Theory of the consumer

The branch of economics known as microeconomics focuses on the behavior of individual consumers and individual firms. This section reviews the theory of the consumer and the following section reviews the theory of the firm. The theory of the consumer describes how individual consumers make economic decisions, given their preferences, their

incomes, and the prices of the goods and services that they desire to purchase.

Utility and Preferences

Individuals consume goods and services because they derive pleasure or satisfaction from doing so. Economists use the term utility to describe the pleasure or satisfaction that a consume obtains from his or her consumption of goods and services. Utility is a subjective measure of pleasure or satisfaction that varies from individual to individual according to each individual's preferences. For example, if an individual's choices for a Sunday evening are to go out for dinner, to real a book or to watch television, then, depending on that individual's preferences, he or she will attribute different levels of utility to each of these three activities. Of course, it is not possible to measure utility, nor is it possible to claim that one individual's utility is higher than another's. Utility is just a unitless measure that economists have found useful in their explanation of consumer choice.

Total and marginal utility. The utility that an individual receives from consuming a certain amount of a particular good or service is referred to as that individual's total utility. The marginal utility of a good or service is the addition to total utility that an individual receives from consuming one more unit of that good or service.

Law of diminishing marginal utility. The law of diminishing marginal utility states that the marginal utility that one receives from consuming successful units of the same good or service will eventually decrease as the number of units consumed increases. As an example of the law of diminishing marginal utility, consider the utility that one obtains from drinking successful glasses of mineral water on a hot day. Suppose the first glass just begins to quench one's thirst. After two glasses, however, the thirst has all but disappeared. A third glass of mineral water might also provide some utility, but not as much as the second glass. A fourth glass cannot be finished. In this example, the marginal utility — the addition to total utility that one obtains from drinking mineral water on a hot day — is increasing for the first two glasses but is decreasing beginning with the third glass and would continue to decrease if one were to consume further glasses.

Consumer Equilibrium

When consumers make choices about the quantity of goods and services to consume, it is presumed that their objective is to maximize total utility. In maximizing total utility, the consumer faces a number

of constraints, the most important of which are the consumer's income and the prices of the goods and services that the consumer wishes to consume. The consumer's effort to maximize total utility, subject to these constraints, is referred to as the consumer's problem. The solution to the consumer's problem, which entails decisions about how much the consumer will consume of a number of goods and services is referred to as consumer equilibrium. Consider the simple case of a consumer who wants to purchase quantities of goods 1 and 2 so as to completely exhaust the budget for such purchases. Suppose that the price of good 1 is $2 per unit and the price of good 2 is $1 per unit. Suppose also that the consumer has a budget of $5. The consumer equilibrium is found by comparing the marginal utility per dollar spent for goods 1 and 2, subject to the constraint that the consumer does not exceed his budget of $5. The consumer's equilibrium choice is to purchase 2 units of good 1 and 1 unit of good 2.

Consumer Equilibrium and Changes in Prices

The consumer's choice of how much to consume of various goods depends on the prices of those goods. If prices change, the consumer's equilibrium choice will also change. The effect of a price change on the consumer's equilibrium choice is often divided into two effects — known as the substitution effect of a price change and the income effect of a price change. When the price of a good changes, the price of that good relative to the price of other goods also changes. Relative price changes cause consumers to substitute from one good to another — this is known as the substitution effect. The income effect takes account of how price changes affect consumption choices by changing the real purchasing power or real income of the consumer.

Individual Demand and Market Demand

The consumer equilibrium condition determines the quantity of each good the individual will demand. The individual consumer, however, is only one of many participants in the market for good X. The market demand curve for good X includes the quantities of good X demanded by all participants in the market for good X found by summing together all the quantities.

Consumer Surplus

The difference between the maximum price that consumers are willing to pay for a good and the market price that they actually pay for a good is referred to as the consumer surplus. For example, the market price is $5, and the equilibrium quantity demanded is 5 units of the good. The

market demand curve reveals that consumers are willing to pay at least $9 for the first unit, $8 for the second unit, $7 for the third unit, and $6 for the fourth unit. However, they can purchase 5 units of the good for just $5 per unit. Their surplus from the first unit purchased is therefore $9 - $5 = $4. Similarly, their surpluses from the second, third and fourth units purchased are $3, $2, and $1, respectively. The sum total of these surpluses equal to 10 is the consumer surplus.

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