Consumer and Firm Behavior

Why do companies market? And why is it very crucial for them to capture the attention of their customers? We have seen in many situations where businesses invest huge amounts of money in their market strategies because they want to get the best profits out. In economics, marketing is an applied science that seeks to explain and impact how firms and consumer act within markets. Note that consumers and firms and two economic variables that are directly related cannot exist without the other. Hence, marketing models are usually applied in standard economic theories and strongly rely on assumptions of the rationality of consumers and producers.

People are naturally rational. In other words, they make decisions based on pre-existing conditions around them, which may affect their decisions. Economists try to understand these behaviors because they help in shaping the general direction of firms, markets, and entire economies. And it is through behavioral economics that the implications of rationality limits are explored and brought into the light. Note that we all make decisions, but our decisions differ in many ways based on what motivates us to take a specific direction. As human beings, each of us has its own weaknesses and strength that impact how we behave within the markets.

This article introduces some of the models and assumptions used in understanding how consumers and firms make decisions. Models are like maps that show the direction of a certain strategy. In econometrics, a branch of economics that studies economic relationships, data is crucial; this is why marketers need specific models that can help achieve the desired results. Generally, we shall also be looking at the concept of game-theoretic equilibrium, which allows decision-makers to make mistakes, recover by learning from the wrong steps they made, or from feedback. Marketing researchers need to understand the consumer and firm behaviors because they help markets make a more informed decision.

The Psychology of firm and consumer behavior

There is a clear relationship between economics and psychology because they all influence the disciplines that define marketing. These subjects are used in developing models and establishing facts when seeking to understand how firms and consumers behave in markets to help managers make more informed decisions. It is safe to say theta these disciplines play a common role in understanding human behavior. However, few studies have linked the ideas outlined separately within these disciplines. In a recent research development concerning behavioral economics, psychological insights, as established from the findings, have found their roots into formal economic models. For many years, behavioral economics has been an essential part of business disciplines like finance (Barberis and Thaler 2003) and organizational behavior (Camerer and Maldendier, in press).

Idea from behavioral economics can be fundamental in establishing functional marketing strategies whereby a psychological approach to consumer behavior is linked to the economic models of consumption choices and market actions. In other words, consumers may be affected by certain occurrences in their lives that affect how they consume certain products, which, by default, affects production within firms. 

We all make decisions in our lives, and these decisions are motivated by certain statuses. In economics, scarcity is the main factor that affects consumption and production – and consequently, decisions companies and individuals have to make. This is because there is a limited amount of resources expected to the quench the unlimited human wants. One may wish to buy the best house, but they will need money, which they will have to work for. With the current state of economies and the growing populations, the labor market is strained, with fewer and fewer job opportunities every day. Even those who employ maybe manage to offer the required wages, especially when labor demand is high.

Today, behavioral economics is growing quite rapidly. The world itself keeps changing due to factors like technological advances and the growth of different institutions. Consumers and firms have to seek better options daily to improve their general lives. It is through psychological studies that we understand human behavior and how to deal with them. If a company a possible line of action for its potential consumer, they will know what to or not produce and by how much. Marketing is very expensive; hence it must bring back the investment. If there are no proper marketing methods, a company is likely to lose large on revenues, similar to marketing that is done without proper consideration of data. There are several models used in the explanation of these facts.

Behavioral regularities  

The consumer of the firm makes a choice depending on the perceived final outcome of that decision. This is explained through the application of the utility theory. Consider the gambles over money for outcomes; for instance, most consumers will define utilities over the final states of the wealth. In other words, it behaves as though different sources of the income that are fungible are combined as one into one "mental account." But this reference is usually avoided because of the psychological judgments of sensation. Reference dependence, on the other hand, states that decision-makers care more about changes in the outcomes just as much as the outcomes themselves. According to reference dependence, when a reference point may affect an outcome change, individuals' choices are sensitive to the change in question. Another important feature of the reference dependence is that people tend to display "loss aversion." This means consumers are more sensitive to changes that may lead to losing, than to those that bring about equal-sized changes.

The best example of reference dependence and loss aversion is Thaler's 'endowment effect' experiment in 1980. He used one group of participants who were endowed with a simple consumer product, like a coffee mug, or an expensive pen. Those with goods were required to say the least among of money they would sell the good for, and those without the good were asked how much they would be willing to for it. Most of the studies indicate that those with the good asked placed a selling price that doubled the initial buying price of the product. In this case, the endowment effect can be linked to an aversion to giving up or losing an endowment in comparison to the value of gaining one. In other words, gifting a person with an object changes their reference point to a state of ownership, and the variance in valuation shows the disutility of gaining a mug is greater than the utility of getting it.

The generalized model

According to the evidence mentioned in the previous section, a realistic model of preference should include two critical empirical regularities:

- What outcomes are considered as changes originating from the reference point, where positive changes are perceived as gains and negative changes as losses.

