Rational economic behaviour

Question 1

What is the assumption behind the traditional view of rational economic behaviour?

Answer 1

Individuals are perfectly rational, fully informed, use perfect logic, and aim to achieve maximum economic gain.

Question 2

Why is the traditional view of rational economic behaviour critiqued?

Answer 2

It is rarely applicable in real-world decision-making due to constraints on information, processing ability, and time.

Question 3

What is bounded rationality?

Answer 3

Rationality is limited by imperfect information, limited mental processing ability, and time constraints, leading individuals to satisfice rather than maximize utility.

Question 4

What are the three main limitations of bounded rationality?

Answer 4

1. Imperfect information: Individuals cannot know all alternatives and their consequences.
2. Limited mental processing ability: Cognitive capacity to analyze complex situations is finite.
3. Time constraints: Decisions often need to be made quickly.

Question 5

How does bounded rationality apply to microeconomics?

Answer 5

• Explains suboptimal consumer and producer decisions.
• Relevant in markets with information asymmetry.
• Justifies policies aimed at simplifying choice, such as nudges or default options.

Question 6

What is bounded self-control?

Answer 6

The tendency of individuals to fail to act in their long-term interest due to limited self-control.

Question 7

Provide an example of bounded self-control.

Answer 7

Breaking New Year’s resolutions.

Question 8

How does bounded self-control relate to economics?

Answer 8

• Explains overconsumption of harmful goods (e.g., smoking, unhealthy food).
• Highlights the role of behavioural interventions like commitment devices (e.g., savings plans).

Question 9

What is dual-system thinking as proposed by Daniel Kahneman?

Answer 9

A theory distinguishing between System 1 (fast thinking) and System 2 (slow thinking).

Question 10

What are the characteristics of System 1 (fast thinking)?

Answer 10

• Intuitive, instinctive, and automatic.
• Quick decision-making with minimal effort.

Question 11

Provide examples of System 1 thinking.

Answer 11

• Buying coffee or groceries.
• Reacting instinctively in a familiar situation

Question 12

What are the advantages of System 1 thinking?

Answer 12

• Efficient for routine or low-stakes decisions.
• Reduces cognitive load.

Question 13

What are the limitations of System 1 thinking?

Answer 13

It is prone to biases and errors.

Question 14

What are the characteristics of System 2 (slow thinking)?

Answer 14

• Reflective, deliberate, and logical.
• Requires concentration and mental effort.

Question 15

Provide examples of System 2 thinking

Answer 15

• Deciding on a car or house purchase.
• Evaluating investment options.

Question 16

What are the advantages of System 2 thinking?

Answer 16

• Allows for complex problem-solving.
• Reduces likelihood of impulsive mistakes.

Question 17

What are the limitations of System 2 thinking?

Answer 17

• Time-consuming and cognitively tiring.
• Overthinking can hinder decisions in high-pressure scenarios.

Question 18

How do bounded rationality and bounded self-control impact policy design?

Answer 18

• Encourage “nudge” policies, like automatic enrolment in pension plans.
• Simplify information for better consumer understanding (e.g., clear food labelling).

Question 19

How does understanding irrational behaviours benefit market analysis?

Answer 19

It helps predict real-world outcomes such as market bubbles and poor financial planning.

Question 20

How do businesses exploit System 1 thinking?

Answer 20

Through branding and advertising.

Question 21

What are heuristics?

Answer 21

Mental shortcuts used to make decisions under uncertainty (e.g., availability heuristic, anchoring).

Question 22

What is prospect theory?

Answer 22

A theory by Kahneman and Tversky describing how people evaluate potential losses and gains asymmetrically.

Question 23

What is loss aversion?

Answer 23

The tendency to prefer avoiding losses over acquiring equivalent gains.

Question 24

What are framing effects?

Answer 24

Decisions influenced by the way choices are presented.

Question 25

What is nudge theory?

Answer 25

Small changes in choice architecture that lead to better decision-making without restricting freedom (e.g., default options).

Question 26

What is Simon’s satisficing model?

Answer 26

A model where decision-makers settle for a satisfactory option rather than the optimal one.

Question 27

What is Thaler’s mental accounting?

Answer 27

The tendency to categorize money into different accounts, affecting spending and saving behaviour.

Question 28

What is hyperbolic discounting?

Answer 28

Preference for smaller, immediate rewards over larger, delayed rewards, explaining procrastination and impulsivity.

Question 29

How does behavioural economics challenge the traditional model of perfect rationality?

Answer 29

By incorporating psychological insights, it provides a more realistic framework for understanding human decision-making.

Question 30

What are the key applications of behavioural economics?

Answer 30

1. Policy design.
2. Business strategies.
3. Market analysis