Theory of Consumer Choices

   This theory will explain how consumers allocate their money among all goods and services which are available on the market.

Consumer Choice and Budget Constraint
       Rational behavior- Consumers are rational individuals who try to spend their money and to get maximum amount of satisfaction. They want to maximize Total Utility (TU) they get.
Preferences- Each consumer has different preferences. We assume that buyers have a good idea of how much marginal utility they will get after each unit of good or service they purchase.
      Budget Constraints–   At any period of time consumers have a limited quantity of money, because they can provide society only a limited amount of human and property resources. Economists call this fact budget constraint (budget limitation). Even these people who own millions of dollars face budget constraint, but it is not severe as at that people who have low incomes.
Prices– Since all goods are scarce relative to demand of them they carry a price tag. Each person purchases are minuscule relative to total demand, because they have relatively small amount of income, so that consumers may buy only a limited amount of goods.
   Consumers must choose the most satisfying mix of goods and services. Different consumers will choose different combinations of items.

 Utility-Maximization Rule
      From all possible combinations of goods and services, which are available for their budget, consumers must choose the mix that offers them maximum utility. But which combination yields more utility?
   In order to maximize satisfaction, consumers should allocate their incomes so that the last dollar spent on each product offers the same MU (marginal utility).This is called Utility Maximization rule.

Marginal Utility per Dollar
      A rational consumer must compare the extra-utility with its cost (price). Suppose you prefer coffee which is 18 UT (units of Utility, at least I call them like that) to a tea whose MU is 6 UT. Coffee’s price is 6$ but price of tea is 1$. Even if coffee provides more total UTs, but when we make a ratio between MU and price we see that coffee offers 3UT/$ but tea gives us 6UT/$. So tea offers more satisfaction than does coffee. To calculate the amount of extra-utility derived from each product we should put MU on per dollar basis.

Law of Demand and Marginal Utility

   The income effect
   The income effect is the impact that change in real income has on quantity demanded of a good. Let’s suppose our good is cheese. If the price of cheese in declined, then the purchasing power or real income is of anyone who purchases it increases. The increase in real income is reflected in increased purchase of normal goods, in our case cheese. For example, with a monthly income of 100$ you can guy 2 kg of cheese which worth 50 $/kg. If the price decreases to 25$ your purchasing power will increase so you’ll be able to buy already 4kg. A decline in price of the cheese increases consumers’ real income, enabling them to buy more amount of this good. This relationship is known as income effect.

Substitution Effect
          Substitution effect is the impact that a change in a product’s price has on its quantity demanded. When the price of the good decreases, the product becomes relative cheaper to other products, so that consumers will try to substitute it for items that became now relatively more expensive. Lower price increase the relative attractiveness of a product, so that the consumers buys more of it. This relationship is called substitution effect.
   The income and substitution effects combined increase consumers’ willingness and ability to buy a good when its price falls.

Law of diminishing Marginal Utility
   This law is another explanation of downward-sloping demand curve.  Although consumer wants are unlimited, wants for particular goods can be satisfied. More of a product people can obtain the less additional product they want.
   Let’s take an example:  When you don’t have an iPhone, your desire for it can be very strong, but the desire for a second iPhone is less intense and for the third, fourth and so on is weaker and weaker. So, the demanders will buy an additional unit of good only if price of that good or service will fall. So the consumer will spend his/her money rather on goods that provides the same or bigger amount of utility than on that which offer less utility. Thus, marginal utility provides the idea that price must decrease for quantity demanded to increase. We can also state that, if successive unit provide a sharp decrease in MU then demand for this good or service is elastic. Conversely, slow declines in MU imply that demand is inelastic. We can state Law of diminishing Marginal Utility as follows – as consumer increase consumption of a good or service then the marginal utility obtained from each additional unit will decrease.

Utility 
   Utility is the want-satisfying power of an item or a service; the pleasure consumers take from keeping or using that good or service. “Utility” and “usefulness” is not the same, for example paintings of Leonardo da Vinci may offer utility for art lovers but they are useless in functionality. Also utility is something subjective, for example an old wrist watch can offer great amount of utility for a collector, but for someone else it may not have such a great utility.
   Now we must make a difference between two important economic terms: TU (total utility) and MU (marginal utility). Total utility is the total amount of satisfaction a consumer can get from a specific quantity (example 5, 20, 100) of goods or services. In contrast, Marginal utility is pleasure taken from consuming each additional unit of good or service (also equal to Total utility divided by quantity of good consumed).

Elasticity and Taxes

   

  Let the following figure represent the market price of an good before and after alplying a tax. Let this good be a CD. Pre-tax equilibrium price of an CD is 6$ and equilibrium quantity is 1 million. So, if goverment levies an tax of an dollar per each CD, who is actually pays it?

Since this price is applied for sellers, it is taken as addition to marginal cost of our CD. Now sellers must get 1$ for each CD to get the same revenue as they got before. While sellers want to offer,for example, ½ million of CDs for 4$, they will have to set the price to 5$ (since 1$ is the tax), to offer the same ½ million of CDs. The tax shift the supply curve  upward. After tax equilibrium price is 6.50$ , whereas the before tax price was 6$. So in our case ½ dollar is paid by suppliers and the same amount of money is paid by demanders.

Also abserve that the equilibrium quantity decreases after the tax was levied and the higher price is imposed to consumers.

 

Elasticities

    If elasticities of demand and supply are different then the tax applied to consumers is also different.  Two ideas should be understood. First, with a constant supply, the more inelastic is demand for the product, the biggest portion of tax should be paid by consumers. To verify this assumption let’s sketch the effect of tax on elastic and inelastic demand (In a perfectly inelastic demand all tax is paid by buyers, but in a perfectly elastic demand all tax is paid by seller).

In the first figure from above, where is shown an elastic demand, a small portion of tax (P_e-P₁) is shifted to consumers and most of the tax (P₁-P_a) is paid by suppliers. However, in second figure where the demand tends to be more inelastic the biggest part of the tax (P_i-P₁) is paid by consumers and less of it (P₁-P_b) is shifted to producers.

Observe that in both figures there is a decline in equilibrium quantity and this decline is less when demand more inelastic, this fact is used by government when levy great taxes on cigarettes, liquor, automobile tires, telephone services and other products which demand is thought to be inelastic. Since demand isn’t so elastic, this tax doesn’t reduce sales too much, so the tax revenue remains high.

Second, with a constant demand, the more inelastic is supply, the larger tax is shifted to producers. Like in the following first figure most of the tax (P_e-P₁) is shifted to consumers and only a small part (P₁-P_a) is going to be paid by suppliers.  But when the supply is inelastic (second figure) major part of the tax (P₁-P_b) falls on sellers and just a small part (P_i-P₁) is shifted to demanders.