entire hot topics

• Rationality


  An underlying assumption in economics that economic agents are rational
• Rational economic agents


  • Consumers aim to maximise their utility from consumption
  • Workers aim to maximise their wages and other work benefits
  • Firms aim to maximise profit
  • Governments aim to maximise social welfare
• In the real world, the assumptions of rationality often do not hold
• Rational consumer behaviour


  Decision-making process that is based on making choices that maximise utility
• Rational consumer behaviour


  • Consumers make all choices independently
  • Consumers have fixed and consistent preferences
  • Consumers have full information
  • Consumers always make the optimal choice given their preferences
• Irrational consumer behaviour


  When people make systematic and persistent deviations from rational choice
• Reasons for irrational consumer behaviour

  • Humans are emotional, impulsive and can lack self-control
  • Humans are social and belong to many networks
  • Humans can be altruistic, generous and forgiving
  • Humans have limited time, energy and brain power
  • Humans have regrets and also have a strong sense of loss aversion
• Bounded rationality


  The idea that the cognitive, decision-making capacity of humans cannot be fully rational because of a number of limits that we face
• Bounded self-control


  Consumers have good intentions but may consume more than is rational (e.g. at a restaurant or pub); this may be because they value the present more than the future; they want instant rewards
• Reasons for irrational behaviour influenced by others

  • Peer pressure (can be negative and positive)
  • Fads/fashion/trends
  • Social networks
  • Social norms & herd behaviour
• Reasons for irrational behaviour: habit and default bias

  • Consumers follow patterns of habitual behaviour
  • Consumers stick to what they know or is easiest (default bias) e.g. choosing the same dish off a restaurant menu
• Default choices

  Options selected automatically if no active choice is made
• Restricted choices


  Limited available options, allowing selection within a defined set
• Mandated choices


  Obligatory selections enforced by a directive or requirement
• Reasons for irrational behaviour: human limitations


  • Limited brain power and limited time to use it; decisions sometimes have to be made quickly; may use a 'rule of thumb' for speed
  • Limited ability to calculate or absorb complex information
  • Emotional responses
  • Can be 'misled' by framing and/or anchoring effects
• Choice architecture


  Refers to how decisions are presented and influenced by the way options are organised, leading to certain decisions over others
• Framing


  Presenting information in a way that influences people's perceptions or decisions, often emphasising specific aspects to shape how a decision is made
• Anchoring


  Cognitive bias where an initial piece of information (the "anchor") influences how people make subsequent judgments or decisions, even if the anchor is irrelevant or inaccurate
• Irrational behaviour: risk aversion & time preference


  • Humans are risk averse; they prefer a certain reward over risking it for a bigger reward
  • Humans are loss averse: losses can be twice as painful as a similar gain
  • Humans are time-sensitive; they typically prefer a reward earlier than at a later date; a desire for instant rewards
• Nudges

  Subtle pushes or prompts to influence and guide people toward making better decisions without limiting their choices or using direct enforcement
• Rational consumer behaviour


  Decision-making process that is based on making choices that maximise utility
• Assumptions of rational consumer behaviour

  • Consumers make all choices independently
  • Consumers have fixed and consistent preferences
  • Consumers have full information
  • Consumers always make the optimal choice given their preferences
• Total utility


  The total satisfaction the consumer gets from purchasing units of a good
• Marginal utility


  The change in total utility from consuming an extra unit of a product
• Law of Diminishing Marginal Utility


  • As a consumer buys and consumes more units of a good, the extra satisfaction gained diminishes
  • This means at higher quantities, consumers are less willing to pay a higher price, helping to explain the downward sloping demand curve
• Marginal cost


  The change in total cost when one more unit is bought
• Marginal benefit


  The change in total when one more unit is consumed
• Information failure


  Occurs when people have inaccurate, incomplete, uncertain or misunderstood data and so make potentially 'wrong' choices
• Information gaps


  Exist when either the buyer or seller does not have access to the information needed for them to make a fully-informed decision, leading to a misallocation of scarce resources = market failure
• Symmetric information


  For markets to work, buyers and sellers need to have the same perfect information
• Asymmetric information


  Buyers and sellers have different amounts of information e.g. buyers often know less than sellers when buying second-hand cars; buyers often know more than sellers when buying car insurance
• Adverse selection


  People taking out insurance are often those at highest risk e.g. a person leading an unhealthy lifestyle is more likely to take out health insurance, meaning more payouts for insurance company
• Moral hazard


  Being insured can make you more careless e.g. banks made risky decisions before the global financial crisis aware that they would likely receive bail-outs
• Principal-agent problem


  Goals of the principals, those who lose/gain from a decision, are different from the agents, those making the decisions e.g. managers (agents) may have more information than shareholders (principals)
• Policies to address information failure/gaps

  • Compulsory labelling on products
  • Improved nutritional information on food/drinks
  • Campaigns on dangers of gambling addiction
  • Hard-hitting anti-speeding advertising
  • Campaigns to raise awareness of risks of drink-driving/drug abuse/smoking/vaping
  • Performance league tables for schools/school inspections
  • Consumer protection laws
  • Industry standards and guarantees for selling used products
• Other business objectives


  • Survival
  • Quality
  • Environmental and social obligations (CSR)
  • Not-for-profit objectives
• Divorce of ownership from control


  Separation between owners (shareholders) who invest capital and managers who make day-to-day decisions
• Shareholders want


  High dividends and stock price appreciation, which may be achieved through short-term profit maximization
• Managers may prefer


  Long-term goals like growth, market share, or employee satisfaction, even if they sacrifice immediate profits
• Short-termism: Pressure from shareholders can lead to decisions that neglect long-term investments in research and development or employee training, potentially hampering future growth