- Decision-makers are considered loss-averse, meaning losses bring about in portion more disutility than equal-sized gains.

These are empirical regularities that were the first capture in prospect theory (Kahneman and Tversky 1979). Later Kaszegi and Rabin (2004) extended this idea with the individual utility model u(x/r), making it to depend on both the final outcome (x) and a reference point (r).

Behavioral regularities

According to standard economic models, people are naturally self-centered, where they are more interested in gaining more wealth for themselves. Self-interest approach could be a useful simplification, but it is not majorly applied because it is a weak assumption in many situations. For instance, it cannot explain the reason decision-maker seem to be concerned about fairness and equality, and may be willing to give up money for more equal outcomes, or why the punish other for actions deemed selfish or unfair. In this type of behavior, we can clearly see the existence of social preferences, which defines why a person would go for a certain utility as a function on their gain or other's gain.

The 'ultimatum' price-posting game is the best demonstration of the presence of social preferences. In this case, a retailer in a monopolistic environment sells goods to a customer by putting up a price (p). The marginal cost of this product for the retailer is $0, while the willingness of the customer to pay for it is priced at $1. Hence, the game theory continues as the seller posting the price p = (0,1), and the customer making a choice whether to buy the product or no. If they buy, the consumer surplus becomes 1 – p, whereas the gain for the retailer is p (for profit), if the consumer declines to buy, each of them will receive a zero payoff. Incase these players are self-interest and only mind about their own profits, there a unique subgame perfect equilibrium in the game, in which the retailer charges p= $.99 (if we assume the smallest unit of money is a penny, and if the customer agrees to pay the price and gains a penny.

The representative consumer and firm

We are all faced with decision-making dilemmas every day, and we cannot avoid making them. As indicated in the section above, both consumers' and firms' behaviors are determined by various factors. To understand this concept better, let us consider the work-leisure decision and profit maximization by both entities.

The representative consumer

The representative theory is the consideration of one consumer who stands for the whole economy. If we consider consumption good and leisure, we can care about the utility function as:

U (C, L), with U as a utility, C the quantify of consumption, and L the quantity of leisure, presented as a particular consumption bundle.

We can, therefore say:

- U (C1, L1) is greater than U (c2, l2), in which case bundle one if strictly preferred.

- U (C1, L1) is equal to U (C2, L2), in which case the consumer remains unsure.

From this information, we can discover three assumptions;

1. What more is better than less.

2. The consumer prefers diversity within the consumption bundle.

3. Consumer and leisure are familiar goods, which are purchased more if the income is higher.

Where the indifference map is involved, a family of indifference curves where points represent consumption bundles. In this case, the indifference curve will slope downward and convex. Also, there is the marginal rate of substitution (MRS) (the willingness rate of the consumer to substitute leisure for consumption items, or vice versa. On a scale, MRSl, c =- the slope the indifference curve passes through.

Among the factors that determine consumer decisions, budget constraints are often at the top. Scarcity may not allow consumers to buy what they want but what they need. In the competitive behavior, the consumer is a price-taker, hence accepts market prices as being given. In a barter economy where the exchange of goods for goods is involved, it may be a bit different.

Time constraints and real disposable income also affect consumer behaviors. Time constraint is represented as;

H= l + N, where h is a time constraint, l is leisure, and N it time working represented as (h-l).

The real disposable income is calculated as wage income + dividend income – taxes. Here w represents the price of labor, Pi the quantity of dividend income, and T, the lump sum paid tax paid to the government by an individual consumer.

The budget constraint is therefore calculated as:

C= wN + Pi – T, or

C + wl = wh + Pi - T

- Consumer optimization

This factor is based on the assumption that the consumer is rational in preferences and budget constraints. It also assumes that T is greater than Pi, and the point of contact for the indifference curve is tangent to the budget constraint, representing the optional consumption bundle.

Consumer optimization is determined by pure income effect, substation effect, income effect, and labor supply curve.

Representative firm

Just like consumer demand good, firms demand labor and supply of consumption goods. This can be represented by a single firm, whereby it is assumed the firm own productive capital and hires workers to enable this function. In this case, the current production technology is represented as:

 Y = zF (K, Nd).

Where, z is the total factor productivity, Y the output of consumption goods, K the quantity of capital input in the production process the quantity capital input for production, and Nd is labor.

There are five key properties of the production functions:

- Constant returns to scale

- Output increases with an increase in either capital or labor input.

- The marginal product of labor reduces with an increase in the quantity of labor.

- The marginal product of capital decreases with an increase in capital quantity.

- The marginal product of labor increase with an increase in capital input quantity.

Where the representative firm behaves competitively, the real wage is taken as given. In this case, the firm will want to maximize its profits; hence it will choose Nd = N* to get maximum profit Pi*.

Author: James Hamilton