4.1.2 Individual Economic Decision Making

Question 1

Define Marginal utility

Answer 1

Marginal utility is the extra satisfaction derived from consuming one extra unit of the
good

Question 2

Define consumer utility

Answer 2

A consumer’s utility is the total satisfaction received from consuming a good or
service.

Question 3

What do consumers have to do when making economic decisions

Answer 3

When making economic decisions, consumers aim to maximise their utility and firms
aim to maximise profits

Question 4

Outline diminishing marginal utility

Answer 4

The demand curve is downward sloping because of diminishing marginal utility.

The law of diminishing marginal utility suggests that consumer surplus generally declines with extra units consumed. This is because the extra unit generates less utility than the one already consumed. Therefore, consumers are willing to pay less for extra
units.

Question 5

Outline Utility maximisation

Answer 5

Maximisation for consumers is when consumers aim to generate the greatest utility possible from an economic decision. Firms aim to generate the highest profits
possible.

It is assumed that economic agents only act in their own interests. Some firms might have philanthropic owners who seek to maximise the utility of
others

Question 6

Outline the process of rational economic decision making for all individuals in the economy

Answer 6

Economic agents respond to incentives, which can allocate scarce resources to provide the highest utility to each agent. For the entrepreneur in a firm, the incentive for taking risks is profit.

Rewards are positive incentives which will make consumers better off, whilst penalties make them worse off. Where incentives are not given properly, resources will be misallocated. Prices in market economies provide signals to buyers and sellers, which is an
incentive to purchase or sell the good. This changes their behaviour.

Question 7

Entrepreneurs rational economic decision making

Answer 7

An entrepreneur wants to avoid loss and gain profit, which makes them want to innovate, so they can reduce their production costs, and improve the quality of their
products.

Firms need an incentive to engage in risk taking, so they innovate. Without innovation, production will cost more and there will be a misallocation of resources.

Question 8

Firms rational economic behaviour

Answer 8

A firm or an individual can make decisions using intuition or rationally. Intuition uses
the feelings or instincts of the consumer and does not use facts. Businesses use this
when they do not have access to facts or when making the decision is difficult. A
rational decision is made using several steps, and it involves analysis and facts.

Question 9

Outline step by step process of firms rational economic behaviour

Answer 9

1) Identify the problem: For a firm, this might be falling profits

2) Find and identify the decision criteria: The firm might have to find information
or criteria that will increase their profits. The firm’s criteria might include, for example, keep a certain number of employees or to not change the price of their
goods. The criteria might include how the decision will affect stakeholders (the
customer and the staff, for instance), and how the quality might be affected.

3) Weigh the criteria: The firm will have to rank the criteria based on their relative
importance. They might think keeping all of their employees is the most
important

4) Generate alternatives: The firm might consider some alternative options. For
instance, they might think that moving their premises somewhere else will
reduce costs and hence increase profits. Perhaps they will consider a loyalty
scheme or a promotion for the consumer. Alternatively, the might decide to
reduce the size of their workforce.

5) Evaluate alternative options: The firm might now consider which of the
alternatives meet their criteria the best, and help them increase their profits the
most.

6) Choose the best alternative: Now the firm will choose the alternative they think
meets their criteria.

7) Carry out the decision: The firm can now see what the consequences of the
decision are.

8) Evaluate the decision: After seeing what effect the decision has on the firm, they
can consider whether this was the best option or not.

Question 10

Outline the importance of the margin when making choices

Answer 10

Thinking at the margin means thinking about the effect of an additional action. An action could involve a marginal increase in product or a marginal cost.

Thinking at the margin is 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, margins can also increase productivity, since the most important tasks which maximise utility the most, are the ones which are prioritised.

Question 11

Define Symmetric information in decision making

Answer 11

Symmetric information means that consumers and producers have perfect market
information to make their decision. This leads to an efficient allocation of resources.

Question 12

Outline the effects of symmetric information

Answer 12

There could also be imperfect information, where information is missing, so an informed decision cannot be made.

This leads to a misallocation of resources. Consumers might pay too much or too
little, and firms might produce the incorrect amount. For example, monopolies might
exploit the consumer by charging them more than they need to

Question 13

Define Asymmetric information

Answer 13

This type of market failure exists when one individual or party has much more information than another individual or party, and uses that advantage to exploit the other party. Finance is a market in information – often a potential borrower (such as a small business) has better information on the likelihood that they will be able to repay a loan than the lender.

