The Modern Theory of Consumer Behavior - Term Paper Example

Saqor Al-kaabi Consumer Behavior Fall - Econ 202-002 Dr. Martin H. Sabo Introduction Economics is a branch of social science and deals with production, consumption as well as distribution of services and goods. Macroeconomics and microeconomics are the two branches of economics. The basic elements of the economy are the main concerns in microeconomics. The agents involved in microeconomics are the households and the firms. Microeconomics can be defined as the study that analyses the actions of the individual players and the market structure where the agents operate. Microeconomics takes into consideration the private, domestic as well as public players. The various market structures that are discussed within microeconomics are perfect competition, monopoly, monopolistic competition, and oligopoly. One of the objectives of microeconomics is to analyze the mechanisms of market. Microeconomics sets up the relative prices amongst the services and the goods and allocates the available amount of limited resources among the alternative uses. Some of the significant fields of study under this branch of economics include asymmetric information, general equilibrium, game theory and choices under uncertainty. Consumer behavior All wealth that fulfills the wants of consumers constitutes the wealth of a nation. Therefore, the aim behind expanding wealth is broadening the choices of the consumers in terms of quality, quantity and variety. Economists are involved in researches on the idea of free market with socially optimal allocation. The notion of competition constitutes the central part of economic theory. The objects of the choices available to the consumer are called the consumption bundle. The consumer has the objective of maximizing the well being. They are well informed about the availability of the goods in the market and desires variety in their consumption bundle. There are two sets of consumption bundles (x1, x2) and (y1, y2). The consumer ranks the availabilities according to their affordability. When the consumer is just satiated consuming the bundle of x goods as compared to the satisfaction he would have earned consuming the other bundle of y goods, according to his own preferences, then it is said that the consumer is indifferent. The axioms of consumer theory are complete, reflexive and transitive (Samuelson, 1956. p.3). The two axes represent a typical consumption pattern of goods 1 and 2. A consumption bundle (x1, x2) is offered along with the other bundles of consumption that are weakly preferred to the selected bundle. The other consumption bundles are called the weakly preferred sets. The indifference curve is formed by the bundles forming the boundary of the selected set i.e. the bundles that will provide the consumer as much satisfaction as the selected bundle. The indifference curve can be drawn through any consumption bundle. One of the disadvantages of using the indifference curve analysis is that it perceives only that consumption bundle chosen by the consumer being indifferent. It fails to depict the bundles which are better or worse. One of its characteristic is indifference curve that represents distinct preferential levels cannot cross. The marginal rate of substitution is the rate at which the consumer likes to substitute goods. It is derived from the slope of the indifference curve. (Varian, 2006, p. 48). Let the budget constraint of the consumer be p1x1+p2x2=m. p1 and p2 are the prices of x1 and x2 respectively while m is the income of the consumer. Let the consumption of good 1 is taxed at rate t. Therefore, the new budget constraint will be as follows: (p1+t)x1+p2x2=m. The effects of the change in price in demand conditions are shown in the figure below. But the effects of the tax on the consumption level are not certain. It is uncertain whether the consumption of the taxable good will increase or decrease. The optimal choice of the consumer must satisfy the budget constraint. (p1+t)x1*+p2x2*=m, x1* and x2* are the optimal choices. The set of consumption bundles that is preferred by the consumer to the optimal choice is below the indifference curve while the set of bundles that is against the affordability is above the indifference curve. So the optimal choice is the best bundle that can be chosen by the consumer. An income tax raises the revenue by the same amount as tax. The effects of income tax on the budget constraint will be as follows: p1x1+p2x2=m-tx1*, where tx1* is the rise in revenue because of tax. The new budget constraint has the same slope as the original budget constraint. The budget line with income tax passes through the optimal choice of the consumer. This establishes the fact that (x1*, x2*) lies on the income tax budget line. But it is not the optimal choice of the consumer. There is some point on the budget line that is preferred to (x1*, x2*) as the budget line cuts the indifference curve t (x1*, x2*). There are two axioms of revealed preference theory, the strong axiom (SARP) and the weak axiom (WARP). The latter states that if a bundle of x-goods is directly revealed preferred to the y-bundle and the two bundles are distinct, then it will not be the case where q1y1+q2y2 is greater than or equal to q1x1+q2x2, (q1, q2) being the prices of the y-bundle consisting of two goods y1 and y2 (Barnett II, 2003, p. 42). Let us consider the table below: Observation p1 p2 x1 x2 1 1 2 1 2 2 2 1 2 1 3 1 1 2 2 Cost of each bundle at each set of prices: Bundles Prices The diagonal terms in the above table shows the required amount of spending of the consumer at each choice. It can be said whether any bundle is revealed preferred to the other. In the above case, bundle 3 