The Flaws of the Economic Model of the Consumer
by Douglas JE Barnes

Capitalism is often sold to a reluctant population as the only system that can deliver the maximum social welfare to society. Hoping to back up that claim, economists have developed Demand Theory. According to mainstream or neoclassical economic theory, the market maximises social welfare. Therefore any interference with markets will result in less than optimal social welfare in a society. As we shall see, ecomonists make this strange conclusion by saying that there is only one person in all of any given society, and that this person always spends the same proportion of their income on the same goods. Additional problems to demand theory will also be outlined.

The Theory

In 1780, Jeremy Bentham proposed that the actions of human beings could be described strictly in terms of pleasure seeking and avoidance of pain. From this, Bentham went on to develop a theory of societal welfare known as Utilitarianism. In the words of Nobel lauriate in economics Amartya Sen, "Utilitarianism has been the dominant ethical theory - and, inter alia, the most influental theory of justice - for over a century."[1]

Bentham started off by saying that society is nothing more than the sum of its parts:

The community is a fictitous body, composed of the individual persons who are considered as constituting as it were its members. The interests of the community then is [sic], what? - the sum of the interests of the several members who compose it. It is in vain to talk of the interest of the community, without understanding what is in the interest of the individual.[2]

Under utilitarian theory, people are said to obtain a certain amount of pleasure or utility from anything they consume. As they consume more, they get more pleasure but at a diminishing rate. Economists call each unit consumed a marginal unit, and say that "marginal utility diminishes". For example, if you are thirsty, a glass of water is very nice. A second glass of water is also nice, but it doesn't give you as much pleasure as the first glass. Similarly, you will get more overall pleasure from your 33rd glass of water, but it won't give you as much pleasure as your 32nd.

By comparing one item to another, you can say that the pleasure attained by eating 4 apples for example is the same as the pleasure attained by using 2 pencils. In such a case, you are said to be indifferent to the choice of 4 apples or 2 pencils in terms of utility which, according to Jeremy Bentham, is all you need to think about in terms of understanding human behaviour.

In this way, the messy problem of trying to measure utility can be avoided. It is only necessary to look at instances when you are indifferent to different choices. By graphing these points, it is possible to plot a person's indifference curve to show the utility for a product in comparison to another product (or bundle of products) at a certain price. Next, by holding the price of one of the products constant and varying the price of the other constant, it is possible to demonstrate the demand for the product at different prices.

A complication arises

Up to this point, the thoery sounds pretty good. However, looking a little deeper reveals problem with an underlying assumption: not all spending remains proportional to income.

By looking at indifference curves known as Engels curves, we can see that not all spending increases or decreases proportionally with corresponding changes in income. Engels curves diagram neutral items that do increase and decrease with corresponding changes in income, necessities that don't change with changes in income, luxuries that increase with increases of income and inferior or Giffen goods that decrease with an increase in income.

Spending on necessities virually does not increase with an increase in income. You would not buy more dental floss if your income changed from $19,000 to $19,000,000 a year.

You would buy more Giffen goods if your income decreased and you would buy less or none if it increased. For example, if you lose your job, you will probably be spending more money on instant macaroni. If your income increases, you will spend less on this and more on something better and perhaps even cut out this item altogether.

As your income increases, your spending on luxuries will increase. If you earn more, you are more likely to spend money on an overseas vacation. Earn less and you are more likely to spend less on fashions.

The Fatal Conceit

The whole theory fails when we try to do what Jeremy Bentham asserted was possible in 1780, namely sum all the demand curves for every member of society to get the societal demand for a product. According to neoclassical economic theory, society's demand curve will have the same properties as an individual's demand curve.

One problem with summing everyone in society together is that not everyone derives the same pleasure or utility from a given item. A similar problem arises with Engels curves. By changing income distribution, spending on different catagories of goods will change for different members of a society. Some will consume more luxuries, others will consume more Giffen goods. Thus, if one were to reverse-engineer a societal demand curve, there would be no guarantee that the society as a whole would be experiencing the the maximum utility from that change in income - be it changing actual income or doing so virtually by raising or lowering the price of a product. In other words, the market does not guarantee maximization of utility.

There is not much to debate here with mainstrean economists really. They know this. In the words of neoclassical economist Hal R. Varian, "The neoclassical theory of the consumer places no restrictions on aggregate behaviour in general." [3]They have a clever way out, though. They say that consumer preferences are homothetic and affine. Homothetic is a fancy way to say identical, and affine means a transformation that carries the same properties from beginning to end. Put in to plain english, every member in society is the same individual and all spending remains proportional to income.

What does it all matter anyway? It matters first because the free market is sold in international development policy circles as the solution to poverty and maximization of welfare in society. However, we have just seen that the market cannot guarantee maximization of societal welfare. Secondly, demand theory is one of the basic building blocks of other economic theories. If the one of the basic building blocks of those theories is incorrect, it is highly unlikely that those theories are correct.

