Individual Economic Decision Making Flashcards
What is rational economic decision making assumption?
Rational economic decision-making assumes that individuals and firms make choices to maximize their well-being or profits, given the constraints they face (such as income, time, or resources).
• Rational behavior is guided by the principle that decision-makers aim to achieve the best possible outcome based on their preferences, available information, and the alternatives available.
• People assess the costs and benefits of their decisions and choose the option that provides the greatest net benefit.
• Economic incentives (e.g., prices, rewards, taxes) influence these decisions by making certain actions more or less attractive.
What are economic incentives? (Monetary and non monetary)
Incentives are factors that motivate individuals to act in a certain way. In economics, incentives can be:
• Monetary incentives: Rewards like wages, profits, or savings interest that encourage certain behaviors (e.g., work, investment, or saving).
• Non-monetary incentives: Intrinsic rewards like personal satisfaction, status, or the desire for future success that influence decisions.
Examples:
• Price signals act as incentives. If the price of a good rises, firms are incentivized to increase supply, and consumers are motivated to reduce demand.
• Taxes on cigarettes are an example of negative incentives aimed at reducing consumption.
What is the utility theory?
Utility theory is a framework used to understand how individuals make choices based on the satisfaction (or utility) they derive from consuming goods and services.
Total Utility (TU): The total satisfaction a person derives from consuming a certain quantity of a good or service.
Example: If you eat 3 slices of pizza, the total utility is the overall satisfaction from those 3 slices.
Marginal Utility (MU): The additional satisfaction gained from consuming one more unit of a good or service.
Example: If eating a 4th slice of pizza brings an additional 5 units of satisfaction, the marginal utility of the 4th slice is 5.
What is the hypothesis of diminishing marginal utility?
The law of diminishing marginal utility states that as more units of a good or service are consumed, the additional satisfaction (marginal utility) derived from each additional unit decreases.
Example: The first slice of pizza gives you a lot of satisfaction, the second a bit less, and the third even less. After a certain point, consuming more may even lead to negative utility (e.g., feeling uncomfortably full).
Why does this happen? As a person consumes more of a good, their desire for variety or saturation sets in, leading to diminishing returns in satisfaction from each additional unit.
What is utility maximisation?
Utility maximization refers to the idea that individuals make choices to achieve the highest possible satisfaction given their budget or constraints.
• Consumers maximize utility by allocating their income across different goods and services in such a way that the marginal utility per dollar spent is equal across all goods.
• Example: If a person has $10 to spend and derives more marginal utility per dollar from apples than from bananas, they will allocate more of their budget to apples until the marginal utility per dollar is the same for both.
How to maximise utility?
- The Equal Marginal Principle: For a consumer to maximize total utility, the marginal utility of each good per dollar spent must be equal:
MU1/ P1 = MU2/ P2
Where MU1 and MU2 are the marginal utilities of goods 1 and 2, and P1 and P2 are their prices.
- Budget Constraint: Consumers face a limited income, so they must make choices that optimize utility within their budget.
Why the margin is important in economic choices?
• Marginal analysis refers to evaluating the additional benefits and costs of a decision before taking action.
• At the margin, individuals assess whether the benefit of the next unit of consumption or production outweighs the cost of that unit.
• Example: A person deciding whether to study for an additional hour considers whether the marginal benefit of improving their grade by one more point is worth the marginal cost of spending more time on studying.
Example of Marginal Analysis in Decision Making
• Business Investment: A firm deciding whether to invest in new machinery compares the marginal benefit (increased productivity and profit) to the marginal cost (cost of the machinery and maintenance).
• Consumption: A consumer deciding whether to buy a new product will weigh the marginal utility gained from the product against the marginal cost (price).
Why information is important for decision making?
Because it allows individuals, firms, and governments to make informed choices that maximize utility, profits, or other objectives. Without accurate or complete information, decision makers may make inefficient choices that lead to suboptimal outcomes.
How information affects decision making?
• Informed Decisions: When decision makers have accurate information, they can predict outcomes and allocate resources efficiently, leading to better choices in consumption, production, and investment.
Example: A firm deciding whether to launch a new product needs market research to understand consumer preferences, competitors, and costs. With reliable data, they can make a better decision.
