Question

Indifference curves allow us to show how an individual consumer is willing to trade off one good for another without changing their overall level of satisfaction or well-being. There are three assumptions that are made about consumers that are central to the consumer choice theory. Explain what each of the assumption means in terms of consumer choice. For each one, provide an example of the assumption not holding in the real world

Answer 1

Indifference curve depicts various possibilities of combination of two goods available to the consumer such that throughout the curve the satiety level is same. If we are to consider only 3 assumptions related to consumer choice which is important for the consumer choice theory:

1) Consumers are assumed to understand their preference that is the theory assumes that a consumer is always sure about his preference of one good over the other. This is not always in tune with the reality. Like for example given coffee and cold drink, a person cannot say he will always prefer coffee over cold drink because let us say in summer his preference will definitely change.

2. Consumers have consistent preference throughout that is if between good A and good B he prefers good A and between good B and good C prefers Good B then he will definitely choose good A over good C. This is the assumption that weeds out the possibility of intersecting indifference curve. The assumption basically is that consumer preferences are linear. But in real world there are many paradoxes which breaks this assumption like the Allias Paradox in finance which says that in a small time period investors will have inconsistent preferences.

3. Consumers have monotonic preferences that is more is better. It is assumed that a consumers have non satiation preference. This assumption of non satiety is mostly due to avoid modelling complications in Economic analysis. But satiation is inevitable because we have 'bads' of which consumer will definitely not want more like pollution. Also, there is a concept of Bliss point in Economics where consumption would be optimum and consumer wouldn't prefer more of the goods like for example salt in your food.