Rational Consumer Behaviour and the impact of price on pruchasing decisions: Indifference curve analysis
A rational consumer will always purchase less of an item as the price increases. Discuss with the use of indifference curve analysis, whether the statement is correct.
A rational consumer makes decisions on what to buy or consume based on utility, aiming to maximise his overall satisfaction. He will carefully evaluate all the different goods available to him and analsye the costs and benefits he will derive from the consumption of the said goods. A rational consumer is assumed to make decisions independently, prioritising his own preference and needs.
Indifference curve (IC) is a curve which represents all combinations of two goods which gives the same satisfaction to the consumer. As depicted in figure 1, IC1 shows a consumer is indifferent between consuming at point A or B. Both points give equal satisfaction to the consumer, hence they are indifferent to consuming either 2 units of Apples and 6 units of Banana, or 3 units of Apples and four units of Bananas. Nonetheless, within this model, consumers always prefer to be on higher indifference curves. For example, a consumer would prefer any combinations from IC2 rather than IC1 because all combinations on IC2 provide greater satisfaction than those on IC1.
Indifference curves (IC) are also convex to the origin due to the principle of the marginal rate of substitution (MRS). The MRS refers to the amount of one good a consumer is willing to give up to obtain an additional unit of another good. In Figure 1, at point B, the consumer is willing to forgo six bananas to acquire one extra apple. However, at point C, the consumer is only willing to give up two bananas to obtain one more apple.
This diminishing MRS can be explained by the concept of diminishing marginal utility. Initially, when the consumer has a greater quantity of apples, the utility derived from each additional apple decreases. As a result, the consumer is more willing to trade several apples for one additional banana. However, as the consumer's apple consumption decreases and the quantity of apples becomes scarcer, the marginal utility of apples increases. Consequently, the consumer becomes less willing to exchange as many apples for an additional banana. This diminishing MRS is represented by the curvature of the indifference curve, which becomes flatter as we move down and to the right along the curve.
As mentioned earlier, if consumers continue to choose higher indifference curves indefinitely, they would not reach a point of equilibrium. Therefore, the concept of a budget line is introduced in the model. The budget line represents the range of affordable combinations of goods based on the consumer's level of income. It serves as a constraint that guides the consumer's decision-making process, ensuring that their choices align with their financial means. By considering the affordability represented by the budget line, consumers can identify the optimal combination of goods that maximizes their utility while staying within their budgetary limits.
Figure 2 illustrates the consumer's budget line and the tangent point between the budget line and the indifference curve (IC) at point X. This tangency represents the consumer's equilibrium, where the optimal consumption level is achieved. Although the consumer may be indifferent between consuming at points Y and Z, the budget constraint limits their ability to afford those combinations. As a result, the consumer's equilibrium is determined at point X, where the budget line and the indifference curve intersect. At this point, the consumer can attain the highest level of satisfaction that is both attainable within their budgetary constraints and maximizes their utility.
Normal good refers to a type of goods for which the demand increases as consumer income rises, while it decreases as consumer income falls. As the price of a normal good increases, consumers tend to purchase less of it. Figure 3 illustrates the impact of an increase in the price of bananas, (assuming both bananas and apples are normal goods.) In response to the higher price of bananas, consumers substitute them with more apples (point A to B). This substitution occurs because the relative price of bananas has risen, making apples relatively more affordable and appealing as a substitute.
However, it's important to note that while point B on the indifference curve may represent a combination of goods that provides the same level of satisfaction to the consumer, it becomes unaffordable due to the increased price of bananas. Consequently, the consumer is forced to move to a lower indifference curve, specifically IC2. On IC2, the consumer reaches a new equilibrium at point Y, where the budget line and the indifference curve are tangent.
