Saturday, November 11, 2006

Econ101: Consumer Choice

Remember our own definition of economics? Yes, choice. Let’s now talk about what an individual actually does when we say "he chooses”. We’re going to talk about a typical consumer. Consumer is the most fundamental decision unit. (Or put it this way: every producer is also a consumer, but not the other way around).1 Understanding what a consumer does helps us understand what the other units do.

What is it that consumer choose over? Anything you can want: food, books, coffee, music, boyfriends, identity, clean air, sex, religion, justice, blog templates, et cetera. We call them commodities.2 Can we have them all? As much as we want? No, because there are constraints. The explanation to Mick Jagger’s “you can’t always get what you want” is because we face restriction(s). And that’s why we have to make a choice.

The first limitation is the physical constraint. This includes time, quantity, place, taste, and institution. We can’t choose a durian simply because it is not a durian season: no one is selling it. We can’t have leisure 25 hours in one day, because one day is only 24 hours, unfortunately. We can’t buy half a car, because the smallest quantity sold is one. We can’t eat u-dong in Seoul and Jakarta at the same time -- and at either place, we're bound to our taste. We can’t drive and drink because the law doesn’t allow us. Given all these restrictions, whatever left you can choose from is called the consumption set.

The second limitation is the budget constraint. This is a matter of affordability that in turns depends on the level of your wealth – usually represented by income. For now we will have to employ two assumptions. First, all the commodities have a price and everybody knows it. Second, no one can affect the price, or more accurately: your individual act of buying doesn’t really affect what is going on in the market.3 Given the prices and your income, your feasible consumption bundles are now captured by what we call your budget set.

Another important assumption is that both the constraints are “convex”. This means, when your consumption set includes bundle A and bundle B, then it should also include any combination of the two bundles (e.g half of bundle A and half of bundle B, rather than A only or B only). Similarly, if both bundles are included in the budget set, so is any combination of them.

When finally you decide to make a choice given the consumption set and the budget set, we say you’re revealing your demand function. That’s the topic of our next talk.

Stay tuned.


1 This principle is very powerful to attack all the pathetic protection asked by producers. And to debunk all the harsh attack on consumerism. How so?

2 Try telling a girl that she is a commodity. If she is flattered ("Oh that so sweet, you’re telling me I’m valuable!"), she might have learned this stuff.

3 This is sometimes called ‘price-taking’ behavior. It doesn’t mean you can’t bargain at all. You can bargain, but whatever the price you and the seller agree doesn’t translate into the same change in the market.


  1. Do you guys know of Lancaster's (~1965) "new" consumer theory (Becker came up with something similar). -- Basically it says that products can be converted to basic characteristics which ppl consume.

    I stumbled upon that theory while writing my thesis, and thought it was a really nice extension to the standard theory which people get taught -- comes that bit closer to marketing (component/factor analysis specifically) and the "real" world.

    It gives microeconomics some traction in explaining preferences based on a product's characteristics (shouldn't go down /that/ road again :)).

  2. Can we use these approaches, the aggregate function of budget set and consumption set to predict the macro variable of consumer durables? If yes, how? I would like to find some kind of temporal opportunity to hedge in some stocks in particular sector, like automobile or consumer durables sector, in the equity market. I'm setting a hedge fund play for sectoral exposure here.

  3. John, Lancaster's consumer theory is still alive and well. Thanks for bringing this up. I deliberately used examples of clean air, religion, and other "non-market" (yes, this term is a misnomer, though) goods to allow for Lancasterian approach. The main idea of Lancaster contribution is that we consume, as you said, characteristics of the commodity in question, not the commodity per se. So when we buy a house, we're not really consuming the house, but its space, its convenience, the number of bedrooms, access to public school, tollroad, etc. This way of thinking helped the development of, among all, the hedonic approach by Rosen, now widely implemented in environmental-, labor-, and health economics. How can we compute the value of clean air? By using the value of a typical house in the area -- the value of which depends on the Lancasterian characteristics.

