Overview

Why do you buy Coke instead of Pepsi? Why do you buy a house instead of renting? Consumer Theory tries to explain every shopping decision you make. It assumes you are a rational robot trying to get the maximum happiness (Utility) for the minimum money.

Core Idea

The core idea is Utility Maximization.

  • Utility: A measure of happiness. (Utils).
  • Budget Constraint: You only have $100.
  • Goal: Spend the $100 in a way that gives you the most Utils.

Formal Definition

The study of how individuals make choices subject to budget constraints. Indifference Curve: A line showing all the combinations of Pizza and Beer that make you equally happy.

Intuition

  • Diminishing Marginal Utility: The first slice of pizza is heaven (100 Utils). The second is good (50 Utils). The tenth makes you sick (-10 Utils). This is why you don’t spend all your money on pizza. You switch to beer when the marginal utility of pizza drops below the marginal utility of beer.

Examples

  • Substitution Effect: If the price of Coffee goes up, you buy Tea.
  • Income Effect: If your rent goes down, you feel richer, so you buy more Coffee and Tea.
  • Giffen Good: A weird exception. If the price of bread goes up, poor people buy more bread. Why? Because they can no longer afford meat, so they have to eat bread to survive.

Common Misconceptions

  • People are rational: Behavioral Economics proves we are not. We buy things on impulse, we are bad at math, and we care about fairness. Consumer Theory is a “Spherical Cow” model—useful but not perfectly realistic.
  • Revealed Preference: Don’t listen to what people say (“I want to eat healthy”). Watch what they do (Buy donuts). Actions reveal true preferences.

Applications

  • Marketing: Companies use this to price products. “Buy one get one free” exploits your desire to maximize utility.

Criticism / Limitations

  • Bounded Rationality: We don’t have the brainpower to calculate the utility of every item in the grocery store. We use shortcuts (Heuristics).

Further Reading

  • Varian, Hal. Intermediate Microeconomics.