4.1.2 Individual economic decision making Flashcards
(15 cards)
Explain Rational Economic Decision Making.
Rational Choice Theory
- Theory of economics that assumes that individuals always make decisions that provide them with the highest amount of personal utility.
- These decisions provide people with the greatest benefit of satisfaction given the choices available.
Define marginal utility.
- Extra utility generated when extra unit is consumed.
- Equal to MPB when unit is consumed.
State how average utility is calculated.
Total utility / Quantity
State why the average utility + marginal utility curves are downward sloping.
• Both downward sloping due to law of diminishing marginal utility.
Define the law of diminishing marginal utility.
• As quantity consumed increases, marginal utility derived from each extra unit decreases.
State when total utility is maximised.
- Total Utility maximised where marginal utility = 0.
Explain how a lack of information has an impact on decision making.
- Overconsumption Of De-Merit Goods: not enough information out there informing consumers of how bad consuming these demerit goods are for individual consumer (e.g. cigarettes, alcohol, e.t.c.).
- Underconsumption of Merit Goods: not enough information informing consumers of how beneficial consuming good is for them (e.g. healthcare, education, exercise). Thus irrational decisions made - not utility maximising.
Explain how asymmetric information has an impact on decision making.
Asymmetric Information: information exists, but isn’t shared equally between 2 parties.
* Labour Markets: between employer + potential worker - has all information about how they work, productivity, work ethic, e.t.c. Employer doesn’t have information + is trying to get it - not necessarily going to be perfect. Thus employer make irrational decision to employ worker - not maximising benefits.
* Second Hand Markets: buyer is lacking information, whereas seller has information - buyer may make irrational decision, even though it wont maximise utility of buy er.
* Insurance Markets: insurance company doesn’t have information - difficult to issue P for insurance. For individual, always incentive to underreport level of risk - to keep insurance P low - not good for insurance company - leads to irrational decisions being made. Notion of moral hazard - if insurance is gaining insurance, but not bearing C of taking on risk + instead insurance company bears C - may lead to individual taking more risks - not in interest of insurance company.
Define behavioural economics.
- Behavioural economics disputes rationality + utility maximisation arguing that emotional, social + psychological factors can influence decision making.
• Consumers aren’t always rational. - Rationality may be bounded- may not have time to make decision, too much choice overwhelms consumer, or information may be lacking / asymmetric.
- Self-Control may be bounded: decision making limited by self-control, have good intentions but lack self-control (e.g. cigarettes, exercise, e.t.c.).
- Consumers follow heuristics: (rule of thumb) to make satisficing decisions (decisions where utility may be sacrificed, but satisfactory outcome will be end result)
State + explain the cognitive biases.
- Anchoring: value is imprinted in our mind as reference point to compare P to (e.g. shops + supermarkets - RRP - creates anchor in mind - compare actual P to RRP) - makes us thing were getting a good deal.
- Social Norms: decisions influenced by rules society has dictated (e.g. tipping in restaurants).
- Availability Bias: make decisions based on how easy it is to conjure up examples - even if examples inflate real possibility of that thing happening (e.g. going swimming in Australian sees - may decide not to due to perceived high risk of shark attack - easy for us to come up with example easily - over inflate risks, even though unlikely to happen. Smoking - elderly relative that’s smoking their whole lives + is relatively healthy - thus think smoking isn’t that risky).
- Framing: idea of us being influenced by the way in which information is presented to us (e.g. if low fat is advertised on product + information is framed in certain way - were more likely to consume it, given we’re influenced by it).
- Loss Aversion: idea that we don’t want to give things up / lose things that we have value towards (e.g. money - instead of I it that may give us more money / utility - we don’t take that risk because we don’t like idea of potentially loosing money - even if risk is very low). Leads to endowment effect - attaching too much monetary value to something you have, compared to something else you could gain.
- Herd Behaviour: making decision because others around us have made same decision (e.g. bull markets - lots of people I in certain stock - another investor makes same decision to buy that stock because everyone else is doing it - can lead to bubble - leads to crash).
- Choice Architecture: idea that our decisions are influenced based on location / placement of something (e.g. location of salad bar in restaurant - if at front of restaurant more likely to consume).
Explain altruism.
- Idea of kindness / selflessness - consumers don’t expect anything back in return for selfless activity.
- Example: charity - traditional economists may suggest that giving to charity may increase utility for individual. Whereas behavioural economics gives better understanding - consumers aren’t all the time utility maximising - they have morals / emotions that influence decision making.
State + explain the choice architecture policies (nudge policies).
Very different to traditional (shove) policies (e.g. taxes, subsidies, regulation, e.t.c.) - whereby they’re forced onto individuals. In contrast with nudge policies, where individuals aren’t forced - they’re nudged to do something, but still have freedom / choice.
* Framing: way in which information is presented to us. Thus, certain policies could be to improve the way low fat, low sugar, low cholesterol, e.t.c. is presented - making decision making more informed + socially desirable. Could be recycling, P information, e.t.c.
* Nudges: ways in which we can be influenced by location / product placement (e.g. positioning salad bars in areas where people are more likely to eat salads, discourage unhealthy options by repositioning where they’re located in supermarkets).
* Default Choice: going to be opted into something, unless we opt out (e.g. organ donation, pension enrolment, salad with burgers).
* Restricted Choice: restricting number of choices available to consumer (e.g. smoking ban - restricts number of places consumers can smoke - disincentivises smoking, school choices - removing unhealthy options from school menus, license plate bans in China - incentive to use public transport instead, e.t.c.)
* Mandated Choice: have to make a choice whether you want to do something (e.g. recycle bins, organ donation.
State + explain the issues with choice architecture policies.
- Too Paternalistic: is gov going too far in influencing are decision making - making decision about what is socially desirable.
- Unpredictable + Costly: no guarantee they’ll work at all - no guarantee consumers will react, can be very costly - big administration costs. If C outweigh benefits - risk of government failure.
- Based On Fallacies + Biases: people may argue that, as individuals, we’re not going to cecum to fallacies + biases that these policies are based on - idea that people are stupid may be looking at people the wrong way + dumbing down that people can make decisions individually.
- Strong Enough Policies? To overcome deep rooted issues (e.g. addiction, information failures, e.t.c.).
Evaluate the use of choice architecture policies.
- Costs Vs. Benefits: are there more costs or benefits - if more costs - government failure risk - argument that gov should stay away from these policies.
- Information Provision Better? If the root cause is under / overconsumption of demerit / merit goods - information provision may be a better policy.
- Integrated Policy Best Approach: shove policies may be better to deal with deep-rooted market failures, as opposed to smaller scale nudge policies. Nudge Policies could be used alongside shove policies - to achieve socially optimum.
Define libertarian paternalism.
- Guiding choices in the public interest while preserving liberty.
