Rationality Economics

Rational behaviour

people make choices to maximise their benefit

What do consumers maximise

utility

What do workers maximise

wages and benefits

what do firms maximise

profit

what do governments maximise

social welfare

why consumers can be irrational

• Limited time, information and brain power.
• May use "rules of thumb" to make quick decisions.
• May struggle with complex information/calculations.
• Emotions and impulses can affect decisions.
• People can be influenced by how choices are presented.

Choice architecture

how choices are presented and organised to influence decisions.

Framing

presenting information in a way that influences decisions.

Anchoring

an initial piece of information influences later decisions, even if irrelevant.

Habit and defaults

• Habit = repeating familiar choices.
• Default bias = sticking with the option automatically selected.
• Default choice = automatically selected unless changed.
• Restricted choice = only a limited number of options are available.
• Mandated choice = a particular choice is required.

Risk aversion

preferring a certain reward rather than risking it for a larger reward.

Loss aversion

losses feel more significant than equivalent gains.

Time preference

preferring rewards now rather than later.

Irrational behaviour

making choices that do not maximise utility.
• Causes include:

• Emotions and impulsiveness

• Lack of self-control

• Social influences

• Limited information and time

• Regret

• Loss aversion

Bounded Rationality

people cannot always make fully rational decisions because of limits on:

• Time

• Information

• Cognitive ability

Bounded self control

• People may know what is best but still choose immediate rewards.
• Example: Eating too much at a restaurant despite intending to eat less.

Influence of others

• Peer pressure
• Fads and fashion
• Social networks
• Social norms
• Herd behaviour = following what other people are doing.

Nudges

small changes that encourage better decisions without removing freedom of choice.
• Example: Automatically enrolling employees into a pension scheme.