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
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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 firms 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-utilitymaximising 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 predetermined utility (production?) function of consumers. Consumers are comparable to

the production process since inputs (goods consumed) have very specific and predetermined 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

Indifference Curve = f(good 1, good 2)

Producer Theory
Isoquant Curve = f(input 1, input 2)

Good 2

Budget Curve I = price(1)*good 1 + price(2)*good2

Input 2

Optimal Choice

Optimal Choice Cost Curve C = price(1)*input1 + price(2)*input2

Good 1

Input 1

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 consumers 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

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 firms 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 consumers choice set unless there are exogenous changes in preferences or income. But for the firm time affects the firms 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.