Further Problems:

Market reliance on altruism

One further problem with the neoclassical theory of consumer behavior is the assumption of unadulterated self-interest in consumer behavior. However, the market needs altruistic behaviour to continue to function. Namely, there is a need for a concept of individual property and a need for a concept of legal exchange. Without these altruistic concepts, people would continually weigh the risks and benefits of defaulting on loans, cheating business associates, loafing at work, shoplifting, stealing cars, and so on. Yet, according to market theory most people are irrational because they don't take advantage of others. In the words of Joseph Stiglitz, winner of the Nobel prize in economics:

...The more ruthlessly individuals pursue their self-interest - the more they behave as we economists teach our students to behave - the less efficient, in a sense, is the economy.[4]

Time

Believe it or not, this dimension of reality is completely absent from neoclassical demand theory. Economist Paul Samuelson outlined four characteristics of consumers necessary for demand theory: completenss, transitivity, convexity and non-satiation. [5]

Completeness means that either consumers prefer one bundle of goods to another or they are indifferent. However, not only does a change in income change consumer preferences, clearly time does as well.

Transitivity means that if consumers prefer product A to B and product B to C, then they prefer A to C. However, it is entirely possibly to prefer C to A at another point in time.

Convexity says that marginal utility (the amount of pleasure you derive by consuming one more unit of something) decreases with each additional unit consumed. This means that to keep utility constant, you need to add units of one product and subtract units of another. However, some products complement one another like Tequilla and limes for instance. Also, you might well get more marginal utility from your second or third beer than from your first. To bring time into the equation, marginal utility will change over time.

Non-satiation means that more is prefered to less. Time ravages all thing, including this assumption of human behavior. If this is true, then on any one day you would prefer 59 cups of coffee to 2. Similarly, you would prefer 3kg of salt on your french fries to 3 grams. Clearly people can be satisfied over time.

Another assumption about consumers is that they are rational. This means that consumers carefully judge what they buy and compare their options fully. To see if this is possible given the reality of time, go to the supermarket and choose between zero and ten units of any 5 goods and spend only 10 seconds thinking about each possible combination of goods. A word of warning first: this little experiment will take you one million seconds or 11.6 days.

Need

A further problem with the Hedonistic view of human behaviour is the issue of need. As psychologist Abraham Maslow argued, people have different priorities of needs at different times. For example, if your body happens to need salt, then you will crave salty food until that need is met. After basic physiological needs are met, people look to meet future security needs, then needs for love and a sense of community, then needs for respect and recognition. Then finally, if all those needs are met, they will look to meet the need for a sense of life purpose. These needs evole or devolve over time. That being so, an individual's demands will constantly be changing over time. Yet, time is not at all considered in neoclassical demand theory.

Happy slaves

An additional problem with utilitarianism worth mentioning is that distributional inequality of utility is not a consideration. As long as utility sums up to a higher number in a society, everything is fine. For example, a society of 100 people in which total utility is 1000 units and 99 people each have one unit of utility and one individual has 901 units would be considered better than a society where each individual has 9 units of utility.

Furthermore, as Nobel lauriate Amartya Sen points out, people tend to adjust to misery.

...The deprived people tend to come to terms with their deprivation because of the sheer necessity of survival, and they may, as a result, lack the courage to demand any radical change, and may even adjust their desires and expectations to what they unambitiously see feasible. The mental meteric of pleasure or desire is just too malleable to be a firm guide to deprivation and disadvantage.

...[I]n the scale of utilities the deprivation of the persistently deprived may look muffled and muted...[6]

The Road Ahead

The most important mesage here is that, contrary to neoclassical claims, the market cannot be trusted to provide the greatest good to society. Indeed, there is plenty of evidence that as a market moves closer to the free market ideal, the more society will suffer. [7] Also shown here is the need for a revised theory of demand - one that takes into account the changes that occur over time. Perhaps an economic system which accounts for the wants and needs of the society in the planning stage via participatory planning, such as Participatory Economics, might be better suited to determining demand.

Notes:

1. Sen, Amartya, (1999). Development As Freedom, Anchor Books, New York, p.58. Also, Keen, Steve, (2001). Debunking Economics: The Naked Emperor of the Social Sciences, Pluto Press, Annandale, p.25

2. Bentham cited by Keen, p.26 Unless otherwise stated, all the material in this article is either from Prof. Keen's Book or his website http://www.debunking-economics.com .

3. Keen, p.40

4. http://www.debunking-economics.com/Hedonism/More/index.htm

5. Keen p.33 and http://www.debunking-economics.com/Hedonism/More/index.htm

6. Sen, p.63

7. For an example, see http://www.cepr.net/globalization/scorecard_on_globalization.htm