4.1.2 - Individual economic decision making

Traditional Economic Theory Assumptions

- Consumers always act rationally. They wish to maximise their utility from consumption by correctly choosing how to spend their limited income.

- Producers always act rationally. They wish to maximise profit by producing at the lowest cost

- Governments always act rationally. They wish to improve the economic and social welfare of its citizens.

Rational Decision-Making =

When individuals compare the costs and benefits of possible decisions and choose the one which maximises their personal net benefit for every £ spent.

Rational Consumer =

Individuals who wish to maximise their utility from consumption by correctly choosing how to spend their limited income by comparing the costs and benefitis of all decisions.

How Behavioural Economic Theory challenges Traditional Economic Theory

Recognises that humans, in reality, when making day-to-day decisions, rarely behave in a well-informed and fully rational way.

- Often, decisions are based on imperfect information which causes a loss of welfare for both people themselves and others/society as a whole.

- Also, emotional factors influence economic decision-making

Daniel Kahneman's Model of Thinking

- SYSTEM 1 thinking

- SYSTEM 2 thinking

SYSTEM 1 Thinking =

Thinking is fast and emotional, automatic, effortless. Decisions that happen without realising.

SYSTEM 2 Thinking =

Thinking is slow, deliberate, logical and rational.

Utility

The satisfcation or happiness an individual derives from consuming a good or service

Marginal Utility

The ADDITIONAL satisfaction an individual gains from consumer one EXTRA unit of a good or service

= Change in Total Utility / Change in Quantity

Total Utility

The aggregate sum of satisfaction an individual derives from consuming a given amount of a good or service

Diminishing Marginal Utility

For a single consumer, the marginal utility derived from a good or service decreases for each additional unit consu,ed.

What curve does the Hypothesis of Diminishing Marginal Utility support?

A downward sloping demand curve

Utility Theory

Assumes that consumers choose the basket of goods and services that will maximise their total utility, subject to the constraint imposed by their limited income.

Examples of Consumer Constraints restricting Choice

- Money - not having enough money to buy everything they want

- Access - not having access to goods

- Laws - laws preventing people buying certain goods

- Time - not having time to do desired activities

- Health or low energy levels

With a SINGLE product, a rational consumer with limited income will make purchases to maximise utility up to the point at which

The marginal utility derived from the next unit consumed is zero.

With MULTIPLE products, a rational consumer with limited income will make purchases to maximise utility up to the point at which

The marginal utility-to-price relationships of each good purchased is identical.

MUA/PA = MUB/PB

[where MU = Marginal Utility, P = Price, A = Good A, B = Good B]

In order to maximise utility, an economic agent must consider margin and undertake the activity involved up to the point where

Marginal Private Benefit received = Marginal Private Cost incurred

Utility-Maximising Point =

when MPC=MPB

- Because if Q consumed is lower than this point, the next unit consumed still gives more private benefit than cost.

- If Q consumed is higher than this point, MPC is greater than MPB so the consumer would be better of not consuming that much.

A utility-maximising consumer must choose to consume a good/service up to the point where

Marginal Utility = Price

because Marginal Utility is Marginal Private Benefit, and Price is Marginal Private cost.

- Because i

Imperfect Information =

Inaccurate or incomplete information crucial to making rational decisions.

Information Failure =

When people have inaccurate or incomplete information so make potentially suboptimal decisions.

• Imperfect information causes information failure

Types of Imperfect Information / Causes of Information Failure

• Incomplete or complete lack of information

• Inaccurate/misleading info (e.g. persuasive ads)

• Complexity (e.g. inability to process technical nutritional info)

• Asymmetric info

• Costs involved in acquiring ‘perfect’ info

Asymmetric Information =

When one party involved in a transaction has more or superior information about the good/service than another party

2 Consequences of Asymmetric Information

• Adverse Selection

• Moral Hazard

Adverse Selection =

When asymmetric information leads to an unfavourable outcome.

(e.g. second-hand car market)

Moral Hazard =

When one party chooses to make excessively risky decisions because they know that another party will have to bear the cost.

(e.g. acting recklessly after buying insurance)

Adverse Selection vs Moral Hazard

• Adverse selection occurs before the transaction

• Moral hazard occurs after the transaction

Adverse Selection leading to Market Failure Chain of Analysis (with contextual example)

• Asymmetric information occurs when sellers know more about the true value of the good or service they are selling than the buyers.

• For example, in the market for Second-Hand Cars, sellers know more about the quality of the car than buyers.

• This means sellers may not reveal all information about the car to the buyer, aiming to attract a higher price from them than would be optimal.

• For example, not telling about an engine defect.

