Study notes

The Cost-Benefit Principle

  • Levels: AS, A Level
  • Exam boards: AQA, Edexcel, OCR, IB, Other

In many decisions where people consider the costs and benefits of their actions – economists make use of the ‘marginal’ idea, for example what are the benefits of consuming a little extra of a product and what are the costs?

  • Rational decision-makers weigh the marginal benefit one receives from an option with its marginal cost, including the opportunity cost.
  • This cost benefit principle well applied will get you a long way in economics!
  • But keep in mind that behavioural economics questions the rationality of many of our decisions!

Consumer Welfare and Rationality

What makes people happy? Why despite several decades of rising living standards, surveys of happiness suggest that people are not noticeably happier than previous generations?

Typically we assume that, when making decisions people aim to maximise their welfare. They have a limited income and they allocate their money in a way that improves gives them the highest total satisfaction.

In reality consumers rarely behave in a well-informed and rational way. Often decisions are based on incomplete information which causes a loss of welfare not only for people themselves but which affect others and our society as a whole.

As consumers we have all made poor choices about which products to buy. Behavioural economics is an exciting strand of the subject that looks at whether we are rational in our everyday decisions. One of the best people to read is Dan Ariely

Behavioural economics

Behavioural Economics is the name given to the discipline that tries to mix insights from Psychology with Economics, and looks at economic problems through the eye of a “Human”, rather than an “Econ”. It uses insights from psychology to explain why people make apparently irrational decisions such as why people eat too much and do not save enough for retirement. 

An Econ is said to be infinitely rational and immensely intelligent, emotionless being who can do cost-benefit analyses at will, and is never (ever) wrong. The reality is often very different. Most of us are not infinitely rational, but rather face “bounded rationality”, with people adopting rules of thumb instead of calculating optimal solutions for every decision

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