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Theory of Consumer Choice and Frontiers of Microeconomics

Stacey Troup

Principles of Microeconomics/ECO-365

August 15, 2016

Ashok Padhi

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Theory of Consumer Choice and Frontiers of Microeconomics

This Week 5 final paper will serve as an analysis of consumer choice and its effect on

microeconomic trends. Included in this analysis will be an overview of the impact the Theory of

Consumer Choice has on demand curves, higher wages and interest rates. Additionally, a review

of the role asymmetric information has on many economic transactions will be done along with a

review of the Condorcet Voting Paradox and Arrow’s Impossibility Theorem. Finally, a review

of irrational behavior in economics will be done, rounding out the subject matter for this final

exam paper.

Theory of Consumer Choice

As we review the demand curves and the impact that the theory of consumer choice has

on these curves, it is important to remember that demand curves for a good reflect a consumer's

willingness to pay for it and that these curves arise naturally from the theory of consumer choice.

As prices for individual items rise, the demand curve slopes downward (or fails) reflecting a

reduced demand for the item. Alternatively, as prices for items decrease, the demand curve

increases which drives the consumption of the item up as well as the demand curve for this item

to be driven up. This reduction or increase in consumption is the foundation of the Theory of

Consumer Choice and its principles (Mankiw, 2015). Sometimes a rare instance causes a

consumer to purchase less even though the relative price of the item has fallen. This “bizarre

property” of consumption is referred to as Giffen goods (Mueller, 2004).

Within higher wages; as people earn more money, they are driven to consume more

because their budget constraints become steeper which directly correlates to the relative price

(Mankiw, 2015). For every increase in a person’s wage, a higher consumption for every hour of

leisure is earned. Additionally, disposable incomes generate a higher return to the local

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economies, driving up demand curves. As these wages are increased, the propensity to spend

more on goods or to purchase more “luxury” goods increases, thus driving up the demand curve

and creating greater equilibrium (Mueller, 2004).

Higher interest rates cause the budget constraint to shift outward and become steeper

(Mankiw, 2015). As interest rates climb, stores may be charged more to purchase the goods they

supply to consumers and those increased costs are passed on to the consumer through retail

pricing. Additionally, consumers may be charged more for their living expenses and other

consumptions as interest rates rise. As these increase in interest rates occur, budget constraints

and consumer spending decrease due to the lack of disposable income (Mankiw, 2015).

The Role Asymmetric Information has on Economic Transactions

Asymmetric information, originally developed in the 1970’s and 1980’s as a way to

explain equilibrium issues and common phenomenon (such as the Giffen goods theory) that

general economics failed to explain. Simply put, asymmetric information sets out to identify the

information imbalances between buyers and sellers in a certain market (Frieden & Hawkins,

2009) s.

Three economists were awarded the Nobel Prize in Economics for their influential work

on this subject in 2001. George Akerlof, Michael Spence, and Joseph Stiglitz each provided

their individual areas of expertise to the Asymmetric Information Theory (Ross, 2015).

Akerlof first provided information relating to the varying knowledge base differences

between car buyers and sellers and argued a theory that encouraged the idea that sellers have the

advantage of selling goods containing “less than average market quality” properties (Ross,

2015). Spence added that the value of employees is unknown to employers and referred to them

as “an uncertain investment”, sighting the uncertainty in capabilities when hiring. Adding to this

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theory he identified asymmetries between employers and employees whereby low-paying jobs

create a trap through “persistent equilibrium” which discourages increasing wages in certain

markets (Ross, 2015).

Stiglitz, however, reached the most acclaim discussing negative externalities and their

impact on the pricing of certain items in the market. The example given was a high-risk

individual and the high premiums for health insurance which are prohibitive to the buyer because

they restrict purchase due to their price (Ross, 2015).

The Condorcet (Voting) Paradox and Arrow’s Impossibility Theorem

Condorcet’s Paradox often referred to as a voting paradox, relates to preferences between

sets of choices A>B>C, and the variables and outcomes of that set of options. When transitivity

exists, you would put A vs B, B vs C and C vs A and expect A to be the overall winner.