• Cost and Benefit Analysis: Information allows for comparing costs and benefits before making choices. This involves evaluating trade-offs—deciding if the marginal benefit of a decision exceeds its marginal cost.
Example: A government deciding on a public health initiative needs to compare the cost of the program with the potential health benefits (reduced disease rates, lower healthcare costs).
• Risk and Uncertainty: Information helps decision-makers assess risk and reduce uncertainty. In the presence of complete and accurate information, decision-makers are more confident in their choices.
Example: An investor uses financial reports to understand a company’s performance, helping them assess the risk of investing in its stocks.
What is the role of information in the market?
Markets rely heavily on the availability and flow of information. Buyers and sellers need information to make decisions regarding pricing, quality, availability, and costs.
• Price discovery: Information about supply and demand helps set the price of goods and services in a competitive market.
• Competition: Information about competitors’ products, pricing, and strategies allows firms to adjust their own offerings to stay competitive.
What is asymmetric information?
Asymmetric information occurs when one party in a transaction has more or better information than the other party.
How asymmetric information affects market outcomes?
• Adverse Selection: This occurs when one party uses its superior information to exploit the other party. In markets with imperfect information, those with more information may select against those with less information, leading to market inefficiencies.
Example: In the insurance market, people who know they are at higher risk (e.g., with a pre-existing medical condition) may be more likely to purchase health insurance. Insurers may, therefore, raise prices for everyone, making the market less efficient.
• Moral Hazard: This occurs when one party takes more risks because they do not bear the full consequences of those risks, knowing that the other party will absorb some or all of the costs.
Example: If a bank knows that the government will bail it out in case of failure (due to a “too big to fail” policy), the bank may engage in riskier financial activities, knowing it will not face the full consequences of failure.
What examples of asymmetric information in the economy?
• Used Car Market (The “Lemon Problem”): In the used car market, sellers often have more information about the quality of the car than buyers. Buyers, unable to distinguish between good-quality cars (peaches) and poor-quality cars (lemons), may offer less for all cars, driving out high-quality cars from the market.
• Labor Market: Employers often have less information about an employee’s true abilities, work ethic, or potential for success than the employee does. This can lead to inefficiencies in hiring decisions.
• Healthcare Market: Patients typically have less information about their medical condition and treatment options than doctors. This can lead to over-treatment, where doctors recommend more expensive treatments than necessary, or under-treatment, where patients avoid necessary procedures due to lack of information.
What are solutions to asymmetric information?
How to overcome asymmetric information problems?
• Signaling: One party may try to communicate its quality or reliability through actions or signals that convey information.
Example: A firm may signal its quality through warranties or certifications.
• Screening: The less informed party can try to obtain more information to reduce the information gap.
Example: Employers conduct interviews or tests to screen potential employees for their skills and qualifications.
• Regulation and Disclosure: Governments can regulate markets and mandate information disclosure to ensure that all parties have access to necessary information.
Example: The Securities and Exchange Commission (SEC) in the U.S. requires companies to disclose financial information to reduce information asymmetry between the firm and investors.
What is imperfect information?
Imperfect information refers to situations where economic agents do not have all the facts or data needed to make the most informed and efficient decisions. This can manifest in several ways:
• Incomplete Information: When an agent has some, but not all, of the relevant information.
• Incorrect Information: When agents have inaccurate or misleading information.
• Asymmetric Information: When one party in a transaction knows more than the other, leading to an imbalance of power or advantage in the decision-making process.
How imperfect information leads to market failure?
Market failure occurs when a market, left to its own devices, does not allocate resources efficiently, leading to a loss of societal welfare. Imperfect information is a common cause of market failure for the following reasons:
• Adverse Selection: In markets where buyers and sellers have asymmetric information, the less informed party may make decisions that lead to suboptimal outcomes. For example, in the insurance market, consumers with higher risks (such as those with pre-existing medical conditions) may be more likely to purchase insurance, leading to higher premiums for everyone and driving out low-risk individuals, reducing the overall market efficiency.
• Moral Hazard: When one party can take more risks because they don’t bear the full consequences of those risks (due to imperfect information), they might act in ways that are inefficient or harmful to others. For example, a bank might engage in risky lending practices, knowing that the government will bail it out if things go wrong, leading to moral hazard.
