The Theory of Consumer Choice I

By M. Northrup Buechner

July 17, 2013

Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

The theory of consumer choice is the theory of how consumers decide what to buy and what not to buy. In advanced undergraduate textbooks, this is the first topic that receives the full treatment. The “full treatment” consists of graphical and mathematical analysis, defining what the consumer does, or should do, in terms of lines on a graph and mathematical equations. The consumer’s goal is assumed to be to maximize the satisfaction he derives from the goods and services he buys.

Why should we care about this? Why would we want to define in complex graphs and mathematics, that only economists can understand, exactly what consumers should do in order to maximize their satisfaction? Ninety-nine percent of consumers could not grasp the instructions.

We can look at it another way: The ultimate units of existence are individual things or entities. The units of a society are individual human beings. The units of an economy are the millions of business firms who produce in order to buy from and sell to one another (and also from and to consumers).

The primary goal of economics is to understand how an economy works. We need to know the principles governing the choices of businessmen, because their choices determine the functioning of the economy. In an economy free of government controls, all the businesses act together like a giant machine, integrated by the price system into another unit—an enormous unit, embracing every market participant.

This is why we need a theory for understanding the choices of businessmen. But why on earth do we need a theory for understanding the choices of consumers. Consumption is the “dead end” of an economy. After we get there, there is nothing left for economists to explain.

The answer of modern economics lies in the diamond/water paradox and in its solution by the law of diminishing marginal utility (LDMU) [Marginalism II, 4/23/13]. The LDMU proposed that the value people place on things depends on the quantity they possess—that water is valued low because it is abundant and diamonds are valued high because they are scarce. This means that there is a parallelism between price and value; things valued low have low prices and things valued high have high prices. It seems hard to believe now, but before the LDMU, that parallelism went unrecognized. Indeed, it was explicitly denied.

Based on that parallelism, modern economics holds that the evaluation of consumers is the starting point for the economy, that the prices of consumer goods are first and foremost a measure of what consumers want and how much they want it. The value of the tools, machines, buildings, and people used in production (the factors of production) depends on the value to consumers of what the factors produce.

I have shown in previous posts (Marginalism V & VII, 6/1 & 6/24/13) that the LDMU applies to money, but that it is largely irrelevant to the goods and services of the economy. Further, it is not true that the economy begins with consumption and flows out of what consumers want. You cannot consume what has not been produced. You cannot want what is yet to be discovered. Production comes before consumption. Consumption depends on and is created by production. The modern economic view has it precisely backward. Modern economists emphasize the theory of consumer choice because they believe consumption comes first.

Nevertheless, economics does need a theory of consumer choice. We need it because two great economic principles depend on and originate in that theory. One is the Law of Demand, the most fundamental law in economics, without which an economic system cannot be understood. The Law of Demand says that people want to buy more at low prices than at high prices.

The second is the Principle of Gains from Trade, the most general and widespread principle of a free economy, underlying every single trade and exchange. The principle of gains from trade says both parties gain from trade. This principle is the basis for holding that there is a harmony of interests in a free economy, which is one of its main pillars of support.

These are the two positive reasons that we need to examine the theory of consumer choice. There is a third reason that comes under the heading of polemics. We will take that up next time.