2.4 Rational Consumer choice

What does 'rational' mean in classical economic theory?

In classical economic theory, 'rational' means that economic agents are able to consider the outcome of their choices, recognize the net benefits of each one, and select the choice which presents the highest benefits (utility).

What is Rational choice theory?

Rational choice theory states that individuals use logical and sensible reasons to determine the right choice connected to an individual’s best self-interest.

What are the three traditional assumptions of rational consumer choice?

The three traditional assumptions are:

1. Consumer Rationality

2. Utility Maximisation

3. Perfect Information

Explain Consumer Rationality.

Consumer Rationality is the assumption that individuals use rational calculations to make choices which are within their own best interest, using all the information available to them.

Explain Utility Maximisation.

Utility Maximisation assumes economic agents select choices that maximize their utility to the highest level.

E.g. If an individual gains greater satisfaction from swimming than going for a run, they will choose to go swimming.

Explain Perfect Information.

Perfect Information assumes that information is easily accessible about all goods and services on the market, meaning individuals have access to all the information available to make the best decision.

How does Behavioural economics contrast traditional economics?

Behavioural economics contrasts traditional economics by challenging the view that economic agents behave rationally.

What is Behavioural economics?

Behavioural economics is a field of study that combines elements of psychology and economics to understand how people make decisions and behave in economic contexts. It recognizes that human decision-making is influenced by cognitive biases, emotions, social, and other psychological factors.

What are the key limitations of the assumptions of rational consumer choice?

The assumptions of traditional economics regarding decision-making do not always hold due to:

1. Biases

2. Bounded Rationality

3. Bounded Self-Control

4. Bounded Selfishness

5. Imperfect Information

What are Biases in decision-making? List and explain types.

Biases influence how we process information when making decisions and these influence the process of rational decision making (e.g., common sense, intuition, emotions, personal/social norms).

Types of Bias:

• Rule of Thumb: Individuals make choices based on their default choice based on experience (e.g., ordering the same pizza).

• Anchoring and Framing:

  • Anchoring bias: Relying too heavily on an initial piece of information (the "anchor") when making subsequent judgments (e.g., an initial price suggestion).

  • Framing: How the presentation or wording of information influences choices (e.g., '80% fat free' vs. '20% fat').

• Availability Bias: Relying on immediate examples or information that comes to mind easily when making judgments, leading to overestimating likelihood (e.g., fear of flying after a plane crash).

What is Bounded Rationality Theory?

Bounded Rationality Theory argues that people make decisions without gathering all the necessary information to make a rational decision within a given time period. It assumes rational decision-making is limited because of an individual's thinking capacity, availability of information, lack of time, and potentially too much choice.

What is Bounded Self-Control?

Bounded Self-Control suggests that individuals have a limited capacity to regulate their behaviour and make decisions in the face of conflicting desires or impulses. It recognizes that self-control is not an unlimited resource and can lead to emotional decisions or impulsive spending (e.g., impulse purchases at checkout).

What is Bounded Selfishness?

Bounded Selfishness challenges the view that economic agents always act within their own self-interest. It recognizes that individuals do things for others without a direct reward (altruism).

Examples include donating money to charity, organ donations, or voluntary work.

What is Imperfect Information as a limitation?

Imperfect Information challenges the assumption that information is perfectly accessible, due to factors such as intellectual property rights, the cost of accessing information, and the sheer amount of information/options available.

What is Choice Architecture?

Choice architecture refers to the intentional design of how choices are presented so as to influence decision making (e.g., salad bar placement, supermarkets placing more profitable products at eye level).

Describe the three types of Choice Architecture.

1. Default Choice: Occurs when an individual is automatically signed up to a choice, and rarely changes it (e.g., organ donation as a default option).

2. Restricted Choice: Limiting the choices available to individuals to help them make more rational decisions (e.g., removing unhealthy food options).

3. Mandated Choices: Requiring individuals to make a specific decision or take a particular action by imposing an obligation (e.g., mandatory car insurance).

What are the advantages of using Choice Architecture?

Choice architecture can:

• Influence behaviour towards desired outcomes.

• Simplify complex decisions.

• Lead to improved outcomes (e.g., healthier habits).

• Enhance decision quality by reducing biases.

What are the disadvantages of using Choice Architecture?

Choice architecture can:

• Be seen as manipulation.

• Raise ethical concerns about free choice.

• Be susceptible to biases inherent in its design.

• Lead to unintended consequences.

What is Nudge Theory, and who is associated with it?

Nudge theory is the practice of influencing choices that economic agents make, using small prompts to influence their behaviour. Richard Thaler coined the phrase 'nudge theory'.

Explain the EAST framework in Nudge Theory.

The EAST framework is proposed by Dr. David Halpern for nudging decision-making:

• Easy: Simplify or make choices straightforward.

• Attractive: Gain people's attention (e.g., personalized messages).

• Social: Influence individuals using what other people do.

• Timely: Identify when people are most responsive to nudges.

What are the advantages of using Nudge Theory?

Nudge theory is:

• Cost-effective compared to other marketing measures.

• Preserves freedom of choice while steering individuals.

• Can improve public health (e.g., encouraging healthier behaviours).

