Economics Micro A level notes
1 Individual economic decision making
Rational behaviour – when consumers or firms act in pursuit of self-
interest, aiming to maximise welfare/utility for consumers and profit for
producers
Law of diminishing marginal utility – as a person increases consumption of
a good, while keeping consumption of others constant, there is a decline
in the marginal utility derived from consuming each additional unit of the
good
- This helps to explain the shape of the demand curve – when the
marginal utility of consuming a good is higher, we will be willing to
spend more on it and this decreases as we increase consumption of
such good
- We maximise utility by consuming one more unit of a good until the
price of the product is higher than the marginal utility gained from
consumption i.e we consume on the margin
Satiation – if households had unlimited income and capacity to consume
goods, they would maximise utility by obtaining all goods which yield
utility, up to the point of satiation (complete satisfaction)
- Any further consumption would yield disutility
Constraints in the market place:
1. Limited income
2. A given set of prices (price takers)
3. Budget constraint – cannot consume more of another good without
reducing consumption of one, assuming income is fixed - shows the
opportunity cost
4. Limited time
- These mean utility must be maximised through a mixture of trade-
offs i.e choices
Assumptions of traditional economic theory:
1. Economic agents are utility maximisers
2. Economic agents are rational
Behavioural economics – aims to challenge these assumptions, using
social, psychological, and emotional factors in decision making to try to
make more realistic predictions about individuals’ decisions
- This doesn’t ignore traditional theory, but instead tries to improve it
and make it more relevant to the real world
Rational agents (homo economicus)
, - Assumed a rational agent will maximise their utility - do this by
comparing the costs and benefits of alternatives, and then choosing
the option that maximises their net utility
- However, this requires perfect (symmetric) information and the
ability to use it to make rational decisions
Consumer sovereignty – when the desires and needs of consumers control
the output of producers
- If what they want is an inferior product, resources may be
misallocated – market failure
Why don’t consumers always act rationally?
1. Limited time
2. Not all information is available, or what is may be incorrect
3. People may not be able to process and evaluate vast amounts of
data, and calculate costs of alternatives (computational weakness)
Imperfect information
- Perfect information includes information about the goods that are
available, their prices and quality, and the utility that will be derived
from their consumption
- Imperfect information will distort the price mechanism, as both
consumers and producers make decisions on logical and rational
thinking
- Asymmetric information occurs when a supplier and buyer have
different levels of information, and this can work both ways e.g
second hand cars or insurance
- Buyers can end up making the wrong decision, or not making a
decision at all
Bounded rationality (Herbert Simon) – explains that people’s ability to
make rational decisions is severely restricted
- Can be limited by the ability to process and evaluate information
- Information is also invariably incomplete or unreliable
- Time in which people have to make decisions is also limited
- People then tend to satisfice i.e limit their time and do not maximise
utility
Bounded self-control – when we know we are doing something that is bad
for us i.e SR private benefits less than LR private costs, but we do not stop
anyway
- E.g consumption of demerit goods
Daniel Kahneman
Thinking fast – system 1
- This is intuitive and instinctive decision making, with little effort
Thinking slow – system 2
- This involves concentration and mental effort to work through a
problem
,Biases – BE argues decisions people make are biased, as they are
influenced by their own likes, dislikes and past experiences
- Psychologists describe these as cognitive biases i.e a mental error
that is consistent and predictable
Examples
1. Confirmation bias – when we seek information that matches what
we already believe, and dismiss information that challenges our
views
2. Positive expectations bias – belief that a run of bad luck will change,
and things must eventually improve
3. Neglecting probability – the inability to grasp a proper sense of peril
and risk i.e overstating small risks and understating more dangerous
risks
4. Rules of thumb (heuristics) – when we use mental shortcuts to arrive
at a decision e.g choosing the middle-priced option, but having no
underlying reason
5. Anchoring – tendency to rely too much on a single piece of
information, frequently the first bit e.g cars
6. Availability bias – when judgements are made about the probability
of an event occurring based on how easy it is to remember such
events occurring
7. Social norms – an individuals behaviour can be influenced by the
behaviour of their social group – especially people we respect –
whereas standard theory assumes we make decisions independently
and preferences are fixed – to have an impact on behaviour, we
must alter social norms
- Examples of policies used to combat these include those used to
alter attitudes towards smoking – however the laws used are
economic sanctions, not nudges, but these too can help/force
people to alter behaviour
- Policies could also be used to alter attitudes to drinking by providing
statistic e.g not as many young people drink as some think
8. Habitual behaviours – doing the same thing over and over again
regardless of any reasons for doing something else
9. Herd behaviour – when individuals act collectively as part of a
group, as they may believe a group will know more than an
individual i.e band wagon effect
10. Default bias – tendency to choose what we always have
without considering other options
- Repeat choices becomes automatic because default choices don’t
involve much cognitive effort
- To get people to change behaviour it may require compelling
incentives
11. Scarcity bias – this is when people unconsciously assume that
something that is scarce is valuable, and abundant things are not
- Loss aversion kicks in as we don’t want to miss out on something
that has become scarce e.g low stock signs on websites
, Loss aversion – when people hate losses more than they enjoy equivalent
gains
- This means people miss out on opportunities as they are reluctant to
risk losses, even when returns may be high
- Can see this on a graph represented by prospect theory
Loss aversion and mental accounting
- When a stock decreases in value, we are sitting on a loss, but we
don’t like this so we then hold onto it, hoping to make a profit
- However, if there are bad conditions, it would be more rational to
sell and minimise losses
- Mental accounting occurs when we compartmentalise spending,
leading to the effects of the sunk cost fallacy e.g when we stay at an
event we are not enjoying because we have paid money to be there
Loss aversion and marketing
- Use this with free trial periods – once a consumer has a product,
they will likely be much less willing to give it up
Reasons for loss aversion
- Attachment to objects
- Feels careless/bad luck to make losses
- Image/reputational costs
Altruism and fairness
- Altruism is the concern for the welfare of others
- In traditional theory an individual may give money to charity
because they gain utility from doing it, but BE recognises individuals
and firms don’t always act out of self-interest, and may have a
sense of fairness and act altruistically
- People may then sacrifice their own consumption by giving to
charity, which is against their own self interest
- This is ultimately due to people wanting to create fairness (a
normative judgement), which may include equality or ‘correct
treatment’
- This can also be significant with incentives, as people don’t always
respond as expected due to altruism and fairness e.g being paid to
give blood
- E.g a firm may pay its employees above the market minimum wage
because they think it is fair
Government policy – BE is used to improve traditional theory, rather than
completely oppose it
- Government intervention can help individuals to achieve an
outcome that is in their own self interest
Choice architecture
- This described how government policy can lead people to make
certain choices, by changing the way in which choices/options are
presented to the decision maker
