Consumer Theory

What is 'Consumer Theory'

Consumer theory is the study of how people decide to spend their money, given their preferences and budget constraints. A branch of microeconomics, consumer theory shows how individuals make choices, given restrains, such as their income and the prices of goods and services. Through consumer theory, we are better able to understand how individuals’ tastes and incomes influence the demand curve. These choices are among the most critical factors, shaping the overall economy.

BREAKING DOWN 'Consumer Theory'

Consumers are able to choose different bundles of goods and services; logically, they choose those, which bring the greatest benefit (that maximizes utility, in economic terms). Working through examples and/or cases in consumer theory usually requires the following inputs: a full set of consumption options; how much utility a consumer derives from each bundle in the set of options; a set of prices, assigned to each bundle; and any initial bundle the consumer currently holds.

Example of Consumer Theory

For example, consider a consumer, Kyle, who has $200 (his budget constraint), who must choose how to allocate his funds between pizza and video games (the bundle of goods). If pizzas cost $10 and video games cost $50, Kyle can purchase any combination of pizzas and video games that costs no more than $200. He could buy 20 pizzas, or 4 video games, or 5 pizzas and 3 video games, or he could keep all $200 in his pocket. But how can an outsider predict how Kyle is most likely to spend his money? Consumer theory can help give an answer to this question.

Limitations of Consumer Theory

Challenges to developing a practical formula for this situation are numerous: people are not always rational; occasionally they are indifferent to the choices available; some decisions are particularly difficult to make, because consumers are not familiar with the products, or the decision has an emotional component, not able to be captured in an economic function. Consumer theory therefore makes several assumptions to simplify the process. For example, in Kyle’s case (above), economics can assume he understands his preferences for pizza and video games and can decide how much of each he wants to purchase. It also assumes there are enough video games and pizzas available for Kyle to choose the quantity of each he desires.