Theory of Demand





Demand is a schedule representing the quantities of a good or service the consumer is able and willing to buy over a given range of prices. It reflects the way consumers react when faced with variations in the price of a good. There is no question that consumers react to price and that there is some hypothetical demand schedule. The real question is what it means. Can demand be interpreted as some sort of subjective measure of the benefits that a good or service provides? Under what conditions can such beneficial results be expected? A definitive answer is not possible, but in neoclassical economics the tendency is to assume that demand is a reflection of the degree of benefits received by consuming a good or service. In order to ensure that markets result in economic efficiency, demand must represent the genuine beneficial value for the consumer of a good or service. Critics of this neoclassical viewpoint commonly argue that demand can be manipulated and does not necessarily represent the genuine value of a good or service for the consumer (for any number of reasons).


This chapter will first develop the traditional neoclassical view of demand and then later put forth the viewpoint of more critical theories. Utility theory is the common neoclassical explanation for demand. Utility is a term applied by economists to the benefits or satisfaction obtained from a good or service (also from a particular course of action). Utility refers specifically to the consumer’s feeling of satisfaction, not the product’s usefulness. A concert in the park by a favorite musician may give you a lot of utility or satisfaction, but is not useful in a practical sense.


Utility Theory

 Demand is the result of consumers making choices among alternative possibilities. How does one make such choices? In utility theory the consumers’ objective is simply to maximize their utility or satisfaction. Consumers who have limited money, income or resources need to have full information about their own desires and how the available choices meet those desires. They need to know the real price of the good or service and the prices of all-possible alternatives, as well as the quality and durability of those goods or services. They need to know whether the good or service will function as advertised and satisfy their need. Usually this information is more easily found with products and services that are consumed often and in small quantities. For instance, if milk or cereal is purchased every week the consumer will personally become very familiar with the price and quality of the products available; therefore they have good direct information. However, information is more difficult to find for a product that is only purchased on occasion such as a stereo set, car, or house. The information available about these products is less personal and more dependent on external secondary sources, and thus is less trustworthy. Utility theorists assume that consumers have full information and can make rational decisions about which products will grant them the most utility. It is necessary to assume complete information on behalf of the consumer to demonstrate that markets serve the consumer (not just the producer).


Another assumption of utility theory is that consumers are both self-interested and rational. Consumers rationally make choices that move them toward their highest level of satisfaction. It is also assumed that they have taste and preferences that are stable and innate.


Maximizing utility

In order to maximize utility, achieving the greatest possible satisfaction, consumers must make judgments about each additional dollar spent on a good or service. More goods mean more utility, but income puts constraints on the level of utility that can be reached. In addition, as more and more goods or services are consumed the additional value that each good or service contributes to total utility declines. This tendency is called the law of diminishing marginal utility. Formally, the law states that as more units of a good or service are consumed, the utility of additional units of the good ultimately decreases (holding other things constant). The common sense rationale for diminishing marginal utility is simply that with more units the consumer becomes satiated. One unit may be highly prized but as additional units are added their additional value declines, and with enough additional units their effect on total utility may actually be negative (such as garbage that must be hauled away). Table 1 contains a utility schedule with both total utility and marginal utility.


Table 1, Total and marginal utility                                

Number of Units

Total Utility

Marginal Utility






































In table 1 note that total utility increases with the number of units (up to nine units and a maximum satisfaction of 45 beyond which satisfaction or total utility declines). The marginal utility (MU) is the amount of utility received by adding an additional unit. The marginal utility declines with each additional unit acquired. For instance, the first unit provides nine units of marginal (additional) utility, while the second unit provides only eight marginal units and so forth. Table 1, thus demonstrates the law of diminishing marginal utility. The ninth unit provides no additional utility (marginal utility is equal to 0). Consumption of the ninth, tenth, or eleventh units by a consumer would not be considered rational behavior, since rationality is defined as the effort to maximize satisfaction, and these units add no additional utility.


In the early days of economics there was an effort to measure utility (i.e. to ascribe numbers to each unit of utility). That effort was abandoned and a consensus developed among economists that utilities are fundamentally subjective and impossible to directly observe or combine. So those units listed in table 1 as utilities are hypothetical and can be no more.


An early application of the law of diminishing utility resulted in an intellectual argument for redistributing income or wealth. It was a radical result for that time.  By redistributing wealth a society could maximize its total utility or satisfaction. The law of diminishing utility states that as income or wealth increases its additional utility declines (diminishing utility). Therefore, a single dollar for both a typical college student and multimillionaire would have vastly different levels of utility. Redistributing dollars from the multi-millionaire to the poor student would increase total social utility (the student’s gain would be greater than the multi-millionaire’s loss). This increase in utility, although conceptual, is not, of course, measurable. These early notions have been superseded in economics by a new criterion called pareto optimality. This criterion is a much more conservative argument. Pareto optimality is an assumed condition of the economy in equilibrium given markets. It argues that no societal redistribution should be undertaken (by governments) that improves the position of any member at the expense of others. Here no comparison of utility is necessary.


The demand curve

In utility theory the demand curve for the individual is derived directly from the law of diminishing utility. In table 1 the number of units, and the marginal utility has an inverse relationship, just as the demand curve. The demand curve slopes downward to the right just as the diminishing marginal utility curve slopes downward to the right. At any given price the quantity demanded by the consumer depends on the good’s marginal utility. If the marginal utility were high then the consumer would be willing to pay a higher price, if marginal utility were low then the consumer would be willing to pay only a lower price.  How much a consumer is willing to pay then depends on the good or service’s marginal utility. The demand schedule then turns out to be equivalent to the schedule of marginal utilities. The two logically must be equivalent.