At this new equilibrium, the consumer reduces the consumption of bananas from Q1 to Q3. This reduction in quantity purchased is a result of both the substitution effect and the income effect. The substitution effect leads the consumer to substitute bananas with apples due to the price increase (Q1 to Q2). Simultaneously, the income effect occurs because the higher price of bananas reduces the consumer's purchasing power, necessitating a decrease in overall quantity purchased.(Q2 to Q3). For normal goods, the substitution effect and income effect both work in the same direction, reinforcing the decrease in quantity purchased as the price increases.
In the case of inferior goods, an increase in price typically leads to a decrease in the quantity purchased. This is because as individuals' income rises, they have the ability to purchase higher-quality substitutes or alternatives to the inferior goods. However, the dynamics of inferior goods differ from those of normal goods due to their lower quality or status. While the price increase initially discourages some consumers from purchasing the inferior goods, there is a countervailing income effect.
The income effect arises because the higher price of the inferior good reduces the consumer's purchasing power. As a result, some consumers who may have preferred to purchase a higher-priced normal good are now inclined to purchase more of the relatively cheaper inferior good due to budgetary constraints. In other words, the increase in the price of the normal good makes the relatively lower-priced inferior good a more affordable option for these consumers.
However, it's important to note that despite the income effect pushing some consumers to buy more of the inferior goods, the substitution effect remains significant. The substitution effect reflects the consumer's tendency to replace the inferior good with a superior alternative as their income increases or as the price of the inferior good rises.
Overall, as shown in Figure 4, while the income effect may lead to a temporary increase in the quantity purchased of an inferior good (Q2 to Q3) when its price rises, the substitution effect (Q1 to Q2) eventually dominates. This results in an overall decrease in the quantity purchased as the price of the inferior good increases, as consumers ultimately seek higher-quality alternatives.
The behavior of Giffen goods deviates from the patterns observed with normal and inferior goods. Giffen goods are a unique type of inferior goods which are characterized by having no close substitutes and being considered essential goods for certain individuals or communities.
Figure 5 represents the behavior of a Giffen good, specifically crushed rice, as its price increases. In this scenario, the quantity purchased of crushed rice actually increases despite the higher price. This phenomenon occurs due to the interplay of the substitution effect and the income effect.
The substitution effect in the case of Giffen goods still operates in the same direction as with other goods. As the price of crushed rice rises, consumers are incentivized to seek alternatives, such as normal rice, which becomes relatively more affordable. The substitution effect would typically lead to a decrease in the quantity purchased of crushed rice (Q1 to Q2).
However, the income effect for Giffen goods works in the opposite direction compared to normal and inferior goods. With the increase in price, the consumer's purchasing power decreases, making it more difficult to afford alternative goods. In this case, the income effect pushes consumers to consume more of the Giffen good, as it becomes a relatively cheaper option compared to the alternatives. In the specific context of Giffen goods, the income effect outweighs the substitution effect, resulting in an overall increase in the quantity purchased as the price increases. This counterintuitive behavior distinguishes Giffen goods from other types of goods, highlighting their unique nature and the complex dynamics that govern their demand.
Using indifference curve analysis, substitution and income effects highlights important insights into consumer behavior concerning different types of goods. Nevertheless it is important to acknowledge a few limitations of the analysis. In this analysis, we are assuming, consumers are rational when making decisions. Nevertheless, in reality, consumers often rely on heuristics or make decisions based on limited information. For example, consumers may also buy goods on an impulse. In this case, consumers are making spontaneous purchases without carefully considering their needs or budget. They may be influenced by emotions, marketing tactics or social pressure. Furthermore, the assumption that consumers have perfect knowledge may not hold true as well. They may not have complete awareness of all available options, the prices of goods, or the specific attributes and qualities of each item. This lack of perfect knowledge can significantly impact the application of indifference analysis.
In conclusion, indifference curve analysis helps us to understand how price changes influence consumer bahaviour. A rational consumer will purchase less of a good as price increases in the case of normal and inferior goods. However, Giffen goods are an exception, as consumers increase the quantity purchased when the price increases. It is also important to recognise the limitation of the analysis since in the real world a consumer may not always be rational.