Remember!!
Economics is a study of assumptions
made about human behaviour.
If you change the assumptions, things
change dramatically
Rational economic decision making
It means that individuals make choices in their best self-
interest that result in the optimal or maximum level of
benefits or utility for them.
The term “homo economicus” is for a consumer who
behaves with perfect rationality.
Rational consumer choice - Assumptions
• Consumer rationality - that the consumer always
makes a rational choice driven by self-interest and
incentives (the invisible hand theory)
● Utility maximisation - that the consumer always
aims to maximize their utility
● Perfect information - that the consumer has perfect
information
Rational students work hard to pass
their IB exams
Limitations of the rational
consumer choice
Where Economics meets
Psychology.......
Pioneered by Richard Thaler who won the Nobel
Prize in 2017
He argued that “rational choice” humans don’t even
exist!
We are homo sapiens, not homo economicus
He reduced it down to “econs” and “humans”
Behavioural economics critique of
rational consumer choice
The concept of rational consumer choice has been
questioned
Behavioural economics has developed to try to reflect
human behaviour using theory from psychology.
This includes:
Biases
Bounded rationality
Bounded self-control,
Bounded selfishness, and
Imperfect information.
Biases
Departures from normal standards of thought or
judgement.
Biases influence how people process complex
information as part of the decision-making process.
Makes it extremely difficult for social beings to make a
pure and instantaneous rational decision.
Biases - kinds
● Rule of thumb - This phrase refers a practical and
approximate way of doing something, without having to be
exact. Based on experience and common sense
● E.g. Samsung make good smartphones, therefore,
Samsung must be a good phone.
● 1 bowl of rice is 2 handfuls of grains.
● Anchoring - making decisions based on earlier, often
unrelated, observations.
● E.g. seeing a nice red car results in buying a red t-shirt.
● Real estate agents also use anchors for property prices –
showing the offer prices for houses on sale acts as an
anchor for potential home buyers.
Biases - kinds
● Framing - framing is about presenting information in such a
way that it creates a bias in favour of a particular decision.
giving information to frame consumers choice
● E.g. fat content of food – 91% fat free (or) 9% fat
● Sugar-free but contains 5% Sucrose
● Availability bias – The availability bias occurs when people
overestimate the likelihood of an event, or the frequency of its
occurrence, either because something similar has happened
recently or because they feel very emotional about a similar
event.
● More people take the bus after reports of a series of train
accidents.
Bounded rationality
Idea developed by Nobel laureate Herbert Simon
Decisions are often based on incomplete information.
because rationality is bounded (restricted) by people’s
thinking capacity, the availability of information and
time.
Consumers satisfice, rather than maximise their utility.
Hence, irrationality causes a loss of social welfare.
It includes:
Good enough by looking at the labels
Convenience
Instant gratification
Bounded self-control
Humans are social beings. As such, they often let their
family, friends and acquaintances influence their
thinking.
They lack the self-control to think for themselves and to
make a rational choice.
The consumers don’t have rational self-control, especially
when buying fast food or a drink (or even buying a car).
Bounded Selfishness
Classical theory assumes that individuals are
selfish and concerned only with their own utility
or benefit.
Bounded selfishness is concern for the well-being
of others. The consumer doesn’t always simply
think of themselves, but sometimes of others
helping strangers without expecting anything in return
donating money to charity
organ donations, such as kidney transplant, to another
person
doing voluntary work, such as beach clean ups.
Incomplete information
Consumers do not and cannot have full access
to information regarding prices, products,
product quality....
Their decisions and choices would not be
optimal
Unable to maximise utility
Choices based on faulty nad incomplete
information
Behavioural economics in
action
In reality, decisions are more often made instinctively
and unconsciously rather than logically and consciously
(*by weighing up all the costs and benefits of a
particular decision).
Choice architecture and Nudges are used to overcome
the pitfalls to reasonable and rational decision-making.
Choice architecture
Refers to the deliberate design of different ways of
presenting choices to members of society, and the
impact of these methods on decision-making.