Market demand is simply the sum of all individual marginal utilities. Figure 1 shows this in a graph. Individual marginal utilities represent the satisfaction that each additional good or service brings to the market for that individual. Summing marginal utilities gives the amount of increased satisfaction for all market consumers. Simply put, increased satisfaction is equal to the benefits consumers receive from consuming the good or services.


Figure 1, Demand Curve and Marginal Utilities



Consumer equilibrium

How do consumers decide how many different goods to consume?  Each good and service has a different price and marginal utility, and the consumer has limited income. Given the logic of utility theory the consumer will equate the marginal utilities, given price (MU/Price) for each good or service. In this way the consumer can maximize satisfaction, and thus reach what is referred to as consumer equilibrium.


Marginal utility/Price (for good A) = Marginal utility/Price (for good B) = Marginal utility/Price (for good C) etc.


The above formulation shows the conditions for consumer equilibrium given three goods. The best way to explain this formulation is to consider the case where marginal utilities and prices are not equal for different goods. If, for instance, the marginal utility of A given price (MU/P) is greater than the marginal utility of B given price (MU/P), then by definition, total utility could be increased by buying more of good A and less of good B. The gain would be the marginal utility of A, while the loss would be the marginal utility of B. Because the marginal utility of A is greater than the marginal utility of B there will be a net gain in utility.


Accordingly, the appropriate action is buying more of good A. The law of diminishing utilities dictates that this action will result in a decline in good A’s marginal utility. The second appropriate action, buying less of good B, will result in an increase in B’s marginal utility, as prescribed by the law of diminishing utilities. As a result of these movements (A’s marginal utility going down and B’s marginal utility going up), the two marginal utilities must eventually become equal. Total consumer equilibrium will exist when all marginal utilities of all goods and services purchased, given their prices, are equal. The simply notion is that a consumer will buy that good which provides the greatest potential increase in satisfaction while selling goods that provide less satisfaction, given price. It is really a simple commonsense proposition.


This logic can be generalized to all consumers’ decisions. For example, decisions regarding savings behavior (whether to consume or save), or decisions regarding work (whether to work, and how many hours to work) can be and are modeled in this way. Equalizing particular marginal utilities, given price (not only in dollar terms but also in total opportunity cost), is the generalized view of consumer equilibrium. Under these conditions, equilibrium exists when no action can lead to greater utility or satisfaction. Pursuing this equilibrium is what utility theorists and neoclassical economists mean when they use the term rationality. Humans are assumed to act rationally.


This definition of rationality is simple. There are no countervailing forces, impulses, and emotional states, which significantly interfere with the process of equalizing marginal utilities. Not that economist does not recognize emotions (those irrational impulsive states) they just assume that there inclusion is unnecessary. The belief is that, their theory of human behavior, although not perfect is good enough to predict and forecast economic activity.


Indifference Curves and Demand Theory

Another neoclassical approach to consumer equilibrium (or modeled consumer behavior) is through the development of indifference curves. These curves provide an alternative graphical way of presenting utility or satisfaction. There are two different hypothetical goods measured on the two axes, as shown in figure 2. Moving out from the origin increases the quantities of both of these goods and increases the utility derived from the consumption of those goods. More of either good increases utility. Indeterminacy (or indifference) exists when the quantity of one good increases and another good decreases in quantity. In figure 2, point B provides more of both good one and good two and thus would provide more utility than point A or C.  Point B would provide more utility and thus be preferred by the consumer. Since point A is further out from the origin it would be preferred to point C. Points on the same indifference curves lead to ambiguity since one point has more of one good while the other point has more of the other good.  Indifference curves are drawn between points of equal utility. They represent positions on the graph where consumers would have an equal preference of goods. By definition, indifference curves cannot cross each other and the indifference curve furthest from the origin will have the largest utility or satisfaction. There is an indefinite number of such curves possible. The curves are drawn bowed in toward the origin as shown in figure 2.


Figure 2, Indifference Curves


Using indifference curves requires assuming that consumers are certain about the utility for each good. Another assumption is that both goods are desired, and that desire will be stable over time. The goods are also assumed to be genuine (innate) and cannot be manipulated by external forces. There also must be no doubt that more of either good increases utility.


The budget line

In order to derive consumer equilibrium one additional element needs to be included, the budget line. The budge line represents an individual’s available income and the prices of the goods the individual has to pay. In figure 3 if only good 1 was purchased, point A could be reached, however if only good 2 was purchased, point B could only be reached.  The prices of good A and good B are determined by the market. The straight line drawn between A and B is the budget line; it represents all the possible combinations of good 1 and 2 that could be purchased at the going price. The ratio of the two prices for A and B determine the slope of the budget line.


The budget line along with the indifference curves, determine consumer equilibrium. The budget line prescribes how much of good A and good B can be purchased by the consumer, given the relative prices of A and B. The consumer cannot purchase at any point beyond the budget line. Given the consumers usual assumption of maximizing utility, the point where the consumer will settle on a purchase is represented in Figure 3 by point C. This is because point C maximizes utility at U1. The utility at U2 is out of reach given the prices of A and B and the income available. The utility at U0 could be easily reached, but it represents less utility or satisfaction than the consumer could obtain at U1. This is true because UO is closer to the origin than the other indifference curves. Only at point C, where there is a tangency point between the budget line and the highest possible indifference curve, can the consumer not further increase utility. Therefore point C is the consumer equilibrium point where quantity D and E are purchased. The movement to point C is, by definition, what economists consider rational.


