2.4 - Behavioural Economics

Assumptions of Rational Consumer Choice

• free markets are built on the assumptions of rational decision making

• in classical economic theory, rational means economics agents are able to consider the outcome of their choices and recognise the net benefits of each one

  • rational agents - will select the choice that reaps highest benefit/utility

• Rational choice theory - individuals use logic and sensible reasons to determine the correct choice (connected to an individual’s self-interest)

• Consumer Rationality

  • assumption that individuals use rational calculations to make choices which are within their own best interest (using all information available to them)

• Utility Maximization

  • economic agents select choices that maximize their utility to the highest level

• Perfect Information

  • information is easily accessible about all goods/services on the market

  • individuals have access to all information available at all times in order to make the best possible decision

Limitations of Assumptions of Rational Consumer Choice

• behavioural economics recognizes that human decision-making is influenced by cognitive biases, emotions, social, and other psychological factors that can lead to deviations from rational behaviour

• individuals are unlikely to always make rational decisions

• 5 limitations are shown below:

1. Biases

• biases influence how we process information when making decisions = influence the process of rational decision making

  • example: common sense, intuition, emotions, personal/social norms

• Types of Bias

  • Rule of Thumb - individuals make choices based on their default choice gained from experience (ex: same product from same company, but not the best possible choice)

  • Anchoring and Framing - individuals rely too heavily on an initial piece of information (anchor) when making subsequent judgements or decisions (ex: car dealer says car is worth $10,000 and you know it’s worth less, but this anchor of information causes you to purchase the car for a higher price)

  • Availability - individuals rely on immediate examples of information that come to mind easily when making judgements/decisions (causes individuals to overestimate the likelihood/importance of events/situations based on how readily available they are in their memory)

2. Bounded Rationality

• people make decisions without gathering all necessary information to make a rational decision within a given time period

• rational decision making is limited because of

  • thinking capacity

  • availability of information

  • lack of time available to gather information

• too many choices also cause people to make irrational decisions

  • example: in a supermarket, there are too many choices of products of the same good, making it difficult to reach a decision

3. Bounded Self-Control

• individuals have a limited capcity to regulate their behaviour and make decisions in the face of conflicting desires or impulses

  • self-control is not an unlimited resource

• because humans are influenced by family, friends, or social settings, it causes social norms to interfere in decision making (does not result in the maximization of consumer utility)

• decision making based on emotions → does not yield the best outcome

• businesses capitalize on the lack of bounded self-control of individuals when appealing to their target audience to maximize sales

4. Bounded Selfishness

• economics agents do not always act within their own self interest

• individuals do things for others without a direct reward

  • ex: altruism - selflessness without expecting anything in return

5. Imperfect Information

• information is not perfectly accessible due to:

  • intelluctual property rights

  • cost of accessing information

  • amount of information and options available

• people make decisions based on limited information

• asymmetric information may also lead to decisions based on limited information

  • when one party has more information than another

Choice Architecture

• intentional design of how choices are presented so as to influence decision making

• simplifies the decision making process

• 3 types, as shown below:

1. Default Choice

• individual is automatically signed up to a particular choice

• decision is already made even when no action has been taken

• individuals rarely change from the default change

2. Restricted Choice

• choices available to individuals are limited which helps individuals make more rational decisions

3. Mandated Choices

• requires individuals to make a specific decision or take a particular action by imposing a requirement or obligation

• mandated choices can be used to ensure compliance with regulations or societal norms, making it necessary for individuals to make certain decisions

Nudge Theory

• practice of influencing choices that economic agents make, using small prompts to influence their behaviour

• firms should use nudges in a responsible way to guide and influence decision making

• designed to guide people toward certain decisions or actions while still allowing them to have freedom of choice

• consumer nudges should be designed with transparancy, respect for individual autonomy, and clear societal benefits in mind

Profit Maximization

• most firms have the rational business objectiveof profit maximization

  • profits benefit shareholders as they receive dividends and also increase the underlying share price

    • an increase in the underlying share price increases the wealth of the shareholder

