Study notes

Rational Decision Making (Behavioural Economics)

  • Levels: AS, A Level, IB, BTEC Level 3
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

Do we always engage in rational behaviour? Are all businesses looking to maximise their profits? Much of introductory economic theory assumes that all "agents" behave rationally. But behavioural economics theories challenge the assumption of pure rationality in our decisions.

What makes people happy?

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

Typically we assume that, when making decisions people aim to maximise their own welfare.

They have a limited income and they allocate money in a way that improves gives them the highest total satisfaction.

In reality, when making day-to-day decisions, consumers rarely behave in a well-informed and fully rational way.

Often decisions are based on incomplete information which causes a loss of welfare not only for people themselves and affect others and our society as a whole.

For most of the Year 1 microeconomics course we assume that

  1. Rational consumers wish to maximize their satisfaction or utility from consumption by correctly choosing how to spend their limited income.
  2. Producers/firms wish to maximize profits, by producing at lowest cost the goods and services that are desired by consumers. Profit = total revenue – total costs.
  3. Government wishes to improve the economic and social welfare of citizens.

Behavioural Economics - Challenging Assumptions of Rationality

Behavioural Economics tries to mix insights from Psychology with Economics, and looks at 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, take too little exercise, or do not save enough for retirement.

An “Econ” is said to be infinitely rational and immensely intelligent, an emotionless being who can do cost-benefit analyses at will, and is never (ever) wrong.

Most of us are not infinitely rational, but rather face “bounded rationality”, with people adopting simple, intuitive “rules of thumb” instead of calculating optimal solutions for every decision they make.

Questioning rational behaviour

Economic agents:

  • Have limited capacity to calculate all costs and benefits of a decision
  • Are influenced by their social networks
  • Often act reciprocally rather than in their own pure self interest
  • Lack self control and seek immediate satisfaction
  • They are loss averse (losses matter more than gains)
  • They make different choices in cold & emotional states
  • Often fall back on simple rules of thumb when choosing
  • Satisfice rather than maximise
  • Have a strong default to maintain the status quo
Bounded rationality

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