Economics and Finance

Constrained Optimisation

Making the most out of what you’ve got. Optimising your limit

Wealth

The market value of someone’s assets at any moment in time

The Feasible Set

The most amount of any good that your wealth can purchase if you liquidate all of your assets

Utilitarianism

Puts human happiness at the centre of all decisions being made

Split up into Value Theory and Theory of Right action

Easterlin Paradox

By raising the income of all, perceived subjective well being does not increase even though income has increased.

You only feel better off if you are better off in comparison to those around you

Maslows Hierarchy of needs

Food, water

Health employment

Friends family

Confidence self esteem

Creativity problem solving

6 assumptions needed for indifference curve

Completeness assumption (people can always make a choice even if the choice is i don’t mind)

Transivity assumption (people are consistent)

Rational choice (always choose the bundle they like the most)

Non satiation (more is better)

Line is continuous

All indifference curves are convex

Marginal rate of substitution (MRS)

The gradient at a given point

Marginalism

Marginal means additional, like one more vote in an election? will that margin make a difference?

Does that choice improve your utility?

The Pareto Critereon

Protecting minority rights, if a decision brings harm to the minority it cannot be exercised

Optimisation of a budget line

Take an indifference curve tangent to the budget line in a central position to maximise bundle size

Responses to a change in income regarding an inferior good

When income decreases, demand for inferior good increases so purchase of inferior good increases

When income increases, demand for inferior good decreases so purchases of inferior good decreases

Normal good should be proportional to income increase or decrease

Risk and uncertainty

Risk is where the outcomes are known just cannot be determined which one (flipping a coin)

Uncertainty is where you do not know the outcomes currently (chance of a general election in the next month)

Bounded rationality

You face constraints on how rational you can be depended on 3 things:

the information they have

their cognitive limitations (intelligence)

the finite time they have for the decision

Satisficer

Considers the cost of a good decision and makes the best decision considering this constraint

“that’s good enough for now”

Kahneman and Tverskys 2 model system of human cognition

The fast system:

Reflexes, is automatic, is frequent, is emotional, is stereotypic, is subconscious

The slow system:

Takes effort, infrequent, logical, calculating, conscious thought

Heuristic

Making an easier way of doing something to shorten the time it takes to do it

Makes the answer less precise but more efficient

Why do we rely on flawed biases

Infrequent choices - don’t know how effective our heuristics are

Difficult choices - don’t know which heuristic would work best

Decisions may have immediate benefits that punish later (myopic preferences)

Decisions with no feedback - cannot tell how well the heuristic was suited

Nudging

Directly addresses our system 1 thinking as it effects your immediate response to a stimulus

Some nudges don’t have your best interests at heart and these are called a Sludge

Libertarian Paternalism highlights how we should influence people’s behaviours

Libertarianism

Individual freedom and judgement is the most important thing for society, No one can be pressured into making a decision

Paternalism

It is ethical to limit someone’s freedom for their own good

They may not know what the best choice is for them at a specific moment

Libertarian Paternalism

Should nudge individuals to make better decisions whilst also giving them freedom to make their own decisions

Accepts that there will always be influences regardless of the environment (cafeteria putting fruit before sweet deserts to encourage better eating)