Unit 2

• Utility


  The total satisfaction received from consuming a good or service
• Marginal utility


  The extra satisfaction derived from consuming one extra unit of the good
• Demand curve is downward sloping


  Because of diminishing marginal utility
• Consumer surplus generally declines with extra units consumed

  Because the extra unit generates less utility than the one already consumed
• Consumers are willing to pay less for extra units
• Utility maximisation for consumers


  Aim to generate the greatest utility possible from an economic decision
• Utility maximisation for firms


  Aim to generate the highest profits possible
• It is assumed that economic agents only act in their own interests
• Some firms might have philanthropic owners who seek to maximise the utility of others
• Rational economic decision making

  Economic agents respond to incentives, which can allocate scarce resources to provide the highest utility to each agent
• Positive incentives


  Rewards which will make consumers better off
• Negative incentives

  Penalties which make consumers worse off
• Where incentives are not given properly, resources will be misallocated
• Prices in market economies

  Provide signals to buyers and sellers, which is an incentive to purchase or sell the good
• High demand and high price for a good


  Gives an incentive to firms to allocate more resources to producing that good
• Entrepreneur wants to avoid loss and gain profit


  Makes them want to innovate, so they can reduce their production costs, and improve the quality of their products
• Firms need an incentive to engage in risk taking, so they innovate
• Without innovation (i.e. new tech), production will cost more and there will be a misallocation of resources
• Intuitive decision making


  Uses the feelings or instincts of the consumer and does not use facts
• Rational decision making

  Involves analysis and facts, and follows several steps

  
• Steps in rational decision making

  1. Identify the problem

  2. Find and identify the decision criteria

  3. Weigh the criteria

  4. Generate alternatives

  5. Evaluate alternative options

  6. Choose the best alternative

  7. Carry out the decision

  8. Evaluate the decision

  
• Rational decision making is not always the best or most realistic way for firms to make decisions

  
• Rational decision making takes significantly longer to decide, which is not practical in a firm with strict time constraints
• Thinking at the margin

  Thinking about the effect of an additional action
• Thinking at the margin allows consumers to keep thinking ahead and prevents them from thinking about things they have already done
• Thinking at the margin allows consumers to consider how to maximise their utility now or in the future
• Thinking at the margin can increase productivity, since the most important tasks which maximise utility the most, are the ones which are prioritised
• Symmetric information

  Consumers and producers have perfect market information to make their decision
• Imperfect information


  Information is missing, so an informed decision cannot be made
• Imperfect information


  Leads to a misallocation of resources
• Imperfect information

  Consumers might pay too much or too little, and firms might produce the incorrect amount
• Asymmetric information


  Unequal knowledge between consumers and producers
• Asymmetric information


  Leads to market failure
• Asymmetric information


  • Car dealer knows about a fault with the car that the consumer is unaware of
  • Consumers know more information than the producer when purchasing insurance policies
• Principal-agent problem


  The agent (politicians or managers) makes decisions for the principal (voters or shareholders), but the agent is inclined to act in their own interests, rather than those of the principal
• Principal-agent problem


  • Shareholders and managers have different objectives which might conflict
  • Managers might choose to make a personal gain, rather than maximise the dividends of the shareholders
• Making information more widely available

  1. Advertising

  2. Government intervention
• Making information more widely available

  • Harmful effects of smoking made public through adverts and messages on cigarette boxes
• Bounded rationality


  Individuals are rational decision makers who endeavour to maximise their utility, but have limitations
• Administrative Man model

  • The first alternative that is satisfactory is selected
  • The decision maker recognises that they perceive the world as simple
  • The decision maker recognises the need to be comfortable making decisions without considering every alternative
  • Decisions could be made by heuristics