1.2.1 Rational decision making

• Behavioural economics


  An area of economics that studies how psychological, social, cognitive, and emotional factors affect economic decisions
• Utility


  The total satisfaction received from consuming a good or service
• Daniel Kahneman


  • Nobel Prize winner in Economic Sciences for his work on behavioural economics
  • Devised a two-system model which explains how decisions are made
• Two-system model of decision making

  1. System 1: Based on common sense estimates and emotional responses, uses shortcuts and quick decisions, dominant but prone to bias and errors

  2. System 2: Takes longer, uses thoughts and reflections, avoids bias and errors of System 1, but can be manipulated
• Intuitive decision making


  Using feelings or instincts, does not use facts
• Rational decision making


  Using several steps, involving analysis and facts
• Rational decision making process

  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
• Bounded rationality/Administrative man theory

  • First satisfactory alternative is selected
  • Recognises the need to make decisions without considering every alternative
  • Decisions can be made using heuristics
• Heuristics


  Simplify the decision making process to come to a reasonable decision, avoid taking too long and having imperfect information
• Heuristics used by consumers

  • Using common sense or intuition
  • Considering goods on sale
  • Having pre-decided criteria or rules-of-thumb
• Heuristics can lead to irrational decisions being made