The market demand curve is important for business in two practical ways. First,
the decision to invest
in expanded production capacity or in a marketing campaign
requires a close
analysis of the expected growth of demand over time.
Second, the firm’s
pricing decision depends on the nature of the demand curve
for the firm’s products.
The pricing decision, of course, is not determined solely
by demand-side
considerations – the company’s cost function and profit objectives,
and the reaction of
competitors, have also to be taken into account – but
demand analysis plays a
crucial part in the decision.
What is
a ‘rational’ consumer?
The theory of demand
explains how an individual responds to changes in key
economic variables such
as prices and income. Five major assumptions about
consumer behaviour are
made which elaborate on the hypothesis that consumers
are utility-maximisers.
These assumptions can be
summarised under the headings
of comparability,
non-satiation, consistency, convexity and independence.
These assumptions are
reasonable, but nobody would claim that they provide a
completely realistic
description of consumer behaviour. For example, when information is costly or
difficult to acquire, we may not have sufficient knowledge to
rank preferences in a
comprehensive and consistent manner. When consulting
professionals ,we are
often unable to assess the quality of the services they are offering. The cost
of acquiring information may lead the consumer to use a rule of thumb, or to
follow the crowd. In such instances, recourse may be had to a less ambitious
definition of rationality, such as ‘bounded’ rationality, whereby the consumer
is assumed to be able to rank relevant,feasible and known options
rather than all possible options.
Another problem arises
when the utility derivable from the consumption of a
particular good or
service is unknown or uncertain. Liberal and authoritarian
ideologies clash as to
whether people are the best judges of their own interests in
such circumstances. For
example, one reason often cited for supporting unpopular
innovative cultural
products is that they will generate better returns in
the long run when people
learn how to appreciate them. Such a ‘failure’ of appreciation on the part of
the individual is ruled out by the assumption of comparability. Of course, the
current preferences of the arts lobby may not be
necessarily more
long-sighted than anybody else’s. The point is that people do not
always have a
well-defined preference field. Tastes and preferences change over
time and the
consequences of many decisions in economic life cannot be predicted. We try to
weigh uncertain future benefits against certain present benefits.
The assumption of
independent utilities has also been challenged. The opposite
proposition has been
propounded: that much of the satisfaction we obtain
from the consumption of
a particular good or service derives precisely from the
fact that others are
unable to afford it. A large house in a good neighbourhood, or
a Rolls-Royce, yields
much less utility if everyone has one. Similarly, we give
certain gifts because
their cost is widely known and will be appreciated by the
receiver rather than
because of any intrinsic usefulness of the gift. This type of
interdependence has
important implications for pricing policy. ‘Position’, ‘gift’ or
‘snob’ goods may be
positively, rather than negatively, related to price. Yet an
upward-sloping demand
curve is an exceptional case and valid only within fairly
limited price ranges. At
a price of £1 million each, even the demand for Rolls-
Royces will start to
decline!
Keeping in mind these
qualifications, the type of behaviour implied by the
above ‘rationality’
assumption is a reasonable approximation of reality.
Consumers weigh up
alternatives, seek out and choose larger and better ‘baskets’
whenever possible. More
consumption is better than less consumption. There is
sufficient independence
of utilities to make economic growth and increased consumption a source of
higher welfare. Formally, we can imagine each consumer as maximising utility, subject
to a budget constraint .One interesting
result of this exercise
shows that this idealised consumer will maximise utility
when the ratio of
marginal utility to price is the same for all products consumed.
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