Individual Economic Decision Making

Question 1

What is utility?

Answer 1

The satisfaction gained from the consumption of a good/service.

Question 2

What is marginal utility?

Answer 2

The extra satisfaction gained from the consumption of the last unit consumed.

Question 3

What are the assumptions of marginal utility theory?

Answer 3

1. Consumers are out to maximise the satisfaction e.g. they are rational.
2. Consumers’ income is limited
3. Consumers tastes are fixed e.g. their assessment of satisfaction does not change
4. Consumers have no power over prices- they are price takers.
5. Utility can be measured- which in all likelihood is not possible in practice.

Question 4

What does Marginal Utility Theory suggest?

Answer 4

The total satisfaction will rise as consumption increases but at a declining rate.

Question 5

What is diminishing marginal utility?

Answer 5

The extra satisfaction gained from each extra unit consumed will be falling.

Question 6

What is consumer surplus?

Answer 6

The difference between the price the consumer is willing to pay and the price they actually pay.

Question 7

What is consumers’ surplus?

Answer 7

The surplus of utility (benefit) the consumer gets on each unit where demand (MU) is greater than mkt. price up to the equilibrium quantity.

Question 8

Where is welfare maximised?

Answer 8

Where D=S (MU=P)

Question 9

What is the relationship between MU and P and supply and demand?

Answer 9

MU is the demand curve.
P is the supply curve.

Question 10

When is total utility maximised?

Answer 10

When MU=0

Question 11

What is ‘Homo Economicus’?

Answer 11

The theory that assumes that every economic actor makes completely rational economic decisions based on perfect information.

Question 12

What does Behavioral Economics argue?

Answer 12

The economic actors do not always act rationally, do no always have perfect information and so will not follow traditional economic models.

Question 13

What is the concept of ‘Bounded Rationality’/

Answer 13

That economic actors’ ability to make rational economic decisions is limited.

Question 14

What are the 3 factors that limit economic actors ability to make rational economic decisions?

Answer 14

Limited knowledge- not perfect knowledge.
Ability of economic actors to make a rational economic decision is limited
Time available is often limited

Question 15

What is the concept of ‘Bounded Self Control’?

Answer 15

that even if economic actors had the information, ability and time to make the rational decision, they may still not do so as they lack the self will, control or discipline.

Question 16

What do behavioural economists argue bounded rationality means?

Answer 16

That individuals often use shortcuts to help them make decisions

Question 17

What was found out about the shortcuts taken by individuals?

Answer 17

That there are littered with cognitive biases that can result in individuals making the irrational decision.

Question 18

What did Daniel Kahneman found about cognitive biases?

Answer 18

Found System 1 ‘thinking fast’- based on intuition means people take shortcuts which lead to cognitive biases. Also found System 2 ‘thinking slow’- where individual considers all the information available to make a rational decision. he found that humans use System 1 more than 2 as system 2 takes more effort and time.

Question 19

What is argued by behavioural economists due to the overuse of System 1?

Answer 19

That our ability to make rational economic decisions is often quite limited.

Question 20

What is the cognitive bias Availability?

Answer 20

Where individual economic actors are trying to make decisions based on the probability of an event happening e.g. the level of insurance to take out.

Question 21

What does the availability bias suggest?

Answer 21

That individual economic actors will base their estimates of probability on their own past experiences of similar events- unlikely to be an accurate estimate of actual probability.

Question 22

What is an example of the availability bias?

Answer 22

Recent bad weather might persuade an individual to take out a higher level of house insurance to protect their property.
However weather could be extreme and evidence suggests a lower probability of it reoccurring.
The individual will purchase more protection than necessary, resulting in an irrational economic decision being taken.

Question 23

What is the key issue with availability bias?

Answer 23

With limited information, the individual economic actor is making a decision based on an over/under estimate of the likely outcome.

Question 24

What is anchoring?

Answer 24

Where individual economic actors make their decision based on the first or a particular piece of information that they use as the ‘anchor’.

Question 25

What are some examples of anchoring?

Answer 25

• Some businesses will quote a very high price to start with and then bring the price down significantly
  -charities which give suggested amounts for donation – e.g. £10, £20, £30. Most people will tend to choose the middle amount – they don’t want to appear stingy but are conscious of their limited budgets as well.
  -used car prices.

Question 26

What are social norms?

Answer 26

The accepted/expected attitudes and behaviour of the group.

Question 27

How do social norms affect individual economic decision makers?

Answer 27

The desire/pressure to comply with social norms may result in irrational choices that do not maximise the individual’s welfare.

Question 28

What are some examples of social norms?

Answer 28

• peer pressure drinking on a night out
• smoking, driving and disability(glasses, injuries etc.)

Question 29

How can social norms influence rational decision making both positively and negatively?

Answer 29

The drinking example increasing mkt failure but changing attitudes to smoking reducing mkt failure.

