Hill – Mankiw 9th Edn Chapter 21 – The Theory of Consumer Choice
Mankiw, N. G. (2021) Principles of microeconomics (9th ed.)
Principles of economics (9th ed.)
Mason, OH: South-Western Cengage Learning.
Rod Hill
University of New Brunswick, Saint John campus
Saint John, New Brunswick, Canada
email: rhill@unb.ca
Here are some things to consider when reading this chapter.
This chapter presents the standard theory of consumer choice that underpins the demand curve. What is most interesting is not what’s in the chapter, but what’s left out.
Preferences are taken as given. Orthodox writers defend this approach by simply asserting that questions of where preferences come from and how they might change is someone else’s business. University of Chicago economist Milton Friedman wrote: “The economist has little to say about the formation of wants; this is the province of the psychologist. The economist’s task is to trace the consequences of any given set of wants” (1976, p. 13).
In Friedman’s view, preferences should be treated as determined outside economic models. That is, they are exogenous. In the same way, other things are treated as exogenous variables in the model of consumer choice: market prices, the consumer’s budget (determined by the labour-leisure choice), and tax rates (determined by political decisions). But Friedman’s position invites students to forget that, in reality, preferences in many markets are the outcome of profit maximizing decisions by producers, decisions in this case about how to use advertising and marketing to influence preferences. This would upset the implicit portrayal in the standard text of consumers as ultimately in charge of what the economy produces. (This used to be termed Consumer Sovereignty; the term has largely gone out of use, but the message remains the same.)
Models necessarily take some things as exogenous, while determining other variables within the model – endogenous variables. In more complex models, more variables may be considered endogenous and their potential determinants are included. All models’ explanatory power is limited; no ‘theory of everything’ with no exogenous variables exists.
We’ve seen in the Commentary on Chapter 16 some economists’ thoughts on the role of advertising in creating and changing preferences.
There are other aspects of preferences and choice that fall squarely into the domain of economics.
- Preferences about preferences.
The standard textbook story never mentions the idea “that consumers may have preferences regarding what their tastes should be. A consumer may, for example, prefer that she lose the taste for smoking, or acquire a taste for jogging. An adequate theory of consumer choice should include such second-order preferences or meta-preferences” (McPherson 1987, p. 2).
As the Commentary on Chapter 16 notes, public policy may recognize this and act to try to shape the development of preferences in the directions that people would prefer. For example, laws can prohibit the advertising of certain products, such as cigarettes, or restrict the advertising permitted to certain audiences, such as children.
- The absence of a social dimension to preferences and utility
The theory of consumer choice in Mankiw’s text (and in virtually all introductory and intermediate textbooks) ignores how individuals’ utility depends on others’ consumption. The standard model assumes that people get utility only from leisure and the goods that they consume, and that they pay no attention to what others consume.
This is strange given that economics is a social science and humans are social animals. We are aware from the earliest age of what others have and that that influences our own wants and the utility we get from what we have. It seems all too easy to forget this while focusing on the logic of deriving a demand curve.
Those people are members of an individual’s ‘reference group’ whose incomes help to determine an individual’s “income reference level”.
Take a moment to consider this question: which of the following would you prefer, A or B?
- Earning $100,000 when others earn $200,000.
- Earning $50,000 when others earn $25,000.
Richard Easterlin, the first economist to research the determinants of subjective well-being, wrote that option B “has been the preference over the course of two decades of more than two-thirds of my undergraduate students. Option B demonstrates the effect of bringing social comparison into the picture” (2023: 202).
As Juliet Schor writes: “While most critics of consumer society focus on ads and the media, it’s important to remember that the more powerful stimulator of desire is what friends and family have” (1998, p. 69). What they have helps to determine an individual’s ‘income reference level’ by which their own situation is judged.
Easterlin’s simple thought experiment contradicts the standard assumption that higher levels of income for everyone leave everyone better off. If individuals’ utilities depend on their relative incomes and not their absolute level, then the long-term growth of average incomes does not increase people’s feelings of well-being.
In addition, people also evaluate their situation by comparing it with their own past experience. Easterlin explains that this is important in the short run such as during recessions when many experience a decline in income (2023:202-203). Given previous commitments (e.g. car and mortgage payments), financial pressures increase, which reduces subjective well-being. The decline is reversed if incomes recover. “Once income rises above its previous peak… [s]ocial comparison resumes as the dominant determine it of the income reference level negates the positive effect on happiness of additional increases in one’s own income” (2023: 203).