• profit maximization rule

  • when MC=MR, then no additional profit can be extracted from producing another unit of output

  • when MC<MR, additional profit can still be extracted by producing another unit of output

  • when MC>MR, the firm has gone beyond the profit maximization level of output and starts making a marginal loss on each unit produced (beyond MR=MC)

• in reality, firms find it difficult to produce at the profit maximization level of output

  • the level may be unknown

  • in the short term, they may not adjust their prices if the marginal cost changes

    • MC changes regularly and regular price changes would be disruptive

  • in the long-term, firms will seek to adjust prices to the profit maximization level of output

  • firms may be forced to change prices by the competition regulators in their country

    • profit maximization level of output often results in high prices for consumers

    • changing prices changes the marginal revenue

Growth

• increasing sales revenue/market share

• maximize revenue to increase output and benefit from economies of scale

  • a growing firms is less likely to fail

1. Revenue Maximization as a Sign of Growth

• in the short-term, firms may use this strategy to eliminate the competition as the price is lower than when focusing on profit maximization

• firms produce up to the level of output where MR=0

  • when MR>0, producing another unit of output will increase total revenue

2. Market Share as a Sign of Growth

• sales maximzation which further lowers prices and has the potential to increase market share

  • occurs at the level of output where AC=AR (normal profit/breakeven)

• firms may use this strategy to clear stock during a sale to increase market share

  • firms sell remaining stock without making a loss per unit

Satisficing

• pursuit of satisfactory/acceptable outcomes rather than profit maximization

  • decision-making approaach where businesses aim to meet a minimum threshold or standard of performance rather than striving for the absolute best outcome

• small firms may satisfice around the desires of the business owner

• many large firms often end up satisficing as a result of the principal agent problem

  • when one group (the agent) makes decisions on behalf of another group (the Principal), often placing their priorities above the Principal’s

Corporate Social Responsibility (CSR)

• conducting business activity in an ethical way and balancing the interests of shareholders with those of the wider community

• extra costs are involved in operating in a socially responsible way and these costs must be passed on to consumers

2.7 - Government Intervention

Why do governments intervene in markets?

• Influence (increase/decrease) household consumption

• provide support to firms

• earn revenue

• influence the level of production of firms

• provide support to low-income households

• correct market failure

• promote equity

Microeconomic forms of government intervention

• price controls

• indirect taxes

• subsidies

• direct provision of services

• command and control regulation and legislation

• consumer nudges

Price controls

• price ceiling + price floor

• Price Ceiling

  • maximum price

  • below equilibrium point

  • the point where the price ceiling is set is Pmax

    • at Pmax, firms are willing to supply Qmax but the consumers demand a quantity above Q*

  • 

    • shaded area - 2 triangles, a and b

      • a = amount by which consumer surplus is reduced

      • b = amount by which produer surplus is reduced

  • excess demand shown by the values Qmax - Q1

    • managed through subsidies and tax breaks → costs

• Price Floor

  • minimum price

  • above equilibrium point (Pmin)

  • common in agriculture

  • 

    • areas c, e, f, g, h are government expenditure → excess supply

  • producer surplus is increased (d+e → b, c, d, e, f)

    • f = directly from the government to the producers

  • a price floor creates welfare loss, indicating allocative inefficiency due to an overallocation of resources to the production of goods

  • society is getting too much of the good

Indirect taxes

• imposed on spending to buy goods and services

  • both consumers and producers pay a share of the tax

  • firms practically pay the tax

• excise taxes - imposed on particular goods/services (ex: imports)

• taxes on spending - value added tax (VAT) or goods/services tax (GST)

• direct taxes are those directly paid to the government by taxpayers

• an indirect tax creates a tax wedge

  • consumers face a higher price, while producers receive a lower price

• 

  • Qt - Q* → lost sales (potential sales but they are lost/didn’t happen because of the tax)

  • Pp - price for producers, marginal cost

  • area of rectangle = government revenue

  • Pc - price for consumers

  • Pc>Pp, so demand decreases

• 

  • shifts from S → S1

  • new equilibrium point formed at (Qt, Pc)