    Anymatters, that's an interesting and tough question. Frankly, I don't know much about hedge fund stuff. But I tend to give a yes to your question. One way to do that is to estimate the demand for automobile (that is, to probe into consumers' preference, consumption-, and budget sets). Then combine that with supply analysis (the production trend being a vital information). Finally, do simulation using macro indicators (CPI, exchange rates, etc).

  4. I am sure such models are used to model industries.

    I am also sure that firms/investment analysts invest millions of dollars into acquiring and making sense of market data to try and get a better picture.

    (IMHO, that's the problem with getting into finance, generally you are playing with people who have more (and better) resources than you. So unless you are /very/ lucky to find some advanced technique that works, you are playing roulette -- but there's always a chance you can hit upon something:):))

    BTW, this is a v interesting book for those interested in finance (a lot of time and spare brain power needed tho)

  5. For things, a sales rep/cust serv sometime provides me a good choice and the loan brokers/credit cards release me from my budget constraint. Eventhough I have to die trying to repay.

    For sex and woman, I've fixed it one. Never chose between two or more, or took more than one. Because I felt awful if I had to put it in the consumer choice context.

    Thanks Aco for the lead for my assignment, sorry it's OOT. In fact, a hedge fund play is actually some kind of a test-driver for some new data, analyses, researches and theories developed by economists. They (the players - some of them are economists/academics - who are brainy/cum laude, has courage and friends) normally bet when, for example, the regulators move in the wrong direction, or the market deviates from the business cycle (existing industry model as mentioned by johnorford). Some of them failed, because they used a complex mathematical model for betting. While it's even better with "head and tail" :) Who knows if a genuine Indonesian hedge fund play might start from this cafe. Wanna bet the nation with our brain?

  6. Hi Aco,
    I'm no economist, but I'm trying to learn how economists (of various ideologies) think.

    I'm intrigued by your take on "Consumer is the most fundamental decision unit." I can understand when you say "every producer is also a consumer, but not the other way around". For example, my children consume, but they don't produce (is this a right example?).

    However, isn't every consumption depends on how much someone produces, be it now or before? For example, how my children consume depends on how much I produce (how much money I make by producing documents for my company).

    So I agree with you that not all consumers are producers, but everyone's consumption depends on someone's production. What do you think of this?

  7. Muli, you're right: without any production, there won't be any consumption (production by mother nature included). But production is a means of an end. The end is consumption. The process of producing incurs cost. The more efficient the production is, the less costly the consumption is. So anything that makes production inefficient is not good for the objective, i.e. consumption. Now if A and B produce X, with A being more efficient (i.e. less costly). The resulting prices, naturally, is higher for Xs made by B. If people produce for the purpose of consumption (as you rightly implied), then there is no reason to buy from B. Protection (for the inefficient producer -- and of course for the inefficent one; what's the point of protecting the efficient one?) is about buying from B.

  8. Please don't play with words. We all know in economic terminology consumption is part of production, in which it also includes investment, government spending and net export (if it's open). don't mix up, it's confusing.

  9. anymatters: i think you're confusing the consumption and production terms here. no sure whether you were joking (hope so!) but i can't stand not commenting. consumption and production that you refered to is the the term used in GDP (gross domsetic product). Those terms used widely in macroeconomics. the aggregate consumption of a nation (along with its gov't spending, investment and net exports) is part of the production of that nation.

    meanwhile, aco refers to the production and consumption terms in the microeconomics. this is production and consumption of goods. firms/supplier produce goods that will be consumed by consumers. in order for you to be able to consume something, that something must be produced first. that's what aco meant.

    i think.

  10. question: is the convexity assumption a technical necessity or there is a good reason to believe it's true?

  11. Weakties, convexity is a technical necessity. And there's good reason to assume it's true.

  12. dhani, however i still believe that microeconomics is part of macroeconomics, where it could be remarked that statistical aggregates (macro) are simply summations of individual behaviour (micro).

    it's obvious that we consume what is first produced.

  13. Anymatters, Dhani, Aco,

    What I read from our discussion is that consumption and production are tightly linked, as are micro-econ and macro-econ. They're all integral parts of what IS economics. So, would I be wrong to say that focusing on solely one aspect *reduces* the science?


