a comparative analysis of neoclassical consumer and producer theory by siya biniza.pdf
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A comparison of the assumptions and technical apparatus of neoclassical consumerand producer theory reveals that the theories are essentially the same with consumersproducing utility and firms producing goods. The theories use similar assumptions, thesame technical apparatus and similarly narrow assumptions about behaviour ofconsumers and firms. But there is a difference in the treatment of time and how itaffects consumers’ and firms’ decision-making. This essay is therefore a comparativeanalysis of both consumer and producer theory.TRANSCRIPT
A Comparative Analysis of Neoclassical Consumer and Producer Theory Written by Siyaduma Biniza 1
A comparison of the assumptions and technical apparatus of neoclassical consumer
and producer theory reveals that the theories are essentially the same with consumers
producing utility and firms producing goods. The theories use similar assumptions, the
same technical apparatus and similarly narrow assumptions about behaviour of
consumers and firms. But there is a difference in the treatment of time and how it
affects consumers’ and firms’ decision-making. This essay is therefore a comparative
analysis of both consumer and producer theory. Due to limited space, this essay only
considers the theories as they relate to the optimal choice and behaviour of consumers
and firms. Although there might be a similar study in the deeper analysis of these
theories, I am not concerned with that analysis here. Firstly I look at the assumptions,
mechanisms and technical apparatus. Then I examine the behavioural assumptions,
parallels and contrasts before some concluding remarks.
For producer theory a key assumptions is that firms have a set production technique
which is referred to as technology or captured as a production function (Varian, 2010).
This is simply the combination of inputs that firms use to produce their output.
Technology is contextually fixed so firms simply choose their specific combination of
inputs. However there are endogenous theories that incorporate technology in the
production function in order to account for technical changes (Fine, 2006). Regardless
though, firms do not control the quantity of their output instead they choose the
relative quantities of inputs they decide to use. Therefore, a specific combination of
inputs used corresponds with a certain level of output and costs of production.
Furthermore the price for inputs and outputs are set exogenously since firms operate
in a perfectly competitive environment. This means that firms cannot decide the price
for the output, which is the same throughout the market. But firms can determine the
level of costs through their choice of inputs (Varian, 2010). Since their technology is
exogenously given the only thing that firms can affect is the cost of their production by
1 Siyaduma Biniza is currently a B.Com. (Hon) in Development Theory and Policy student at the
University of the Witwatersrand, holding a B.Soc.Sci in Politics, Philosophy and Economics from the
University of Cape Town.
choosing a specific combination of inputs. So a simple example would be a firm
deciding to employ a specific number of workers which all need to be paid a certain
wage resulting in a specific wage-bill which forms part of their variable costs. Therefore
employing a different number of workers will represent different costs due the impact
on the firm’s wage-bill.
Firms are also assumed to maximise their profits which is closely related to the fact that
firms are run by individuals that are conceptualised as motivated self-interested-utility-
maximising behaviour. I will unpack this more below. Therefore, given the behaviour of
firms and the limited resources at their disposal, firms also seek to minimise their costs
which maximises their profits since firms do not choose the price of their inputs or
outputs (Varian, 2010). These assumptions are analogous to the case of consumers.
Consumers have set preferences which are described using a utility function (Varian,
2010). This is simply an explanation for the utility that consumers gain from a specific
combination of goods that they consumed. Therefore consumers cannot determine
amount of utility gained, which is exogenously given, but they can determine the
consumption of goods that they consume. Preferences are contextually fixed and the
only thing changing is the consumption bundle and the utility associated with it.
Similarly to the case with firms, specific consumption bundles are associated with a
certain level of utility and costs or expenditure. In addition consumers face fixed prices
for goods. So the decision on how much of which goods to consumer is associated with
a certain amount of expenditure. Given that consumers are seen as maximising their
utility and using limited resources, their preference and income are constraints on
consumer behaviour.
There are many parallels between consumer theory and producer theory as may be
apparent from this preliminary discussion on the key assumptions and mechanisms.
Both firms and consumers have contextually fixed internal logics that determine either
output or the utility gained. Firms’ output is determined by their production function
and all they choose in the quantity or combination of inputs to be used to produce
goods. Meanwhile consumers choose the quantities or combination of goods to be
consumed in order to gain utility. So, in similar fashion to the production of goods,
consumption can been seen as a process of producing utility as determined pre-
determined utility (production?) function of consumers. Consumers are comparable to
the production process since inputs (goods consumed) have very specific and pre-
determined outputs (utility) which strips away any alternative meanings of
consumption (Fine, 2010) equating it essentially to the production of utility.