Figure 3, the Budget Line and Consumer Equilibrium




















The Theory of Demand—The Critics




There is a general agreement among economists that preferences and utilities are not directly observable or measurable. Therefore, testing whether people actually do equate marginal utilities, given prices, or attempt to maximize utility is next to impossible. Most mainstream empirical work, instead, has centered on testing whether the demand curves slope downward to the right, thus testing for consistency of consumer preferences. Revealed preference theory, which argues that consumers, by making choices, reveal their preferences or utility, is an approach employed by economists who want to avoid measuring utility directly. Critics argue that these efforts are in vain, and that tests for consistency of choice, and stable preferences are not really possible. The argument is that empirical testing requires too many questionable assumptions, allowing the mainstream economist to make easy explanations for all sorts of behavior that may be incorrect. For instance, if a consumer bought something he/she had previously turned down, the consumer might only be expressing a taste for change or novelty, and not showing inconsistency of choice. Or if consumers are found to have altruistic motives, it signifies only that consumer’s preferences or utility functions include the well being of others.


The critics of the use of consumer rationality argue, that the theory’s premise is principally non-testable and thus its acceptance is a matter of faith. Adopting the consumer rationality model has a strong methodological attraction for mainstream economists. It provides a simple deductive logical premise that can lead to quantitative results. The belief is that, it has all the characteristics that a good scientific model should have (something sought by neoclassical economists). Tellingly the defenders of neoclassical economics attack the critics by arguing that they have no better theory to use. What they mean is that there is no replacement that can provide for the simple deductive logical premise of current theory, and that can promise such simple quantitative results (faulty as they may be). These differences are as much over methodology (what a good theory is and should be) as over substance.


Consumer rationality and equilibrium underlies much of neoclassical microeconomics. For instance, in the area of public finance it’s been used to argue that a tax has a hidden cost (a cost above and beyond the actual taxed dollars). This additional burden is a result of taxpayers trying to avoid taxes by consuming a different set of goods and services than they would without the tax. With the tax the optimal set of goods and services determined in the consumer equilibrium process is no longer the choice. The taxpayer and consumer are seen as worst off, because they will now consume an inferior set of goods and services. This condition is, of course, true only if consumers had maximized their utility before the tax by equalizing their utilities. Most economists in public finance believe that a tax is a burden (beyond the tax dollars); this belief, in turn, relies on the condition of consumer equilibrium. Critics of the theory argue that this belief is a non-testable assumption, based on a narrow definition of economic behavior and rationality. This argument is developed further in the following pages.


Consumer Rationality and Equilibrium; Critically Examined

There are two positions taken by critics of consumer rationality. The first critique is that the theory’s very existence helps justify and encourage the self-centered behavior it describes. The rational consumer gets what he/she wants and wants what he/she gets. It is a portrait of human behavior ruled by unquestioning, self-interested desires. Altruistic behavior is not portrayed as an element of our rational behavior, and the fear by the critics is that the model encourages both amoral and antisocial behavior.


The second critique is that consumer rationality does not sufficiently describe actual consumer behavior. They argue that humans are not simple calculating maximizer of utility, and since testing for consumer rationality is not possible, a more realistic version of consumer behavior should be established. They conclude that modeling purchasing behavior may need to be inductive (studying actual human behavior), and may not allow for strict deductive and quantitative results. Such a model, they claim, may need to be simply descriptive with few allusions to strict testability. But the model must come closer to real human rationality and behavior in order for it to be useful.



The object of actual human desires can be viewed at different levels of abstraction. They can be understood from the level of the desired goods and services or by considering the underlining psychological needs of the individual.  Both perspectives will be described here.


In the real world, the connection between human desires and their satisfaction is full of unexplained uncertainties. However, for the sake of developing models, neoclassical economists commonly assume certainty. It is, in fact, one of the crucial assumptions allowing economists to consider the demand curve as representing the benefits received by the consumer. Neoclassical critics argue that in a world of uncertainty, the assumption of certainty is not useful. They question how can we know with certainty whether the purchase of a good or service will satisfy the desires that motivated our purchase? While they admit that those goods and services which fulfill basic needs, are purchased often, and consumed directly (such as milk, bread or a local bus ticket) may have fairly certain outcomes, they argue that less often purchased goods and services that are intended to fulfill more amorphous desires, have uncertain outcomes. For instance, it is uncertain whether purchasing vacation packages, cars (particularly used ones), insurance policies, or making tuition payments for college will satisfy the desires you intended to fulfill. This uncertainty is pervasive and cannot be easily quantified.


Self-contained or learned desires

Mainstream economists typically do not engage in analyzing people’s desires. There are two principle reasons, first they believe that only the self-contained individual can determine their individual desires because only the individual can know what provides them satisfaction. There is a fear that if human desires were not always seen as coming from our own innate human drives and were somehow manipulated, it would provide a rationale for the government intervention in the economy. This conviction emanates from a historically populist belief in the rights of  humankind to have the free will to make their own decisions. Economists, therefore see no reason to further explore the determining factors of individual desires. The second reason that economists don’t analyze desire is that the deductive models used by economist do not lend themselves to such an analysis. To maximize utility in consumer theory is automate and there is no need for an outside unit to direct or interfere with the satisfaction of utility. 


The critics generally believe that desires for goods and services are not primarily individually determined, but instead are learned and shaped by the wider environment. This wider environment provides consumers with both objective information about goods and services, as well as information intended to motivate and direct them. Critics have no problem with the provision of objective information such as often provided in individualized classified ads, but in the United States, at least, such ads are the exception and not the rule. Instead, information provided about a good or service typically attempts to be persuasive and appeal directly to consumer’s emotions. Critics argue that successful marketing efforts can, to some degree, manufacture demand or at least manipulate what people desire. In fact a successful ad campaign is an effort to take some amorphous desire by the consumer, and direct it to a particular good or service. Therefore, it is argued that expressed desires for goods and services can be manipulated and do not necessarily represent individualized, self-contained or “genuine” desires.


