Consumer Sovereignty 2 - Cengage · PDF file2 Consumer Sovereignty Andrew Trigg Concepts and...

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Transcript of Consumer Sovereignty 2 - Cengage · PDF file2 Consumer Sovereignty Andrew Trigg Concepts and...

  • 2Consumer SovereigntyAndrew Trigg

    Concepts andtechniques Consistent preferencesIndifference curvesOrdinal preferences; utility

    maximizationMarginal rate of substitutionDiminishing marginal rate of

    substitution; convexity

    Feasible consumption set; budgetconstraint

    Slope of a line; slope of a curve;tangency

    Income and substitution effectsNormal, inferior and Giffen goodsLexicographic preferencesSlutsky approximationRevealed preference

    Links This chapter shows how two of the core assumptions of neoclassical

    economics, methodological individualism and rationality, explored inChapter 1, form the basis of the neoclassical theory of consumption.

    The consumer demand curve forms one of the essential building blocksof the general equilibrium model. It was introduced in Chapter 1 andwill be explored further in Chapter 18.

    Similar techniques of maximization under constraints will be used inChapter 5 to derive a households labour supply curve, and in Chapter 10 to consider how firms choose between competingtechniques of production.

    Alternative theories of consumption will be explored in Chapter 3.

    In Chapter 4, demand curves and the Slutsky approximation are used toderive price indices and provide one measure of household welfare.

  • 1 Introduction

    The free enterprise economy is the truecounterpart of democracy: it is the onlysystem which gives everyone a say. Everyonewho goes into a shop and chooses one articleinstead of another is casting a vote in theeconomic ballot box: with thousands ormillions of others that choice is signalled toproduction and investment and helps tomould the world just a tiny fraction nearer topeoples desire. In this great and continuousgeneral election of the free economy nobody,not even the poorest, is disfranchized: we areall voting all the time. Socialism is designedon the opposite pattern: it is designed toprevent people getting their own way,otherwise there would be no point in it.

    (Powell, 1969, p.33)

    In this quotation from the late Enoch Powells bookFreedom and Reality, the once prominent UKpolitician conveys the idea of consumer sovereignty the idea that in a free market economy, individualconsumers choose which goods are produced.Instead of a king, dictator or central planner makingdecisions, sovereignty is vested in the everydaychoices of individual consumers. These individualchoices lead by an invisible hand to the bestpossible outcome for the economy as a whole.

    This view of the free market became increasinglydominant with the emergence of Thatcherite andReaganite policies in the early 1980s, and thecollapse of the eastern European bloc of centrallyplanned economies in the late 1980s. Indeed, it hasbeen argued that the inability of the Soviet system tosatisfy consumer demand was one of the mainreasons for its demise. John Kenneth Galbraith, forexample,has pronounced that the Soviet system:

    could not satisfy the infinitely diverse andunstable demand for the services and

    products that make up the modernconsumers goods economy. Here socialism,both in planning and administration, provedfar too inflexible. One may marvel at theattraction of often frivolous and dispensableconsumer artifacts and entertainments in ourtime, but their ultimately controlling appealcannot be doubted.

    (Galbraith, 1992, p.78)

    An enduring image of the collapse of communismin eastern Europe was that of East Germans queuingto cross into the west in their patched-togetherTrabants. These 1950s style vehicles revealed howstarved the East Germans had been of westernconsumption goods during the years of stateplanning. More than anything, the car has providedthe symbol of the triumph of consumerism. Forthose on the right of the political spectrum, themotor car epitomizes the freedom of privateconsumers to go where they please, without relyingon government, business or anyone else to run thebuses, coaches or railways on time (Gabriel andLang, 1995, p.16). In this view, the triumph ofwestern capitalism can be attributed more toMercedes Benz and BMW than to Cruise and Tridentmissiles.

    Mirroring this dominance of capitalism in theworld economy, the worlds economics professionhas been dominated by neoclassical economics(Chapter 1 outlined the framework of neoclassicaleconomics and some alternative approaches).Although neoclassical economists vary in theirindividual political allegiances, their approach hasbeen used to provide a technical demonstration ofwhy free market capitalism offers the best systemfor organizing an economy. In neoclassicaleconomics, the choices of the individual consumerare shown to determine what is produced: this iswhat is meant by consumer sovereignty.A definingassumption of neoclassical economics is that allindividuals follow their own self-interest, whetheras producers deciding which is the most profitablemethod of production, or as consumers choosingwhich goods to purchase. To make profits, pro-ducers must sell their wares. To do so, they mustproduce what consumers want. The neoclassicalapproach shows how consumer sovereignty isachieved by a market economy in which bothproducers and consumers act according to theirself-interest.


