1.2.1 Rational Decision Making Flashcards
What is Rational Decision Making?
- A key assumption of neo-classical theory is that individual agents make decisions in a rational way.
- “Rational” economic agents can rank the order of different outcomes from an action in terms of their net benefits to them. Firms aim to maximise profits
- Consumers will act in way that will maximise their own utility or net benefits.
What is the Rational Choice Theory?
- That people were rational, self-interested actors who made decisions based on maximising their own utility or benefit.
- This theory suggests that individuals have complete information, act in their own self-interest and make decisions that maximise their own welfare. However, the behavioural economics revolution highlighted how people often make decisions that are not fully rational and are influenced by emotional, cognitive and social factors.
- The idea of maximising utility is central to the rational choice theory. Utility is the satisfaction or benefit that a person gets from consuming a good or service, it is often measured in terms of “utils”. The goal of maximising utility is to make decisions that provide the most utility or benefit to the individual.
- The rational choice theory assumes that people have perfect information about the options available to them and the consequences of each option they need to make the most rational choice. But, people often have imperfect or incomplete information.
Imperfect information can lead to suboptimal decisions
What is Behavioural Economics?
It mixes insights from Psychology and Economics. It uses insights from psychology to explain why people make apparently irrational decisions.
An “Econ” is said to be infinitely rational and immensely intelligent, an emotionless being who can do cost-benefit analyses at will, and is never wrong.
Most of us are not infinitely rational, but rather face “bounded rationality”, with people adopting simple, intuitive “rules of thumb” instead of calculating optimal solutions for every decision they make.
What is Bounded Rationality?
- Most consumers do not have sufficient information to make fully-informed judgements when making their decisions
- The increasing complexity of products also makes life difficult
- Bounded rationality suggests that consumers opt to satisfy rather than maximise
- They will use rules of thumb and approximations when active in different markets
What is Heuristics?
- Heuristics are mental shortcuts or rules of thumb for decision-making to help people make a quick, satisfactory, but perhaps not perfect, answer to a complex question.
- The economist Gerd Gigerenzer argues that heuristics can be an optimal way to respond in occasions where we lack information or time. People learn from experience and develop many different heuristics over time
- Optimal behaviour is not the same as maximising behaviour
What is Default Bias in Choices / Habitual Behaviour?
The idea that people prefer to carry on behaving as they have always done.
Repeat choices / purchases often become automatic because default choices don’t involve any mental (cognitive) effort
What is Choice Architecture?
- Choice architecture describes how the decisions we make are affected by the layout / sequencing / range of choices that are available
- E.g. Smart building designs might make it more attractive / easier to take the stairs rather than use a lift
What are our Choices Influenced by Social Norms?
Our day-to-day behaviour is influenced strongly by what we understand to be the prevailing social norms
E.g. The changing social stigma of drink driving and speeding, Queuing behaviour in shops, Making seat-belts compulsory – this appears to have created new habits
What is Herd Behaviour?
We are herd animals, and we often make decisions based in part on who is around us and the choices they make.
E.g. Choosing items off a menu in a restaurant
What is Anchoring?
Value is often set by anchors or imprints in our minds which we use as mental reference points.
Some anchors establish in our mind a low price, others help to establish a higher basic price that we should be prepared to pay
E.g. Pricing of new Apple products, McDonald’s has a lower anchor price that Starbucks
What is Priming?
Our behaviour by cues that work subconsciously and prime us to behave / choose in certain ways
E.g. Playing of certain types of music in a shopping mall, Labelling a product as premium affects our expectations
What is Framing?
Framing a question or offering in a different way often generates a new response by changing the comparison set it is viewed in
E.g. 90% fat free or 10% fat?
Asymmetric framing:
- Involves including an obviously inferior 3rd choice or a hyper-expensive 3rd option rather than a simple expensive/cheap choice can guide consumers to more expensively-priced items
What is Availability Bias?
- The availability bias happens when people often judge the likelihood of an event, or frequency of its occurrence by the ease with which examples and instances come to mind.
- Most consumers are very poor at risk assessments e.g. they over-estimate the likelihood of attacks by sharks or plane crashes
What is Commitment?
The more public our position, the less willing we are to change it
We feel more strongly about activities in which we have already made a commitment
E.g. Buying self-assembly furniture and completing it
What is Homo Economicus?
- Homo economicus is based on the idea that people are rational and self-interested and make decisions based on maximising their own utility or satisfaction.
- This model assumes that people have complete information about their options and the possible consequences of their decisions, and that they make these decisions without any irrationality, emotion, or outside influences.