The difference between self-contained, individualized taste, and socially manipulated, learned taste is a matter degree. The critics of neoclassical consumer theory would agree that individual taste does matter, but is constrained and directed by society. For instance, consumers raised in Korea might develop a taste for dog meat, or if the consumer were rather raised in a few particular European countries they might develop a real liking for horsemeat. Social mores in the United States, however, persuade consumers not to consume such goods. The consumption of such socially outlawed products is stigmatized and the consumer seeks to avoid being ostracized.


Producers’ sovereignty

There are a number of alternative schools of economics that would argue that successful producers are the ones that have learned how to create demand for their products by manipulating consumer desires. In economic terms the producer becomes sovereign (in control) and not the consumer. These views contrast with the traditional economic populist view that the consumer is in control and decides what is produced (with a competitive supplier).


There is a middle ground, where critics and observers believe producers can affect demand for their products, but this process of demand creation (as most advertising agencies would certainly agree) is certainly not well understood or guaranteed. Critics of consumer theory would argue that demand creation happens as a matter of degree, depending on the nature and age of the customers, their desires, and the nature of the particular product. Ads between competing companies that have competing claims can negate each other, and be received skeptically by the consumer. Often, companies must undertake such ad campaigns frequently just to defend their market share from other firms. 


The combined effects of all firm advertising and their promotion of products and services have a particularly important global effect, which is often overlooked. The combined effects of advertising create among consumers the sense that all desires can be fulfill by consumption (or just the act of buying itself). In the end, the strongest message to consumers may be to simply buy, and then buy more. In the United States, this commercial message permeates all of our media. Some sociologists and economist would argue that the overwhelming commercialization of the United States (relative to other countries) is due to the extensive degree of such selling efforts. This also might help explain why Americans save so little, and why aggregate national demand can be so easily stimulated.  


These critics would argue that the tobacco industry is the worst example of producer control.  Here the cost of the actual product is minimal (a few cents per cigarette); the real cost for the firms lay in the process of creating an attractive image for each brand (usually by using advertising). Competition between dominating firms is usually only important in terms of brand advertising. The industry cannot help but be extremely profitable (with many billions of dollars in profits each year); with low costs and addicted customers (who find it thus difficult to quit) sales are guaranteed. The demand of smokers for cigarettes is classified by the economic term, inelastic. The tobacco industry’s customers, who began smoking usually as adolescents, were seeking to fulfill their need (economists prefer using the word desires) to belong to a group (to fit in, and belong) and sometimes to show their independence (from adults). Usually cigarettes (or at least the first few) are not a source of pleasure. Psychologist believe that people smoke in order to fit in and be accepted, which is certainly a universal human need. However, in terms of goods and services, this human need can have many different expressions. Drugs, and alcohol can also be used as a means to seek approval and fit in. Even if drugs, alcohol or cigarettes are successful in making the adolescent more accepted in the short-run, with age those change (at least their intensity), and the consequences of those products usually are re-evaluated.


Society (who know better) believes that the adolescent cannot fully grasp the social and individual impact of alcohol and cigarettes. Therefore society understanding the intensity of those early adolescent needs, mediates by restricting or outlawing the availability of those products.  Drugs, which are believed to have even more series consequences, are of course, illegal regardless of age.  Here society does not accept individualized preferences, but make criminal their consumption. The markets for drugs are thus driven underground.



Global Youth Market


The global youth market is one example of a market developed recently by creating a new youth reference group with new global communication technology. Worldwide one of the developments of the 1990s has been the growing similarity of youthful attitudes and spending habits. This has been the result of both an increased prosperity for urban youth, combined with the rapid spread globally of cable & satellite TV.  Because the programming is disproportionately American you have emerging consumer appetites and desires that looked increasingly like those in New York or Minnesota. Today MTV networks has more viewers in the developing world than in the United States; over 70 million households get MTV Brazil, MTV Latin America, MTV Mandarin, MTV Asia and MTV India. Consumer attitudes across countries are strikingly similar, especially among teenagers.  In a study of 24,000 teenagers (Study by the advertising firm, D’Arcy Masius Benton & Bowles) it was found, for example, that the United States ranked as the world's No. 1 fashion leader by 68 percent of the respondents around the world.  The survey also found that 87% watch music videos.  And MTV network appears to be the beneficiary of this emerging youth market boom.  MTV provides at all-news bulletin for creating brand images.  The only differences, (MTV) image wise between the United States and elsewhere, is that the network in the United States is hip, and at times rebellious, while its overseas audience wants only upbeat tunes and established stars.  The general message is just unbridled consumerism. (Bernard Wysocki Jr., Wall Street Journal, June 1997)



Japanese adolescents


Of course most goods and services do not have negative consequences for adolescent, nor are the large producers always in control. For example recently in Japan, adolescents’ girls have taken up different fashion looks that harmlessly sets them apart from others, but gives each girl (in the example given below) a sense of belonging to that group (this is true for adolescent worldwide, but in Japan it is very visible given their rule bound society). Firms supplying these teenagers are seldom in control and usually are trying to catch up with the latest trend.

In the late 1980s, most Tokyo trendies wore only black, but by the late 1990s, the youth scene was fragmenting. Before, just one or two fads ruled at a time, but with the fragmentation teens and young people had far more choices. The increasingly open market had led to a burst of offerings in everything from food to fashion to music. But while choice means new modes of self-expression, it hasn't led to an explosion of true individualism. Instead, there's a proliferation of new groups to join, each with its own set of rules. The "Gals," is an attention-grabbing group of girls who bleach their hair, toast their skin, wear skimpy clothes and hobble around in stilt-like beige boots with seven-inch platform heels. The Big Sisters is a clique, whose members also wear platform boots but favor sexier clothes and fake leather. The Sports Clique is a group that prefers low-heeled Air Mocs and Gap clothes, while the Back-Harajuku Group prefers baggy sweatshirts, colorful jeans, sneakers and long scarves. A small number of boys have taken up the "Gal Boy" look, which consists of long, bleached hair and dark tan, but no tall boots. (Yumiko Ono, Wall Street Journal, Dec. 1999).


