4.1.2 Individual Economic Decision Making Flashcards
What is individual economic decision-making influenced by
Rationality, incentives and marginal utility
Marginal utility
The additional benefit a consumer gains from consuming one more unit of output
Economic agents
Producers, consumers, workers, governments, special interest groups
Rational
that economic agents are able to consider the outcome of their choices and recognise the net benefits of each one
Rational agents are incentivised to select the choice which presents the highest benefits
How do consumers act rationally
By maximising their utility (the satisfaction gained from a good/service)
How are producers assumed to act rationally
By selling goods and services in a way that maximises their profits
How are workers assumed to act rationally
by balancing welfare at work with consideration of both pay and benefits
How are government assumed to act rationally
placing the interests of the people they serve first in order to maximise their welfare
How is the assumption of rational decision making flawed
consumers are often more influenced by emotional purchasing decisions than a rational computation of net benefits
An example of how utility gained from consuming the first unit is usually higher than the utility gained from consuming the next uni
a hungry consumer gains high utility from eating their first hamburger. They are still hungry and purchase a second hamburger but gain less satisfaction from eating it than they did from the first hamburger
Total utility
the marginal utility of each unit consumed is added together
This means that total utility keeps increasing even while marginal utility is decreasing
Law of diminishing marginal utility
states that as additional products are consumed, the utility gained from the next unit is lower than the utility gained from the previous unit
How does law of diminishing marginal utility explain why the demand curve is downward sloping
When the first unit is purchased, the utility is high and consumers are willing to pay a high price
When subsequent units are purchased, each one offers less utility and the willingness of the consumer to pay the initial price decreases
Lowering the price makes it a more attractive proposition for the consumer to keep consuming additional units
This is one reason why firms offer discounts such as ‘50% off the second item’
How can a consumer achieve utility maximisation
when they spend their limited income in such a way that they will achieve the most satisfaction from their money
Influence of marginal analysis on choices
When deciding at the margin, they weigh whether to consume a little more or a little less of something
This involves considering the additional happiness or utility gained from each extra unit (marginal benefit) and the extra money spent (marginal cost)
What does every choice involve
Every choice involves a balance between benefits and costs, taking into account each additional unit consumed
Assumption of free market
that there is a perfect flow of information
This would include information on pricing, the availability of substitutes, the truthfulness of the product claims, etc
What do information gaps result in
Market failure
Market failure
When the price mechanism leads to an inefficient allocation of resources and a dead loss of economic welfare
4 parts of price mechanism
Rationing
Signalling
Allocate
Incentive
Symmetric information
Perfect information in the market means that buyers and sellers have exactly the same level of information about the good or service
Asymmetric information
In many markets, buyers and sellers have different levels of information
Example of asymmetric information
there is asymmetric information in the used car market: sellers know more about the vehicle than the buyers
What does asymmetric information do
distorts socially optimal prices and quantities in markets, resulting in over or under-provision of goods or services
What do behavioural economists argue
It argues that many economic decisions made by an individual are biased
What does behavioural economics combine
elements of psychology and economics to understand how people make decisions and behave in economic contexts
Cognitive bias
Systematic errors in thinking that can affect decision-making. Examples include confirmation bias, loss aversion and anchoring bias
Anchoring
Contributes to how customers perceive the value of an item and how they compare to the alternatives
Loss aversion
phenomenon where a real or potential loss is perceived by individuals as psychologically or emotionally more severe than an equivalent gain
Bounded rationality theory
people make decisions without gathering all the necessary information to make a rational decision within a given time period
Why does bounded rationality theory assume rational decision-making is limited
An individual’s thinking capacity
Availability of information
Lack of time available to gather all of the information and make a judgement