  • 2 triangles, a and b

    • a + b - welfare loss, Dead Weight Loss (DWL)

      • both disappear, allocative inefficiency

      • a - consumer surplus loss

      • b - producer surplus loss

  • 2 prices, C.S. and P.S. at different equilibriums

Subsidies

• assistance by the government to individuals (firms, consumers, industries)

• results in greater consumer and producer surplus

  • society loss as government spending on subsidy

• loss from government spending is greater than the gain in surplus

  • welfare loss (allocative inefficiency) due to overallocation of resources to the production of goods (overproduction)

• 

  • Pp and Pc switched (from indirect taxes), as consumers pay less and producers receive more

• 

  • a = dead weight loss (DWL) due to overproduction

  • supply curve shifts (S → S1) because of one of the non-price determinants of supply (subsidies)

    • S1 = S + subsidy

2.8 - Market Failures

• externalities are market failures, both positive and negative

Positive externality of consumption

• goods that when consumed, both the consumer and third parties benefit from it (ex: healthcare)

• 

  • MSC - marginal social cost

  • MPB - marginal private benefit

  • MSB - marginal social benefit

  • in a free market, people would consume where MPB=MSC (Q1, P1)

  • (Q*, P*) where MSB=MSC is the socially optimal level (potential welfare gain) because from Q1-Q*, MSB>MSC

  • if MPB shifts from Q1-Q* (toward MSB), then the welfare loss is gained (potential welfare gain = welfare loss)

• underallocation of resources to this market (underproduction)

Merit Goods

• goods that are beneficial to consumers but people do not consume enough

  • people underestimate/ignore potential benefits, caused by imperfect access to information

• causes the demand to be lower than it should be

• examples: healthcare, education

Government “fix”to positive externality of consumption

• subsidies/direct provision

  • shifts the MSC curve downwards

  • new socially efficient level at Q* but at a lower price (P2)

  • P2 < P1 < P*

  • 

• improving information (merit goods)

• legislation: government passing laws that force citizens to consume the good

Positive externality of production

• production of a good creates external benefits for third parties

  • ex: human capital: training employees

• 

  • MPC - marginal private cost

  • produces where MPC=MSB, where Q1 is located (Q1 < Q*)

  • if production increases to Q*, there is a welfare gain (welfare loss turned into welfare gain)

• underallocation of resources → market failure, allocative inefficiency

Government “fix” to positive externality of production

• subsidies

  • causes MPC to be shifted downwards

  • full subsidy causes MPC=MSC when shifted

• direct provision

  • high cost

  • offering training through the state for firms causes MPC=MSC

Negative externality of consumption

• consumption causes adverse effects to third parties

  • ex: second hand smoking

• in a free market, people maximize their private utility so they consume at MPB=MSC

  • there is a welfare loss as MSC>MSB from Q*-Q1

  • overconsumption of goods

  • too many resources allocated

Demerit Goods

• goods that are harmful to the consumer but people still consume either because they are unaware of or ignore the potential harm

  • caused by imperfect information

  • demand is higher than it should be

  • creates negative externalities when consumed

• example: cigarettes

Government “fix” to negative externality of consumption

• indirect taxes

  • taxes reduce consumption

  • 

• legislation/regulation

  • making laws against the overconsumption of demerit goods

• education/raising awareness

Negative externality of production

• production of a good negatively impacts third parties

  • example: fumes from a factory

• 

  • MSC<MPC so MPC=MSC+costs

  • MPC is below MSC, because there is an external cost added to society

  • producers produce at Q1

  • from Q1-Q*, MSC>MSB

  • welfare loss → market failure

Common Pool Resources

• rivalrous and non-excludable (linked to negative externalities)

  • rivalrous: if one person uses, others cannot at the same level of utility

  • non-excluable: very difficult to exclude people/groups of people from using

• typically natural resources

  • examples: fishing grounds, forests, atmosphere, etc.

Government “fix” to negative externality of production

• international agreements

• tradable permits

• carbon taxes

• legislations/regulations

• subsidies