Relative Consumption


Although the example above, regards fashion among Japanese’s youth and adolescents, the underlining sets of desires are universal, with goods and services serving as nothing but a necessary ticket for joining a group. All fashions serve that purpose; there is always an in-group, and an out-group. Consuming goods provide both a sense of belonging and differentiation for the consumer. One theory of consumption then suggest that consumption provides the consumers a means to match the self-image of the consumer with the group (reference group) they wish to identify with, and want to be accepted by. The consumer self-identifies with some wider group, and in order to fit in with that group, they need the appropriate car (or 4X4), wear the right clothes; live in the right house and neighborhood. For most this drive is unconscious and certainly not as obvious as that of the fashion conscience Japanese youths. And the group may be less constraining with more generalized requirements than the tight requirements of the Japanese’s youth groups, but they are just as real. Sociologists have referred to the group that consumers identify with as a reference group. The theory suggests that contentment (utility or satisfaction) depend on the success of the consumer in matching those internalized group expectations.  Satisfaction then depends on both, the level of consumption and the group the consumer wishes to emulate. Given this type of behavior it is possible to imagine a case where low levels of the consumption can be associated with high levels of satisfaction.  And in other words, the rich (consuming many goods) may not be as contended with their consumption level as the poor.


Economists have long recognized these consumption desires and have used the saying “ keeping up with the Jones” (neighbors, or just a wider group of friends) to describe this type of behavior. But this was usually just considered oddball behavior. If this behavior is significant, however, it immediately makes the indifference curves of consumer theory questionable. With relative consumption, increasing quantities (movement out from the origin on the indifference curve graph) does not guarantee increase welfare or utility. More in this case does not guarantee more satisfaction and happiness.


Examples of Relative Consumption


The evidence for relative consumption come from many sources a few antidotal examples will be commented upon here. In this country there is a well documented evidence that those winners of the lottery with substantial winnings, who after an initial burst of excitement and happiness (and consumption), adjust within six months or more (to a wealthier reference group) to their usual level of contentment (or discontentment). The lottery’s winners had increased their consumption, but also changed in the process their reference group and thus their own personal expectations.

This consumer behavior is also seen among the new rich employees at Microsoft (due to the value of their stock options), and among the other software entrepreneurs in Silicon Valley during the stock boom of the late 90ies. One newly rich employee for instance, stated “that the richer one becomes the less money matters for direct consumption”. Estimates vary when this effect kicks in, but when one stop evaluating extra assets in terms of the leisure, possessions, choices or other things you can buy and instead think of them mainly as markers of how one stands relative to others at the top, it has kicked in. The founder of one Internet company says, for instance, “that every dollar earned up to $300 million is positive, but beyond that point, since it mainly becomes a gauge for comparison with others, it increasingly reminds one that others have more -- like coming in fifth in the Miss America contest”. (Wall Street Journal, March 2000)

There is good empirical information in survey data for the above consumer-modeled behavior.  In international surveys between both rich and poor countries, the participants show no differences in their self-identified level of satisfaction or happiness. The poor in the richer countries, whom have more assess to consumer goods, than many of the rich in poorer countries, feel less contented, than the rich and successful in the poorer countries. It is their relative consumption and position in their respective countries and societies, which determined their level of contentment.


Conspicuous Consumption


The term “conspicuous consumption” has also been used to describe the relative nature of consumption. Thorstein Veblen popularized its use, to satiric effect in his book  “The Leisure Class” in the early part of the last century. It stood for goods and services that were consumed almost entirely for the purpose of impressing others of one's standing in that society. There are no doubt such goods today, some of which might include breast implants, sports utility vehicles, and diamond rings, but it would be difficult to come to a consensus on a list, since that what we consume, and how is socially structured. Just as the Japanese youth had no single social standard (reference group), society in general provides today no unambiguous list of goods and services.


All consumption has some social meaning, but it differs from society to society and through time. Consuming the most common goods and services can make a statement about one’s status or social identity. All goods and services make different statements, to different degrees, in different societies. In addition that social meaning changes overtime. For instance, eating vegetarian at a banquet makes a statement, (while not eating vegetarian also makes a statement) and the meaning of that statement has changed overtime. In an earlier time eating vegetarians would have been considered as quaint and done by foreigner or eccentrics, and most likely would have been thought to be unhealthy. Today with a better understanding of general nutrition, vegetarians are consider healthy (as long as they eat more that french fries and ice cream), and eating vegetarian may be a way of signaling to others that one is environmentally-conscious, socially-conscious, health-conscious and disciplined.


Innate Desires


While there is a definite social and learned component to consumption, our natural biology put constraints and directs that consumption. We all face the same biological strictures; we all sleep, eat, get sick, grow old, and die. And certainly age has a big impact on our desires. As we go through our life cycle from child, to teenager, to young adult (without children), to young adults with children, to middle age adults, to seniors, our needs and desires change. Gender also has its strong impact. But distinguishing learned and culturally based desires from biological based desires is not easy or clear. However, many of the needs by age and gender are found across cultures and ethnic groups, and thus suggest the basis of many of our needs is in our biology.


Innate biologically based desires are usually the example, given for modeling consumer equilibrium in mainstream theory.  In most textbooks explaining consumer equilibrium, consumers are pictured as making decisions between two ordinary common items such as food. They are seen as contrasting the marginal utility given prices between the two food items, such as pizza and hotdogs (unconsciously of course). The model seems reasonable, because information is readily available, which minimizes both uncertainty and possible external manipulation (by both producers and our culture). In addition the goods and services used are seen as fulfilling the same underlying desires (hunger). But consumer theory is expanded to all goods and services regardless of underlying desires. There is no recognition that humans have different underlying desires, which are not directly comparable. For consumer theory all desires are treated the same with all goods and services being tradable. The following humanistic psychology presents a contrasting point of view.


