AM05 Consumer Theory

Lecture 5 of Advanced Microeconomics at PIDE. The base for this lecture Hill & Myatt Anti-Textbook Chapter 4 on Consumer Theory.

Hill and Myatt cover three criticisms of conventional microeconomic consumer theory.

  1. Economic theory considers preference formation as exogenous. If the production process also creates preferences via advertising, this is not legitimate.
  2. Consumers are supposed to make informed choices leading to increase welfare. However, deceptive advertising often leads consumers to make choices harmful to themselves. The full information condition assumed by Economics is not valid.
  3. Economic theory is based on methodological individualism, and treats all individual separately. However, many of our preferences are defined within a social context, which cannot be neglected.

Before discussing modern consumer theory, it is useful to provide some context and

1      Historical Background:

In a deeply insightful remark, Karl Marx said that Capitalism works not just by enslaving laborers to produce wealth for capitalists, but by making them believe in the necessity and justness of their own enslavement. The physical and observable chains tying the exploited are supplemented by the invisible chains of theories which are designed to sustain and justify existing relationships of power. Modern economic consumer theory is an excellent illustration of these remarks.

As we have discussed elsewhere, the basic dynamic of industrial societies is massive overproduction. But how can this excess product be sold? Initially, after England acquired a 50 year lead in the industrial revolution over Europe, the Free Trade theory was invented as a weapon – those who bought it, permitted England to export its surplus, and acquire wealth in return. As Paul Bairoch notes in Economics & World History: Myths and Paradoxes, this resulted in recession all over Europe. Friedrich List created the infant industry argument to protect Germany, successfully fighting soft power with soft power. Imposition of trade barriers against England led to recovery and growth in European economies. Competition with England led to a scramble to industrialize in Europe, which created the potential for massive overproduction in the European economies.

To realize this potential, it was essential to find markets for these goods. These were created by imperialism and colonialism, which destroyed self-sufficient societies all over the globe, in order to create markets for surplus European products. Wars against China and Japan had the end result of forcing them to open their economies to trade, again to create markets for European surplus. Destroying local economies and institutions also provided a vast labor force, harnessed by economic necessity to the factories producing wealth for the capitalists. Production-Consumption chains were set up all over the world, to absorb the excess production. For instance, Opium addicts were created in China, an addiction to tea was induced in India, English laborers were addicted to sugar, and so on. This artificially created demand enabled artificially increased production, by transporting African slaves to produce sugar in the Caribbean, and similarly harnessing laborers trapped by newly created needs into laboring for wages, in the new market economies created all over the world.

2      Modern Consumer Theory

The same pattern of creation of production-consumption chains can be found in modern times. As Galbraith wrote in the Affluent Society, corporations sell products by creating demand for them through advertising, and other means. This is “Say’s Law” but with a radically different meaning. This artificial demand creation is harmful to consumers, since it creates aspiration and desires in all, but only a small part of this can be fulfilled. Furthermore, it necessitates all consumers to labor more in order to meet their artificially increased demands. All this rat-race for higher and higher standards of living does not buy happiness, as noted by Easterlin, and confirmed by many psychological studies.   An important factor in happiness is the difference between aspirations and actual consumption levels – if the production process increases aspiration more than it increases consumption, this can lead to a decline in happiness. See for example, Lane in Loss of Happiness in Market Economies.

CONCLUSION: It is not legitimate for economists to treat preferences as exogenous, since they are created by the production process itself.

3      Failure of Full Information

The assumption that consumers make choices with full information can easily be proven wrong, as Hill and Myatt do by a broad range of examples. There are two levels of failure. At one level, corporations deliberately deceive consumers regarding the benefits of purchase of consumer goods. Examples are given from Big Pharma deceptive advertising to market dangerous or useless drugs. Prominent examples are Tobacco, and Baby Milk Powder, known to cause deaths. The 2014 documentary “Fed Up” shows how the search for profits has led the sugar industry to create massive amounts of obesity, and related diseases such as diabetes, deliberately. Corporations guided by the making of profits as the sole “moral” principle make cold-blooded calculations of profits from sales versus costs of being sued by damaged customers. In an environment where massive amounts of advertising is carried out to shape preferences and deceive consumers, the idea that consumers make informed choices which maximize their welfare cannot be sustained.

An even deeper problem, is that people do not know what is good for them, and may make wrong choices which lead to unhappiness. There is massive amounts of empirical evidence that there are systematic errors made routinely which cause regret in later life. For example, market societies teach people to value wealth and career over friends and relationships, but people in hospices express regret at making these choices. Psychological studies show that social relationships bring us more happiness than consumption. This leads to the third way in which modern consumer theory is deeply misleading, both empirically as a guide to real human behavior, and theoretically, as a normative guide to “rational” choices required to maximize our welfare.

4      The Social Dimensions of Preference

Methodological individualism adopted by economists blinds them to social dimensions, which are central aspects of preferences and welfare, as demonstrated by strong empirical evidence. Envy, conspicuous consumption, and externalities created by the need to keep-up-with the Joneses, are crucial to understanding consumer behavior, and completely neglected by economic theory. The simple idea that we evaluate the utility of a consumption bundle by comparison with our neighbors has radical implications for consumer theory. This immediately invalidates the Pareto principle, since making a certain group of consumers better off will make the rest worse off in comparison. Furthermore, relative consumption creates a rat-race. Everyone believes, correctly, that if they increase their consumption they will be better off, ceteris paribus. That is, assuming everyone else remains where they are. But of course, when all people strive to increase their standard of livings, then the average standard of living increases so that no one is better off (except the capitalists, who extract profits from laborers in the process of production, and profits from the consumer in the process of sales). There are many ways to prevent this rat race, which will make everyone better off. But these measures require social consensus.

Another aspect of economists failure to understand social preference arises from the false and misleading idea taught in textbooks that aggregate demand of the consumers is just the sum of the individual demand functions. As we learn from complexity theory, the whole is not the sum of its parts when interaction are important. This is precisely what happens when social dimensions of consumption matter. Mathematically, the Sonnenschien-Mantel-Debreu theorem shows that the aggregated demand function need not satisfy any of the properties of the individual demand. This has been labeled the “anything-goes” theorem and create massive difficulties for conventional consumer theory. This problem has been highlighted by Steve Keen in Debunking Economics: The Naked Emperor De-Throned?

90min Video Recording of AM05: Consumer Theory

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