Question 30

What is a rule of thumb (heuristics)?

Answer 30

A way of making decisions that is made on the basis of what the individual economic actor already knows or believes to be true and so simplifies the process and hence reduces the time taken to make the decision.

Question 31

What are some examples of rules of thumb that are not always true?

Answer 31

It is generally true that buying in larger quantities reduces the average cost of purchase. Assuming this a consumer might pick up the multipack of a product without bothering to check whether they are getting the best deal or not.

Question 32

What is loss aversion?

Answer 32

A bias within individuals which means that we tend to prefer avoiding losses to achieving equivalent gains.

Question 33

What does loss aversion mean to decision making?

Answer 33

That individuals will behave differently and make different decisions based on whether a loss or a gain is involved.

Question 34

What is the example of loss aversion?

Answer 34

Scenario 1- potential gain
Given £10- either gain £5 straight away or gamble to win £10 or nothing.
Scenario 2- potential loss
Given £20- either lose £5 straight away or gamble to lose £10 or nothing.
More people did not take the risk in scenario 1 but did take the risk in scenario 2.
Individuals were prepared to take more risk when faced with a loss and avoided the risk when faced with a gain.

Question 35

What does loss aversion demonstrate?

Answer 35

Individuals will avoid situations where potential losses are involved and take less risks where a potential loss may arise. At the same time, they will be prepared to take greater risks when a loss has actually occurred. e.g. New York cabbies clocking off on rainy days but not clocking off on sunny days as they want to meet their target income. Another example is house prices- people are less likely to want to sell their house when house prices are falling.

Question 36

What is altruism?

Answer 36

A concern for the welfare of others.

Question 37

What is fairness?

Answer 37

A normative judgement of what is right/reasonable.

Question 38

How is altruism explained?

Answer 38

Some are not out to maximise their own welfare, and have an allowance for the welfare of others. Looking after the welfare of others provides welfare for the individual economic actor concerned. e.g. giving to charity makes an individual feel good about themselves whilst a similar action by a firm may enhance their reputation.

Question 39

How does altruism go further than just traditional self-interest and so push past traditional economic theory?

Answer 39

Studies into blood donation have found that offering financial rewards has led to a reduction in the number of blood donors – the belief being that payment undermines the values that have prompted them to donate in the first place.

Question 40

Can traditional economic theory explain fairness?

Answer 40

No, it cannot explain why a firm would willingly pay above the profit maximising real wage rate or why a manager would choose to accept a lower wage to ensure the gap between the highest and lowest paid worker was limited, as might be the case with Co-operative businesses or social enterprises for instance.

Question 41

How can an understanding of behavioural economic help governments?

Answer 41

Can help Govt’s to structure policies that might change economic decision making more effectively and at lower cost than traditional methods such as tax, subsidy, regulation etc.

Question 42

How does behavioural economics fit into traditional theory?

Answer 42

It is not meant to replace traditional theory. behavioural economics is seen as complementing traditional theory to arrive at a better outcome more efficiently. There is still a need for tax, subsidy and regulation etc. as well as behavioural insights.

Question 43

What is framing?

Answer 43

Where the way in which the information is presented to an individual economic actor can influence their choices and behaviour.

Question 44

What are some examples of framing?

Answer 44

• food is often labelled 95% fat free rather than 5% fat.
• a study which showed that a sign in a doctor’s surgery saying 80% of people turned up to their appointments was more effective at increasing attendance rates than a similar sign saying 20% failed to turn up.

Question 45

What is choice architecture?

Answer 45

Where the way in which the choices are presented to an individual economic actor can influence their choices and behaviour.

Question 46

What are some examples of choice architecture?

Answer 46

• opt in and opt out choices. Opt out choices will generally result in more people doing the action. Firms use this sometimes when trying to get people to accept marketing material.

Question 47

What are the 3 different types of choice architecture?

Answer 47

Default choice, restricted choice, Mandated choice.

Question 48

What is a default choice?

Answer 48

Where a choice is automatically chosen unless the individual chooses otherwise. e.g. opt out.

Question 49

What is restricted choice?

Answer 49

Where too many options can be confusing and hence the individual is less likely to choose one and participate in the activity. e.g. pensions, mobile data providers.

Question 50

What is a mandated choice?

Answer 50

Where the individual is legally forced to make a choice. e.g. decisions about organ donation and pensions.

Question 51

What is a nudge?

Answer 51

ANY attempt at influencing individuals’ judgement, choice or behaviour in a predictable way without forbidding any particular options.

Question 52

What are some examples of nudges?

Answer 52

-putting healthy snacks next to the checkout rather than chocolate is a nudge.
- painting strips on roads to make people more aware of their speed
- cigarettes behind a screen
- idea of fun to change peoples thinking e.g. piano stairs Stockholm- short term increased use of stairs.