Practical Application of the Neoclassical Model of Consumer Choice
Word count: 1902
Introduction
The neoclassical model of consumer behavior is founded on the basic idea that the consumer is looking to obtain the next bundle of goods and services they possibly can. Therefore, in deciding on this best bundle, the neoclassical economists assumed that consumers do have preferences which could be represented by a utility function that assigns a number to the specific bundle of goods and services (Robertson, 2020, 69). The bundle that the consumer prefers is assigned a higher number and vice versa, it is prudent to note that the preferences by the utility function establish the ‘best’ bundle of goods and services.
Nevertheless this fundamental idea of a consumer choosing their best bundle when they can ‘possibly can’ is very important. The typical consumer is normally constrained by limited income levels and hence their best bundle of goods and services is determined by considering the available income. To this effect, in establishing their ‘best’ bundle, the consumer seeks to maximize their utility subject to the budget or income constraints, the utility function will establish what is best, the budget or income constraint which will determine the set of possible bundles which the consumer could obtain.
This essay is to look into the main assumptions of the neoclassical model of consumer choice between two goods, specifically use of one’s entire weekly allowance on purchasing deserts and having to choose between two preferred types; a bowl of jello and a piece of pumpkin pie.
Budget Sets in the Neoclassical Model
In this model, the budget set comprises all combinations of the goods that the consumer can afford. In this case, the two goods to be considered are a bowl of jello and a piece of pumpkin pie. These two products are expected to exhaust the consumer’s entire income allowance which is normally represented by the budget frontier. To graphically represent the budget set of these two products, the vertical intercept represents the point at which the socumer spends all income on the piece of pumpkin pie (Good 2). The horizontal intercept represents the number of units that the consumer obtains after spending all their income on the bowl of jello (Good 1). With M representing the total income to be used in the products, the number of units in the vertical intercept would be while the units on the horizontal intercept would be
Notably, following the neoclassical approach, the economist used the indifference curve for representing the preferences of the consumer in relation to these goods. The indifference cursive will demonstrate the combination of the two products that the consumer needs to choose to have the optimal bundle (Salvatore, 2008, 62). The higher indifference curve refers to the higher satisfaction levels and the lower indifference curve represents less satisfaction, it is prudent to note that the ordinal measure of utility is fundamental in drawing this indifference curve, the assumption taken in ordinal utility include that the consumer can determine which combinations one prefers or whether they are indifferent towards the combinations. In this case, the combinations would be preferring the bowl of jello to the piece of pie or they prefer the piece of pie over the bowl of jello or they are indifferent between the two.the second assumption is that the consumer’s tastes are consistent or transitive. The third assumption is that the consumer will prefer more of a commodity to having less of it and they will never be satisfied with the product.
Therefore, drawing the graphical representation of the indifference curve in this case with the default position of an income of 250, the bowl of jello’s price at $25 and the price to the piece of pie being $10. The conditions of the situation is that the consumer will have one unit of a bowl of jello and 12 units of the pieces of pie to attain a particular satisfaction level. Therefore the concern of how many units of pie pieces he is willing to give up in exchange for additional bowls of jello means that the level of satisfaction is not changed, the consumer could agree to give up 6 units of the pie pieces for an additional bowl of jello. Therefore, the two combinations of the two items to give equivalent satisfaction yo combination will include:
1. 1 unit of the bowl of jello and 12 units of pieces of pie.
2. 2 units of the bowls of jello and 6 units of pieces of pie.
Other combinations include:
Combination Bowl of Jello Pieces of Pie
A 1 12
B 2 6
C 3 4
D 4 3
Figure 2: The Consumer’s Indifference Curve
Figure 3: The Consumer’s Optimal Choice.
From the above Figure 3, the Points A, B, and C are on the budget frontier. The consumer is said to exhaust their income at the three points. It is only at point C where the decision will be optimal and hence the preferred choice due to convexity. Ultimately, the utility function would have placed point C at a higher indifference curve. In actual fact it is impossible toi find a point within the consumer’s budget set that is more preferred than point C. Therefore, point C is the best bundle which the consumer can afford containing both the bowl of jello and the pieces of pumpkin p=ie. At this point the indifference curve will be tangent to the budget frontier line.
Marginal Rate of Substitution
The marginal rate of substitution (MRS) is a reflection of the amount of one good that the consumer is willing to forego for the additional unit of the other good while maintaining similar satisfaction levels. Rather it reflects the maximum amount of the pieces of pie that the consumer is willing to give you in order to obtain additional units of the bowls of jello. The consumer is happy to give less of the pieces of pie since it would place the consumer at a higher utility level from the original indifference curve. It is prudent to note that the consumer is not willing to give up more pieces of pie since it would position them below the utility level depicted from the initial indifference curve.