• This leads to adverse selection, where the second-hand car buyer might buy a car they wouldn’t have bought if they’d have perfect information about the car, such as knowing about an engine defect.

• Therefore, information failure has caused market failure, which has resulted in a misallocation of resources; thus, allocative inefficiency and a loss of social welfare.

Moral Hazard leading to Market Failure Chain of Analysis (with contextual example)

• Asymmetric information occurs when buyers know more about their risk profile / their behaviour after a transaction than sellers.

• For example, in the market for Car Insurance, once a driver has purchased full insurance cover, the insurer cannot fully observe how carefully the driver behaves on the road.

• The insured driver now bears less of the financial risk of an accident, so they have a reduced incentive to drive carefully

• For example, they may drive faster or leave their car unlocked.

• This is moral hazard - the insured customer chooses to make excessively risky decisions because they know that the insurer will have to bear the cost.

• This leads to too many accidents occuring relative to the social optimum - overconsumption of risky activity

• Therfore, information failure has caused market failure, which has resulted in a misallocation of resources; thus, allocative inefficiency and a loss of social welfare.

Explain why imperfect information can lead to market failure (15 marks)

Demerit Goods

• Imperfect information can lead to overprovision of demerit goods

• Imperfect information arises when consumers attribute goods with benefits that are not true or fail to take account of long-term costs of consumption.

• For example, [application] sugary drinks can lead to obesity, diabetes, cancer.

• As a result, consumers overestimate the private benefits & underestimate the private costs of consuming the demerit good. This often occurs as a result of short-term bias in decision-making.

• This causes consumers' actual demand to be determined by information that is only partial (shown by D (partial)), so the free-market equilibrium occurs at point A at Pm,Qm

• However, with full information about the good the demand would be lower at D (full), which results in the social optimum being at point C at Ps,Qs.

• Therefore, information failure results in consumers overestimating the benefits of consuming the good so causes overconsumption of the good.

• There is over allocation of scarce resources to the good, resulting in deadweight welfare loss shown by area ABC

• Therefore, the free market mechanism has caused allocative inefficiency, resulting in partial market failure.

‎

Adverse Selection

• Asymmetric information occurs when sellers know more about the true value of the good or service they are selling than the buyers.

• For example, in the market for Second-Hand Cars, sellers know more about the quality of the car than buyers.

• This means sellers may not reveal all information about the car to the buyer, aiming to attract a higher price from them than would be optimal.

• For example, not telling about an engine defect.

• This leads to adverse selection, where the second-hand car buyer might buy a car they wouldn’t have bought if they’d have perfect information about the car, such as knowing about an engine defect.

• Therefore, information failure has caused market failure, which has resulted in a misallocation of resources; thus, allocative inefficiency and a loss of social welfare.

‎

Moral Hazard

• Asymmetric information occurs when buyers know more about their risk profile / their behaviour after a transaction than sellers.

• For example, in the market for Car Insurance, once a driver has purchased full insurance cover, the insurer cannot fully observe how carefully the driver behaves on the road.

• The insured driver now bears less of the financial risk of an accident, so they have a reduced incentive to drive carefully

• For example, they may drive faster or leave their car unlocked.

• This is moral hazard - the insured customer chooses to make excessively risky decisions because they know that the insurer will have to bear the cost.

• This leads to too many accidents occuring relative to the social optimum - overconsumption of risky activity

• Therfore, information failure has caused market failure, which has resulted in a misallocation of resources; thus, allocative inefficiency and a loss of social welfare.

Behavioural Economics:

• Questions the assumption of traditional economic theory that individuals are rational decision makers who endeavour to maximise their utility.

• It rejects the view that economic agents are fully 'rational', due to cognitive biases, psychological and emotional factors.

Bounded Rationality

= Rational decision-making is limited because of:

BID

B - Brain - The human mind has limited capacity to process and evaluate all information

I - Information - Available information is incomplete & often unreliable

D - Deadlines - Limited time available to gather all information and make decisions

What is the result of Bounded Rationality?

• Result is that we usually end up making satisficing decisions, rather than optimizing, rational decisions.

• To make decisions, we end up using "rules of thumb"

Bounded Self-Control =

When individuals have good intentions but lack the self-discipline to see them through.

• Make impulsive decisions that don't align with long-term interests due to discounting long-term value in favour of immediate rewards.

(e.g. knowing it's not a good idea to eat a piece of cake, but eating it anyway because they lack the willpower to resist)

Biases in Decision-Making (that lead to irrational decision-making)

- Rules of Thumb (Heuristics)

- Anchoring Bias

- Availability Bias

- Social Norms

- Loss Aversion

Cognitive Biases Lead To...

irrational decision making that does not maximise their economic welfare

Rules of Thumb (Heuristics) =

Thinking shortcuts that individuals use to help make decisions more quickly, given the problem of bounded rationality.

