The standard
economic model assumes humans behave rationally and seek to maximize utility subject to
the constraint of limited income.
Increased consumption raises total utility up to a point but marginal
utility falls as consumption increases and is called the law of
diminishing marginal utility.
A consumer’s budget constraint shows the possible combinations
of different goods he can buy given his income and the prices
of the goods. The slope of the budget constraint equals the
relative price of the goods.
The consumer’s indifference curves represent his preferences. An
indifference curve shows the various bundles of goods that
make the consumer equally happy. Points on higher indifference
curves are preferred to points on lower indifference curves. The slope of an indifference
curve at any point is the consumer’s marginal rate of substitution – the rate at which the
consumer is willing to trade one good for the other.
The consumer optimizes by choosing the point on his budget constraint
that lies on the highest indifference curve. At this point, the
slope of the indifference curve (the marginal rate of
substitution between the goods) equals the slope of the budget
constraint (the relative price of the goods).
When the price of a good falls, the impact on the consumer’s choices can
be broken down into an income effect and a substitution effect. The income
effect is the change in consumption that arises because a lower price makes the consumer better off.
The substitution effect is the change in consumption that arises
because a price change encourages greater consumption of the good that has become
relatively cheaper. The income effect is reflected in the movement from a lower to a higher
indifference curve, whereas the substitution effect is reflected by
a movement along an indifference curve to a point with a different
slope.
The study of psychology and economics reveals that human decision
making is more complex than is assumed in conventional economic theory. People are not
always rational, they use rules of thumb (heuristics) and are influenced by the way in which
information is presented (framing effects) which may alter the
outcomes suggested by expected utility theory.
The product differentiation inherent in imperfectly competitive markets
leads to the use of advertising and brand names. Critics of
advertising and brand names argue that firms use them to take
advantage of consumer irrationality and to reduce
competition. Defenders of advertising and brand names argue
that firms use them to inform consumers and to compete more
vigorously on price and product quality.
In many economic transactions, information is asymmetric. When there
are hidden actions, principals may be concerned that agents
suffer from the problem of moral hazard. When there are
hidden characteristics, buyers may be concerned about the
problem of adverse selection among the sellers. Private
markets sometimes deal with asymmetric information with
signalling and screening.
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