1.1.1 Economics as a social science
Economists use developing models to explain how the economy works e.g., theory of supply
and demand or circular flow of income.
Theory=Model
Assumptions must be made
Ceteris paribus- All other things being/remaining equal
A) Thinking like an economist: the process of developing models in economics,
including the need to make assumptions:
Economists try to understand the economy through making assumptions to help them create
models. These assumptions help to simplify their analysis. For example the production
possibility frontier is used in order to simplify two products to help illustrate the maximum
productive potential, opportunity costs and efficiency as well as challenge whether these are
realistic assumptions. For example, an economy may be difficult to maintain at full capacity
and moreover is unsustainable operating at points outside of the PPF curve.
B) The use of the ceteris paribus assumption in building models:
The majority of the models used in Economics assume that all things remain equal (Ceteris
paribus) thus allowing them to focus on the particular changes in the economy that will take
place as a result policy changes. For example, when identifying the effects that a decrease
in interest rates will have on the Aggregate demand, only components of Aggregate demand
will be considered. However, other determinants of the impacts that are not included due to
ceteris paribus may be included as evaluation e.g. it may depend on business confidence
levels, if it is low then the increase in investment and therefore AD may be lower if business
confidence is low. Overall, ceteris paribus helps to simplify the analysis for the economist.
C) The inability in economics to make scientific experiments:
Rather than proving the relationship between two variables through experiments, economists
do this through the use of simplified models. For example, the Phillips curve helps to explain
,the relationship between employment and inflation. There are many models used in
Economics and this can make it easier to justify changes within the economy.
1.2.1 Rational decision making
What is rational decision making?
Rational consumers make choices with the aim of maximising utility (satisfaction or benefit)
from purchasing and consuming goods and services using a limited budget.
The assumption of people acting rationally has dominated theory for decade but has been
questioned by the rise of behavioural economics
Assumptions of rational choice model
• Consumers choose independently (i.e., my preferences do not affect your choice)
• A consumer has fixed and consistent preferences; so if A is preferred to B and B is
preferred to C, then A is preferred to C
• They gather complete (full) information on the alternatives
• They always make an optimal choice given their preferences
Maximising consumer welfare
• Consumer welfare can be illustrated using the concept of consumer surplus
• Consumer surplus is the difference between what people are willing and able to
pay and what they actually do pay in the market
• Consumer surplus is highest at an equilibrium price where price charged= the marginal
cost of supply
• Firms with monopoly power can raise prices above a competitive level leading to a
deadweight loss of consumer welfare
• This means that there is a loss of allocative efficiency
, • This is an area of behavioural economics.
• When making economic decisions, consumers aim to maximise their utility and firms
• aim to maximise profits.
• A consumer’s utility is the total satisfaction received from consuming a good or
• service.
• Daniel Kahneman is a Nobel Prize winner in Economic Sciences, which he won for his
work on behavioural economics. He devised a two-system model which explains how
decisions are made.
o The first system is based on common sense estimates and emotional responses to the
choice made. It uses short cuts and quick decisions are made. This is the dominant system,
but the bias and potential for error in the system can mean irrational decisions could be made.
o The second system takes longer than the first. It uses thoughts and reflections, and avoids
the bias and errors from the first system. However, because of how easily the system is
manipulated, the decisions made could be harmful to the consumer or others around them.
A firm or an individual can make decisions using intuition or rationally. Intuition uses the
feelings or instincts of the consumer and does not use facts. Businesses use this when they
do not have access to facts or when making the decision is difficult. A rational decision is
made using several steps, and it involves analysis and facts.
1) Identify the problem: For a firm, this might be falling profits.
2) Find and identify the decision criteria: The firm might have to find information or criteria
that will increase their profits. The firm’s criteria might include, for example, keep a certain
number of employees or to not change the price of their goods. The criteria might include
, how the decision will affect stakeholders (the customer and the staff, for instance), and how
the quality might be affected.
3) Weigh the criteria: The firm will have to rank the criteria based on their relative
importance. They might think keeping all of their employees is the most important, for
example.
4) Generate alternatives: The firm might consider some alternative options. For instance,
they might think that moving their premises somewhere else will reduce costs and hence
increase profits. Perhaps they will consider a loyalty scheme or a promotion for the consumer.
Alternatively, the might decide to reduce the size of their workforce.
5) Evaluate alternative options: The firm might now consider which of the alternatives meet
their criteria the best, and help them increase their profits the most.
6) Choose the best alternative: Now the firm will choose the alternative they think meets
their criteria.
7) Carry out the decision: The firm can now see what the consequences of the decision
are.
8) Evaluate the decision: After seeing what effect the decision has on the firm, they can
consider whether this was the best option or not.
Limitations:
This is not always the best or most realistic way for firms to make decisions.
Although it might be fairer than making an intuitive decision, it takes significantly
longer to decide, which is not practical in a firm with strict time constraints.
The Administrative Man:
Herbert Simon recognised these limitations, so he devised the bounded rationality
model, which is also known as the administrative man theory.
The assumptions of this model are:
