2. CONSUMER THEORY: FROM PREFERENCES TO DEMAND FUNCTIONS

The introduction to demand and supply analysis in the previous reading basically assumed that the demand function exists, and focused on understanding its various characteristics and manifestations. In this reading, we address the foundations of demand and supply analysis and seek to understand the sources of consumer demand through the theory of the consumer, also known as consumer choice theory. Consumer choice theory can be defined as the branch of microeconomics that relates consumer demand curves to consumer preferences. Consumer choice theory begins with a fundamental model of how consumer preferences and tastes might be represented. It explores consumers’ willingness to trade off between two goods (or two baskets of goods), both of which the consumer finds beneficial. Consumer choice theory then recognizes that to consume a set of goods and services, consumers must purchase them at given market prices and with a limited income. In effect, consumer choice theory first models what the consumer would like to consume, and then it examines what the consumer can consume with limited income. Finally, by superimposing what the consumer would like to do onto what the consumer can do, we arrive at a model of what the consumer would do under various circumstances. Then by changing prices and income, the model develops consumer demand as a logical extension of consumer choice theory.

Although consumer choice theory attempts to model consumers’ preferences or tastes, it does not have much to say about why consumers have the tastes and preferences they have. It still makes assumptions, but does so at a more fundamental level. Instead of assuming the existence of a demand curve, it derives a demand curve as an implication of assumptions about preferences. Note that economists are not attempting to predict the behavior of any single consumer in any given circumstance. Instead, they are attempting to build a consistent model of aggregate market behavior in the form of a market demand curve.

Once we model the consumer’s preferences, we then recognize that consumption is governed not only by preferences but also by the consumer’s budget constraint (the ability to purchase various combinations of goods and services, given his or her income). Putting preference theory together with the budget constraint gives us the demand curve we are seeking. In the following sections, we explore these topics in turn.