2 - Indvidual Economic Decision Making Flashcards
What is rational behaviour?
Acting in pursuit of self-interest satisfaction or utility gained from the goods and services consumed
When making economic decisions, what do consumers and firms aim to maximise?
- Consumers aim to maximise utility
- Firms aim to maximise profits
What is consumer’s utility?
The total satisfaction received from consuming a good or service
What is marginal utility?
The extra satisfaction derived from consuming one extra unit of the good
Why is there a downward sloped demand curve under total utility and marginal utility curves?
Diminishing marginal utility
What does the law of diminishing marginal utility suggest?
That consumer surplus generally declines with extra units consumed because the extra unit generates less utility than the one already consumed. Therefore, consumers are willing to pay less for extra units.
How do economic agents act relating to maximisation?
In their own interests
What type of incentives do economic agents respond to?
Incentives which can allocate scarce resources to provide the highest utility to each agent
What is the incentive for taking risks as a entrepreneur?
Profit
What type of incentive are rewards?
Positive incentives which will make consumers better off, whilst penalties make them worse off
What happens where incentives aren’t given properly?
Resources will be misallocated
What do prices in market economies provide?
- Signals to buyers and sellers to purchase or sell the good(s). This changes their behaviour
- E.g. a high demand and high price for a good will give an incentive to firms to allocate more resources to producing that good
As entrepreneurs want to avoid loss and gain profit, what does that make them do and how would they do so?
Makes them want to innovate so they can reduce their production costs, and improve the quality of their products.
What do firms need, to engage in risk taking?
- Incentive, so they innovate
- Without innovation, production will cost more and there will be a misallocation of resource
How does a firm or individual make decisions using intuition and why?
- Intuition uses the feelings or instincts of the consumer and doesn’t use facts
- Businesses use this when they don’t have access to facts or when making the decision is difficult
What are the steps that makes a rational decision?
1) Identify the problem
2) Find and identify the decision criteria
3) Weigh the criteria
4) Generate alternatives
5) Evaluate alternative options
6) Choose the best alternative
7) Carry out the decision
8) Evaluate the decision
What are the limitations of the steps that make a rational decision?
- Not always the best or most realistic way for firms to make decisions.
- Although it might be fairer than making an intuitive decision, it takes significantly longer to decide, which is not practical in a firm with strict time constraints.
What does thinking at the margin mean?
- The effect of an additional action
- An action could involve a marginal increase in product or a marginal cost.
- E.g. working for one extra hour could produce 6 more units of output. However, each extra unit of output costs 10 minutes.
Why is thinking at the margin important?
Because it allows consumers to keep thinking ahead. It prevents consumers thinking about things they have already done, and allows them to consider how to maximise their utility now or in the future.
When making choices, what can margins increase?
- Productivity
- Since the most important tasks which maximise utility the most, are the ones which are prioritised.
What is the traditional economic theory on information?
If individuals possess perfect information, they will make decisions that maximise their welfare
What is a contradiction with the traditional economic theory on information?
When attempting to maximise total utility, most of the time consumers possess imperfect information
What is symmetric information?
When consumers and producers have perfect market information to make their decision
What does symmetric information lead to?
An efficient allocation of resources
What is imperfect information?
Where information is missing, so an informed decision cannot be made.
What does imperfect information lead to?
- A misallocation of resources
- Consumers might pay too much or too little, and firms might produce the incorrect amount.
- E.g. monopolies might exploit the consumer by charging them more than they need to
What things does Asymmetric information lead to?
- Market failure
- Misallocation of resources
- Consumers knowing more information than the producer e.g. when purchasing insurance policies
What is Asymmetric information?
When there is unequal knowledge between consumers and producers
What problem can asymmetric information be linked to?
The principal-agent problem
What is the principal-agent problem?
- When the agent makes decisions for the principal, but the agent is inclined to act in their own interests, rather than those of the principal
- E.g. shareholders and managers have different objectives which might conflict
How can information be made more widely available?
- Through advertising or government intervention
- E.g. the harmful effects of smoking could be made public through adverts and messages on cigarette boxes
What is behavioural economics?
A method of economic analysis that applies psychological insights into human behaviour to explain how individuals make choices and decisions
What is bounded rationality?
When making decisions, individuals’ rationality is limited by the information they have, the limitations of their minds, and the finite amount of time available in which to make decisions
What is bounded self-control?
Where individuals have limited self-control to act rationally in their own interests
What is the idea on rational decisions individuals make?
Individuals are rational decision makers who endeavour to maximise their utility
Who devised the bounded rationality model (administrative man theory) and why?
Herbert Simon recognised the limitations of the decision making model, so he devised the bounded rationality model
What are the assumptions of the the bounded rationality model (administrative man theory)?
- The first alternative that is satisfactory is selected
- The decision maker recognises that they perceive the world as simple
- The decision maker recognises the need to be comfortable making decisions
without considering every alternative - Decisions could be made by heuristics
What does bounded self-control assume?
Consumers are able to exercise self-control
How might consumers be unable to exercise self-control with some decisions?