Furthermore, the technical apparatus, proposed mechanisms and theoretical
framework of both consumer and producer theory are pretty much identically
mirrored. Firstly both theories use marginal analysis to explain impact of changes in
input on the output. For producers this takes the form of marginal product which is
essentially the same as marginal utility in consumption. Hence, “the concept of
marginal product is just like the concept of marginal utility … except for the ordinal
nature of utility” (Varian, 2010, p.338). Secondly, both theories assume that the
marginal changes are diminishing hence the laws of diminishing marginal utility and
diminishing marginal product. In other words adding more of an input or consuming
more of a good leads to increasing less additional output or utility each time. But these
are simply pragmatic laws since there are cases where increases in consumption have
increasing marginal utility such as the case with addictions, or even varying marginal
changes in utility and production (Becker, 1991; Varian, 2010). These laws are simply
based on observations instead of inherent features of marginal product or marginal
utility. Nevertheless, the technical apparatus is clearly the same in both marginal utility
and marginal product – so is the assumption of diminishing marginal changes.
Thirdly, the concept of marginal rate of substitution, which is exchanging one
consumption good for another whilst keeping utility constant, is directly analogous to
the concept of marginal rate of technical substitution which is exchanging one factor
input for another whilst keeping output constant. Furthermore, these are also
mathematically derived to equate to the relative prices of goods in the case of utility or
the inputs in the case of production. Therefore, indifference curves, which characterise
various combinations of goods that result in the same utility, are essentially equivalent
to isoquants which characterise various combinations of inputs that result in the same
output. Moreover, given the underlying assumptions of diminishing marginal changes,
both isoquants and indifference curves have the same shape. This is illustrated below.
Comparison of Consumer Theory and Producer Theory
Consumer Theory Producer Theory
Optimal Choice for Consumers
( ) ( )
( )
Optimal Choice for Firms
( ) ( )
( )
This is essentially the same theoretical framework with consumers and producers
respectively maximising their utility and profits under specific constraints. Consumers
maximise their utility by choosing a combination of goods that offers the highest utility
considering their budget constraints. Under a fixed utility level as embodied by the
indifferent curve any combination of goods will lead to the same utility. Similarly, for
firms, any combination on the isoquant will lead to the same output.
The optimal choice then for utility-maximising consumers is that specific combination
of goods that exhausts the consumer’s income. Analogously, firms maximise profits by
choosing a combination of inputs to produce a specific quantity of goods that is
consistent with the lowest costs. But of course these deductive outcomes regarding
consumer behaviour is undermined by individuals’ savings, amongst other things,
which suggests that consumers do not just maximise their utility by consuming as
many goods as their income can purchase. Also, this narrow assumption about the
behaviour of firms is undermined by the concept of an efficiency wage which is higher
than the equilibrium wage (Stiglitz, 2002) since the efficiency wage is not consistent
Budget Curve I = price(1)*good 1 + price(2)*good2
Indifference Curve Ū = f(good 1, good 2)
Go
od
2
Good 1
Optimal Choice
Cost Curve C = price(1)*input1 + price(2)*input2
Isoquant Curve Ÿ= f(input 1, input 2)
Inp
ut
2
Input 1
Optimal Choice
with the cost minimisation matrix. Nevertheless, despite the strong similarities in the
behavioural assumptions and parallels, there is an important difference in the
treatment of time in these theories.
In the short-run at least one a firm’s inputs is fixed which means it cannot choose
different quantities of that input in production (Varian, 2010). This is different from
consumer theory only takes a static comparative approach to time differences (Fine,
2010) so time has not difference on the consumer’s choice set unless there are
exogenous changes in preferences or income. But for the firm time affects the firm’s
choice set. In the long-run firms can utilise varying quantities any of its inputs and the
analysis becomes the same as the consumer case.
Therefore the theories use similar assumptions, the same technical apparatus and
similarly narrow assumptions about behaviour of consumers and firms – but they differ
in their treatment of temporal change. Thus consumers basically produce utility
through consumption and firms produce goods through production.
Bibliography
Becker, G.S., 1991. Habits, Addictions, and Traditions. Working Paper No. 71. Chicago:
Center for the Study of the Economy and the State University of Chicago.
Fine, B., 2006. Endogenous Growth Theory: More Problem Than Solution. In K.S. Jomo &
B. Fine, eds. The New Development Economics: A Critical Introduction. New Delhi and
London: Tulika and Zed Press. pp.68-86.
Fine, B., 2010. Consumers and Demand. mimeo.
Stiglitz, J.E., 2002. Information and the Change in the Paradigm in Economics. The
American Economic Review, 92(3), pp.460-501.
Varian, H.R., 2010. Intermediate Microeconomics: A Modern Approach. 8th ed. New York &
London: W. W. Norton & Company.