Rational economic decision making and economic incentives Flashcards
Consumer behaviour -> Individual economic decision making -> Microeconomics
Key Assumptions of Rational Economic Decision-Making
What does rationality mean in economic decision-making?
Rationality means consumers act to maximise their utility (satisfaction) within the constraints they face, such as income or prices, and make choices in self-interest based on available information.
Key Assumptions of Rational Economic Decision-Making
How does opportunity cost factor into rational decision-making?
Rational decision-making involves choosing the best alternative while rejecting the next best alternative, considering the opportunity cost of any decision.
Key Assumptions of Rational Economic Decision-Making
What is utility maximisation?
Utility maximisation is when consumers allocate resources to achieve the highest possible level of satisfaction or benefit from consuming goods and services.
Key Assumptions of Rational Economic Decision-Making
How is marginal analysis used in decision-making?
Marginal analysis involves comparing the marginal benefit (additional satisfaction) of consuming one more unit of a good to its marginal cost (additional expense).
Economic Incentives and Consumer Behaviour
What are economic incentives?
Economic incentives are factors that motivate or influence consumer decisions, such as changes in prices, income, or preferences.
Economic Incentives and Consumer Behaviour
How does price act as an incentive?
A fall in price relative to other goods increases the quantity demanded (law of demand), while a price increase creates the incentive to consume less of the good.
Economic Incentives and Consumer Behaviour
What are the substitution and income effects?
- Substitution Effect: Consumers switch to cheaper alternatives when the price of a good rises, increasing demand for substitutes.
- Income Effect: A price change affects purchasing power, increasing demand for normal goods when prices fall, but potentially reducing demand for inferior goods as consumers shift to superior substitutes.
Economic Incentives and Consumer Behaviour
What other factors act as economic incentives?
Changes in preferences due to trends or advertising, and government policies like taxes, subsidies, or price controls.
Theories and Models
What does the traditional demand theory state?
Traditional demand theory states that the demand curve represents the relationship between price and quantity demanded, which is typically downward-sloping due to the substitution and income effects.
Theories and Models
What is rational choice theory?
Rational choice theory assumes that consumers rank preferences and allocate resources to maximise utility under constraints like budgets.
Theories and Models
How does behavioural economics challenge traditional models?
Behavioural economics incorporates psychological factors, biases, and heuristics (e.g., loss aversion, bounded rationality), challenging the assumption of perfect rationality.
Theories and Models
What is indifference curve analysis?
Indifference curve analysis is a graphical tool that combines budget constraints with indifference curves to show utility-maximising choices.
Key Concepts
Define utility in economics.
Utility is the satisfaction derived from consuming goods and services.
Key Concepts
What is opportunity cost?
Opportunity cost is the value of the next best alternative foregone.
Key Concepts
What is marginal utility?
Marginal utility is the additional satisfaction from consuming one more unit of a good.
Key Concepts
What is a budget constraint?
A budget constraint is the limit on consumption based on income and prices.
Key Concepts
What is price elasticity of demand (PED)?
PED measures the sensitivity of quantity demanded to changes in price, influencing the magnitude of consumer response to price incentives.
Applications and Implications
How do changes in prices, income, or preferences affect market demand?
Changes in prices, income, or preferences shift the demand curve.
Applications and Implications
What are some policy implications of economic incentives?
Taxes on harmful goods (e.g., cigarettes) create disincentives, while subsidies on essential goods (e.g., education) incentivise consumption.
Applications and Implications
What are critiques of rationality in economic decision-making?
Real-world decisions often deviate from rationality due to information asymmetry, emotional influence, or cognitive limitations.
Additional Concepts
What is time preference?
Time preference refers to the preference for receiving goods, services, or rewards sooner rather than later, capturing the trade-off between immediate gratification and future benefit.
Additional Concepts
How does asymmetric information affect decision-making?
- Adverse Selection: Consumers may make suboptimal choices due to incomplete or misleading information.
- Moral Hazard: Incentives are distorted when one party takes risks knowing the other bears the consequences.
Additional Concepts
How do markets address asymmetric information?
Through signalling (e.g., warranties, branding) and screening (e.g., reviews, third-party evaluations).
Rational Choice Theory and Game Theory
What does game theory study?
Game theory studies strategic interactions where the outcome for one participant depends on the decisions of others, assuming participants act rationally to maximise their payoff.
Rational Choice Theory and Game Theory
What are key concepts in game theory?
- Nash Equilibrium: No player can improve their outcome by unilaterally changing their strategy.
- Dominant Strategy: The best course of action regardless of what others do.
Rational Choice Theory and Game Theory
How is game theory applied in consumer behaviour?
In price wars, firms lower prices strategically, influencing demand, and in network effects, consumers’ choices depend on others (e.g., social media platforms).
Rational Choice Theory and Game Theory
What are critiques of game theory?
Game theory assumes full information and rationality, which may not align with real-world behaviour. Behavioural economics integrates concepts like bounded rationality and fairness preferences.