Humanistic psychology

Modern psychology’s views of consumer behavior are more complex than the underlying premise of economic consumer theory. Humanistic psychology, the one school of thought that will be commented upon here, in particular emphasizes the differences between underlying needs.


Abraham Maslow was the founder of the school of humanistic psychology, a school that has gained popularity in recent years. His theory of human needs emphasizes personal growth, and his theory is embodied in the need hierarchy shown in figure 4.  In the need hierarchy humanists categorize desires. Those needs from different levels cannot be meaningfully traded-off. Long-term hunger for instance, cannot be effectively satisfied by a pat on the back, or a new stylish set of cloth.


Figure 4,  Maslow’s need Hierarchy





There are a number of key features regarding Maslow's need hierarchy.  First, the consumer’s felt need depends on his/her particular environment. And there is a systematic order within which those basic needs will be expressed.  Second, when a lower level need is satisfied, it is no longer active.


The physiological needs are the demands are body (our biology) place on us for survival and health.  These needs must be satisfied before other needs are activated.  In most cases these needs are taken for granted, although the homeless in the United States constantly are confronted by these needs. Where to sleep each night, what to eat, how to stay safe; are some of those physiological and safety needs.  Maslow's theory suggests that the homeless would primary focus on satisfying these lower level needs, and only after their fulfillment would other needs be expressed.


The social needs, which include the need for love, belonging, and self-esteem, become dominant once the physiological and safety needs are moderately provided for.  These are the universal needs to give and receive love, to feel a sense of belonging and acceptance, and to feel good about one's self.  These social needs have to be constantly maintained, and are not easily ignored once they have been obtained.  If these needs are satisfied, a person feels self-confidence and capable, while if not satisfied, a person feels inferior and sometimes helpless.


For Maslow the ultimate need was the need for self-actualization. Self-actualization means the fulfillment of a person’s unique potential; the becoming of everything that one is capable of becoming. And certainly not everyone would be expected to reach this level. This stage is certainly one of the more controversial aspects of his model.  And although not everyone accepts every aspect of Maslow's needs hierarchy, his model does help provide insights into today's consumer culture.


Humanistic economics


This alternative paradigm builds upon Maslow’s hierarchy of need.  The details of Maslow's model are not important. The important contention is that the needs between categories are not interchangeable. And the best goods and services that are effectively supplied in the market system are those essential for the fulfillment of basic survival needs. Markets do best with Maslow’s lower level needs. But the argument is that the goods and services supplied by the market are not as effective in fulfilling many social or achievement needs (Maslow's higher level needs). It is argued that it is a contradiction to expect with the strong work ethic in the United States that consuming goods and services will fulfill the intangible social needs. Buying and consuming goods is no way of fulfilling the need for self-actualization or to provide a sense of belonging and acceptance.


This general argument may have greater validity for certain age/gender groups, and with certain cultural and ethnic groups. It should not be seen as fixed or absolute either overtime or between groups. In the United States, and other affluent countries, where basic physical survival (Maslow's physiological and safety needs) is not an issue, social and achievement needs dominate.  Given the dominant cultural value, where the work ethic dominates, these needs could only be satisfied in the job market.  The work environment provides opportunities to fill those needs.  Work provides one with identity, a sense of belonging and, if successful a feeling of achievement.  The need to succeed, to belong, and to achieve becomes much more important than the goods and services that are consumed from the wages received. Work alcoholics are rational, in this context, because they fulfill their own personal social and achievement needs at work.  Although money income may not by itself be the primary motivating factor, it is still extremely important in our culture as an indicator of success.  It is well understood that those who do well and are successful, and achieve results, are well compensated for it with a high wage.


In public surveys in the United States when asked what motivates and what’s important (in an work environment, or otherwise), money income and consumer goods always lose out to family and friends. In fact money income and consumer goods are usually way down the list. Our friends and family form a social network, and the interaction with that network; determine how successful the individual is in fulfilling their social needs.


The tragedy of a recession is the job losses and dislocation, not the goods and services that would have been produced if the economy had stayed fully employed.  Losing one's job is a shock to the ego, to the self-esteem and to a sense of achievement. This loss causes tremendous embarrassment. The sense of failure from job loss, threatens all of Maslow's higher level needs, even if there is no serious threat to one's physiological and safety needs. This is true even if another job is readily available. The goods and services that are not produced during recession, and the resulting waste of labor resources that are not utilized, are not usually of public concern. In contrast, in a poor country that is just barely producing the necessities of life, a recession threatens much more. Both Maslow's lower level needs as well as Maslow's social needs are put at risk.  Here loss of production of goods and services are not so easily ignored. A recession in Japan in the 1990’s (a rich developed nation) had vastly different consequences, for instance, than a recession in Indonesia (a poor developing country where food shortages and starvation threaten as part of the South East Asia recession in 1998). 


The views of this humanistic paradigm strongly contrast with the neoclassical economic paradigm (of which consumer theory is a part). A healthy growing economy would be seen as important in both cases, but for vastly different reasons.  Consumer theory sees desires as met through more goods and services, while the humanistic paradigm sees desires met through a good, stable, and secure job market.  Neoclassical economics sees work as a necessary evil, necessary for the production of goods and services, while the humanistic paradigm's sees work as necessary to meet humans’ social needs.  Work itself is the source of satisfaction in our culture. Scarcity for the neoclassical paradigm is the scarcity of goods and services given unlimited wants.  Scarcity for the humanistic paradigms is good jobs or opportunities that can satisfy our important social needs.