was purchased when bundle 1 is affordable. This implies that bundle 3 is revealed preferred to bundle 1. This is shown with the star sign. This is a violation of WARP. It can be concluded that a consumer who has stable preferences cannot generate the data in the above tables as he always chooses the best affordable goods. SARP states that if x-bundle revealed preferred to y-bundle either in direct or indirect fashion and the two bundles are distinct, then it will not be the case where the same y-bundle is revealed preferred to x-bundle either directly or indirectly. Bundles Prices Bundle 1 is revealed preferred directly to bundle 2 and again bundle 2 is revealed preferred directly to bundle 3. This implies that bundle 1 is indirectly revealed preferred to 3. This is indicated by the star in the parenthesis. Income and Substitution effects The substitution effect is defined as the change in demand due to the change in the exchange rate between the two goods while the income effect is defined as the change in demand for a good due to an adjustment in purchasing power of the consumers. The movement in prices is of two folds. In the first case the relative price changes keeping the purchasing power as constant and income adjusts accordingly while in the second case the relative prices are kept constant and the purchasing power changes. Let the price of good 1 decrease. The budget line gets flatter as a result. The pivoted budget line has the same slope as the original budget line and that is the reason for the relative prices to remain the same as well. The vertical intercept changes as the amount of income associated with two budget lines differ. In this case the original consumption bundle (x1,x2) is just affordable. Taking the pivoted line into consideration, the purchasing power has remained the same and same consumption bundle is affordable to the consumer. The money income that will make the original consumption bundle just affordable be m1. It is also the income associated with the original budget line. Therefore, m1=p11x1+p2x2 and m= p1x1+p2x2 as the original consumption bundle is affordable at (p1, p2, m) and (p11, p2, m1). So, m1-m= x1[p11- p1]. Thus it can be concluded to make the new consumption bundle is affordable at new prices a change in income is necessary. There will be negative adjustments if the price goes down. When the price level rises, the purchasing power goes down and a positive income change is necessary to keep the purchasing power at constant level. The original consumption bundle is not the optimal choice of the consumer is spite of the bundle being affordable at the pivoted budget line. The optimal budget line is denoted in the diagram with Y. This bundle of goods is the optimal bundle of goods when price changes and income adjusts to keep the old bundle affordable. The movement from X to Y is called the substitution effect. When income changes and relative prices are at the constant level there will be a parallel shift of the budget line. The income of the consumer changes from m1 to m which keeps the prices constant at (p11, p2). The figure depicts the movement from (y1, y2) to (z1, z2). This movement is called the income effect since the income level changes while the prices are still constant at the new level. More precisely, income effect, Δ x1n, is the change in demand for good 1 when there is a change in income from m1 to m, holding the price of good 1 at p11. Δ x1n= x1(p11, m)- x1(p11, m1). Suggested areas of further research The researchers can group the respondents according to income class. Then select a commodity that is necessary for all the income class. It is important the commodity to be a necessity for people for all levels of income since it is a necessity for some while a luxury for others, proper inference cannot be derived. The research will be conducted by changing the price of the commodity selected. The objective of the research will be to magnify the effects of the price change on different levels of income. The proportionate effect on demand conditions from all levels of people can also be judged from the study. Such researches will provide the researchers a rough idea on how a price change affects the different levels of people. It can be anticipated that the price change will affect the people in lower levels of income more than the people belonging to the upper class. Conclusion The income effect can act in either way. The income effect acts either to increase or decrease the demand for a certain good depending on whether the good is normal or inferior. If the good is considered to be normal, then a decrease in income will decrease the demand for the good. In case of substitution effect, a fall in the price of a good will brings a change in the demand conditions for the good and the substitution effect must be non negative. If p1> p11, then x1(p11, m1) is greater than equal to x1(p1, m), so that Δ x1s is greater than equal to zero. The substitution effect directs in opposite direction to the price effect. The change in demand conditions, due to substitution effect is opposite to the change that incurs because of price effect and therefore it can be said substitution effect is negative. The demand for a certain good due to substitution effect falls if there is increase in the price. Works Cited Samuelson, P. Social Indifference curves. Web. 1956. Retrieved From: http://gatton.uky.edu/faculty/hoytw/751/articles/samuelsonsic.pdf. Print. Varian, H. Intermediate Microeconomics. 7th Edition. Web. 2006. Affiliated East-West Press Private Limited. Barnett II. W. The Modern Theory of consumer behavior: ordinal or cardinal?. Web. 2003. Retrieved From: http://mises.org/journals/qjae/pdf/qjae6_1_3.pdf. Print. Read More