Consumer theory explains how consumers make purchasing decisions based on their income and preferences. Consumers aim to maximize the benefit they receive for the money they spend, but are limited by their budget constraint. The theory also considers the substitution and income effects on consumer behavior.
Consumer theory is a theory in economics that tries to explain the relationship between a consumer’s purchasing choices and income. The idea behind consumer theory is that consumers will try to buy the products that will give them the highest levels of benefit or enjoyment for the amount of money they can afford to spend. With a limited budget, they will buy less expensive products if prices rise and more expensive if prices fall. Likewise, they will buy more expensive products if their income increases and less expensive products if their income decreases. Consumers make these decisions in an effort to maximize the benefit they receive for the money they spend.
The theory assumes that consumers will spend only the money they actually have and does not account for saving money. This is called a budget constraint. According to consumer theory, the budget constraint will affect consumer spending decisions by limiting their choices. If a consumer can spend only the money he has, then any option that costs more should be eliminated. For example, when purchasing a refrigerator with a budget of $800 US Dollars (USD), a consumer will choose the best model for that amount or less, but will not choose a model that costs $900 USD.
Next, consumer theory looks at preferences. In general, the theory assumes that the consumer prefers a group of packaged products, commonly referred to as a bundle. A consumer will often prefer a package without regard to the brand, but will instead base a purchase decision on something like the number of products in the package or the size of the package. For example, a consumer might prefer a pack of extra-large bottles of brand A shampoo and conditioner to a pack of smaller bottles of brand B shampoo and conditioner. However, if the bottles are the same size, the consumer may not have a preference for either brand, which is called indifference.
Consumer theory also looks at a factor called the substitution effect. This factor states that if the price of a product rises, the consumer will have to choose to buy less or substitute a less expensive product to buy the desired quantity. In most cases, the consumer will substitute the less expensive product when faced with this choice. For example, if the consumer usually buys a particular brand of coffee and the price goes up, they will probably switch to a less expensive brand of coffee. Alternatively, if prices fall, the consumer may choose to buy more of the less expensive brand, but will typically switch to their preferred, more expensive brand.
The income effect is another factor in consumer theory. The income effect indicates that if the consumer’s income increases, he or she will be able to buy more of a desired product. The consumer could also choose to substitute a different product that was previously too expensive for their budget.
An example of the income effect would be if a woman generally buys a certain brand of handbag because the brand is within her budget, but she really wants a more expensive brand of handbag. If her income increases, she will generally switch brands and buy the desired, more expensive brand. Conversely, if the consumer’s income declines, she will typically switch to a less expensive brand.
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