Anchoring Bias =

= When individuals rely too much on a particular piece of information (an "anchor) when making subsequent judgements.

• A form of priming effect whereby initial exposure to a number serves as a reference point when making subsequent decisions.

(e.g. when buying a second-hand car, the seller may suggest an initial price of $10,000. Even if u know the market value is lower, the anchor of $10,000 may influence judgement of its value and may cause you to pay a higher price)

Availability Bias =

= When people overstimate the likelihood of something happening because of examples that come to mind easily, such as a similar event happened recently or because we feel very strongly about a previous similar event.

(e.g. after a plane crash, more people use alternative modes of transport)

Social Norms =

= Unwritten rules that guide behaviour in social groups.

• Concept that individual decision-making may be influenced by prevailing social norms because people conform to fit in

Loss Aversion =

= The tendency to prefer avoiding losses over acquiring equivalent gains. People feel losses more than equivalent gains.

Altruism =

= To act in ways that sacrifices personal welfare for someone else's benefit.

• Standard economic theory states that people behave to maximise utility, however behavioural economic theory recognises that people have a conscience and often choose to do the right thing - acts of altruism.

Perceptions of Fairness =

• Fairness involves value judgements, therefore statements about it are usually normative.

• People are not only influenced by how they are affected, but also take into account the impact of their actions on others

• Individuals may be more concerned with more equitable outcomes for society than their own self-interest

Choice Architecture

The intentional design of how choices are presented to consumers to influence decision making.

(i.e. the attempt to influence an individual's decision through the way in which choices are presented to the decision-maker)

Choice Architecture is often used in policy-making:

Marketing, Healthcare to promote beneficial behaviours, Encourage Savings, Increase Organ Donations, Promote Energy Conservation

Choice Architecture is more effective when...

it encourages simplicity in decisions. It aims to simplify the decision making process.

Framing

A form of choice architecture: The tendency for an individual's choice to be influenced by the context in which a choice is presented.

(i.e. the attempt to influence an individual's decision through the context in which it is presented)

• The same information can be framed in a positive or negative way to evoke different responses.

(e.g. This medication has 90% survival rate (positive frame) vs This medication has 10% mortality rate (negative frame))

Types of Choice Architecture:

- Nudges

- Default Choice

- Restricted Choice

- Mandated Choice

Nudges

An aspect of choice architecture through gentle prompts to influence people's behaviour without limiting freedom of choice and changing economic incentives.

Default Choice

An option that is selected automatically if nothing is specified by the decision maker.

(e.g. When going on a website, the default choice for accepting cookies may be to Accept all, Pension schemes)

Restricted Choice

Offering people a limited number of options so that they are not overwhelmed by the complexity of the situation.

- helps individuals make more rational decisions

Mandated Choice

People are required by law to make a decision; required to state whether they wish to participate in an action.

(e.g. Whether you wish to sign up for organ donation)

Advantages of Nudges

- Maintains freedom of choice

- Cost effective - cheap to implement

- Fast-acting - no laws needed to be implemented

- Can change people's preferences over time

Disadvantages of Nudges

- Does not guarantee change of behaviour - may not be significant enough

- May only change behaviour briefly - people may become immune to nudging over time

- Nanny state / Ethical concerns - Arguably manipulative & gov interfering unduly with personal choice

Advantages of Behavioural Policies

- Cheaper to implement and administer than traditional policies (e.g. regulation)

- Maintains freedom of choice

- Does not require legislation and less bureucratic so can be implemented faster

- State seen as having smaller role in society compared to lots of new laws/taxes etc

- Positive and supportive messages of change are more effective than those that seek to shock or patronise

Disadvantages of Behavioural Policies

- Not effective in influencing most serious market failures - need a "shove" in these cases (i.e. regulation to deal with violent crime)

- Nanny state extending too far - ethical concerns - Arguably manipulative & gov interfering unduly with personal choice

- May only change behaviour briefly - people may become immune to nudging over time

- Requires constant modification to ensure still consistent and applicable - due to continuously changing nature of individual preferences

- "Poor" decisions may not be due to individual behavioural flaws, but because of poverty, inequality or lack of hope, which nudges won't affect.

- May be influenced by private pressure groups/businesses

- Government failure applies to behavioural eco policies just like traditional

Can behavioural economic policies replace traditional policies?

It is imperative to note that the behavioural economic concept is too flawed to replicate traditional regulation outright.

Instead, need to compare behavioural policies with traditional economic policies to consider how they might complement each other and work in combination to solve market failure.