As an expert, I have been asked by my organization to assist the marketing department to understand better, how consumers make economic decisions. The analysis will entail a detail discussion on the impact the theory of consumer choice has on demand curves, higher wages, and higher interest rates. Similarly, we will analyze the role of asymmetric information, the Condorcet Paradox and Arrow’s Impossibility Theorem in the political economic and people not being rational in behavior economics. Consumer choice encompasses the decisions consumers make regarding the products and services (Mankiw, 2012). Therefore, the theory of consumer choice explains how consumers face trade-offs, make decisions and respond to changes in their environment.
The Impact of the Theory of Consumer Choice on Demand Curves
Demand curves show the relationship between what the consumer demands and the price. The theory of consumer choice plays a critical role in explaining why demand curves slope downward. First, according to the law of demand, as the prices of goods and services increases the consumption rate will reduce. Therefore, at a higher price, consumers would demand less and prefer to switch to other goods and service that offer lower prices. The situation will shift the demand curve downwards. Conversely, with a lower price, the demand of goods and service will increase.
Second, the income of the consumers influences their demand. A fall in the price of the goods would increase the consumer demand because consumers would be able to purchase more from their real income (Mankiw, 2012). On the other hand, an increase in the price of the goods and service will force consumers to cut back their consumption because of a reduction in real income. Third, the substitution effect determines the consumer’s demand for goods and services. A decrease in the price of one good would make it less expensive to the consumer. Since the goods appear cheaper, the consumer will make a choice of moving from the expensive alternative to the cheaper one.
The Impact of the Theory of the Consumer Choice on Higher Wages
Higher wages has two possible outcomes on the quantity of labor supply. At a higher wage, the consumer gets more consumption for every hour of leisure he/she gives up (Mankiw, 2012). Therefore, the decision the consumer makes between consumption and leisure determine their labor supply because the more they enjoy leisure, the less time they devote to work. The increase in wages has the following effects on the optimal quantity of labor supplied. First, the substitution effect is that a higher wage would result in leisure becoming more expensive compared to consumption. Therefore, the consumer would have to substitute consumption for leisure. Precisely, due to the substitution effect, the consumer would work harder in response to the increase in wages hence the labor supply would slope upwards. Second, with the income effect, an increase in wages would make a person move to a higher indifference curve. In this situation, a person would feel better off than previously (Mankiw, 2012). Given that consumption and leisure are normal goods, the consumer would utilize the increase in well-being on both higher consumption and leisure. Precisely, due to the income effect, a person would work less; hence, the labor supply curve will slope backward.
The Impact of the Theory of the Consumer Choice on Higher Interest Rates
Individuals face the decision to determine the amount of income to consume today and the amount to save for the future use. The theory of consumer choice is useful in this situation since it provides an explanation of how people make decisions and how their savings depend on the interest rate. For instance, in a case when the person is young and working, he/she will consume part of the income and save the rest. Similarly, when the same person is old and retired, he/she will consume all the savings including the interest earned. When the interest rates increase, the individual’s budget constraint will shift outwards (Rima, 2015). A person will get more consumption when old for every amount that he/she gave up when young. Therefore, the two possible outcomes include the following. First, with the substitution effect, a higher interest rate means that consumption when old is cheaper relative to when one is young. Rima (2015), due to the substitution effect, a person will save more. Second, considering the income effect, an increase in interest rate would make a person move to a higher indifference curve, and this would make him/her better off than the previous situation. Due to the income effect, a person will save less. Therefore, a higher interest rate could either encourage or discourage a person from saving.
The Role Asymmetric Information has in many Economic Transactions
Asymmetric information refers to the situation when one party has more or better information compared to the other when making decisions and transactions (Lazear & Gibbs, 2014). The existence of asymmetric information creates an imbalance in transactions. Regarding the economic transactions, the asymmetric information relates to the principal-agent problem. According to Lazear and Gibbs (2014), the decision made by an individual often depends on the advice they get from the experts. Therefore, a principal-agent problem can occur in circumstances when decision makers rely on information provided by people who have more knowledge than they do. For instance, in an organization, shareholders usually delegate decision-making responsibilities to managers. In such a case, a situation of asymmetric information occurs whereby the manager knows more about the organization compared to shareholders thus creating the possibility of inefficiency.
The Condorcet Paradox and Arrow’s Impossibility Theorem in the Political Economy
The Condorcet’s Paradox indicates that although individual voters might have transitive preferences, it might be different with the electorate as a whole. For instance, more than 50% of the electorate might prefer A to B, B to C and C to A without the pattern being true of any person. Therefore, transitivity occurs, a person will arrange A vs. B, B vs. C, and C vs. D. from this arrangement you will expect A to emerge as the overall winner. In a situation when transitivity does not exist, a Condorcet Paradox will occur (Mankiw, 2012). Condorcet Paradox consists of winners and cycles. A Condorcet winner refers to the alternative that gains the majority of votes when you pair it against each of the other alternatives. On the other hand, a Condorcet cycle exists transitivity is violated in the social preference ordering (Mankiw, 2012). Regarding the Arrow’s impossibility theorem, people have rational preferences over alternatives. The theorem includes independence of irrelevant alternatives, unanimity, transitivity and no dictatorship.
People not being Rational in Behavior Economics
Although the demand curve slopes downwards due to the rational behaviors of consumers, irrational behaviors do occur. With the existence of irrational behavior, the demand curve will remain negatively inclined (Wilkinson & Klaes, 2012). The following is an example of irrational behavior that people portray. For instance, once a price of a product is established in a person’s mind, he/she will compare other similar items to the anchor price. The situation explains the reason iPhones are expensive. When people establish prices in their mind, everything they will encounter in future would be affected by the anchor price. Consumers experience irrational behavior because they lack analytical review of the necessary information.
The theory of consumer choice explains how individuals make decisions. Consumers’ choices are constrained by the availability of their financial resources. Therefore, given the constraints, consumers tend to do their best to attain the highest level of satisfaction possible. Although several factors affect the demand and supply curves, consumers’ irrational behaviors have a negative impact on demand curves. Consumers who make analytically based decisions regarding their consumption to keep the demand curve in equilibrium portray rational behavior. Consumers need to exhibit best practices if they want to enjoy long-term financial health.
Lazear, E. P., & Gibbs, M. (2014). Personnel economics in practice. Hoboken, NJ: John Wiley & Sons.
Mankiw, N. G. (2012). Principles of microeconomics. Mason, OH: South-Western Cengage Learning.
Rima, I. H. (2015). Labor Markets in a Global Economy: A Macroeconomic Perspective. Routledge.
Wilkinson, N., & Klaes, M. (2012). An introduction to behavioral economics. Palgrave Macmillan.
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