5. Consumer choice revisited - how does the market work when people do not know their own best interests? Flashcards
The assumption of optimal rationality
Strict assumption that consumers are rational. Knowing preferences and remaining rational means no mistakes are made, so no regret, which people experience all the time so the assumption is too strict
What is behavioural economics
Who are the key thinkers in behavioural economics?
What does a linear utility equation mean?
What happens when θ<1
What happens when θ=1?
What happens when θ>1?
What is a hot state and cold state
What happens if there is a difference between the decision and experience utility?
Regret
What do hot and cold states refer to?
* What causes it?
.
(Danny Kahneman)
What is slow thinking?
Logical reasoning and analysis
(Danny Kahneman)
What is fast thinking?
Quick and irrational thinking
Infrequenct decision (E.g. Marriage) leads to regreat, as big consequences
Why do we make the wrong choice
*Attracitve forecasting
.
What is the issue associated with time inconsistency?
Make a decision now which is not optimal in the future
Utility when making a decision in the hot state and consumption in the cold state
Implications of advertisement
- Creating tempting products that are bad for us but we buy anyway, or introduce complexities that play to our cognitive bias
- Creating imagery to enhance our decision utility
- High-pressure sale tactics
What is anchoring bias?
Find out randomly prices of certian goods. First number anchors expectations of alternative prices and how expensive the good is.
What is a cooling off period?
- 14 days to change mind about purchase as people are not always rational
Potnetial solutions to irrational consumers
Define internality and how does it relate to hot and cold states
A negative externality on oneselfs future
Hot state behaviour is lowering the utility of the cold state future self
Implications of Tax
- Requires government to know best and act in the interest of citizens
- Not everyone is a behavioural consumer, but everyone has to pay the tax distorting the market
Impact of rationality when there are Vulnerable consumers
Poverty creates stress about affording goods therefore there is short-term decision making so they choose cheaper goods. This then causes bias
What is the impact on consumer 2 if a tax is enacted?
.
What determines whether we should implement a tax?
It is a normative judgement
Nudges
Example of nudges
Self-control
Commitment device
Example: Clocky
Commitment device
Example: Saving devices
Heterogeneity
General equilibrium with hot and cold state
*Prices
*
Utility curves: General equilibrium with hot and cold state
Under the utility curves, which decision is Pareto efficenct?
When can government intervention be justified?
Saying there is an externality associated (E.g. Tax industry because the amount of pollution produced by the industry is an externality)
General equilibrium effect
Depends on whether you think the component of scoiety with behavioural consumer is significant enough to change demand and market prices.
What is the impact of irrational consumers on paraeto efficency?
Will not pan out
u: Gym membership utility
Indicator variable sign on slide 43
This is the indicator variable to show whether the alternative good is bought or not
What is a numeraire good?
Generic good (E.g. Food)
What is a discrete good?
Either you buy it or you don’t (E.g. Gym membership)
Richer model: What are the assumptions about u in this model?
Richer model: Uniform distribution of utility graph
RICHER MODEL: How to work out the probability when there is a uniform distribution of utility?
Richer model: Budget constriant
Utility if they buy a membership
Richer model: What is the utility constraint that will determine if a consumer buys a gym membership?
Richer model: Downward sloping demand and the impact on the uniform distribution of utility
* What does higher price mean?
Richer model: Supply side
Bertrand competition
Nash equilibrium
Richer model: What is the Bertrand competition?
Many firms competitng on price (Selling homogenous goods). Sell at marginal cost as they will be undercut by competitior if they do not
Richer model: Market equilibrium graph drawing
Richer model: Consumer welfare under supply and demand
Richer model: Market equilibrium
* What determines whether someone purchases the gym membership?
* What are the assumptions for everyone in the market?
* Is this outcome pareto efficent?
Richer model: Behavioural consumers
Demand decisions for irrationl consumers
Richer model: What does it mean for the amount bought when β>1
Overoptimistic about the benefits
Richer model: What does it mean for the amount bought when β<1
Undervalue the benefits
Richer model: Overall demand for rational and behaioural consumers
Richer model: Overall demand equation with behavioural consumers
Richer model: Overall demand when β>1?
Richer Model: Overall demand when β<1?
Richer Model: Pareto improvement when β>1?
Richer Model: Pareto improvement when β<1?
Richer Model: What externality is ignored?
Congestional externalities
What is the utilitarian social welfare?
Sum of expected welfare of each group
Utility for
* Rational consumers
* Behavioural consumers
* Gyms
Experienced utility for rational consumers
Experienced utility for behavioural consumers
Social welfare computations
* Working out the probability of the areas for behavioural and rational consumers
* Then overall computations
Overall welfare without behaviour comsumers and overall welfare with behavioural consumers
Slide 63-64
What can be done about irrational consumers?
Richer model: Tax and subsidy when
* β>1
* β< 1
* Implications of such policy
Grubb (2015)
What is the difference between overconfidence and overprecision? Can you give examples?
- Overoptimistic: Overestimate their own abilities or prospects, in either absolute terms or relative to others. (Overpay for gym membership you will not use, as they overestimate gym attendence)
- Overprecision: Placing narrow confidence intervals around forecasts underestimating uncertainity (Choose the wrong calling plan)
Grubb (2015)
How might firms exploit consumer overconfidence (memory hurdles, self-control traps, or attention hurdles)?
- Charge more if they are overconfident
- Inflate marginal price above marginal cost
*
Grubb (2015)
When will overconfidence distort prices upwards and when downwards?
- Overestimate their consumption of investment goods (E.g. Gym attendance) and underestimate their consumption of lesiure goods (E.g. Credit card borrowing). Marginal prices of investment goods will be discounted below marginal cost but the marginal price of leisure goods will be inflated above amrginal cost.
Grubb (2015)
What is the impact of overconfidence on social welfare? May some win from the distortion?
- Creates deadweight loss in competitive markets
- “Exploitation and participation distortians”, as prices reflect the overconfidence and distort quanitty choices
- But in some cases if demand is low overvaluation can increase demand which increases welfare
Grubb (2015)
Can you give an example of a policy that might protect consumers from errors in judgement?
- Firms disclose expected costs and beenfits upfront
- EU and US customers are alerted if they go above their usuage allowance, susbittue for consumers own attentiveness.
- Regulating prices
