Paper 1 hot topics

• Neoclassical thought


  Economic agents will always look to maximize their benefit
• Economic agents assumed to maximize

  • Firms - profits
  • Governments - social welfare of citizens
  • Workers - welfare derived at work
  • Consumers - utility
• Utility


  Satisfaction derived from consumption
• Marginal utility


  The extra utility gained when one more unit is consumed
• Average utility


  Total utility divided by quantity
• Marginal utility and average utility curves are downward sloping due to the law of diminishing 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 zero
• The shape of the total utility curve is derived due to the law of diminishing utility
• Rational consumer


  Consumes units up until where marginal utility is zero to maximize total utility
• Price is equal to utility

  Rational consumer will consume up until marginal utility is equal to price to maximize utility
• The marginal utility curve is the demand curve
• Price increases


  Quantity demanded decreases
• Price decreases


  Quantity demanded increases
• The downward sloping demand curve comes from the law of diminishing marginal utility
• According to traditional economic thought, consumers will look to maximize their utility where marginal utility is equal to zero or when there are prices for goods and services where marginal utility is equal to that price
• In the real world, something can break down where consumers don't make rational utility maximizing decisions
• Imperfect information


  Information that can prevent consumers acting in a rational utility maximizing way
• Ways information can be imperfect

  • Lack of information
  • Information not presented clearly
• Lack of information


  Can lead to over-consumption or under-consumption of products
• Merit goods are under-consumed because there is a lack of information regarding how good those products are for the individual consumer
• Demerit goods are over-consumed because there is a lack of information or the information is not clearly presented regarding how bad consuming these products is for the individual consumer
• Asymmetric information


  Information that exists but is not being shared equally between two parties
• Asymmetric information in labor markets


  • Employer lacks information about potential worker's productivity, skills, work ethic
• Asymmetric information in second-hand car markets


  • Seller has more information about the car's condition than the buyer
• Asymmetric information in insurance markets

  • Car driver has more information about their driving risk than the insurance company
• Moral hazard


  When an individual takes more risks because they are not bearing the cost of those risks, which is instead borne by the insurance company
• Imperfect information can lead to irrational decisions being made where utility is not necessarily being maximized
• Behavioral economics


  Disputes the idea that consumers are always rational and will always look to maximize their utility
• Behavioral economics


  • Emotional, social and psychological factors can play a very important role in influencing consumer Behavior
  • Consumers are not always rational utility maximizing robots
• Behavioral economics is very useful in adding to what traditional economics say
• Behavioral economics is not a replacement for traditional economics
• Where traditional economics committee let us down in explaining all real life scenarios about how consumers make decisions, behavioral economics can maybe fill those gaps and give us greater understanding of consumer decision making
• Traditional economics view of consumer decision making

  Consumers are always rational and they will always look to maximize their utility
• How consumers make decisions according to traditional economics

  1. Gather all the information

  2. Evaluate the information

  3. Weigh up all the costs and benefits

  4. Make a rational utility maximizing decision
• Bounded rationality


  • Consumers don't necessarily have the time to do all of this and to make a satisfactory utility maximizing decision
  • The choice that's out there is just so large that to evaluate all the costs and benefits is too much to ask for a consumer
  • There is a lack of information, asymmetric information, or the information is not clear or complex
• Bounded self-control


  Consumers' self-control gets in the way of taking decisions which will maximize utility
• Heuristics


  Mental shortcuts or rules of thumb that provide a satisficing decision, where utility might be sacrificed but a satisfactory outcome will be the end result
• Emotional, social and psychological factors that can influence decision making are known as cognitive biases
• Behavioral economics is not a replacement for traditional economics, but an extension that can fill the gaps where traditional economics falls short in explaining real-life consumer decision-making scenarios.