Behavioural economics

Behavioural Economics disputes rationality and utility maximization arguing that emotional, social and psychological factors can influence decision maxing.

It adds on to traditional economics, its there to replace it but fill in the gaps

Where economics can let us down a bit.

Rational Consumer - will gather up all the info on the good, will then analyse the pros and cons and then take time and make a utility maximizing decision.

Behavioural consumer - They wont all make a decision based on that. How?

In three ways

1) they might not have the time

2) The choice out there is so large so they can’t evaluate, all the pros and cons of a good.

3) the information doesn’t exist, is not clear, really complex, asymmetric information.

Consumers are bounded by self - control - gets in the way.

Consumers follow heuristics (rule of thumb) to make satisfying decisions. (Easy decision to make)

Utility Theory

Marginal utility is the extra utility gained when one extra unit has been consumed.

Average utility is the total utility divided by the total utility.

Law of diminishing utility - as quantity consumed increases the marginal utility derived from each extra unit decreases.

Total utility is maximized

Where: Marginal utility is equal to 0

Consumer surplus - The difference between the price a consumer is willing to pay and the price they paid.

Producer surplus - the difference between the price producers are willing and able to supply a good for and the price they actually receive.

Society surplus is consumer surplus + producer surplus.

Paradox of value, economist struggled with the problem of what determines the relative prices of products. The value consumers place on the last unit consumed of any product, its marginal utility, is equal in equilibrium, to the products price.

Implications of marginal utility theory on demands curves is that they are all negatively sloped. This is because if consumers where already maximizing utility and the price of one product fell, to restore equilibrium consumers would have to by more of that product.

The indifference curve shows combination of two goods that yield equal satisfaction and between which the consumer is indifferent.

Budget line shows all the combinations of the goods which are obtainable by a consumer

Equilibrium occurs when the budget line is a tangent to the indifference curve.

Substitution effect - when a change in the price of a good makes it more or less expensive relative to other goods, causing consumers to substitute one good for another.

income effect - a change in the price of a good affects the consumers purchasing power, changing their real income.

Difference between income effect and substitution effect

Substitution effect leads to an increased consumption of the thing whose price has fallen. The income effect leads to an increased consumption of both goods.

Substitution effect on affects demand for substitutes and compliments, income effect affects all goods.

Price discrimination - Where a firm charges different prices to different consumers for an identical good/service with no differences in cost of production.

Conditions necessary for price discrimination.

1) Price making ability (Monopolistic powers)

2) information to separate the market - indentify different consumers via price elasticity of demand.

Charge higher prices to inelastic demand consumers.

Identify consumer with price elastic demand to charge lower prices.

3) Prevent Re-Sale (Market seepage)