Theory of Consumer Choice and Frontiers of Microeconomics

Theory of Consumer Choice and Frontiers of Microeconomics


Theory of Consumer Choice and Frontiers of Microeconomics


How do consumers make economic decisions? There are many tools and theories used by economists that can help answer this question. Some of these tools and theories that are used include: 1) how the theory of consumer choice affects demand curves, higher wages, and higher interest rates, 2) asymmetric information in economic transactions, 3) the Condorcet Paradox and Arrow’s Impossibility Theorem, and 4) behavior economics. These tools and theories are helpful in determining how consumers make economic decisions.

The Theory of Consumer Choice

The theory of consumer choice affects demand curves, higher wages, and higher interest rates in different ways. Most people would like to have everything they want—bigger house, more extended vacations, fancier car, eat at better restaurants, or buy more luxury items, but due to financial limitations, that isn’t always possible. When a consumer has a limited budget, they must decide what combination of items they can afford to buy. If they purchase more of one item, they can purchase less of another. When the consumer has the same level of satisfaction from any combination of items, they are indifferent to the bundles. Indifference curves can be used to show the consumers levels of satisfaction for the possible consumption bundles. Consumers prefer higher indifference curves—they prefer to consume more goods than less. Their willingness to substitute one item for another determines the slope (marginal rate of substitution) of the indifference curve. The consumer will choose the bundle where the relative price (the price at which the market is willing to trade one good for another) equals their marginal rate of substitution. When a person’s income changes, they can choose a better or lower combination of items. When the price changes, they can purchase more of one good than the other. The change in income or price creates a new optimum. As prices and consumption change, the consumer’s choices change. When the consumer’s choices change, the demand curve increases or decreases. The same concept and indifference curves can be applied to a person’s change in income. When their wages increase, they must choose between work and leisure. When they work, they give up time for leisure. When they take more leisure time, they are giving up income. The higher wage causes the labor-supply curve to change its slope. Just like goods and changes in income, the theory of consumer choice can be used to choose between saving and spending and how interest rates affect a person’s choice. If a person chooses to spend everything now, they will have nothing for later. A higher interest rate could encourage or discourage a person to save. With a higher interest rate, the person could choose to consume more while young rather than save for later, or they could choose to consume less and have more for later. The theory of consumer choice does not determine what choices a person will make. It is merely a model, but using various indifference curves will show their best choices or bundles that will provide the highest level of satisfaction.

Asymmetric Information in Economic Transactions

What is asymmetric information and how is it used in economic transactions? Asymmetric information is present when one person has more knowledge about what is going on than another. Some common places where information asymmetry exists include the workplace and in the market. In the workplace, a worker will know more about the effort they put in at work and their behavior than will their employer. In the market, the seller will know more about the quality of their product than will the buyer. Asymmetric information can lead to market failure or it can provide an opportunity for new innovations. Market failure can be caused by products of inferior quality, allocation of stakeholder control, or distribution of property rights. The opportunity for new innovations is available because not everyone has the same information to create new products (Barbaroux, 2014). Moral hazard and adverse selection are negative results of asymmetric information. A moral hazard is the tendency of an unmonitored person to participate in behavior that is dishonest or undesirable such as an employee putting forth less effort than the employer would prefer. Adverse selection occurs when the seller knows more about the characteristics of the good they are selling than the buyer does. One of the ways markets respond to asymmetric information is signaling, an informed party acts to reveal private information to a party that is uninformed. Another response by markets to asymmetric information is for the uninformed party to persuade the informed party to disclose information. Asymmetric information can create many problems because one individual has more information than another.

The Condorcet Paradox and Arrow’s Impossibility Theorem in Political Economy

When the market is inefficient or inequitable, the government may have to act to change the situation. Political economy is the study of government using economic analytical methods. The Condorcet paradox and Arrow’s impossibility theorem can be used to explain how voting represents people’s preferences. Collective choice problems are usually decided by majority rule. When voters prefer one alternative over all other alternatives in a pairwise vote, there is a Condorcet winner. However, there may not be a Condorcet winner, and then the Condorcet paradox happens (Herings & Houba, 2016). The Condorcet paradox occurs when there is no majority rule that produces transitive preferences for society. When more than two choices exist, the order in which they are voted on can impact the outcome. No voting system can satisfy all the desired properties of society, also known as Arrow’s impossibility theorem. In other words, there will always be mechanism flaws for social choice regardless of what voting system society chooses for collecting member’s preferences. Individual preferences cannot be combined into one set of social preferences. Sometimes the government must act to make changes in the market and determine what most of society wants or what is the best solution.

Rationality in Behavior Economics

Behavioral economics is a recently added field of economics that uses basic psychological insights. Although the assumption of rational behavior clarifies how many successful economic institutions function, it is also correct that actual human behavior falls short of complete rationality (Erev & Roth, 2014). Real people are not rational. They can be confused, forgetful, sensitive, impetuous, and shortsighted. Some of the most common mistakes that people make in decision making include overconfidence, giving more weight to small numbers of observations, and unwilling to change their minds. Economists often assume rationality because they are overconfident and unwilling to change their minds. Even though rationality assumptions are not exactly right, they are correct enough to provide reasonably accurate models of behavior.


Economists use tools and theories to study and explain how consumers make economic decisions. They use the theory of consumer choice and its impact on demand curves, higher wages, and higher interest rates, role of asymmetric information in economic transactions, the Condorcet paradox and Arrow’s impossibility theorem in the political economy, and the rationality of people in behavior economics. Understanding how consumers make decisions, provides insight into the workings of market goods and services and supply and demand.


Barbaroux, P. (2014). From market failures to market opportunities: Managing innovation under

asymmetric information. Journal of Innovation and Entrepreneurship, 3(1), 1-15.

Erev, I., & Roth, A. (2014). Maximization, learning, and economic behavior. Proceedings of the

National Academy of Sciences of the United States of America, 111, 10818-10825. Retrieved from

Herings, P. J., & Houba, H. (2016). The Condorcet paradox revisited. Social Choice and

Welfare, 47(1), 141-186.