Microeconomics Final Paper for University of Phoenix

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Theory of Consumer Choice and Frontiers of Microeconomics
Stacey Troup
Principles of Microeconomics/ECO-365
August 15, 2016
Ashok Padhi

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Theory of Consumer Choice and Frontiers of Microeconomics
This Week 5 final paper will serve as an analysis of consumer choice and its effect on
microeconomic trends. Included in this analysis will be an overview of the impact the Theory of
Consumer Choice has on demand curves, higher wages and interest rates. Additionally, a review
of the role asymmetric information has on many economic transactions will be done along with a
review of the Condorcet Voting Paradox and Arrow’s Impossibility Theorem. Finally, a review
of irrational behavior in economics will be done, rounding out the subject matter for this final
exam paper.
Theory of Consumer Choice
As we review the demand curves and the impact that the theory of consumer choice has
on these curves, it is important to remember that demand curves for a good reflect a consumer's
willingness to pay for it and that these curves arise naturally from the theory of consumer choice.
As prices for individual items rise, the demand curve slopes downward (or fails) reflecting a
reduced demand for the item. Alternatively, as prices for items decrease, the demand curve
increases which drives the consumption of the item up as well as the demand curve for this item
to be driven up. This reduction or increase in consumption is the foundation of the Theory of
Consumer Choice and its principles (Mankiw, 2015). Sometimes a rare instance causes a
consumer to purchase less even though the relative price of the item has fallen. This “bizarre
property” of consumption is referred to as Giffen goods (Mueller, 2004).
Within higher wages; as people earn more money, they are driven to consume more
because their budget constraints become steeper which directly correlates to the relative price
(Mankiw, 2015). For every increase in a person’s wage, a higher consumption for every hour of
leisure is earned. Additionally, disposable incomes generate a higher return to the local

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economies, driving up demand curves. As these wages are increased, the propensity to spend
more on goods or to purchase more “luxury” goods increases, thus driving up the demand curve
and creating greater equilibrium (Mueller, 2004).
Higher interest rates cause the budget constraint to shift outward and become steeper
(Mankiw, 2015). As interest rates climb, stores may be charged more to purchase the goods they
supply to consumers and those increased costs are passed on to the consumer through retail
pricing. Additionally, consumers may be charged more for their living expenses and other
consumptions as interest rates rise. As these increase in interest rates occur, budget constraints
and consumer spending decrease due to the lack of disposable income (Mankiw, 2015).
The Role Asymmetric Information has on Economic Transactions
Asymmetric information, originally developed in the 1970’s and 1980’s as a way to
explain equilibrium issues and common phenomenon (such as the Giffen goods theory) that
general economics failed to explain. Simply put, asymmetric information sets out to identify the
information imbalances between buyers and sellers in a certain market (Frieden & Hawkins,
2009) s.
Three economists were awarded the Nobel Prize in Economics for their influential work
on this subject in 2001. George Akerlof, Michael Spence, and Joseph Stiglitz each provided
their individual areas of expertise to the Asymmetric Information Theory (Ross, 2015).
Akerlof first provided information relating to the varying knowledge base differences
between car buyers and sellers and argued a theory that encouraged the idea that sellers have the
advantage of selling goods containing “less than average market quality” properties (Ross,
2015). Spence added that the value of employees is unknown to employers and referred to them
as “an uncertain investment”, sighting the uncertainty in capabilities when hiring. Adding to this

