The Impact of the Theory of the Consumer Choice on Demand Curves, Higher Wages and Higher Interest Rates
The theory of consumer behavior shows how the choice is affected by the price of goods, income and preferences, and the way buyers maximize their net gains from the purchase of goods and services. The price change of a good affects the consumer demand structure in two ways. Any change in the price results in the appearance of the income and substitution effects, as it changes the amount of available goods and their relative prices. The above effects are consumer reaction to changes in relative prices and real income (Mankiw, 2014).
The substitution effect is the change in the structure of consumer demand as a result of changes in the price of one of the benefits included in the consumption bundle. The essence of this effect is that the consumer at a price growth for one good is reoriented to the other benefit with similar consumer characteristics, but with remained price. In other words, consumers tend to replace the more expensive goods with cheaper ones. As a result, the demand for initial benefit falls and the demand curve moves to the left (Sloman, Wride, and Garrat, 2012).
The income effect is the impact exerted on the structure of consumer demand due to changes in his/her real income caused by changes in benefit rates. It can be likened to the growth of wages in the consumer, since the latter can now buy more goods. The process that causes the income effect passes through three stages: the fall of the price of the goods; increase in the real income of the consumer; and the increase in demand. However, the rise of the product price causes the opposite effect: the real income of the customer drops, which leads to a reduction in the volume of demand. The income effect is manifested in that portion of changes in demand, which is caused by the change in price of goods. The growth of prices, for example, reduces the purchasing power of the consumer (i.e., his/her real income), thereby changing the volume of the demand for this product. This change is the income effect. The income effect is graphically expressed by a shift in the individual demand curve to the right, but it is characteristic only for normal or high quality goods (Varian, 2009).
For goods of the lowest category, the resultant of both effects depends on the degree of influence of each of them on the consumer choice. If the substitution effect is stronger than income effect, the demand curve for the commodity of the lower category will have the same shape as a normal commodity. Thus, the law of demand is satisfied. If the income effect is stronger than substitution effect, the volume of demand for the product of lower category falls with a decrease in the price of this commodity. In other words, the law of demand is not satisfied. Goods, for which the law of demand does not work, are called Giffen goods (Mankiw, 2014).
When the interest rate increases, the old-age consumption is less expensive in comparison with the consumption in youth. Consequently, the substitution effect causes to consume more in old age, and less – in adolescence. Otherwise speaking, the substitution effect encourages the growth of savings. Through the growth of the interest rate, the upsurge in measurable welfare is shown in the transition to the updated indifference curve positioned over the initial curve. Meanwhile consumption in old age and adolescence concerns the normal products, people will tend to its increase in both periods of life. In other words, the income effect stimulates reduction of savings. Of course, the final result will depend on the cumulative impact of both effects. If in the increase in interest rates the impact of the income effect is stronger than the impact of the substitution effect, people will increase the savings. If the substitution effect prevails, people will reduce savings. Thus, the theory of consumer choice leads to the conclusion that the increase in interest rates may contribute to both increase and decrease in savings (Mankiw, 2014).
The Role of Asymmetric Information
The meaning of asymmetric information explains that purchasers and traders do not constantly have immediate access to the comprehensive and accurate data with the aim of taking the most effective solution. Markets become uncompetitive and ultimately, tolerate inconsistency. The functioning of markets in conditions of information asymmetry has a negative impact on the effectiveness of the competitive process, and the existing mechanisms for smoothing the effects of information asymmetry may not prevent the monopolization of the market. The need for state intervention, the development of information and economic mechanisms aimed at reducing the negative effects of information asymmetry and increase in the intensity of competitive interaction in the industry market is clear (Sloman, Wride, and Garrat, 2012).
In general, information asymmetry is a factor that reduces the effectiveness of price competition. Asymmetry of information is a source of price discrimination. The same product can be sold in different packages at different prices by different names. Not only consumer suffers from the information asymmetry. Hidden characteristics of buyers often serve the cause of shortfall in income, even for companies that have significant market power. Depending on the degree of information asymmetry due to its negative effects may occur in a non-optimal allocation of resources, and in the impossibility of establishing market equilibrium (Varian, 2009).
The Condorcet Paradox and Arrow’s Impossibility Theorem in the Political Economy
Kenneth Arrow proved his famous theorem on the impossibility. The theorem states that there is no function of public choice that satisfies all four requirements at the same time. These criteria include the principles of unanimity, the universality, the lack of “dictator”, and the independence of irrelevant alternatives (Krugman and Wells, 2012).
A Condorcet paradox, or the paradox of cyclical polling, is an illustration of the fact that the criteria mentioned above are incompatible. It consists in the fact that public choice is transitive, i.e. its coherence and consistency with the vote on the principle of simple majority is not met. Thus, coherent and consistent public option is not possible (Krugman and Wells, 2012).
Irrelevance of People’s Behaviors
In real life, any buyer (consumer) in the selection of goods (services) satisfies his/her interest, meaning tends to behave more rationally. In this regard, the person selects a set of goods (services), the most satisfying his/her preferences for given restrictions on own revenues and market prices (Varian, 2009).
Thus, rationality means that the buyer will never give up the acquisition of a set of products that can bring him/her the greatest satisfaction compared with other sets. Of course, in reality, not all customers come exclusively rational. However, if to examine the actions of not individual customers, but their total weight, then it is certainly characterized by the desire to achieve maximum efficiency when shopping (Mankiw, 2014).
References
Krugman, P. and Wells, R. (2012). Microeconomics, 3rd ed. New York: Worth Publishers.
Mankiw, N. G. (2014). Principles of Microeconomics, 7th ed. Boston: South-Western College Pub.
Sloman, J., Wride, A. and Garrat, D. (2012). Economics, 8th ed. New Jersey: Pearson Prentice Hall.
Varian, H. R. (2009). Intermediate Microeconomics: A Modern Approach. 8th ed. New York: W. W. Norton & Company.
