The consumer theory is a theory in economics that tries to explain the relationship between a consumer's purchasing choices and income. The idea behind consumer theory is that consumers will try to purchase the products that will give them the highest levels of benefit or enjoyment for the amount of money that they can afford to spend. Restrained by a budget, they will buy less expensive products if prices increase and more expensive ones if prices decrease. Likewise, they will buy more expensive products if their income increases and less expensive products if their income decreases. Consumers make these choices in an effort to maximize the benefit they receive in return for the money they spend.
The theory assumes that consumers will spend only the money that they actually have and does not account for saving money. This is called the budget constraint. According to consumer theory, budget constraint will affect a consumer's spending decisions by limiting his or her choices. If a consumer can spend only the money he or she has, then any choices that cost more must be eliminated. For example, when purchasing a refrigerator with a budget of $800 US Dollars (USD), a consumer will choose the best model for that amount or less, but he or she will not choose a model with a cost of $900 USD.
Next, consumer theory looks at preferences. In general, the theory assumes that the consumer prefers a group of products packaged together, which is commonly called a bundle. A consumer often will prefer a bundle without regard to the brand, instead basing a purchase decision on something such as the number of products in the bundle or the size of the bundle. For example, a consumer might prefer a bundle with extra large bottles of brand A shampoo and conditioner over a bundle of smaller bottles of brand B shampoo and conditioner. If the bottles are the same size, however, then the consumer might have no preference of either brand, which is called indifference.
Consumer theory also discusses a factor called the substitution effect. This factor states that if the price of a product goes up, the consumer will have to choose to buy less or substitute a less expensive product in order to purchase the desired amount. In most cases, the consumer will substitute the less expensive product when faced with this choice. For instance, if the consumer usually buys a particular brand of coffee and the price goes up, he or she probably will switch to a less expensive brand of coffee. Alternatively, if prices then go down, the consumer can choose to buy more of the less expensive brand but usually will switch back to his or her preferred, more expensive brand.
The income effect is another factor in consumer theory. The income effect states that if a consumer's income increase, he or she will be able to purchase more of a desired product. The consumer also might choose to substitute a different product that previously was too expensive for his or her budget.
An example of the income effect would be if a woman usually purchases a certain brand of handbags because the brand is within her budget, but she really wants a more expensive brand of handbag. If her income increases, she usually will switch brands and purchase the desired, more expensive brand. Conversely, if the consumer's income decreases, she usually will switch to a less expensive brand.