The term choice architecture was coined by Richard
Thaler and Cass Sunstein in their book “Nudge:
Improving Decisions about Health, Wealth, and
Happiness (2008)”.
A choice architect is an individual or organization
responsible for shaping the context in which people
make decisions. – parent, teacher, friend......
Categories of Choice
Architecture.....
Default choice - A default choice occurs when a person
is automatically signed up into a system
minimize the costs of choosing and deciding what to
do. Hence, a default choice is the given decision of the
economic agent if no action is taken. - using Google or
Amazon
Restricted choice - limits the choices available to
people, such as placing healthier food items on a menu
and restricting the choice of unhealthier foods.
The choice for consumers is restricted, but it is still
there. The nudge is created to encourage consumers to
opt for the less unhealthy food.
Categories of C A.....
Mandated choice - A mandated choice is when people
are required to make an advanced decision and declare
whether they wish to participate in a particular
activity.
Policymakers use this to ensure people make a choice
on matters that are deemed to be important to society
and the economy.
Example - when people apply for a new driving licence
or renew their driving licence, they may be asked to
declare whether they wish to donate their organs in the
event of death.
Nudge Theory
The practice of influencing the choices that
people make.
Nudges are created by choice architects using
small prompts or tweaks to alter social and
economic behaviour, but without taking away
the power for people to choose.
The term coined by Richard Thaler and Cass
Sunstein in in their book – Nudge – Improving
Decisions about health, Wealth & Happiness”-
published in 2008.
Nudge Theory
“To count as a mere nudge, the intervention must
be easy and cheap to avoid. Nudges are not
mandates. Putting the fruit at eye level counts as a
nudge. Banning junk food does not.”
– Richard Thaler
When a cheap and easy device is used to nudge or
prompt consumer behaviour. e.g. putting warning
labels on cigarettes, alcohol or sugar drinks/food.
It does not include banning a product as this is
somewhat radical.
Placing books at eye-level in public
libraries or bookstores
Supermarkets are experts at using
nudges
Nudge Theory
Nudge theory is used in advertising and
marketing; placing products at eye-height at the
end of an aisle in a supermarket, or placing the
basics at the back of a shop.
Putting information of sugar content on
packaging, health warnings on cigarette packets or
alcohol are all part of nudge theory
Nudges are limited in its use as a policy tool.
Business Objectives
A firm or business is assumed to always aim to maximise profits.
Other business objectives may include:
Corporate social responsibility - the concept that firms
have an ethical responsibility, not just to their
shareholders to maximise profit, but to society as a whole,
to pay workers reasonable wages with decent conditions
(internal) and maintain the environment (external).
reducing carbon footprints to combat the problems related to
climate change
engaging in fair trade practices
participating in charitable and volunteer work in local communities
improving the well-being of workers
Video on CSR
Market share
Market share refers to a firm’s portion of the total value
of sales revenue in a particular industry.
● Firms with largest market share – Market Leaders
● Firms may aim to increase or maintain their market share
rather than simply maximise profits.
● Increases brand loyalty
● Higher profits
● Economies of scale
● Maintaining market share may go with corporate social
responsibility and increasing it may go with growth.
Profit satisficing
Satisficing is about aiming for a satisfactory or adequate level
of profit, rather than the maximum profit.
Firms do not aim to maximise profits, but simply make
enough.
While the shareholders or owners of a company might want
to maximize profits, the workers and managers might lack the
incentive to do so; they want sufficient profit to ensure there
is job security but do not want to overwork.
This may be because of corporate social responsibility or
simply limits of what is practically possible.
Growth
Growth refers to increasing the size and scale of
operations of a firm.
While new firms tend to aim to break-even and survive,
established businesses might aim for growth and to
expand their operations.
Growth can be measured in numerous ways, such as an
increase in the firm’s:
sales revenue and/or profits
product range (the different products sold by a business)
number of employees
number of stores/outlets
volume of output and/or production capacity
value of its assets or the capital invested.