However, when transitivity does not exist, we experience a Condorcet Paradox (Olken, 2012).

Condorcet’s Paradox contains both winners and cycles. Condorcet winner is considered

an alternative that gains the majority vote when it is paired against the other alternatives (Olken,

2012). Condorcet cycle occurs when there are transitivity violations in the social preference

ordering (Olken, 2012).

Kenneth Arrow’s ‘impossible” theorem assumes that buyers have “rational preferences

over alternatives” (Stanford University, 2014). Important to note is that Arrow’s Theorem

include the uses of unanimity, transitivity, independence of irrelevant alternatives and no

dictators (Mankiw, 2015) Defined as a “mathematical theory showing that under certain

assumed conditions there is no scheme for aggregating individual preferences into a value set of

social preferences” (Vandeem, 2014).

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Irrational Behavior in Economics

While traditional economic theory assumes that demand curves are “negatively inclined”

(Becker, 1962) based on rational behavior, causing them to be consistent and transitive, irrational

behaviors do exist.

When irrational behaviors exist, demand curves are negatively inclined. In a more recent

example of irrational behavior in economics exists the Brexit argument. According to a

University of Chicago professor who specializes in Behavioral Economics, the protestors seeking

to leave the EU are not “acting or thinking the way traditional economics would expect them to”.

The reasoning for this irrational behavior lies in the lack of analytical review of all information

and the associated costs correlating to the overall happiness of the consumer (Pfeiffer, 2016).

Economics say that the Brexit decision is a prime example of irrational behavior for this reason.

Conclusion

While several factors affect the supply and demand curves, irrational behaviors have their

own, often negative, effects on the demand curves. Informed buyers who make analytically

based decisions on their consumption based on best practices of financial health keep the demand

curve in equilibrium and represent rational behavior. Consumer choice needs to be driven by

these best practices rather than brand loyalty if the consumer is to enjoy long-term financial

health.

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Works Cited

Becker, G. S. (1962). Irrational Behavior and Economic Theory. Journal of Political Economy,

1-13. Retrieved from https://www.jstor.org/stable/1827018?

seq=1#page_scan_tab_contents

Frieden, B. R., & Hawkins, R. J. (2009). Asymmetric Information and Economics. Physica A:

Statistical Mechanics and its Applications. Retrieved from

http://www.sciencedirect.com.contentproxy.phoenix.edu/science/article/pii/

S037843710900781X

Mankiw, N. (2015). Principles of Microeconomics. Retrieved from

https://phoenix.vitalsource.com/#/books/9781305892811/cfi/6/10!/4/2/2@0:0.

Mueller, O. L. (2004). Autodetermination in Microeconomics: A Methodological Case Study on

the Theory of Demand. Analyse Und Kritik, 322-325. Retrieved from

http://search.proquest.com.contentproxy.phoenix.edu/docview/208535279/fulltextPDF/

FD95C91427BA4CAFPQ/1?accountid=458

Olken, B. (2012). Sometimes It Gets Complicated. Retrieved from MIT:

http://ocw.mit.edu/courses/economics/14-75-political-economy-and-economic-

development-fall-2012/lecture-notes/MIT14_75F12_Lec12.pdf

Pfeiffer, C. (2016, 06 21). Thaler: Brexit Shows Irrational Behavior. Retrieved from Business

Insider: http://www.businessinsider.com/thaler-brexit-shows-irrational-behavior-2016-6

Ross, S. (2015, 04 25). What is the theory of asymmetric information in economics? Retrieved

from Investopedia: http://www.investopedia.com/ask/answers/042415/what-theory-

asymmetric-information-economics.asp

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Stanford University. (2014, 10 13). Stanford Encyclopedia of Philosophy. Retrieved from

Arrow's Theorem: http://plato.stanford.edu/entries/arrows-theorem/

Vandeem, A. (2014). On the empirical relevance of Condorcet's paradox. Public Choice, 2-4.

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