4.1.2 — Individual Economic Decision Making Flashcards
What is the homo economicus theory? (Behavioural economics)
neoclassical (free-market) economics, based on the assumption of homo economicus (economic man) who bears 3 key characteristics:
- utility maximiser
- rational decision maker
- makes decisions based on own best interest
Define rational behaviour
Acting in the pursuit of self interest by attempting to maximise the welfare, satisfaction or utility gained from the goods and services consumed
Define utility
Satisfaction or economic welfare an individual gains from consuming a good or service
Define marginal utility
The additional welfare, satisfaction or pleasure gained from consuming one extra unit of a good
What is the equation of marginal utility?
Change in total utility
——————————
Change in units
What are some constraints which restrict the choices made by consumers?
- limited income
- given set of prices
- budget constraints
- limited time available
Define utility maximisation
When consumers aim the generate the greatest utility possible from an economic decision
What is an economic agent?
Consumers, producers, and / or influencers of capital markets and the economy as a whole
What do incentives do? (Think allocation of resources)
Economic agents respond to incentives, which can allocate scarce resources to provide the highest utility to each agent
(i.e for a business owner the incentive of taking risks is making profit)
How does price act as an incentive to buyers / sellers?
They provide signals to buyers and sellers which is an incentive to purchase or sell the good — this changes their behaviour
I.e high demand and high price for a good gives firms an incentive to allocate more resources into manufacturing it for higher profits
What are the 8 steps in the rational decision making model?
- Identify the problem
- Find / identify the decision criteria
- Weigh the criteria based on relative importance
- Generate alternatives
- Evaluate alternative options
- Choose the best alternative
- Carry out the decision
- Evaluate the decision
Define total utility
Total utility is the aggregate amount of satisfaction or fulfillment that a consumer receives through the consumption of a specific good or service.
What is the law of diminishing marginal utility?
the marginal utility from each additional unit declines as consumption increases. The first unit of good provides more satisfaction / purpose than those following it.
I.e consuming one chocolate bar has the highest benefits, if one more is consumed the benefits are less etc
(Downward sloping demand curve)
What does it mean to think at the margin, and why is it important?
Thinking at the margin means thinking about the effect of an additional action.
This thinking is important because it allows consumers to keep thinking ahead, preventing thoughts about the past and how to maximise utility in the present or future
Margins can increase productivity
What is symmetric information?
Where consumers and producers have perfect market information to make their decisions which leads to an efficient allocation of resources
What is imperfect information?
This is where information is missing, so an informed decision cannot be made
Leads to a misallocation of resources as consumers might pay too much / too little and firms might produce the incorrect amount I.e charging more
Linked to principal-agent problem
What is asymmetric information?
Where there is unequal knowledge between consumers and producers which can lead to market failure because some people have an advantage
I.e a car dealer might know about a fault with the car that a consumer is unaware of
How can information be made more widely available?
Through advertising or government intervention I.e the harmful effects of smoking could be made public through adverts and messages on cigarette boxes
Define heuristics in terms of decision making, and is it optimal / maximising behaviour?
When we make mental shortcuts or ‘rule of thumb’ which allows us to make a sufficient decision, although it may not be optimal (they simplify decision making)
This isn’t maximising behaviour
Define bounded rationality
When making decisions, an individuals rationality is limited by information they have, therefore they have limitations on their minds
How do traditional economists and behavioural economics view bounded self control?
Traditional economist theory which assumes that when making choices, individuals have complete control.
Behavioural economists believe individuals have a lack of self control
What is a social norm?
Forms or patterns of behaviour considered acceptable by a society
I.e drinking alcohol which is considered to be sociable (-ve)
I.e less acceptable to be discriminatory now (+ve)
What is anchoring?
A cognitive bias where humans tend to rely too heavily on the first piece of information offered (anchor) which helps them make subsequent judgements
I.e. if a cars original price is high, but it’s on sale for a lower price, consumers will be inclined to think this is reasonable even if the lower price is more than the cars value
What is availability? (Behavioural economics)
A form of bias towards events that were recent, personal or memorable. This is because they are overestimated and emotive (spread via media and news)
I.e consumers may believe plane crashes are more likely to occur if they know someone affected which influences how the consumer behaves
What is altruism?
The act of being selfless and considerate towards others even though we may suffer as a consequence in financial loss or incurring personal risk
Involves a value judgement
Define choice architecture
A framework setting out different ways in which choices could be presented to consumers and the impact of that presentation on choice
I.e organ donation: opt in / opt out schemes
Define framing
It’s the tendency for people to be influenced by the context in which the choice is presented when making a decision
I.e Facebook default privacy setting is public account
Define restricted choice
A limited number of options for people so that they are not overwhelmed by the complexity of the situation
Therefore making poorly thought out decisions / no decisions
I.e altering number of options available
Define default choice
A choice which is automatically selected unless an alternative is specified
I.e automatic pension enrolment: opt in or out
Define mandated choice
A decision which is required to be made by law rather than just going along with the default choice
I.e in the UK everyone who applies or renews their driving licence is asked if they wish to sign up for organ donation
What are some example of government nudges?
- A provision of information
I.e calorie counts on menus - Changes to an environment
I.e designing builds with fewer lifts - changes to defaults
I.e making salad a default side
What are some example of government shoves?
- financial disincentives
I.e cigarette tax - restricting choice
I.e banning takeaways being set up near schools
What is an example of government hug?
- financial incentives
I.e vouchers in exchange for healthy behaviour
What is an example of government smack?
- eliminating choice
I.e banning goods or services
What is a shove?
A policy which instructs people to behave in certain ways, often by responding to financial incentives and disincentives for different decisions
- uses tax / subsidies to alter incentives and fines, bans and regulations to alter behaviour
GOV POLICY BASED ON TRADITIONAL ECONOMIC THEORY TENDS TO SHOVE NOT NUDGE
What is a nudge?
An alternative to using standard government intervention in markets
(Less forceful)
I.e
- opt out schemes rather than opt in
- it’s not a legal requirement
governments should explain why they introduce nudges to help people make informed decisions
What is the administrative man / bounded rationality model?
It assumes:
- the first alternative that is satisfactory is selected
- the decision maker recognises they perceive the world as simple
- the decision maker recognises the need to be comfortable with making decisions
- decisions could be made using heuristics
What does bounded self control assume?
That consumers are able to exercise self control
What is a nudge?
Something that aims to change the behaviour of consumers without taking away their freedom of choice
I.e rather than banning fast food, replacing it with healthier alternatives
How can nudges mitigate market failure?
Due to imperfect information existing between consumers and firms, nudges can help prevent consumers making irrational or poor choices — their welfare is maximised
Constraints on rational and utility maximising decision making?
- limited income
- given set of prices
- budget constraints
- limited time available
- limitations on your mind
- info failure and asymmetric info failure
- cognitive bias