    Consumer sovereignty

    Consumer sovereignty holds when consumershave the power to dictate what is produced in theeconomy.

  • This chapter focuses on the individualconsumer whose behaviour provides the keybuilding block for the neoclassical theory ofconsumption. In this theory, the individuals prefer-ences provide the basis for choosing betweendifferent goods and services. I may, for example,according to my own particular tastes, prefer tobuy a Top 10 CD than a record by Showaddywaddy.It follows,since others obviously feel the same way,that we will be prepared to pay the full price for aTop 10 CD in a Virgin Megastore, but we will onlybuy Showaddywaddy records when they arediscounted for 99p in Woolworths.The point hereis that my preferences drive my demand and henceprovide the signal in the marketplace as to whatprices can be charged. This relationship betweenpreferences, demand and price provides the focusof Section 2 of this chapter which demonstrateshow the tastes and preferences of individualconsumers are communicated in the marketplace.

    The rest of the chapter critically discusses theneoclassical theory of consumer behaviour. Ofparticular interest is the way in which consumersrespond to changes in price. Say the price of breadfalls sharply in your supermarket.This can have twoeffects. It may encourage you to buy more breadinstead of,say,potatoes;and it will also mean that youare better off in real terms and can, therefore, affordto buy more bread and more potatoes. Section 3provides an initial analysis of these two impacts of aprice change, using the neoclassical theory ofconsumer behaviour.

    In Section 4 I look at this theorys core assumptionthat consumers act according to their own prefer-ences, like rational calculating machines,and that thisgives them a full say in the ballot box of consumerdemocracy. I shall consider the implications of con-sumers either being too poor to exercise muchchoice in this ballot or being irrational in theirbehaviour.

    As part of this discussion, a test of the model isprovided by introducing an example from experi-mental economics.The problem with economics, incomparison with many physical sciences, is that it isvery difficult to carry out controlled experiments. Achemist can control the amount of chemicals in hismeasuring jar and test whether or not they willgenerate an explosion. Experimental economicstries to carry out its own tests by setting up arti-ficial environments in which economic behaviourcan be observed.

    2 The neoclassical theory ofconsumption

    A schoolboy calling at the corner shop on the wayhome from school has to decide how to allocate hispocket money on crisps and chocolate; a youngexecutive decides how to spend her months salaryon clothes and jewellery; and Lennox Lewis,surviving yet another challenge to his world heavy-weight boxing title, decides whether to spend hisearnings on a helicopter or a yacht.

    Neoclassical consumer theory is based on theassumption that, in making a comparison betweendifferent items of consumption,individuals have pref-erences which they use to rank the possible alterna-tives. Assume, for example, that the schoolboy has tochoose between two possible combinations of crispsand chocolate.In one shopping basket there are threepackets of crisps and three bars of chocolate thiscan be referred to as bundle A. In the other shoppingbasket there are two packets of crisps and two bars ofchocolate, referred to as bundle B.

    In choosing between these two bundles, the indi-vidual, in this case the schoolboy, must decide Do Iprefer bundle A to bundle B? We use the symbol > toindicate the direction of preference:

    A > B; read this as A is preferred to B.


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  • Since the schoolboy likes both crisps andchocolate,he will prefer bundle A to bundle B, and itfollows that he ranks bundle A more highly thanbundle B. The bundles are arranged in a particularorder, in which A is ranked higher than bundle B.Notice that we are not assuming that the individualplaces any particular absolute value on either basket,merely that one is valued more, or ranked higher,than the other. Since preferences produce a rankedordering in this way, they can be said to be ordinal.

    The assumption that individuals use preferencesto rank alternatives provides the starting point forthe neoclassical theory of consumption.

    In addition to assuming that consumers rankalternatives, neoclassical economics also assumesthat their rankings are consistent. Consumers mustbe consistent in their choices: if an