Factors Influencing Individual Consumer Choice (HSC SSCE Economics): Revision Notes
Factors Influencing Individual Consumer Choice
Introduction to consumer choice
When consumers decide to spend their income, they face an enormous range of possible purchases. Economists assume that consumers seek to maximize their utility when making spending decisions. Utility refers to the satisfaction or well-being that individuals gain from consuming goods and services. Higher utility means an individual has satisfied more of their wants.
In attempting to maximize utility, consumers must choose which goods and services to purchase. However, their choices are limited by two key constraints: the market prices of goods and services, and their level of income. The demand of each consumer for a particular good or service is known as individual demand.
Consumer choice is fundamentally a balancing act between unlimited wants and limited resources. Every purchasing decision involves trade-offs, as buying one item means forgoing the opportunity to buy something else.
The main factors influencing consumer expenditure
1. The level of income
A person's income level is one of the most significant influences on their spending pattern. As individuals earn higher incomes, they typically choose to buy more items and goods of higher quality.
For example, the range of purchases available to an investment banker earning $300,000 annually would be vastly different from those available to a pensioner living on $30,000 per year from the age pension and superannuation. An overseas holiday might increase the pensioner's utility, but their limited income may prevent them from satisfying this want.
The wealth effect
Rising house prices can also influence consumption through what economists call the wealth effect. When house prices increase, homeowners feel wealthier, even if they haven't sold their property. This perception of increased wealth encourages higher spending.
Research cited by the Governor of the Reserve Bank of Australia in 2019 found that a 10 per cent increase in housing wealth raises consumption levels by 1.5 per cent in the long term. This demonstrates how asset values, not just income, can affect consumer spending decisions.
2. The price of the good or service itself
When considering a purchase, consumers must decide whether they are willing to pay the stated price for an item, given their income level. The relationship between price and demand varies significantly depending on the type of good.
Necessities versus luxuries
Some goods are considered necessities for daily life. People will continue to buy these items even if prices increase, because they need them for survival. For example, if the price of basic food increases, people will not greatly reduce their demand, as food is essential. However, gourmet foods like caviar or oysters are not necessary for survival and would see much larger reductions in demand if their prices increased.
In contrast, luxury items face much more elastic demand. Consumers are likely to significantly reduce their purchases of luxury goods when prices rise, as these items are not essential to daily living.
The distinction between necessities and luxuries is crucial for understanding consumer behavior. Necessities show low price sensitivity (inelastic demand), while luxuries show high price sensitivity (elastic demand). This difference has major implications for businesses and policymakers.
3. The price of substitute and complement goods
The quantity of a good demanded at any time is affected not only by its own price, but also by the prices of related goods. These related goods fall into two categories: substitutes and complements.
Substitute goods
A substitute is a good that consumers may choose to buy in place of another good. Common examples include butter and margarine, or tea and coffee. Consumers can replace one with the other to satisfy similar needs.
When the price of one substitute increases, demand for the other substitute tends to increase. For instance, if the price of margarine rises, consumer demand for butter (its substitute) will typically increase, as consumers switch to the relatively cheaper alternative.
Worked Example: How Substitutes Affect Demand
Consider butter and margarine as substitute goods:
- Initial situation: Butter costs $5, margarine costs $3
- Price change: Margarine price increases to $5
- Consumer response: Demand for butter increases as consumers switch from the now equally-priced margarine
- Result: Consumers maintain similar satisfaction by substituting between products based on relative prices
Complement goods
A complement is a good that is used in conjunction with another good. Consumers tend to purchase complementary goods together. Examples include:
- iPhones and iPhone cases
- Cars and petrol
- Surfboards and wet suits
When the price of one complement falls, demand for both goods typically increases. For example, if the price of iPhones decreases, we would expect higher consumer demand not only for iPhones but also for their complements, such as iPhone cases.
Worked Example: How Complements Affect Demand
Consider iPhones and iPhone cases as complement goods:
- Initial situation: iPhone price is $1,500
- Price change: iPhone price decreases to $1,000
- Consumer response: Demand for iPhones increases due to lower price
- Secondary effect: Demand for iPhone cases also increases as more people own iPhones
- Result: A price decrease in one complement boosts demand for both products
4. Consumer tastes and preferences
Personal tastes and preferences represent another major influence on spending decisions. Individuals choose to purchase goods and services that provide them with the highest level of utility or personal satisfaction.
Individual variation in preferences
Generally, economists assume that consuming more of most goods increases consumer utility. However, different goods provide different levels of satisfaction to different people. A consumer who prefers fruit juice and dislikes soft drinks will naturally spend more on juices and less on soft drinks.
Some goods may actually reduce consumer satisfaction. For example, a person who dislikes classical music would experience reduced utility from purchasing a symphony ticket, as they gain no satisfaction from the purchase.
Changes in tastes over time
Consumer preferences can change through experimentation and learning. Someone who initially dislikes classical music might change their opinion after hearing a Mozart symphony used as background music in a film.
As consumer tastes shift over time, so does demand for particular goods. Clothing coming into fashion experiences increased demand, while items going out of fashion see decreased demand.
Technological progress and innovation
Innovation and technological advancement lead consumers to demand new and improved products instead of older, superseded ones. This shift in preferences has significant impacts on consumption patterns.
Technology Reshaping Consumer Preferences
Global sales of laptops and tablets exceeded desktop computer sales by more than three times in 2019. This reflects changing consumer preferences driven by technological innovation and the increased portability and functionality of mobile devices.
Another example is communications spending. Australians now allocate a much higher proportion of their income to communications than in the past. This change reflects the explosive growth of mobile telephony, internet usage, and cheaper call costs. According to the ABS Internet Activity Survey, 14.7 million Australians were internet subscribers as of July 2018. A decade earlier, less than half that number subscribed to internet services, demonstrating how technological change drives shifts in consumer behaviour.
5. Advertising
Advertising can exert a major influence on individual consumer choice. In some cases, advertising can even create demand for goods or services where none previously existed.
Saturation of advertising
Modern consumers encounter advertising constantly throughout their day. Common forms include:
- Pop-up advertisements on the internet
- Telemarketing phone calls
- SMS marketing messages
- Billboards on streets and at railway stations
- Messages on other people's clothing
Economic significance
Advertising and marketing represent major economic activities in modern market economies. In Australia, billions of dollars are spent annually on advertising, reflecting its perceived importance to businesses.
Impact on price sensitivity
Advertising can make demand for goods and services less responsive to price increases. By building consumer loyalty to particular brands over time, advertising reduces consumers' willingness to switch to cheaper alternatives when prices rise. This brand loyalty can insulate companies from competitive price pressure.
Advertising doesn't just inform consumers about products—it fundamentally shapes preferences and buying behavior. By creating brand loyalty, advertising can reduce price sensitivity, allowing companies to maintain higher prices without losing customers to competitors.
Remember!
Key factors influencing consumer choice:
- Income level: Higher incomes enable purchase of more goods and higher quality items; the wealth effect from rising house prices also encourages spending
- Own price: Necessity goods show low price sensitivity; luxury goods are highly price-sensitive
- Related goods prices: Rising substitute prices increase demand for a good; falling complement prices increase demand for both goods
- Tastes and preferences: Individual satisfaction varies; preferences change with fashion, technology, and learning experiences
- Advertising: Creates and sustains demand; builds brand loyalty; reduces price sensitivity
Essential definitions:
- Utility: The satisfaction or pleasure that individuals derive from consuming goods and services
- Substitute: A good consumers may buy instead of another (e.g., butter and margarine)
- Complement: A good used together with another (e.g., cars and petrol)