Some time ago, General Mills introduced a new breakfast cereal. The new brand, Apple-Cinnamon Cheerios, was a sweetened and more flavorful variant on General Mills’ classic Cheerios product. But before Apple-Cinnamon Cheerios could be extensively marketed, the company had to resolve an important problem: How high a price should it charge? No matter how good the cereal was, its profitabil- ity would depend on the company’s pricing decision. Knowing that consumers would pay more for a new product was not enough. The question was how much more. General Mills, therefore, had to conduct a careful analysis of consumer preferences to determine the demand for Apple-Cinnamon Cheerios.
General Mills’ problem in determining consumer preferences mirrors the more complex problem faced by the U.S. Congress in eval- uating the federal Food Stamps program. The goal of the program is to give low-income households coupons that can be exchanged for food. But there has always been a problem in the program’s design that complicates its assessment: To what extent do food stamps pro- vide people with more food, as opposed to simply subsidizing the purchase of food that they would have bought anyway? In other words, has the program turned out to be little more than an income supplement that people spend largely on nonfood items instead of a solution to the nutritional problems of the poor? As in the cereal example, we need an analysis of consumer behavior. In this case, the federal government must determine how spending on food, as opposed to spending on other goods, is affected by changing income levels and prices.
Solving these two problems—one involving corporate policy and the other public policy—requires an understanding of the theory of consumer behavior: the explanation of how consumers allocate incomes to the purchase of different goods and services.
How can a consumer with a limited income decide which goods and services to buy? This is a fundamental issue in microeconomics—one that we address in this chapter and the next. We will see how con- sumers allocate their incomes across goods and explain how these allocation decisions determine the demands for various goods and services. In turn, understanding consumer purchasing decisions will help us to understand how changes in income and prices affect the demand for goods and services and why the demand for some products is more sensitive than others to changes in prices and income.
Consumer behavior is best understood in three distinct steps:
- Consumer Preferences: The first step is to find a practical way to describe the reasons people might prefer one good to another. We will see how a consumer ’s preferences for various goods can be described graphically and algebraically.
- Budget Constraints: Of course, consumers also consider prices. In Step 2, therefore, we take into account the fact that consumers have limited incomes which restrict the quantities of goods they can buy. What does a consumer do in this situation? We find the answer to this question by putting consumer preferences and budget constraints together in the third step.
- Consumer Choices: Given their preferences and limited incomes, consum- ers choose to buy combinations of goods that maximize their satisfaction. These combinations will depend on the prices of various goods. Thus, understanding consumer choice will help us understand demand—i.e., how the quantity of a good that consumers choose to purchase depends on its price.
These three steps are the basics of consumer theory, and we will go through them in detail in the first three sections of this chapter. Afterward, we will explore a number of other interesting aspects of consumer behavior. For example, we will see how one can determine the nature of consumer preferences from actual observations of consumer behavior. Thus, if a consumer chooses one good over a similarly priced alternative, we can infer that he or she prefers the first good. Similar kinds of conclusions can be drawn from the actual decisions that consumers make in response to changes in the prices of the various goods and services that are available for purchase.
At the end of this chapter, we will return to the discussion of real and nomi- nal prices that we began in Chapter 1. We saw that the Consumer Price Index can provide one measure of how the well-being of consumers changes over time. In this chapter, we delve more deeply into the subject of purchasing power by describing a range of indexes that measure changes in purchasing power over time. Because they affect the benefits and costs of numerous social-welfare programs, these indexes are significant tools in setting government policy in the United States.
WHAT DO CONSUMERS DO? Before proceeding, we need to be clear about our assumptions regarding consumer behavior, and whether those assump- tions are realistic. It is hard to argue with the proposition that consumers have preferences among the various goods and services available to them, and that they face budget constraints which put limits on what they can buy. But we might take issue with the proposition that consumers decide which combinations of goods and services to buy so as to maximize their satisfac- tion. Are consumers as rational and informed as economists often make them out to be?
We know that consumers do not always make purchasing decisions rationally. Sometimes, for example, they buy on impulse, ignoring or not fully accounting for their budget constraints (and going into debt as a result). Sometimes consumers are unsure about their preferences or are swayed by the consumption decisions of friends and neighbors, or even by changes in mood. And even if consumers do behave rationally, it may not always be fea- sible for them to account fully for the multitude of prices and choices that they face daily.
Economists have recently been developing models of consumer behavior that incorporate more realistic assumptions about rationality and decision making. This area of research, called behavioral economics, has drawn heav- ily from findings in psychology and related fields. We will discuss some key results from behavioral economics in Chapter 5. At this point we simply want to make it clear that our basic model of consumer behavior necessarily makes some simplifying assumptions. But we also want to emphasize that this model has been extremely successful in explaining much of what we actually observe regarding consumer choice and the characteristics of con- sumer demand. As a result, this model is a basic “workhorse” of economics. It is used widely, not only in economics, but also in related fields such as finance and marketing.
Source: Pindyck Robert, Rubinfeld Daniel (2012), Microeconomics, Pearson, 8th edition.