Topic 2 - Individual Economic Decision Making

• Utility theory


  Total and marginal utility, diminishing marginal utility
• Consumers


  Aim to maximise their utility
• Firms


  Aim to maximise profits
• Consumer's 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
• Law of diminishing marginal utility

  Consumer surplus generally declines with extra units consumed
• Extra unit generates less utility


  Consumers are willing to pay less for extra units
• Utility maximisation


  Consumers aim to generate the greatest utility possible, firms aim to generate the highest profits possible
• Economic agents only act in their own interests
• Some firms might have philanthropic owners who seek to maximise the utility of others
• Economic agents respond to incentives


  Incentives can allocate scarce resources to provide the highest utility to each agent
• Positive incentives


  Make consumers better off
• Penalties


  Make consumers worse off
• Without proper incentives


  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, which makes them want to innovate to reduce production costs and improve product quality
• Firms need an incentive to engage in risk taking, so they innovate. Without innovation, production will cost more and there will be a misallocation of resources.
• Intuitive decision making


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


  Involves analysis and facts, follows a process
• 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
• Thinking at the margin


  Thinking about the effect of an additional action
• Thinking at the margin prevents consumers thinking about things they have already done, and allows them to consider how to maximise their utility now or in the future</b>
• 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
• Asymmetric information


  Unequal knowledge between consumers and producers
• Asymmetric information


  Leads to market failure
• Principal-agent problem


  Agent makes decisions for the principal, but the agent is inclined to act in their own interests, rather than those of the principal
• Information could be made more widely available through advertising or government intervention
• Bounded rationality


  Individuals are rational decision makers who endeavour to maximise their utility, but have limitations
• Bounded self-control


  Consumers are able to exercise self-control, but unable to with some decisions
• Law of diminishing marginal utility

  Every extra unit consumed provides a smaller benefit to the consumer
• Consumers know saving for pension will benefit them long-term, but this limits short-term spending, leading to irrational decisions
• Heuristics


  Simplify the decision making process to come to a reasonable decision, avoid taking too long and imperfect information
• Social norms


  Behaviour of other people affects how the consumer acts
• Anchoring


  Human tendency to rely on the first piece of information they are given, biases subsequent information