Economics Part 2 Flashcards
What is individual economic decision making influenced by
Rationality
Incentives
Marginal utility
Rational
Economic agents being able to consider the outcome of their choices and recognise the net benefits of each one
How are workers assumed to act rationally
By balancing welfare at work with consideration of both pay and benefits
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
Marginal utility
The additional utility(satisfaction) gained from the consumption of an additional product
How to calculate total utility
The marginal utility of each unit consumed is added together. This means total utility keeps increasing even while marginal utility is decreasing
Law of Diminishing Marginal Utility
States as additional products are consumed, the utility gained from the next unit is lower than the utility gained from the previous unit
Why does the 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 do rational consumers decide at the margin?
They weigh whether to consume a little more or a little less of something:
1. This involves considering the additional happiness or utility gained from each extra unit(marginal benefit) and the extra money spent(marginal cost)
2. Consumers continue to consume until the extra happiness from each unit equals the extra cost, which is making decisions at the margin.
Asymmetric information
When buyers and sellers have different levels of information in many markets e.g. there’s asymmetric information in the used car market: sellers know more about the vehicle than the buyers
How does asymmetric information result in over or under-provision of goods and services
Asymmetric information distorts socially optimal prices and quantities in markets, resulting in over or under-provision of goods or services:
e.g. goods/services with dangerous side effects would be sold in lower quantities if buyers were aware of these effects. Fewer factors of production should be allocated towards these
Why does market failure occur?
Due to information gaps existing in nearly all free markets that distort market outcomes
One false assumption of free markets
There’s a perfect flow of information
Traditional economics
Assumes consumers are rational, and driven by the utility they get from consumption.
Consumers make long term plans and follow them.
Consumers take as much time as they need to absorb all of the information in the market.
Consumers focus on the facts in a very logical manner, knowing exactly what they want and why they want it.
Behavioural economics
Assumes humans are complex:
Information overload can complicate decision making
Consumers take risks, sometimes going against reason
Emotions play a large role in the decision-making process
The ability to make the best decision is influenced by many biases
People care about more than just maximising their self interest
Behavioural economics
A field of study combining elements of psychology and economics to understand how people make decisions and behave in economic contexts, challenges the view economic agents behave rationally
Bounded Rationality Theory
Argues people make decisions without gathering all the necessary information to make a rational decision within a given time period, the theory assumes rational decision-making is limited. Our decisions take into account time, choice of goods(wide range of goods and services in a free market economy) and information
Limitations - individuals are unlikely to always make rational decisions
Bounded rationality
Bounded self-control
Cognitive biases - we base our decisions upon them
How do businesses take advantage of the lack of bounded self-control
Businesses use marketing to capitalise on the lack of bounded self-control of individuals when appealing to their target audience to maximise sales e.g. supermarkets place a range of items at the checkout register to encourage impulse purchases
Influence of biases on decision making
Biases influence how we process information when making decisions and these influence the process of rational decision-making
Types of cognitive bias
Rule of Thumb
Anchoring and framing
Availability bias
Social norms
Loss aversion: Endowment effect
Herd behaviour
Choice architecture
Rule of Thumb
When individuals make choices based on their default choice based on experience e.g. individuals may also order the same pizza anytime they order from Pizza Hut.
Anchoring bias
When individuals rely too heavily on an initial piece of information when making subsequent judgements or decisions
Example of anchor bias
When buying a used car, the seller may initially suggest a price of $10,000. Even if you know the market value is lower, the anchor of $10,000 might still influence your perception and as a result, the consumer ends up paying a higher price than intended
Framing
How the presentation/words of information can significantly influence people’s choices or judgements e.g. consumers are more likely to purchase a product stating 80% fat free than 20% fat.
Availability bias
When people rely on immediate examples/information coming to mind easily when making judgements or decisions e.g. people use alternative modes of transport when there’s a plane crash, even though the probability of a crash happening is very low. We make decisions depending how easy it is to conjure examples, despite the probability of an event not being too high e.g.if we expect business rates to go up, consumers spend less money.
Traditional economics assumption
People always act in their own self interest
Altruism
The idea behaviour benefits a group, at the expense of the person performing it
Major drivers in non-rational decision making process
Altruism
Perception of fairness - what individuals and societies deem to be right or wrong
Choice architecture
Choice architecture refers to the intentional design of how choices are presented to influence decision making
Example of choice architecture
Supermarkets place more profitable products at eye level on the shelves
Choice architecture e.g. how it aims to simplify the decision making process
Restaurants present information about food options in a particular format to encourage individuals to make a particular choice
Types of choice architecture
Default choice
Restricted choice
Mandated choices
Default choice
Occurs when an individual is automatically signed up to a particular choice/decision
Examples of default choices
When signing up for an online service, the default choice for receiving promotional emails may be set to “opt-in”
Mandated choices
Mandated choices require individuals to make a specific decision or take a particular action by imposing a requirement or obligation
Examples of mandated choices
Some countries mandate car insurance, which require all vehicle owners to make an active decision to choose and purchase car insurance, rather than leaving it as an optional choice
Advantages of choice architecture
Influences behaviour
Simplifies decision-making
Improved outcomes e.g. effective choice architecture can encourage healthier eating habits
Enhances decision quality e.g. can provide guidance, reduce biases and increase the likelihood of individuals making choices they would consider to be better
Disadvantages of choice architecture
Manipulation - influences people’s decisions without their explicit consent
Ethical concerns - the way choices are presented means individuals may not be aware their choices are being influenced or of the consequences of their decisions
Potential for bias - inherent in the design process, may be used by companies to increase profits
Unintended consequences - Changes in the presentation of choices can have unforeseen effects and the outcomes may not align with the original goals.
Heuristics
Using the rule of thumb in decision making(debating and collecting information) rather than rationality - where we base most of our decisions on common sense/our lives experience. Consumers follow heuristics to make satisfying/satisficing decisions(even when utility/maximisation may be sacrificed)
Endowment effect
Attaching too much monetary value to something you have