This contrast is useful as explanation for the two contrasting worldviews, but in the real world economic scarcity can take many forms. Absolute poverty, where Maslow’s lower level physical and security needs are not being satisfied does exist (homeless in the United States, and famine victims in far off Africa, are obvious examples), but much poverty (and scarcity) could be seen in a relative sense. Relative poverty, in this sense is the inability to keep up with the neighbors (the Jones), or with that reference group that one so closely identifies. The conventional definition of relative poverty is usually defined as that level of income below which society considers, one living with a financial hardship. That is, what the pubic thinks of as poverty (which is higher than the official poverty level in the United States). The chosen reference group is what makes the difference. 


The strong modern work ethic is certainly responsible for the direction of the argument made above by the humanist.  In some sub-cultures within the United States that work ethic is not necessarily as strong, or is held more selectively.  Women, for instance if they can afford it, can still find social support and acceptance within some groups by staying home and raising healthy children, or volunteering outside the home (Men generally are expected to work). Healthy retirees generally are not expected to work in the United States, although this may be changing for some groups. Certainly overtime these social mores have changed. An example of a rather dramatic change in social mores has occurred with the meaning of work in Western Europe over the last three centuries. Gentlemen (the wealthy aristocracy) who were held in high esteem, never worked for money. Working for money was beneath them, and would have been viewed as disgraceful. These types of social strictures and mores, that evolve overtime are still important today, and constrain and direct our social and individual economic behavior.


Connections to Desires


One argument made is that as consumers move up Maslow's hierarchy the less direct connection there is between the underlying desire, and the good and services bought.  The need for nutritional food, to stay warm and dry, to be physically safe all provide direct feedback.  With these products providing directly for our physical well-being, there is less open discretion for there fulfillment by both culture, and the producers of those goods and services (although there is still some).  But with higher level social needs there is less of a direct connection to specific goods or services. In many case this connection is only symbolic, for instance in the military a prized ribbon or badge can be connected to a sense of esteem and accomplishment. In any case, there is great variability and discretion in making any specific connection.


Empirically in the United States consumption has increasingly moved to services. This is a well-documented feature of the modern world. As wealth in the West has increased, consumption increases had moved first from agricultural products, to industrial produced goods, and now to services of all kinds.  One could argue that this progression reflects the movement up Maslow’s hierarchy of need. This would suggest that actual physical products generally satisfy lower levels needs. Food, clothing, and housing, are needs that are satisfied by physical products.


Novelty and entertainment are also suggested as innate desires, which are important once Maslow’s basic needs are satisfied. Spending on services that support a hobby, a family’s shared pastime and outings are dominated by services.  A vacation, travel (in general), the Internet and other high tech services, education, music, sports, movies, and plays are all novel and satisfied by services. And their increased consumption is expected as one becomes identified with difference reference groups. Their importance has continued to increase in the economies of the wealthy countries.   


The problem of the firm is a marketing problem. The question is how to entice affluent consumers to buy more goods and services in order to satisfy various active and felt social needs. The answer is to try and associate in the consumer's mind the product and the felt need-- to associate drinking beer with being one of the guys, or to associate a new car with status and success. The marketer attempts to direct that consumption to a particular product or service, but in the process encourages consumption in general for all such products. A successful advertising campaign will make a product indispensable in satisfying a social need. It makes the product indispensable for a certain reference group and in the process directs the consumers to what they need, in order: to belong, to be accepted, to be successful, and to achieve. And of course, depending on how successful it is, it puts the firm in a position of economic power.



Rationality Examined


For consumer theory the idea of rationality is rather specific.  The goal of consumption is utility or satisfaction, and the above discussion centers on determining the desires, and the products and services that provide that utility.  Rationality is simply the choosing of those goods and services by the consumer that provide the greatest amount of utility given the consumer’s limited income.  Rationality is the maximization of utility.  In consumer theory, it is equating the marginal utilities given prices, for all the goods and services possible.  Or given indifference curves, it is the movements on the budget line toward the tangency point of the highest indifference curve possible.


The already discussed problems of uncertainty, and the large number of possible items to purchase make it unlikely that humans are strictly rational.  The quantities of goods and services available (just check out a typical grocery store) and their possible utilities, and the unconscious calculations needed make this improbable.  The theory falls back to the concept of bounded rationality, where shortcuts are used to restrict and limit the goods and services considered. In neoclassical economics bounded rationality, still allows consumers, on average to act rationally, and thus economist to use rationality to model economic behavior.


There are other economic analysts and psychologist (particularly the work of Kahneman and Tversky), who can point to plausible evidence denying, that rationality as economist defined it, represents human behavior. And depending on rationality to model behavior distorts actual behavior. Richard Thaler calls such behavior quasi-rational (Richard Thaler, Quasi Rational Economics, Russell Sage Foundation 1991). The experimental and observational evidence points to a much more complex process of decision-making.


The following is a list of human behaviors from experimental and observational date that suggest that humans are not the rational maximizer portrayed in mainstream theory.


First, humans have an emotional and impulsive component. And this component may be at odds with human’s more thoughtful and reasoned logic.  In fact as mentioned elsewhere advertising emphasizes the appeal to our emotions. And this appeal can be very effective, particularly for some types of goods.  Food, for instance appeals to our appetite and for many eating is always in conflict with the desire to lose weight.  Or to drink for many is in conflict with the desire to stay sober.  Or smoking the next cigarette is in conflict with stopping altogether.  Or going on a trip, is in conflict with the desires to reduce spending (increase savings).  With regards to this economic concept of saving in the United States most savings, use a forced savings technique; such has pensions, home equity, and especially social security. People restrict their current choices, when they think they will later regret them. It is as if we are in conflict with ourselves.


