a good as its price falls and vice versa. This is so, because a decline in the price of a good will enhance the individuals purchasing power with respect to that good and increase consumption. Another reason for an increase in consumption can be that an individual will prefer a cheaper substitute good in favour of the one that sells for a higher price. As consumption of a good increases its marginal utility decreases and as a result of this decline consumers are only willing to pay a much lesser price as compared to what they paid for the first unit of consumption. This implies that the demand curve is a downward sloping one with a negative slope. This slope reflects the diminishing nature of marginal utility. Therefore an individual’s cure can be derived from a marginal utility curve or schedule. Every consumer faces certain constraints when making consumption decision. These constraints can be classified primarily as income of the consumer, and the prices of the goods and services which the consumer plans to purchase. The constraints are reflected on a budget line which shows all the possible combinations of two goods or consumption bundles that a consumer can purchase with a given income level and fixed prices. Whenever a consumer buys a combination of goods which lies on the budget lines he is considered to be maximizing his consumption for a given income level and hence, utility. Any point below or within the budget line represents a less than maximum consumption with the given income level. In the utility theory we also assume that the investor is willing to let go of one choice for some other choice. This explains the marginal rate of substitution. In a situation where the assumption is made that the investor will be willing to take a higher risk in hopes of higher returns on his/her investment, the investor would do this to an extent which is called the saturation point. At the saturation point, the investor would no longer be willing to invest at a higher risk, bringing the marginal rate of substitution to zero. ( Kauder, E. ,1965). Karl popper stated that a theory should be considered scientific if and only if it is falsifiable. The term "falsifiable" does not mean something is made false, but rather that, if it is false, it can be shown by observation or experiment. In accordance to Karl Popper’s conception of science, the utility theory cannot be categorized as scientific. The utility theory is based on empirical findings which have been proven time and again in regard to human behavior referring to consumption patterns and expenditure schedules. Since, the utility theory is not falsifiable, it cannot be termed as scientific with respect to Popper’s ideologies. However, parts of the utility theory are based on assumptions and can be subjected to questioning. According to Kuhn’s stance, the characterization of what is known as normal science is primarily based on the imperfections and the gaps of the current data-theory. According to Popper, all theories would be rejected if failure to fit were to be the basis of rejecting theories. Hence, according to Kuhn, the utility theory can be categorized as a scientific one. Kuhn came up with the concept of paradigm to support scientific theories, a paradigm guides the research efforts of scientific communities, and it is this criterion that most clearly identifies a field as a science. Since the implications underlying the utility theory can be formulated in a given paradigm, it can be classified as a scientific concept according to Kuhn’s conception of science. As far as Lakatos is concerned, rather than questioning whether the hypothesis is true or false, Lakatos concentrated on the question of how one research program compares to another, giving it a rational basis for preference. Lakatos said that some research programs might be progressive in nature where as its rivals might be degenerating in nature. A research program which is progressive in nature can be identified by the growth, discovery of new facts, new experimental technique, etc. On the other hand a degenerating research program is one in which there is a lack of growth and lack of generation of novel facts or ideas. Hence, according to Lacatos, utility theory can be a defined as scientific because even in the face of alternative theories, the utility theory will hold its place. Various criticisms have been raised from early 1950’s. one of these criticisms is the incorrect interpretation of what maximum expected utility is. A very famous example of the decision rule pertaining to the short run can be stated to explain it better. An individual makes a bet over the flipping of a coin, with a gain of $200 and a loss of $100. An individual may claim that the loss would be felt more than the gain even if it of a lower amount, unless he is allowed to make a hundred of the same bets. This is to show that for the long run and the short run, decision rules may vary for the one making the decision. The famous American economist, Paul Samuelsson said that the decision rule, instead of maximizing expected utility, focuses more on the probability of gain as the basis to making a decision. The utility approach has been extensively criticized ever since its conception. Today critics deny that households maximize any functions or that any function maximized is consistent or transitive. They deny that households act rationally, since rational behavior is now taken to signify maximization of a consistent or transitive function. Gary Becker was an early proponent of applying rational actor models more widely. Rational choice theory narrows down the definition of ‘rationality’, meaning that an individual weighs the cost against the benefits which maximizes their personal advantage. This is similar to the utility theory whereby an individual’s preferences lie where maximum satisfaction is achieved. Hence Gary Becker’s standpoint would refute the criticisms of the utility theory, as it relies on the assumption that an individual consumer is rational. Alternative paradigms to the utility approach exist, for example, the Decision Theory. Decision theory as described in the study of economics deals with highlighting the uncertainties, problems that may arise while making a decision and other relevant obstructions that may be present when making a decision, the rationality, and lastly the best possible decision. A famous criticism on the decision theory is that it only takes into account the expected variations and disregards the unforeseen events, which gives rise to the argument (as in black swan theory) that these unforeseen events have great importance and should be considered. The ‘ludic fallacy’, which is the name given to this argument, points out that these events are unavoidable and the real world cannot be analyzed on a few models and blindly following these models, limits an individual. (White, D. J. ,1969) BIBLIOGRAPHY 1) Fishburn, P. C. (1970). Utility theory for decision making. New York: Wiley. 2) Kauder, E. (1965). A history of marginal utility theory. Princeton, N.J: Princeton University Press 3) White, D. J. (1969). Decision theory. Chicago: Aldine Pub. Co. Read More