Consumer theory models how individuals make choices to maximize satisfaction. Utility is the abstract measure of satisfaction from consuming a good or service, and marginal utility is the additional utility gained from consuming one more unit. The law of diminishing marginal utility states that each additional unit consumed adds less utility than the previous one, providing a foundation for understanding downward-sloping demand curves. Utility maximization occurs when consumers allocate spending so that the marginal utility per dollar is equal across all goods purchased.
This analysis is represented graphically using indifference curves, which depict combinations of two goods yielding the same total utility, with the marginal rate of substitution describing the rate at which a consumer would trade one good for another while maintaining utility. The budget constraint describes the combinations of goods affordable given income and prices. Consumer choice theory combines these tools to predict that consumers maximize utility subject to their budget constraint, sometimes reaching a corner solution in which one good is consumed in zero quantity. When prices change, two effects emerge: the substitution effect captures changes in quantity due to relative price shifts holding utility constant, while the income effect captures changes in purchasing power. The principle of revealed preference holds that preferences can be inferred from observed choices, anchoring empirical work in consumer behavior.
Behavioral economics shows that real people often deviate from the perfectly rational model. Bounded rationality recognizes that decisions are made within cognitive limits. Loss aversion means people feel losses more strongly than equivalent gains, and the endowment effect describes how people value possessions more once they own them. Anchoring occurs when decisions rely too heavily on the first piece of information offered, while mental accounting leads people to treat money differently depending on its source or intended use. The sunk cost fallacy tempts people to let past unrecoverable costs influence current decisions, and hyperbolic discounting describes the tendency to prefer smaller immediate rewards over larger delayed ones. Commitment devices help bind future behavior to overcome present bias, and nudge theory uses subtle design changes to influence behavior without removing choice.
Under uncertainty the expected utility hypothesis describes how rational agents choose among risky prospects, and individuals can be classified as risk averse, preferring a sure outcome over a gamble with equal expected value; risk neutral, indifferent between the two; or risk seeking, preferring the gamble. Insurance pools risk through premiums, but introduces moral hazard, when insured behavior becomes riskier, and adverse selection, when high-risk individuals are disproportionately likely to buy insurance.