Theory of Consumption

Group 9 Report by:

Mikhail Dy / Shaneika Ho / Kenneth Visto

What is the Theory of Consumption?

Consumer theory is the study of how people decide to spend their money based
on their individual preferences and budget constraints. A branch of microeconomics,
consumer theory shows how individuals make choices subject to how much income
they have available to spend and the prices of goods and services.

Understanding Consumer Theory

Consumer theory seeks to predict their purchasing patterns through the 3 steps:
1. Consumer preference - indifference curve/map
Based on 3 main assumptions:
A. Completeness - implies that consumers can rank all combinations
of goods available to them
B. Transitivity - asserts that if a consumer prefers Bundle A to Bundle
B, and Bundle B to Bundle C, then the consumer will also prefer
Bundle A to Bundle C. This assumption is essential for rational
consumer decision-making
C. Non-satiation - Otherwise known as the "more is better"
assumption, non-satiation implies that given two bundles of goods,
consumers will prefer the bundle offering more of at least one good
and no less of other goods
2. Budget constraints - budget line
3. Consumer decisions - maximizing utility (level of satisfaction) subject to a
constraint

1. Consumer Preference

What is an Indifference Curve?

A device used in contemporary microeconomics to demonstrate consumer
preference and the limitations of a budget. An indifference curve is used by
economists to explain the tradeoffs that people consider when they encounter
two goods that they wish to buy.

What is indifference?
- Indifference exists when a consumer gains equal satisfaction from the
consumption of certain combinations of goods or services and prefers
neither combination to the other. Meaning all choices give equal util to the
consumer.
 Composed of the following:
a. Market Basket
- A market basket is a selected mix of goods and services that
tracks the performance of a specific market or segment.
b. Indifference Curve
- An indifference curve is a graph used in economics that
represents when two goods or commodities would give a
consumer equal satisfaction and utility. It contains 2 or more
market baskets.
c. Indifference Map
- The Indifference Map refers to a set of Indifference Curves
that reflects an understanding and gives an entire view of a
consumer's choices. It contains 2 or more indifference
curves.

Characteristics of an Indifference Curve:

- Downward sloping curve
- Convex curve
- 2 or more market basket

Characteristics of an Indifference Map:

- Downwards sleeping curve
- Convex Curve
- 2 or more indifference curve
- Curves do not intersect
2 types of Utility / Utill:

1. Ordinal - generates a ranking of market baskets from most to least preferred

Rank Market Basket

1 C

2 A&B

3 D

2. Cardinal - how much one market basket is preferred to the other

(A vs C): C is more preferred

(D vs B): B is more preferred

2. Budget Constraints

What is the Budget Line?

The budget line, also known as the budget constraint, is a graphical
portrayal of all possible combinations of two commodities that a customer can
manage to afford at the provided market prices and within the particular earning
degree.

Example of a Budget Line:

Radha has P50 to buy a biscuit. She has a few options to allocate her income so
that she receives maximum utility from a limited salary. A Cream biscuit is P10/pk and a
plain buiscuit is P5/pk.
 Budget Line

Combination Cream biscuit Plain biscuit Budget allocation

A 0 10 10 × 0 + 5 × 10 =
50

B 1 8 10 × 1 + 5 × 8 =
50

C 2 6 10 × 2 + 5 × 6 =
50

D 3 4 10 × 3 + 5 × 4 =
50

E 4 2 10 × 4 + 5 × 2 =
50

F 5 0 10 × 5 + 5 × 0 =
50

To get an appropriate budget line, the budget schedule given can be outlined on a
graph.
 3. Consumer Decision
It’s the process by which consumers become aware of and identify their
needs; collect information on how to best solve these needs; evaluate alternative
available options; make a purchasing decision; and evaluate their purchase.
Here are the 5 steps of consumer decision that are basically used by the
consumers.

STEP 1
Need recognition (awareness):

The first and most important stage of the buying process, because every sale begins
when a customer becomes aware that they have a need for a product or service.

STEP 2
Search for information (research):

During this stage, customers want to find out their options on what a certain product
they buy contains features and other benefits.

STEP 3
Evaluation of alternatives (consideration):

This is the stage when a customer is comparing options to make the best choice like
how can they use a certain product to be more complex.

STEP 4
Purchasing decision (conversion):

During this stage, buying behavior turns into action – it’s time for the consumer to buy,
for example, like in the stock market investors know how to determine when to buy and
when to sell for their own benefit.

STEP 5
Post-purchase evaluation (re-purchase):

After making a purchase, consumers consider whether it was worth it, whether they will
recommend the product/service/brand to others, whether they would buy again, and
what feedback they would give.
Final Output of the 3 steps

Market basket E is the consumer choice/decision because market basket E is in line

with consumer budget and satisfaction of desired goods.
Conclusions

KEY TAKEAWAYS
● Consumer theory is the study of how people decide to spend their money based
on their individual preferences and budget constraints.
● Building a better understanding of individuals’ tastes and incomes is important
because these factors impact the shape of the overall economy.
● Consumer theory is useful but not flawless, as it is based on a number of
assumptions about human behavior.

Sources:

Liberto, D. (2023, March 24). Consumer Theory: Definition, meaning, objective, and example.

Investopedia. https://www.investopedia.com/terms/c/consumer-theory.asp

Consumer preferences. (n.d.). StudySmarter UK.

https://www.studysmarter.co.uk/explanations/microeconomics/consumer-choice/consum

er-preferences/

Admin. (2022, January 27). Budget Line: Meaning, definition, example. BYJUS.

https://byjus.com/commerce/budget-line/?fbclid=IwAR3v9crXfEHSprTml8yRdJOLXCP-c

KSISIfgwiFRzMOimf2dy9qCOzAq5rc

Banton, C. (2023, July 1). Indifference curves in Economics: What do they explain?

Investopedia. https://www.investopedia.com/terms/i/indifferencecurve.asp

Admin. (2020, December 11). Indifference Curve: Meaning, definition, features, indifference

map. BYJUS. https://byjus.com/commerce/features-of-indifference-curve/

Yotpo. (2023, November 22). Understanding the consumer Decision making process | YOTPO.

https://www.yotpo.com/resources/consumer-decision-making-process-ugc/