Rational decision-making
Rational decision-making
Level: AS Levels, A Level, GCSE – Exam Boards: Edexcel, AQA, OCR, WJEC, IB, Eduqas – Economics Revision Notes
Rational Decision-Making
Traditional neo-classical economists believe that consumers act rationally by making decisions that maximise their utility. They also believe firms act rationally to maximise their profits.
However, many economists have challenged this school of thought with another called behavioural economics
What is Utility?
Utility is the satisfaction a consumer gets from the consumption of a product or service.
Behavioural Economics
Behavioural economists believe that consumers and producers make decisions using the process of psychology e.g. emotions and habits
Additional Content – AQA Spec
Bounded Rationality Model – The Administrative Man
This model was devised as Herbert Simon recognised the limitations of the decision making model proposed a developed model known as the ‘Bounded Rationality Model’
Assumptions of the Model:
- The first option which is satisfactory is selected
- The world is perceived as ‘simple’ by the decision maker
- The decision maker needs to be comfortable making decisions without worrying about other alternatives
- Decisions could be made by heuristics
Consumers are able to exercise self-control with some decisions, as per the theory of Bounded Self-Control
Law of Diminishing Returns – in some circumstances – for example food – some consumers will choose to consume more food regardless of the fact that it wont increase the optimal benefit
Short Term vs Long Term view – some consumers will go by a choice which will provide them will a short term gain, rather than thinking long-term and acting accordingly
Biases in Decision Making
Homo Economius – a consumer who acts rationally by making rational decisions and maximising utility
Heuristics – encourage a rational decision to be made through a simplified process; they are shortcuts to avoid lengthy decision making processes and also prevent the problem of having imperfect information
Social Norms
People’s decisions are often influenced by the behaviour of others. Social pressure from a third party encourages consumers to pick choices which they may not necessarily choose otherwise.
Consumers are reluctant to change certain habits even if they will benefit society, as they would rather ‘stick with the crowd’
Anchoring
Humans tend to rely on the first piece of information given and causes biasness towards any subsequent information they are provided with
Availability
This is bias created towards events that were recent, personal or memorable – this is because they are overestimated and can cause emotional responses
The importance of altruism and perceptions of fairness
Altruism – the act of being selfless, considering the interests of others
The Ultimatum Game
This game is used to describe altruism and explain the importance of fairness.
There are two players: the proposer and the responder. The proposer chooses a specific amount of money to offer to the responder, in which they can either accept or decline the offer.
The sum of the money is divided if the responder accepts the money. However both will receive nothing if the responder declines the offer
The perception of fairness is highlighted through the proposer usually offering a range of 40% – 50% of the total sum
Responders do not usually accept values below 25% of the total sum
IAL Spec – Additional Content
Reasons why may not aim to maximise utility
Inertia
The idea that individuals have a tendency to remain in the same situation, without wanting to change a habit or try something else
Herding
Individuals decide to follow each other and imitate group behaviours instead of acting independently. The behaviour of others influences their own
Poor computational skills
Consumers struggle to calculate the probability of an outcome occurring when making purchasing decisions – hence their decisions are dominated by computational weakness
Framing and bias
This suggests that the way information is presented affects the likelihood of a consumer following it. If information is presented in a way that exercises a gain to a consumer, they are more likely to listen to it
Quick Fire Question – Knowledge Check
1. Explain the two Neo-classical assumptions of Rational Decision-Making (4 marks)
2. Define ‘Utility’ (2 marks)
3. Explain what is meant by ‘Behavioural Economics’ (2 marks)
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A Level Economics Past Papers
