BEHIND THE DEMAND CURVE: THE THEORY OF CONSUMER CHOICE
Here, the purpose is to explain the derivation of the demand function and to provide an understanding of the consumer decision-making process.
Individuals make choices based on their personal tastes and preferences. Tastes and preferences are shaped by many factors. Some of the factors are family environment, physical condition, age, sex, education, religion, and location. In the analysis that follows, tastes and preferences will be viewed as a given, and discussion will focus on how those tastes and preferences are transformed into consumption decisions. Bundle B
2 units of X
6 units of Y
5 units of X
2 units of Y
In the well-established tradition of economics, four basic assumptions are made developing the theory of consumer choice. First, it is assumed that individuals can rank their preferences for alternative bundles of goods and services. Consider a world in which only two goods X and Y are available. Suppose that a consumer is confronted with the following combinations of those two goods: Bundle C
4 units of X
4 units of Y
The ability to rank means that the individual can assess the relative amount of satisfaction that would result from each bundle of goods. For example, suppose that B is considered the most desirable bundle, and that C and A are viewed as providing equal but lesser amount of satisfaction than B. Using the terminology of the theory of consumer choice, it is said that B is preferred to both C and A, and that the consumer is indifferent between C and A. Bundle D
3 units of X
7 units of Y
The second assumption is non-satiation. This means that individuals consider themselves better off if they have more of a good or service than if they have less. Consider bundle D that consist of
The non-satiation assumption implies that this bundle would be preferred to bundle B because it includes more X and more Y. Transitivity is the third assumption. It can be thought of as requiring that preferences be consistent. Transitivity stated that if bundle D is preferred to bundle B and if B is preferred to both A and C, bundle D must be preferred to bundles A and C.
Finally, it is assumed that in order to get additional unit of one good, consumers are willing to give-up successively fewer units of other goods. For example, a consumer may be willing to give up the purchase of five units of Y to obtain the first unit of X. However, if the person already has three units of X, the value of another unit of X in terms of Y is likely to be less than 5 units. Key Concepts
Four assumptions form the basis for the theory of consumer choice. They are 1. Individuals can rank their preferences
2. Non-satiation – people prefer more to less
3. Transitivity – ranking are consistent
Recall that bundles A and C were viewed as being equally desirable. That is, an individual would be indifferent to having A rather than C. Now suppose that other bundles, designated as E, F, G and H, are also considered equivalent to A and C. If these bundles are plotted on a graph as shown in Figure – 1, the points can be joined to form an indifference curve that represents all bundles of goods that provide an individual with equal levels of satisfaction. Units of Y
Units of X
Figure - 1
Note that Figure – 1 shows several indifference curves. All points on the curve through B are considered equivalent to that bundle. Because B is preferred to A, the assumption of transitivity guarantees that all the points on the indifference curve passing through B are preferred to all the points on the curve passing through A. Similarly since D provides more satisfaction than B, all points on the curve passing through D are preferred to those on the curve passing through B and C. Because of non-satiation higher indifference curve denote higher...