4.1.2 — Individual Economic Decision Making

Question 1

What is the homo economicus theory? (Behavioural economics)

Answer 1

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

Question 2

Define rational behaviour

Answer 2

Acting in the pursuit of self interest by attempting to maximise the welfare, satisfaction or utility gained from the goods and services consumed

Question 3

Define utility

Answer 3

Satisfaction or economic welfare an individual gains from consuming a good or service

Question 4

Define marginal utility

Answer 4

The additional welfare, satisfaction or pleasure gained from consuming one extra unit of a good

Question 5

What is the equation of marginal utility?

Answer 5

Change in total utility
——————————
Change in units

Question 6

What are some constraints which restrict the choices made by consumers?

Answer 6

• limited income
• given set of prices
• budget constraints
• limited time available

Question 7

Define utility maximisation

Answer 7

When consumers aim the generate the greatest utility possible from an economic decision

Question 8

What is an economic agent?

Answer 8

Consumers, producers, and / or influencers of capital markets and the economy as a whole

Question 9

What do incentives do? (Think allocation of resources)

Answer 9

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)

Question 10

How does price act as an incentive to buyers / sellers?

Answer 10

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

Question 11

What are the 8 steps in the rational decision making model?

Answer 11

1. Identify the problem
2. Find / identify the decision criteria
3. Weigh the criteria based on relative importance
4. Generate alternatives
5. Evaluate alternative options
6. Choose the best alternative
7. Carry out the decision
8. Evaluate the decision

Question 12

Define total utility

Answer 12

Total utility is the aggregate amount of satisfaction or fulfillment that a consumer receives through the consumption of a specific good or service.

Question 13

What is the law of diminishing marginal utility?

Answer 13

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)

Question 14

What does it mean to think at the margin, and why is it important?

Answer 14

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

Question 15

What is symmetric information?

Answer 15

Where consumers and producers have perfect market information to make their decisions which leads to an efficient allocation of resources

Question 16

What is imperfect information?

Answer 16

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

Question 17

What is asymmetric information?

Answer 17

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

Question 18

How can information be made more widely available?

Answer 18

Through advertising or government intervention I.e the harmful effects of smoking could be made public through adverts and messages on cigarette boxes

Question 19

Define heuristics in terms of decision making, and is it optimal / maximising behaviour?

Answer 19

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

Question 20

Define bounded rationality

Answer 20

When making decisions, an individuals rationality is limited by information they have, therefore they have limitations on their minds

Question 21

How do traditional economists and behavioural economics view bounded self control?

Answer 21

Traditional economist theory which assumes that when making choices, individuals have complete control.
Behavioural economists believe individuals have a lack of self control

Question 22

What is a social norm?

Answer 22

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)

Question 23

What is anchoring?

Answer 23

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

Question 24

What is availability? (Behavioural economics)

Answer 24

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

Question 25

What is altruism?

Answer 25

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

Question 26

Define choice architecture

Answer 26

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

Question 27

Define framing

Answer 27

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

Question 28

Define restricted choice

Answer 28

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

Question 29

Define default choice

Answer 29

A choice which is automatically selected unless an alternative is specified

I.e automatic pension enrolment: opt in or out

Question 30

Define mandated choice

Answer 30

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

Question 31

What are some example of government nudges?

Answer 31

• 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

Question 32

What are some example of government shoves?

Answer 32

• financial disincentives
  I.e cigarette tax
• restricting choice
  I.e banning takeaways being set up near schools

Question 33

What is an example of government hug?

Answer 33

• financial incentives
  I.e vouchers in exchange for healthy behaviour

Question 34

What is an example of government smack?

Answer 34

• eliminating choice
  I.e banning goods or services

Question 35

What is a shove?

Answer 35

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

Question 36

What is a nudge?

Answer 36

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

Question 37

What is the administrative man / bounded rationality model?

Answer 37

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

Question 38

What does bounded self control assume?

Answer 38

That consumers are able to exercise self control

Question 39

What is a nudge?

Answer 39

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

Question 40

How can nudges mitigate market failure?

Answer 40

Due to imperfect information existing between consumers and firms, nudges can help prevent consumers making irrational or poor choices — their welfare is maximised

Question 41

Constraints on rational and utility maximising decision making?

Answer 41

• limited income
• given set of prices
• budget constraints
• limited time available
• limitations on your mind
• info failure and asymmetric info failure
• cognitive bias