    Thanks for your explanation. I'm with you so far. But I'd go on and ask, "then what happens to inefficient producers?" If they have to close up shop, and become unemployed, and maybe become criminals if they're unemployed for too long (say, a year or two), what should be done?

    And we're talking about a lot of people here. Not just inefficient rice producers, but also inefficient oil and gas managers, inefficient teachers & researchers, inefficient market traders (compare to Carrefour), etc.

  14. Anymatters, Dhani, and Muli, thanks for all this. Let me clarify. I'm not saying that production is a not important. It's just that most arguments for protection raised by producers are ill-founded. If I can't convince you, maybe Frédéric Bastiat can. Believe me, this debate has been going on forever.

    As for the confusion coming out from GDP nomenclature. I'm sorry to tell you, even "GDP" is a misnomer. I don't know who's responsible, but GDP is really not gross domestic product -- at least not the 'product' as we know it. The Y in C+I+G+(X-M) is more aptly called national economic activity. But no one cares, unfortunately. This has raised a lot of confusion.

    What I mean by 'production' in this series is, well, production: an act of transforming something else for consumption purpose. Yes, in production we need inputs, e.g. labor and capital. So yes, production activity 'consumes' labor and capital, but I'm not talking about 'intermediate consumption' like this. I'm concerned with consumption of 'final goods'.

    Muli, again thanks for your kind words. I understand your concern. There are indeed justified arguments for protection. We can talk about this. But I can tell you now that many of these arguments have been abused. You're right that when cutting protection we should also consider employment effect and all that. Alas, studies have shown that even after taking employment effect into account, protection might still unambiguously increase poverty figures (for recent study, try search Peter Warr of ANU on rice import ban).

  15. Aco, thanks for the explanation of the misnomer GDP. However, what I remember from my past macro class, the sum of the value added of your production definition can be GDP as well.

    I never dream if the surplus value has given me no choice to not consume some products, referring the budget set. I think, so do most Indonesian labours.

    For e.g., try to track production, surplus value and consumption data in car assembly or cigarettes industry, we might find the "no-choice consumer theory". Producers could have taken away lots of surplus value and so does the govt with its taxes.

    Thanks for the free knowledge from this blog.

  16. On the contrary, I think production is not important. It's just a means to the end, and that end is consumption. The reverse is simply not true.

    Let me illustrate: Would anyone rather be Paris Hilton or some investment banker that work 100 hours a week? Or would anyone refuse a gift of US$1 million because s/he'd rather 'produce it' her/himself?

    The point being: Most of us (read: individual human beings) only care about consumption -- consumption, not production, makes most of us happy. But why did we produce anything anyway? Aco's intro lesson: Scarcity.

    That is why microeconomics focus on maximising consumption -- it's what matters for human welfare. And consumption does not always need production: Nobody produces the air we breath, the (clean) water off the spring, the animals in the wild etc.

  17. Arya, production is important. But consumption is more important. If production is not important at all, it should have no value; hence non-existent in the first place.

  18. Aco,
    Most people need to be compensated to produce -- so, if you think of it, production gives negative value.

    As I said, thanks to scarcity, production is a necessity. Production is 'valuable' because it allows the really valuable consumptions.

  19. "But why did we produce anything anyway? Aco's intro lesson: Scarcity."

    elaborate please...
    it seems only a few people produce (entrepreneurs), why not everyone produce?

  20. Weakties,
    Imagine a world with no scarcity -- you can have anything that you want (to consume) at any quantity at any time. Is production necessary?

    Only the few produce? Well, on the contrary, only the few do not -- the Paris Hiltons of the world -- because they have more than enough to consume.

    The rest produce with varying productivity (the so-called "value added") and entrepreneurs often give the greatest value-added.

  21. Arya, the Paris Hiltons approach is unsuitable for economic model. It's still relevant but just out of context of generality and rational expectation. I would use, for example, baby boomer, generation X/Y or MTV generation approach, for understanding a consumption model. Anyway, do you mean "Paris Hilton" could be your product as you consume it?