Applications of Choice Theory: the Theory of Demand

Preference Theory tells us that individuals who can express opinions about the various alternatives available to them will act as if they are maximizing a utility function. It is important to remember that this isn’t meant to be a description of what people actually do when they make decisions. Obviously people don’t consciously maximize anything when they make choices. Consumers who never got the hang of finding x in high school, nonetheless seem perfectly capable of deciding how to spend their money. The basic presumption in economics is that there is no way to know what people are actually thinking when they make decisions. The fact that individuals’ choices will look just like solutions to maximization problems allows us to use methods and concepts from mathematics to help describe behavior. This mathematical representation of behavior ultimately leads to the greatest contribution of economics, the concept of equilibrium behavior. We will begin the description of equilibrium behavior later on in this course. To make use of the method that the utility theorem provides, we have to add something to what we have so far. Suppose we are trying to figure out howpeoplewill react to a price change. At the initial price, we can use the theorem that we proved in the chapter on preferences to show that there is a utility function and that the choices our consumer makes maximize this utility function subject to whatever constraints she faces. The construction of this utility function depends on the alternatives over which the consumer has to decide.