Behavioural Economics & Rational Decision Making (Theme 1)

• What is utility

  The satisfaction a consumer derives from consuming a good or service
• What is marginal utility

  The extra utility derived from consuming one more of a certain good
• What is the law of diminishing marginal utility

  As quantity consumed increases the marginal utility derived from each extra unit decreases
• How do we calculate Average utility

  Total Utility / Quantity
• How do rational consumers maximise their utility

  A rational consumer will maximise their utility by consuming until MU = P
• Why are the MU and AU curves downward sloping

  Because of the law of diminishing marginal utility
• What can prevent consumers from acting in a rational utility maximising way

  Imperfect information
• What are the 2 ways information can be imperfect

  Through: 1 A lack of information - If information doesn’t exist or isn’t presented clearly there could be an underconsumption or overconsumption of goods and services taking place where consumers consumers make irrational decisions

  2 Asymmetric information - When information exists but isn’t shared equally between two parties
• How can asymmetric information lead to irrational decision making in second hand markets

  In second hand markets the buyer always lacks the information whilst the seller has all the information. This can lead to the buyer making an irrational decision to purchase that Good / service even if it doesn’t maximise their utility
• What does behavioural economics dispute

  Behavioural economics disputes rationality and utility maximisations arguing that emotional, social and psychological factors can influence decision making.

  These factors are known as cognitive biases.

  It disputes the idea consumers are always rational and aim to maximise utility
• What does traditional economics suggests

  According to traditional economics consumers are always rational and maximise their utility when making consumption decisions.

  According to traditional economics, when making decisions consumers gather all the available information and then evaluate that information by weighing up the costs and benefits. They’ll then take time to consider all of that information and then make a rational utility maximising decision
• What does behavioural economics suggest consumers do

  According to behavioural economics consumers aren’t necessarily rational and so they may not always look to maximise utility

  This could be due to: 1 Bounded rationality

  2 Bounded self-control
• How can consumers end up having bounded-rationality

  1 Consumers may not have the time to weigh up costs and benefits of information to make a satisfactory utility maximising decision

  2 The choice of goods and services may be so large, that it becomes overwhelming for consumers to evaluate every single cost and benefit

  3 The information may not exist, be clear, be asymmetric, too complex or there could be a lack of it

  These ultimately prevent consumers from maximising utility
• How does bounded self-control lead to irrational decision making

  If consumers have poor self control or are bounded to their self control they may be incapable of making rational decisions that maximise their utility, even if they have adequate information
• Behavioural economics suggest consumers may follow heuristics due to bounded rationality and bounded self-control. These are simple ways of making decisions which will provide a satisfactory decision to be made
• What is rational decision making

  The ability for consumers to make ratIonal decisions that maximise their utility
• What are the different cognitive biases that influence rational decision making

  Price Anchoring

  Social Norms

  Availability Bias

  Framing

  Loss Aversion

  Herd Behaviour

  Choice Architecture

  Habitual Behaviour
• What is price anchoring

  This is where a value is imprinted in our mind as a reference point to compare prices. For example, shops having recommend retail prices on price labelling. This creates an anchor in our mind and we compare the actual price to the recommended retail price which is usually lower. Due to the actual/ retail price being lower than the anchored price in our head it makes consumers believe they’re getting a great deal
• What are social norms in terms of cognitive biases

  This is when our decisions are influenced by rules created by society. For example getting a gift for your friend’s birthday
• What is availability bias

  This is when we make decisions based on how easy it is to create examples in our head

  For example if you know an elderly person who smokes but is still healthy that example may come into mind when deciding whether to smoke or not, increasing the likelihood of the individual doing it
• What is framing

  The idea of us being influenced by the way information is presented to us
• What is Loss aversion

  The idea that we don’t like to lose things that we have a value toward.

  For example consumers are unlikely to risk putting money into other things that could provide more money and utility such as investment, because they don’t want to take the risk of loosing that money.

  This leads to the endowment effect, which is when individuals attach too much monetary value to something they have compared to something you can gain
• What is herd behaviour

  When people take decisions based on the actions of others, rather than rationally evaluating the situation and making a choice themselves
• What is choice architecture

  The idea that our decisions are influenced based on the location or placement of something

  For example if stairs are positioned at the front of the building and escalators are at the back, individuals are more likely to use the stairs, promoting healthy exercise
• What is habitual behaviour

  When consumers persist in acting a particular way even when conditions have changed

  For example individuals paying for a gym membership even when they don’t go to the gym may pay for it due to inertia ( meaning it’s easier to keep paying than to cancel the membership) or because they have good intentions
• What does the nudge theory suggest

  The nudge theory suggests people’s behaviours can be influenced by making desireable decisions easy.

  Firms and governments have become aware of the nudge theory and now try to exploit it.

  This exploitation can occur through nudge policies.
• What are the different nudge policies

  Framing

  Nudges

  Default choice

  Restricted choice

  Mandated choice
• What are nudges

  Influencing the behaviour of people through subtle interventions or changes in the environment.

  For example the location of salad bars in canteens can influence the likelihood of people eating them.
• What is a default choice

  When individuals are automatically assigned to a particular option / scheme until they choose to opt out of it.

  This exploits peoples’ reluctance to make decisions which encourages a specific behaviour.

  For example, automatically enrolling employees into a workplace pension scheme but allowing them to opt out if they choose to do so
• What is a restricted choice

  When you limit the number of choices available for a consume.

  For example public smoking bans restricts the choice smokers have by limiting the amount of areas they can smoke, meaning they have less choice.

  This gives them the incentive to stop smoking.
• What is a mandated choice

  Making people make one choice or the other instead of defaulting to inaction. This requires individuals to actively choose between options, which makes them more likely to consider the cost and benefits of their decisions, which encourages rational behaviour.
• What is an example of a mandated choice

  For example many councils have different coloured bins to encourage recycling. This forces people to make a choice of deciding what bin to use which overcomes inertia by preventing people from doing nothing
• What are issues of nudge policies

  1 Too Paternalistic - Nudge policies can reduce the free will of individuals as they’re not making decisions entirely on their own. If consumers feel manipulated they may loose trust in policy makers / the government. This can lead to resistance to future policies that may benefit consumers. As a result government failure occur.
• What are issues of nudge policies (2)

  2 Unpredictable and Costly - There’s no guarantee that these policies may work as consumers may not necessarily act in the way that was intended by the policy.

  Moreover, many nudge policies have large administration Costs. If the costs outweigh the benefits there may be a risk of government failure.

  As a result the overall effectiveness of the policy is reduced.
• What are issues of nudge policies (3)

  3 The policies are based on the fact that people are influenced by biases - These nudge policies believe individuals are heavily influenced by biases which may not always be the case. As a result these policies, will be less effective in altering individuaL / consumer behaviour

  4 Policies may not be strong enough - The policies may not be strong enough in solving deep-rooted issues such as over drinking. This limits their effectiveness
• What is EVAL of nudge policies

  1 Cost Vs Benefits - If there’s greater costs than benefits obtained from these policies, government failure can occur, so the government should avoid using such policies

  2 Information Provision may be better - If the lack of information / imperfect information is the root cause of cosumers’ irrational decision making, information provision would be more suitable to alter consumer behaviour
• What is EVAL of nudge policies (2)

  3 Shove Policies may be better - Shove policies such as taxation, subsidies, regulation may be better suited to solve market failures