• Imperfect Competition: Imperfect information can also prevent markets from reaching perfect competition. If consumers are unaware of all the available options or prices, firms may not compete effectively, allowing them to charge higher prices or restrict output, leading to market inefficiency.
• Consumer Exploitation: Firms may take advantage of consumers’ lack of knowledge. For example, a firm may produce low-quality goods or services and mislead consumers about their quality, leading to an inefficient allocation of resources and suboptimal choices for consumers.
• Under- or Over-consumption: If consumers are unaware of the full benefits or costs of a good or service, they may either under-consume or over-consume it. For example, if a person doesn’t know the full health benefits of exercise, they may not engage in it enough. Conversely, if they are unaware of the risks of smoking, they might over-consume it.
What are examples of imperfect information in different markets?
• Financial Markets: Investors may not have all the necessary information about a company’s future prospects, leading to poor investment decisions. Stock price bubbles can form if investors are influenced by misleading or incomplete information, resulting in market inefficiency and the eventual collapse of the bubble.
• Used Car Market: In the market for used cars, sellers typically have more information about the condition of the car than buyers. As a result, sellers may sell low-quality cars (lemons) at the same price as high-quality ones, causing buyers to be wary and driving prices down for all cars, even high-quality ones.
• Labor Market: Employers may not have full information about the skills, work ethic, and productivity of potential employees, leading to inefficient hiring decisions. This can also result in wage inefficiency, where workers are paid less or more than their actual productivity, distorting the labor market.
How could government addressing imperfect information?
• Regulation: Governments can require firms to disclose certain information to reduce information asymmetry. For example, the Securities and Exchange Commission (SEC) in the U.S. mandates that companies release financial statements to ensure investors have accurate information.
• Education and Information Campaigns: Governments can provide consumers with information to make more informed decisions, such as health warnings on tobacco or nutrition labels on food products.
• Consumer Protection Laws: To combat exploitation due to asymmetric information, governments can enforce laws that protect consumers from misleading advertising, fraud, and the sale of unsafe products.
• Subsidies and Incentives for Transparency: Governments can encourage firms to provide more information by offering incentives for transparency or penalizing businesses for withholding crucial information.
What is bounded rationality?
Bounded rationality is a concept introduced by Herbert Simon that suggests that individuals, when making decisions, are limited by cognitive constraints, time, and available information. In other words, people do not always make perfectly rational decisions due to the limitations of their thinking capacity and the complexity of the environment. Instead of finding the optimal solution, individuals often settle for a satisficing option—one that is good enough given their constraints.
Example: A consumer shopping for a car may not have the time or information to evaluate every possible car model, so they may choose one that seems adequate rather than the absolute best option.
What is bounded self control?
Bounded self-control refers to an individual’s limited ability to control their impulses or desires in the face of long-term goals. This can lead to decisions that are suboptimal or inconsistent with long-term welfare.
Example: A person may understand that saving for retirement is important but still choose to spend money on immediate gratification (e.g., buying a new gadget) instead of contributing to their savings, despite knowing it would be better for them in the long run.
What biases in decision making?
- Rules of thumb
- Anchoring bias
- Availability bias
- Social norms
What is rules of thumb?
In decision making, individuals often rely on heuristics or rules of thumb—simple, efficient strategies used to make quick decisions. These can help simplify complex decisions but may lead to biases or errors.
Example: When choosing a restaurant, people may rely on the rule of thumb that higher prices equate to better quality, even though this is not always the case.
What is anchoring bias?
Anchoring occurs when individuals rely too heavily on the first piece of information they encounter (the anchor) when making decisions. Subsequent judgments are often biased toward that anchor, even if it is irrelevant or arbitrary.
Example: If a person sees a $1000 jacket first, and then a $200 jacket, they may perceive the $200 jacket as a good deal, even if $200 is still more than they initially planned to spend.
What is availability bias?
Availability bias refers to the tendency to rely on readily available information when making decisions, rather than considering all relevant data. If something is easily recalled, people tend to think it is more likely or more significant
Example: After hearing news about a plane crash, people may overestimate the risk of flying, even though statistically flying is safer than driving. The vividness of the crash makes the risk more salient in their minds.