- The law of diminishing marginal utility suggests that every extra unit consumed provides a smaller benefit to the consumer
- Yet, if the example of food is taken, some consumers will still eat more than gives them optimal benefit
What is cognitive bias?
A systematic error in thinking that affects the decisions and judgements that people make
What does acting rationally mean?
Making a decision that results in the most optimal level of utility or benefit for the consumer
Who is the rational consumer?
- Homo Economicus
- Is a utility maximiser and makes rational decisions
What are ‘Heuristics’?
- They simplify the decision making process to come to a reasonable decision
- They are shortcuts to avoid taking too long to make the decision, and they avoid the problem of having imperfect information or limited time
What is are examples of heuristics?
- The consumer might use common sense or intuition
- They might consider how it is cheaper to buy goods in the sale
- They might have pre-decided criteria, or a rule-of-thumb, and only buy the good if it is in a sale which could lead to irrational decisions being made
What are the biases in decision making?
- Rules of thumb
- Anchoring
- Availability bias
- Social norms
What are rules of thumb?
Thinking shortcuts, or informed guesses, that individuals use to make decisions in order to save time and effort
What are social norms?
Forms or patterns of behaviour considered acceptable by a society or group within that society
What does the idea of social norms and social pressure encourage?
- Encourages consumers to do things they would not otherwise do, or that they know could be harmful
- Consumers become unwilling to change, even if it is of benefit to them, if it goes against the norms of their society.
What is anchoring?
A type of bias created by the human tendency to rely on the first piece of information they are given
What is an example of anchoring?
If a car’s original price is high, but it is on sale for a lower price, consumers will be inclined to think this is reasonable, even if the lower price is more than the car’s value.
What is availability bias?
A form of bias towards events that were recent, personal or memorable
What is an example of availability bias?
- Thinking plane accidents are much more likely to occur, if they have been involved in one or know someone else who has
- Even though they are very rare, they overestimate the probability which then influences how the consumer behave
What is altruism?
The act of being selfless and considerate towards other people
What is used to describe altruism?
The Ultimatum Game
What is the Ultimatum game and how does it work?
- There are two players: a proposer and a responder
- The proposer has to offer the responder a portion of the sum of money they are given
- The proposer can choose how much to offer
- The responder can either accept or decline the offer
- If the responder accepts the offer, the sum of money is divided
- If the responder declines the offer, both players receive nothing.
What does altruistic behaviour/ the ultimatum game highlight and how?
- The perception of fairness
- A popular view is that fairness involves treating people equally or in a way that is right or reasonable
- Proposers and responders do not aim to get as much money as possible, but they aim to distribute the money according to what is considered fair.
What is fairness thinking economically?
A normative term incorporating value judgements, as different people have a range of different views on the meaning of fairness
How do responders ‘punish’ proposers for treating them unfairly?
-Responders choose to accept nothing rather than be treated unfairly (with offers below 25%)
- They offer them a small amount
- Proposers might try and be fair, but they also try to offer an amount which will be accepted by the responder
What can consumer behaviour influence?
The policies that governments employ
What is a possible better alternative of polices that can be used to deal with economic issues instead of ones developed from consumer behaviour?
Policies developed from the theories of behavioural economics
What is choice architecture?
- The way choices are presented to consumers
- The different designs affect the choice consumers make.
What can well-designed choice architectures help with?
- Can help consumers avoid making irrational decisions and poor choices
- This could improve consumer welfare
- E.g. a consumer might be offered fewer choices, to avoid the time cost and consideration it takes to evaluate an extra choice
What is an example of choice architecture?
Canteen designs usually have salad and fruit bars at the front, more people will buy and use it, nudge to healthy meals.
What is framing?
- The way by which consumers are influenced by the context of how a choice is presented
- The context is made includes word choices and it affects the choice consumers make
What is an example of framing?
If consumers are told the monthly payment for a good or service, rather than the aggregate yearly payment, they are more likely to purchase the good or service, since it seems more affordable
90% fat-free instead of 10% fat
What are nudges?
They aim to change the behaviour of consumers without taking away their freedom of choice
What is an example of nudges?
- Rather than banning something like junk food, replacing it with healthier food is a nudge
- This still allows consumers to make a free choice, but it alters their behaviour to choose the healthier option.
What is the evaluation (a pro and a con) of nudges?
- It is sometimes argued that nudges are manipulative and consumers do not get a free choice with them
- However, due to imperfect information that exists between consumers and firms, nudges can help prevent consumers making irrational or poor choices, so their welfare is maximised
What is a default choice?
- When a consumer is automatically enrolled into a system, such as a pension scheme
- Consumers are more likely to participate when they are automatically enrolled
- It is the choice the consumer takes if they take no action
What is a restricted choice?
When the choice of the consumer is restricted, but it is still there
What is a mandated choice?
- When consumers are required to state whether they wish to participate in an action
- E.g. in the UK everyone who applies or renews their driving licence is asked if they wish to sign up for organ donation.
Draw a diminishing marginal Utility and total marginal Utility graphs.
Explain this graph briefly.