Richard Thaler relates an incident that took place at his home while friends were socializing before dinner.  He brought out a large bowl of cashew nuts, which were quickly eaten.  Realizing that appetites were in danger, he withdrew the bowl of nuts.  His audience applauded the action.  But in consumer theory more choice is associated always with greater utility and yet in this case, less choice was seen as the preferred state.  Restricting choice is in conflict with utility maximization in conventional consumer theory.



The impulsive Shopper


There is a category of consumers, who can’t for some reason, restricts their choices and their impulses.  These well-documented consumers are compulsive shoppers.  In the United States the saying “shop to you drop” describe these shoppers.   The more serious of these compulsive spenders (most psychologists say) have an addiction.  And like any addictive behavior, it’s an effort to compensate for some sense of inadequacy.  Many seriously compulsive shoppers focus on a particular type of purchase like shoes, books, antiques, clothing, but whatever it is, the purchased item is secondary.  April Benson a New York psychotherapist, who specializes in buying disorders, believes that the acquisition, the quest, the shopping is first and primary.  The object is irrelevant.  People use compulsive shopping as self-medication. (Chris Gay, New York Times, July 1999)


Addictive behavior cannot be described as economically rational.  The question is how pervasive is this type of behavior. The extreme cases of shopping addiction usually like gambling addiction lead the shopper into trouble. Financial ruin can result. But there is some belief that beyond this extreme case, there is much shopping in the United States, which is done just for the act of shopping.  A mild high, a feeling of success, comes with the purchase, while the item purchased is again secondary.  The large accumulation of unused stuff is one sign of such behavior. The restrictions on consumers, of course, are financial.  And when those restrictions are seen as lifted, which happens when a credit card is used instead of cash or a check (credit cards are a move away from cash, a symbol of cash), then conventional shoppers will spend up to 25 percent more on goods and services (as found in various surveys). There is increased fear that as Internet shopping becomes easier and more common, which is even a further move away from cash that the problem of impulsive shoppers will escalate.


The contention is that shopping is valued as an activity in and of itself. And this type of shopping is pervasive particularly in the United States.  This could explain why individual savings in the United States are so low as compared to other countries. And why the United States is viewed as the world’s engine of growth, in a world constrained by lack of effective demand.


The emotional and impulsive components of our human nature are most dramatically seen in the operation of the stock and bond markets.  In these well-documented markets conventional economics sees rationality and efficiency.  The investor rationally evaluates each financial instrument on its current and potential return given price (Price/Earning ratio), and buys and sells as a result.  The competition in the market is seen as guaranteeing that each price represents the true underlying value for that stock or bond.  This is called the efficiency theory of the bond and stock markets. But many observers believe that this rationality is not always evident and that there are systematic tendencies to over react.  Brokers have a saying that there are two emotional states in the market, greed and fear and that they often drive the market.  Financial panics and financial bubbles can result.  But even in calmer times there is overreaction. Richard Thaler did studies that indicated that low valued stock actually out performed the market, while high valued stock under performed the market.  Such results should not be a part of an efficient market.


Second, with consumer theory sunk costs should be ignored.  Sunk costs are costs that occur before the final costs, and its consumption. In economics, its only rational, if the consumer considers the marginal utilities at each point in time and thus ignore past cost.  Sunk costs are essentially water under the bridge, and should not be considered. But sunk costs are seldom ignored, and do affect consumption.  People who are forced to pay a price for a ticket, before an event, are likely to attend that event.  For instance, a football fan, that prepaid $50 for a ticket, will more likely to go to the game, in spite of the weather, than if it was purchase at the gate.  Most people feel obliged to follow through on the implied commitment that sunk costs represent.  People have trouble ignoring sunk cost.


Third, decisions are changed; depending on what immediately precedes that decision.  For instance betting behavior definitely is influenced by how well the gambler is doing.  Players who are ahead become more reckless, while players who are behind are more cautious. The odds have not changed just the behavior.


Fourth, there is evidence that there is a disparity between buying and selling prices.  In conventional consumer theory there should be no difference in the selling and buying price, because marginal utilities are the same. If marginal utility of A was less than B then you sell A and buy B, and if marginal utility of A was greater, you buy A and sell B. Initial ownership shouldn’t matter. But in human experiments it does matter. Subjects given a coffee mugs, for instance, demanded twice as much to sell, as other subjects (who were are not given such mugs), were willing to buy to get one.  This is sometimes called the endowment effect. Behavior (buying and selling) differs depending on the initial ownership regardless of wealth (which in experiments need to be controlled for).


Fifth, there is a sense of fairness that affects consumers’ willingness to buy.  Markets do not always clear with equal numbers of buyers and sellers. Sporting events that sell out are good examples. Why don't sports teams just raise the price of the event, until there are just enough buyers for the seats? The answers suggested here, is that consumers have a sense of fairness about the appropriate price, and prices significantly above that point could cause outrage. Consumers would feel taken advantage of, and would want to punish the violator. In the long run it would be wise for the firm not to violate those expected price levels.  The term “war profiteer” has a strong negative connotation in most countries, and yet many times the war profiteer are just charging a price to clear the market during a crisis of war.  But that price charged is way beyond the socially accepted level, and thus the sense of disgust the public holds for those sellers. These price standards of fairness are generally held within the society but certainly can change over time.


Rationality is used in economics to model consumer behavior.  Does the narrow definition of rationality as used in consumer equilibrium, represent well enough how consumers actually behave?  Neoclassical economics answers in the affirmative, arguing a methodological argument, that the relevance of an assumption such as rationality is not important, but affirming a model needs only clear-cut test results. They obviously believe that the model has passed the test.


Alternative schools of thought in economics, believe that there are no clear-cut test results in economics. Test results do not unambiguously affirm consumer theory. Therefore realistic assumptions are indeed necessary.  The five points made above, suggest that rationality as narrowly defined in economics is not a rational or realistic assumption for human behavior.