Tag Archives: demanders

Theory of Consumer Choices

5 Jul

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.


Market System part II

29 Jun

There are two important components of market system: households (consumers) and firms (producers). The main roles of households are to sell resources and to purchase goods and services. In free market system households are able to buy the goods they want, so that they are dictating the demand. This kind of system don’t collapse, because firms produce the kind of goods and services that demanders need and the latter ones provide resources and labour force  that firms need.
You may ask “from where firms know what to produce?”.  The answer is quite easy. Suppliers seek profit and try to avoid losses, so they will produce the goods and services that continue to offer them profit.
Consumer register their needs on the demand side of the market, so firms and products suppliers respond to this demand by completing this demand.

Dollar Votes
Consumer sovereignty is represented by consumer demand, which is crucial for determining the type and quantity of goods to be produced. They spend their wages on the goods they are willing and able to buy. By these dollar votes consumers registers their needs on the demand side of the market. If a dollar vote for a certain good is high enough to produce a profit, the industry will expand so will production quantity of it. Otherwise, if there exist a decrease in demand, or fewer dollar votes cast for that good, industry will contract. We may say that the consumers are sovereign, because they collectively direct the market, in sense to produce more goods of some type or not.

Freedom of Market
Actually, firms don’t produce the goods and services they want, they rely on consumer’s buying decision and demand. Ones which don’t obey the rule of the market may face great losses or even bankruptcy.

This fact remains true also for resource suppliers. The demand for resources is called derived demand, derived from demand for goods and services. Consumers register their wants on the demand side of the market, producers and resource suppliers respond to these wants by creating supply for these goods.

Production Techniques
In each industry the firms which are able to survive are the most profitable. Competition eliminates producers which are not profitable and efficient, and ones that require less production costs survive.
Least-cost production means that these producers must have the most economically efficient production technique.  Efficient production depends on:

  • Available technology
  • Prices of resources

Economic efficiency means obtaining a particular output by using least input of scarce resource, while both input and output are calculated in the same currency.

Let’s suppose that buyers change their taste and don’t want to buy apple but they are willing to buy cherries. These changes are communicated to producers by an increase in demand of cherries, so the price of apples will decrease and that of cherries will increase. Some of these firms that activated in apple production may leave this industry, because they don’t seek losses. In contrast, in cherries industry some new firms will enters, because they seek self-interest. Higher profit will make cheery industry to expand. Firms will pay even more money to resources producers, who will find some alternatives to get more cherries. So demand can contract or expand an industry.

Technological Advances
New capital permits firms to spend less money on production of a good. So the costs are decreasing which offers suppliers higher revenue. Market system is conducted by a very fast spread of technological advances through industries. Rival firms must follow these technological advances elsewhere they may suffer losses or even a total failure. Creative destruction is destruction of market positions of firms that are using older ways of production, by creating new products and new production methods.
Entrepreneurs sometimes spend their revenue on purchasing capital goods. This yields higher revenue in future if new technology is more effective.  By selling ownership shares the firm casts dollar votes for buying new capital goods.

Key Terms:
Consumer Sovereignty-Determination by consumers of the types and quantities of goods and serv­ices that will be produced with the scarce resources of the economy.
Dollar votes- The “votes” that con­sumers and entre­preneurs cast for the production of consumer and capi­tal goods, respec­tively, when they purchase them in product and resource markets.
Derived Demand-The demand for a resource that depends on the demand for the products it can be used to produce.

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