Question 14

Outline the link between Asymmetric information to principal agent-problem

Answer 14

Asymmetric information can be linked with the principal-agent problem. This is 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.

For example, shareholders and managers have different objectives which might conflict. Managers might choose to make a personal gain, rather than maximise the dividends of the shareholders. Information could be made more widely available through advertising or
government intervention

Question 15

Outline the idea of bounded rationality

Answer 15

Herbert Simon recognised the limitations of the decision making model, so he devised the bounded rationality model, which is also known as the administrative man theory.

The assumptions of this model are:
o The first alternative that is satisfactory is selected
o The decision maker recognises that they perceive the world as simple
o The decision maker recognises the need to be comfortable making decisions
without considering every alternative
o Decisions could be made by heuristic

Question 16

Outline bounded self-control in economic decision making

Answer 16

Bounded self-control assumes consumers are able to exercise self-control.

However, consumers are 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.

Question 17

Give an example of bounded self control

Answer 17

Another example could use the short term and long term view. Consumers know that it will benefit them in the long run if they save for their pension, but this will
limit their spending in the short run. Spending less in the short run instils fear in the consumer, even if they are aware that unless they save, they will not be able to
consume as much in the long run. With the long run view, consumers feel as though they ‘could always start saving tomorrow’. It is this procrastination which leads to
consumers making irrational decisions by not having self-control.

Question 18

Outline Social norms and its effect on economic behaviour

Answer 18

Assume there are two restaurants; one is empty whilst the other has a long queue. Consumers are more likely to queue for their food than go straight into the other
restaurant. The behaviour of other people affects how the consumer acts.

Other people’s behaviour creates a bias within the consumer. This social pressure 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.

Question 19

Outline Anchoring and its effect on economic behaviour

Answer 19

This is a type of bias created by the human tendency to rely on the first piece of information they are given. This first piece of information causes consumers to be biased towards it when subsequent information is given.

For example, 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

Question 20

Outline availability in the aspects of behaviour economic theory

Answer 20

This is a form of bias towards events that were recent, personal or memorable. This is because they are overestimated and cause emotional responses.

For example, consumers are likely to think 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. This then influences how the consumer behaves. This type of bias is spread across populations by reporting them in the news and media.

Question 21

Define Altruism

Answer 21

Altruism is the act of being selfless and considerate towards other people.

Question 22

Outline the ultimatum game

Answer 22

The Ultimatum Game is used to describe altruism. 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.

Proposers do not just offer the minimum amount.
Usually, it is in the range of 40%- 50% of the total. Responders usually accept offers above 25%. This highlights the perception of fairness. 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. Responders choose to accept nothing rather than be treated unfairly (with offers
below 25%). This essentially ‘punishes’ the proposer for treated them unfairly by offering a small amount. Proposers might try and be fair, but they also try to offer an amount which will be accepted by the responder.

Question 23

Explain what consumer behaviour effects

Answer 23

Consumer behaviour can influence the policies that governments employ. These policies might be different to traditional policies, and the two types of policy could work with each other. Policies developed from the theories of behavioural economics could be more
effective for dealing with economic issues.

Question 24

Outline what a choice architecture is

Answer 24

Choice architecture refers to the way choices are presented to consumers. The different designs affect the choice consumers make. Well-designed choice
architectures can help consumers avoid making irrational decisions and poor choices. This could improve consumer welfare. For example, a consumer might be
offered fewer choices, to avoid the time cost and consideration it takes to evaluate an extra choice. An example of choice architecture is organ donation. Countries with opt-out organ donation have higher rates of organ donation than countries which have opt-in systems. This is because of the perceived effort with signing in or out of the system

Question 25

Outline Framing in behavioural economics

Answer 25

Framing is 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. For example, 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.

Question 26

Outline the use of Nudges in behavioural economics

Answer 26

Nudges aim to change the behaviour of consumers without taking away their freedom of choice. It comes under the category of choice architecture. For example,
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. 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.

Question 27

Define Default choice in behavioural economics

Answer 27

A default choice is 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.

Question 28

Define Restricted choice in behavioural economics

Answer 28

A restricted choice is akin to the example of junk food and healthier food. The choice
of the consumer is restricted, but it is still there.

Question 29

Define Mandated choice

Answer 29

A mandated choice is when consumers are required to state whether they wish to
participate in an action. For example, in the UK everyone who applies or renews
their driving licence is asked if they wish to sign up for organ donation.