Understanding how Consumers Make their Decisions

As mentioned by Hansen & Christensen (2007), the theory of consumer choice seeks to explain the manner in which individuals make their spending decisions based on their preferences and the available budget. The subsequent sections provide a comprehensive description about the impact of consumer choice theory on demand curves, higher rates of interests, and higher wages. The analysis also explains the role of asymmetric information in economic transactions, describes the Condorcet Paradox and Arrow’s Impossibility Theorem, and gives brief information about people not being rational in behavior economics.

Impact on Demand curves

Increase in the price of a good or service has two possible effects on consumer choices. The effects are referred to as substitution and income effect. Increase in a good’s or service’s price means the good becomes relatively more expensive compared to alternative goods and services. Since the theory assumes consumers are rational, this will lead them to switch to other alternative goods and services (substitution effect). The increase in price also reduces disposable income of consumers, which in turn leads to a reduced demand (income effect). The income effect analyzes how much the reduced disposable income lowers demand of the good or service. A decrease in price has an opposite effect where it leads to an increase in demand. This theory however excludes giften goods whose demand increases as their prices increases. In these goods, their income effect usually outweighs the substitution effect and their demand curve slopes upwards.

Impact on Higher wages

Proponents of the theory of consumer choice argue that workers are normally faced with a choice between leisure and work. Therefore, when wages increase, working becomes more profitable and thus more attractive than leisure (substitution effect). The higher wages means a worker can afford a better living standard through less work (income effect). The theory argues that workers will substitute leisure for work due to higher wages as they perceive work to carry more rewards for a life insurance product. However, it will reach a point where the higher wages make people afford to work less but still maintain their preferred living standard (Hansen & Christensen, (2007).

Impact on Higher interest rates

Changes in interest rates have different effects on consumer spending. Increase in interest rates means consumers will tend to increase their savings so as to receive a higher rate of return in turn reducing consumer spending (substitution effect).When interest rates increase, inflation usually increases which forces consumers to spend more (income effect). A decrease in interest rates has opposite effects (Hansen & Christensen, 2007).

The role of asymmetric information on economic transactions

Wankhade & Dabade (2010) define asymmetric information as a situation where one of the parties involved in a transaction has better or more information than the other party does. This situation means a market does not function properly and the more informed party can take advantage of the other party resulting in a market failure. Economists argue that information asymmetry results in two major problems. The first problem is adverse selection. Adverse selection occurs when a market stops working or falls apart because of asymmetric information between the parties involved, usually the buyers and sellers. A market failure in a free market system results in inefficient allocation of resources. In such a case, the immoral behavior of the informed party benefits from the asymmetric information prior before carrying out a transaction. For example, an individual in good health is less likely to sign up for a life insurance product. The situation also leads to a moral hazard. A moral hazard is a situation where an individual is willing to take higher risks because he/she knows that costs of his/her actions will not be felt by them but by the other party. This happens after concluding a transaction. For example, someone might commit arson to benefit from his/her fire insurance policy. However, advancement in technology is reducing cases of asymmetric information as more people can now access more information easily.

The Condorcet Paradox and Arrow's Impossibility Theorem in political economy

understanding social

People are not usually rational in behavior economics

Frey & Stutzer (2007) observe that while economic theorists argue that consumers (people) are rational when making up purchase decisions, other areas of study seem to argue otherwise. Studies by psychologists, biologists, anthropologists, and neurologists suggest that people are not always rational when making various decisions including economic decisions. These other fields argue that making a choice is more complicated and physically exhausting than what economic theorists assume. They argue that when one is forced to make many decisions at a time gets exhausted. Proponents of the irrational theory argue that consumers are irrational reactors who are exposed to various habits and biases that divert them from behaving rationally. For example, shops put candy almost at the exit to capture the attention of already exhausted consumers who usually will not behave rationally when placing the candy in their shopping baskets. This means businesses need to revise their understanding of the consumer behavior towards making purchase choices. Businesses need to rethink how these consumers make their purchase decisions to create effective strategies to influence the decision-making process of their consumers. Businesses have to embrace a new, multi-dimensional model approach on consumer behavior that makes a clear connection between behavior and mindset.


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