Figure 5: The MRS
The MRS is portrayed by the slope of the indifference curve. This depicts the amount of the piece of pie that is given up by the power unit of the bowl of jello, the slope between point A and B is represented by Y0/X, between B and C is Y1/X, and between C and D is Y2/X. considering that the product on y axis (piece of pie) is declining the slope gets flatter and flatter, for every small increments in the units of good X (the bowl of jello), the slope of the indifference curve will be tangent to it, therefore, the MRS could be referred to the absolute slope that is tangent to the indifference curve. In the above figure 4, the tangent gets flatter as one moves from point A to B to C to D. It is prudent to note that the MRS being the absolute slope of the indifference curve declining reflects the convexity of the latter. This means that as the consumer moves down then indifference curve and is left will less pieces of pie to more and more bowl of jellos, each remaining unit of the good Y increases in valuable to the consumer and each additional unit of good X becomes less valuable, it is this feature that makes the MRS decline and the indifference curve to convex to the origin.
The Impact of Taxes and Tax Breaks On Consumers’ Behavior
Generally, the effect of changes in income and prices on demanded quantities, also known as income elasticity and price elasticity, will have an impact on the utility the consumer can obtain from their best bundle (Piana, 2003, 5). Specifically, an increase of income will normally boost both quantities of X and Y [2] – as well as the utility enjoyed. When the government reduces the various taxes that the consumer has to pay, then their disposable income increases considerably. For this consumer, having their disposable income increase would mean that they will have more income to purchase more of the deserts. The higher the units obtained leads to a subsequent increase in the utilities obtained regardless of the combinations they choose.
The vice versa will happen if more taxes are imposed on the consumer’s income. Iomore taxes reduce the consumers’ disposable income prompting the consumer to choose another ‘best combination’ of the two deserts and try to attain as much utility as they did prior to the taxes being imposed. However, this becomes impossible since the income has reduced. The consumer will have to get a lower utility level. This impact of higher taxes is similar to the effect of price on demanded quantities which shows that the increase of the price of X is a damage: utility falls and the quantity of X decreases as well.
Figure 6: Effect of Tax Upon the Economic Well-being of The Consumer
In the above figure, it is assumed that good Y (piece of pie) stands for all the goods other than X (bowl of jello). The consumer’s money income to be spent on the two goods is M. If the sellers can pass on the whole tax to the consumers, the price of X will rise by the amount of the tax, and the x-intercept of the budget line will reduce from OB to OB1, and the post-tax budget line would become AB1. The consumer’s equilibrium before the imposition of the tax was at the point of tangency C between the budget line AB and one of his indifference curves (ICs), IC3, and now it would be at the point of D where the post-tax budget line AB1 has touched IC1 which is a lower curve than IC3. Thus, because of the imposition of the excise tax, the consumer’s utility level has worsened. The imposition of the tax has caused an increase in the price of one of the two goods, X, that the consumer purchases.
Opinion on the NeoClassical Model of Consumer Behavior
While the neoclassical model of consumer behavior provides an insightful approach to understand economic behaviors of its players, the assumption inthe model that all participants behave rationally is not very practical. In real life, there are a myriad of factors that affect a consumer and business that might make their choices or decisions irrational. Market corrections and bubbles in conjunction with income inequality, are all the consequences of choices made by participants which some economists would deem to be irrational. While in the ideal world, the consumer wants to spend their extra earnings on burning deserts constantly, to make these decisions constantly is not as clear cut as the neoclassical economists want to claim. The economists have assumed the consumer has fully understood their preferences and they can decide how much of something they would want to buy. It also assumes that the market will constantly have the quantity that the consumer is demanding. The real world does not work as per these assumptions and it is very rare to find a consumer making decisions based on the utility they are likely to obtain from a particular product. To this effect, the neoclassical model does not provide the best explanations of consumer behavior and in any case, human behavior.
Reference List
Robertson, M., 2020. 5 HOW AND WHY ARE THINGS CONSUMED?. Recharting the History of Economic Thought, p.69.
Piana, V., 2003. Consumer theory: the neoclassical model and its opposite evolutionary alternative. J. Econ. Issues, 31, 651-664.
Salvatore, D., 2008. Chapter 3: consumer preferences and choice. Microeconomics: theory and applications. OUP Catalogue.