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theory he identified asymmetries between employers and employees whereby low-paying jobs
create a trap through “persistent equilibrium” which discourages increasing wages in certain
markets (Ross, 2015).
Stiglitz, however, reached the most acclaim discussing negative externalities and their
impact on the pricing of certain items in the market. The example given was a high-risk
individual and the high premiums for health insurance which are prohibitive to the buyer because
they restrict purchase due to their price (Ross, 2015).
The Condorcet (Voting) Paradox and Arrow’s Impossibility Theorem
Condorcet’s Paradox often referred to as a voting paradox, relates to preferences between
sets of choices A>B>C, and the variables and outcomes of that set of options. When transitivity
exists, you would put A vs B, B vs C and C vs A and expect A to be the overall winner.
However, when transitivity does not exist, we experience a Condorcet Paradox (Olken, 2012).
Condorcet’s Paradox contains both winners and cycles. Condorcet winner is considered
an alternative that gains the majority vote when it is paired against the other alternatives (Olken,
2012). Condorcet cycle occurs when there are transitivity violations in the social preference
ordering (Olken, 2012).
Kenneth Arrow’s ‘impossible” theorem assumes that buyers have “rational preferences
over alternatives” (Stanford University, 2014). Important to note is that Arrow’s Theorem
include the uses of unanimity, transitivity, independence of irrelevant alternatives and no
dictators (Mankiw, 2015) Defined as a “mathematical theory showing that under certain
assumed conditions there is no scheme for aggregating individual preferences into a value set of
social preferences” (Vandeem, 2014).

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Irrational Behavior in Economics
While traditional economic theory assumes that demand curves are “negatively inclined”
(Becker, 1962) based on rational behavior, causing them to be consistent and transitive, irrational
behaviors do exist.
When irrational behaviors exist, demand curves are negatively inclined. In a more recent
example of irrational behavior in economics exists the Brexit argument. According to a
University of Chicago professor who specializes in Behavioral Economics, the protestors seeking
to leave the EU are not “acting or thinking the way traditional economics would expect them to”.
The reasoning for this irrational behavior lies in the lack of analytical review of all information
and the associated costs correlating to the overall happiness of the consumer (Pfeiffer, 2016).
Economics say that the Brexit decision is a prime example of irrational behavior for this reason.
Conclusion
While several factors affect the supply and demand curves, irrational behaviors have their
own, often negative, effects on the demand curves. Informed buyers who make analytically
based decisions on their consumption based on best practices of financial health keep the demand
curve in equilibrium and represent rational behavior. Consumer choice needs to be driven by
these best practices rather than brand loyalty if the consumer is to enjoy long-term financial
health.

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Works Cited
Becker, G. S. (1962). Irrational Behavior and Economic Theory. Journal of Political Economy,
1-13. Retrieved from
https://www.jstor.org/stable/1827018?seq=1#page_scan_tab_contents
Frieden, B. R., & Hawkins, R. J. (2009). Asymmetric Information and Economics. Physica A:
Statistical Mechanics and its Applications. Retrieved from
http://www.sciencedirect.com.contentproxy.phoenix.edu/science/article/pii/S0378437109
00781X
Mankiw, N. (2015). Principles of Microeconomics. Retrieved from
https://phoenix.vitalsource.com/#/books/9781305892811/cfi/6/10!/4/2/2@0:0.
Mueller, O. L. (2004). Autodetermination in Microeconomics: A Methodological Case Study on
the Theory of Demand. Analyse Und Kritik, 322-325. Retrieved from
http://search.proquest.com.contentproxy.phoenix.edu/docview/208535279/fulltextPDF/F
D95C91427BA4CAFPQ/1?accountid=458
Olken, B. (2012). Sometimes It Gets Complicated. Retrieved from MIT:
http://ocw.mit.edu/courses/economics/14-75-political-economy-and-economic-
development-fall-2012/lecture-notes/MIT14_75F12_Lec12.pdf
Pfeiffer, C. (2016, 06 21). Thaler: Brexit Shows Irrational Behavior. Retrieved from Business
Insider: http://www.businessinsider.com/thaler-brexit-shows-irrational-behavior-2016-6
Ross, S. (2015, 04 25). What is the theory of asymmetric information in economics? Retrieved
from Investopedia: http://www.investopedia.com/ask/answers/042415/what-theory-
asymmetric-information-economics.asp

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Stanford University. (2014, 10 13). Stanford Encyclopedia of Philosophy. Retrieved from
Arrow's Theorem: http://plato.stanford.edu/entries/arrows-theorem/
Vandeem, A. (2014). On the empirical relevance of Condorcet's paradox. Public Choice, 2-4.
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