In a pathbreaking 1974 study, Easterlin presented empirical evidence that long-term growth of average incomes in already-affluent countries didn’t increase people’s subjective well-being. The result was termed the Easterlin Paradox. The result was largely ignored for more than 20 years. An exception was Tibor Scitovsky’s The Joyless Economy (1992, first edition 1976) which has a chapter “Income and Happiness”, citing Easterlin’s work.
However, since the late 1990s research by both economists and psychologists has flourished, so textbooks have no excuse for continuing to ignore it. For the latest research, see the World Happiness Report, which has been produced annually since 2012.
- Poverty and Social Comparison
The relative deprivation concept of poverty, described in section 4(iii) in the Commentary on Chapter 20, is based on the importance of income comparison. Having a minimum amount of goods and services becomes less and less satisfactory as the general standard of living rises. A poverty line, such as 50% of median income, reflects the idea of social comparison and also incorporates social inclusion, i.e. people’s ability to participate in normal social activities.
- Work and leisure if relative position matters
Mankiw sets out the standard theory of how individuals make choices to allocate time between leisure and work hours, and therefore wage earnings and the consumption it finances (pp. 436-439). The result is a labour supply curve: the hours of work supplied at various wages.
As with the decisions about how to spend on goods and services, the labour supply decision is assumed to be unaffected by other people’s decisions. But what if people care about their income and consumption levels relative to others, as well as their ability to participate in normal social activities?
This can result in a ‘rat race’ in which individuals work longer hours, take second jobs, shift to two-income households, trying to improve income and consumption relative to others. Yet they find themselves no further ahead when everyone else does the same thing. As Robert Frank and Philip Cook have written, “if we worked less than we currently do, we would have less income, but then if everyone worked less, we would need less income, because the amount of income we need is in part determined by the amount that others have… private incentives favor excessive of work” (1995: 144).
These effects can extend beyond just work hours. In a futile bid to stay one step ahead of other people, workers may accept riskier or less pleasant jobs, which offer higher wages. They may invest in more education or training, only to find that their credentials have been devalued as others pursue the same strategy.
In each case, individuals’ decisions impose external costs on others, a cost termed a positional externality, because it affects people’s relative income/consumption positions If one person works more, increasing their income and consumption, that devalues the utility-value of the income and consumption of other people.
Government regulation could help to address these externalities: legislating a minimum number of paid holidays, for example. In the European Union, legislation requires a minimum of four weeks of paid vacation per year, although some countries legislate five or six weeks. However, in the United States, where labour unions are weak and the power of business lobbies is exceptionally strong, one in five workers have no paid holidays or paid sick leave, and almost one in four have no paid vacations.
REFERENCES
Easterlin, Richard A. (1974) “Does economic growth improve the human lot?”, in A. David Paul and Melvin Reder, eds., Nations and Households in Economic Growth: Essays in Honor of Moses Abramovitz, Academic Press.
Easterlin, Richard A. (2023) “Why does happiness respond differently to an increase vs. decrease in income?”, Journal of Economic Behavior and Organization, 2009: 200-204.
Frank, Robert H. and Philip J. Cook (1995) The Winner-Take-All Society, Penguin.
Friedman, Milton (1976) Price Theory, Chicago: Aldine.
McPherson, Michael M. (1987) ‘Changes in tastes’, in Palgrave Macmillan (eds.), New Palgrave Dictionary of Economics, New York: Palgrave Macmillan. doi.org/10.1057/978-1-349-95121-5_305-1.
Schor, Juliet (1998) The Overspent American: Upscaling, Downshifting, and the New Consumer, New York: Harper Perennial.
Scitovsky, Tibor (1992) The Joyless Economy: The Psychology of Human Satisfaction, Revised Edition, New York Oxford: Oxford University Press.
Related commentaries
Further Reading
Goodwin, Neva (2021) “Consumerism and the denial of values in economics”, real-world economics review, issue 100: 224-241.
Roach, Brian, Neva Goodwin and Julie Nelson (2023) “Consumption and the Consumer Society,” Economics in Context Module on Social and Economic Issues, Global Development Policy Center, Boston University.