4.1.2 Individual economic decision making

what is rational behaviour / decision making?

assumes individuals make choices that maximise their satisfaction, using incentives and marginal reasoning to allocate scarce resources efficiently

what does traditional economic theory assume about economic agents (producers, consumers, workers)?

economic agents are:

• utility maximisers

• rational

how are economic agents assumed to act rationally?

• consumers - aim to get the most happiness (maximise utility) from what they buy

• producers - focus on making the most profit from selling goods and services

• workers - try to balance job satisfaction, pay, and benefits

• govts - expected to put people’s welfare first to create the greatest good

what is total utility?

the overall satisfaction / benefit gained from consuming a good or service

what is marginal utility?

the benefit gained from consuming one additional unit of a good or service

what is the law of diminishing marginal utility?

for each additional unit of good that’s consumed, the marginal utility gained decreases

(e.g. each additional biscuit eaten gives a consumer less satisfaction than the previous one)

how does the law of diminishing marginal utility explain why the demand curve slopes downwards?

• suggests consumer surplus generally declines w/ extra units consumed

• → the extra unit generates less utility than the one already consumed

• therefore, consumers are willing to pay less for extra units

what is utility maximisation?

when consumers aim to maximise personal welfare by evaluating the costs and benefits of alternatives to choose the option that increases their net utility

what is meant by the margin when making choices?

the change in a variable caused by an increase of one unit of another variable

what is “thinking at the margin”?

• thinking about the effect of an additional action

• an action could involve a marginal increase in product or marginal cost

what’s the importance of the margin when making choices?

• helps consumers think ahead rather than past decisions

• allows them to maximise their utility now / in the future

• also boosts productivity → (most important tasks which maximise utility the most are prioritised)

what is imperfect information?

when economic agents lack accurate or complete data to make rational decisions

why is imperfect information important in economics?

can cause market failure leading to

• wrong choices

• misallocation of resources

• inefficient markets

what is information failure/gaps?

a type of market failure where individuals or firms have a lack of information about economic decisions

(evident in real markets unlike perfectly competitive markets which assume full knowledge)

what are four causes of information failure?

1. long term consequences (e.g. consuming legal highs)

2. complexity (e.g. pensions)

3. unbalanced knowledge between buyer and seller

4. price information gaps (misleading prices from monopolies)

what is symmetric information (perfect information)?

buyers and sellers have exactly the same level of information about the good or service in the market

what is asymmetric information?

buyers and sellers have different levels of information

(e.g. in the used car market: sellers know more about the vehicle than buyers - Akerlof’s “lemons” market)

what is a moral hazard (asymmetric)?

one party takes more risks as they know the other party will bear the costs if things go wrong

e.g. insured people and their insurer

what is adverse selection?

asymmetric information causes the “wrong” people to self-select into a market

how does adverse selection create market failure in insurance?

• high risk individuals more likely to seek insurance

• insurers raise average premiums

• low risk/healthy consumers are priced out

• high risk individuals remain insured

• → market failure (under provision of insurance)

how can governments address information failure?

• imposing regulations

• transparency (e.g. labelling the risks of cigarettes)

• provide consumer education

how does information failure relate to merit and demerit goods?

• consumers undervalue merit goods (education, vaccines) because they don’t know all the benefits → underconsumption

• underestimate harms of demerit goods (smoking, gambling) → overconsumption

both misallocation of resources

what is behavioural economics?

a method of economic analysis that applies psychological insights into human behaviour to explain how individuals make choices and decisions

how does behavioural economics differ from traditional economics?

• questions the assumption that people are rational decision makers who aim to maximise their utility

• shows decisions are influenced by emotional, social and psychological factors

what is bounded rationality?

when making decisions, an individual’s rationality is limited by

• the information they have

• the limitations of their mind

• the finite amount of time available in which to make decisions

what is satisficing?

• a result of bounded rationality

• individuals settle for an option that is “good enough” (satisfy + sacrifice)

(instead of maximising)

what is bounded self-control?

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

(e.g. dieting, saving money, exercising)

what are the four key decision making biases?

1. rules of thumb (heuristics)

2. anchoring

3. availability

4. social norms

what are rules of thumb?

thinking shortcuts / informed guesses individuals use to make decisions in order to save time and effort

e.g. choosing the middle-priced option when faced w/ a range of different prices for similar products

what’s anchoring?

placing too much emphasis on one piece of information

e.g. the first price quoted for a job can influence the view of what’s a fair price

what’s availability bias?

when judgements are made about the probability of events based on recalling recent instances

e.g. overestimating plane crash risk after hearing about a recent accident

what are social norms?

when individuals are influenced by others when making decisions

e.g. purchasing certain goods because peers do so, regardless of personal need

what are the biases of altruism and fairness?

when individuals are motivated to do the right thing

e.g. giving to charity