• Supports better decision-making.

• Contributes to environmental sustainability.

What are the disadvantages of using Nudge Theory?

Nudge theory has:

• Ethical concerns, as it can be manipulative and raises questions about autonomy.

• A lack of transparency, making it hard for individuals to question influences.

• Potential for unintended consequences (e.g., citizens working against nudges).

• Variable success rates among individuals.

What is the rational business objective for most firms?

The rational business objective for most firms is profit maximisation.

How do profits benefit shareholders?

Profits benefit shareholders as they receive dividends and also increase the underlying share price, which increases their wealth.

What is the profit maximisation rule?

Firms follow the profit maximisation rule when marginal cost (MC) equals marginal revenue (MR).

Explain how firms achieve profit maximisation based on marginal cost and marginal revenue.

1. When MC < MR, additional profit can still be extracted by producing an additional unit of output.

2. When MC = MR, no additional profit can be extracted by producing another unit of output.

3. When MC > MR, the firm has gone beyond the profit maximisation level of output and is making a marginal loss on each unit produced.

What are the advantages of pursuing profit maximisation?

Advantages include:

• Financial Stability and Growth

• Shareholder Value Creation

• Resource Allocation Efficiency

What are the disadvantages of pursuing profit maximisation?

Disadvantages include:

• Ethical and Social Concerns

• Risk of Neglecting Non-Financial Metrics

• Potential for prioritizing short-term profits over long-term value creation

What is Revenue Maximisation as a sign of growth?

Firms aim to maximise revenue to increase output and benefit from economies of scale. In the short-term, this strategy can eliminate competition due to lower prices compared to profit maximisation.

What is the output level for Revenue Maximisation?

To achieve revenue maximisation, firms produce up to the level of output where marginal revenue (MR) equals zero.

What is Market Share (Sales Maximisation) as a sign of growth?

Sales maximisation is a business objective that further lowers prices and has the potential to increase market share by producing at the level of output where average cost (AC) equals average revenue (AR).

What happens to profit at the sales maximisation level of output?

At the sales maximisation level of output (where AC = AR), the firm is breaking even and making normal profit.

What are the advantages of pursuing growth as a corporate objective?

Advantages include:

• Increased market share and competitive advantage

• Improved financial performance and shareholder value

• Stimulation of innovation and attraction of top talent

• Creation of opportunities for employees

What are the disadvantages of pursuing growth as a corporate objective?

Disadvantages include:

• Inherent risks and complexities (e.g., straining resources, disrupting processes)

• Potential for loss of focus if diversifying into unrelated markets

What is Satisficing?

Satisficing refers to the pursuit of satisfactory or acceptable outcomes rather than profit maximisation. It is a decision-making approach where businesses aim to meet a minimum threshold or standard of performance rather than striving for the absolute best outcome.

Why do small or large firms often satisfice?

Small firms may satisfice around the desires of the business owner for well-being. Large firms often satisfice due to the principal-agent problem, where managers (agents) settle for an output level between profit and sales maximisation to increase their wages and reduce conflict with shareholders (principals).

What are the advantages of pursuing Satisficing?

Advantages include:

• Opportunity for internal stakeholders to develop a healthy work-life balance or focus on other important goals.

• Reduces decision-making costs and speeds up the decision-making process.

What are the disadvantages of pursuing Satisficing?

Disadvantages include:

• Potential for mediocrity or suboptimal results, missing out on opportunities.

• May discourage the pursuit of innovative and creative solutions.

• Risk of falling short of higher expectations, leading to dissatisfaction.

What is Corporate Social Responsibility (CSR)?

Corporate Social Responsibility (CSR) involves conducting business activity in an ethical way and balancing the interests of shareholders with those of the wider community.

Give examples of Corporate Socially Responsible activities.

Examples include:

• Sustainable sourcing of raw materials and components.

• Responsible marketing practices.

• Protecting the environment (e.g., offering discounts for reusable cups).

• Responsible customer service (e.g., price matching).

What are the advantages of CSR objectives?

Advantages include:

• Enhancing business image and reputation.

• Attracting stakeholders and potentially being profitable.

• Improving employee motivation and productivity.

• Helping to recruit strong candidates.

• Contributing to solving social problems.

What are the disadvantages of CSR objectives?

Disadvantages include:

• Significant financial and resource commitments.

• Increased expectations from stakeholders.

• Challenges in defining and measuring the impact of CSR initiatives.

• Risk of 'greenwashing' or 'socialwashing' if not genuinely committed.

Why might firms find it difficult to achieve profit maximisation in reality?

Firms may not know the exact profit maximisation level of output, may avoid frequent price changes due to changing marginal costs to prevent disrupting customers, or might be forced to change prices by regulators.

What is a potential negative consequence of profit maximisation for consumers?

The profit maximisation level of output often results in high prices for consumers.

How do large companies commonly demonstrate their commitment to CSR?

Large companies often publish annual Corporate Responsibility Reports, auditing the steps taken to meet commitments to stakeholders alongside financial reports.

What is a potential impact of CSR on consumers due to associated costs?

Extra costs involved in operating in a socially responsible way may be passed on to consumers as higher prices.