Rational Consumer Choice

Rational Consumer Choice

• Free markets rely on rational decision-making assumptions
• Rationality in economics: agents consider outcomes and recognize net benefits
• Rational agents choose options maximizing benefits (utility)
• Rational choice theory: individuals use logic for choices best for self-interest
• Many economic theories assume agents maximize satisfaction in decisions
• Example: The law of demand states that consumers increase demand as prices fall

Consumer Rationality

• Individuals use rational calculations to make choices in their best interest
• All available information is used

Utility Maximisation

• Economic agents select choices that maximize their utility
• Example: Choosing swimming over running for greater satisfaction

Perfect Information

• Assumes easy access to information about goods and services on the market
• Individuals have sufficient information for the best decision

Limitations of Rational Consumer Choice

• Behavioural economics challenges the traditional view of rational economic agents
• Combines psychology and economics to understand decision-making in context
• Recognizes influence of cognitive biases, emotions, social factors, and psychological factors
• Deviations from rational behaviour occur
• Traditional economics assumptions do not hold.
• Several limitations hinder fully rational decisions

Biases

• Influence information processing during decision-making
• Impact the rationality of the decision-making process
• Examples include common sense, intuition, emotions, and social norms

Rule of Thumb

• Choices are made based on default choices of experience
• Individuals may repeatedly order the same pizza from a restaurant
• A better option might be available at a discount

Anchoring and Framing

• Anchoring bias: reliance on an initial piece of information ("anchor") for decisions
• Example: A seller initially suggests a car price of $10,000; even if the market value is lower,the consumer may still overpay due to the initial anchor.
• Framing: Presentation or wording significantly influences choices
• The same information framed differently can lead to different consumer decisions
• Consumers more likely purchase a product labeled "80% fat-free" than "20% fat"

Availability Bias

• Occurs when relying on readily available examples in judgments
• Leads to overestimating event likelihood based on memory recall
• Influenced by personal experiences, vividness, media exposure, and emotional impact
• After a plane crash, people may opt for alternative modes of transport even though the probability of a crash is very low.

Bounded Rationality Theory

• Decisions occur without gathering all necessary information for rationality
• Individuals may not understand technical jargon
• Rational decision-making is limited by:
  • Thinking capacity
  • Information availability
  • Time constraints for information gathering
• Too much choice can cause irrational decisions

Bounded Self-Control

• Individuals have limited capacity to regulate behaviour and desires in the face of conflicting desires
• Self-control is not unlimited
• Humans are social beings influenced by family, friends, and social settings
• Decision making then conforms to social norms

Bounded Self-Interest

• Economic agents do not always act within their own self-interest
• Altruism means helping others selflessly, expecting nothing in return
• Examples of bounded selfishness:
  • Donating to charity
  • Organ donations
  • Voluntary work

Imperfect Information

• Rational Choice Theory assumes perfect information accessibility, but this is often incorrect
• Intellectual property protections such as patents, copyrights and trademarks can limit information access
• Cost of accessing information
• Volume of information and options available can hinder research
• Decisions making occurs based on limited information
• Asymmetric information can lead to decisions based on incomplete information
• Second-hand car sellers typically have more information than buyers

Choice Architecture

• Intentional design of how choices are presented to influence decision-making
• Salad bar placement at the beginning of buffets encourages people to put fruit and vegetables on their plate
• Supermarkets place more profitable products at eye level

Simplifying the Decision-Making Process

• Restaurants bundle food options in a particular format to encourage certain choices
• Example: Tesco places healthier options at the checkout to encourage better choices

Default Choice

• Individuals are automatically signed up for a particular choice
• This reduces choice, as a decision is already made
• Individuals rarely change from the default choice
• Driver's license agencies may select 'organ donation' as the default choice
• Online services may default to "opt-in" for promotional emails

Restricted Choice

• Individuals are limited in their available choices to promote rational decisions
• Unhealthy options are substituted for healthy ones
• Replacing sugary soft drinks with water in cafeterias, encouraging consumers to purchase water

Mandated Choices

• Individuals must make a specific decision or take a particular action
• Mandated choices help to regulate societal norms and may be a requirement
• Some countries mandate car insurance, obligating owners to actively purchase it

Evaluating Choice Architecture

• Advantages and disadvantages merit evaluation

Influences Behavior

• Choice architecture can nudge individuals in their best interest.

Simplifies Decision-Making

• Clear and understandable options can simplify complex decisions by design.

Manipulation

• It can manipulate by influencing decisions and infringes on freedom of choice

Ethical Concerns

• Unawareness possible, as well as lack of understanding of consequences due to choice presentation

Improved Outcomes

• Effective choice architecture can lead to improved outcomes
• Encourage healthier eating habits or combatting obesity

Potential for Bias

• Choice architecture is susceptible to biases and can enable companies to increase profits

Enhance Decision Quality

• Careful structuring choices can provide guidance and likelihood of better decisions

Unintended Consequences

• Presenting choices can have unexpected outcomes with original goal misalignment

Nudge Theory

• Influencing choices via small prompts
• Firms should use nudges responsibly to guide decision-making

Transport For London - Baby On Board Badge

• Baby on board badge supplied to expectant mothers by Transport for London
• Other commuters should give up their seat

EAST Framework to Nudge Decision Making

• Simplify or make it straight forward
• Gain people's attention using personalized messages, encouraging them to seize opportunities
• Influenced by what other people do, not by rules and regulations
• Identify when people are most responsive

Evaluating Nudge Theory

• Consumer nudges guide decisions while allowing choice freedom
• Interventions are rooted in economics and aim to help individuals and society as a whole
• Designed with transparency, respect for autonomy, and benefits in mind
• Ethical considerations ensure interventions are not manipulative and coercive

Ethical Concerns

• Manipulative due to individuals not being aware

Lack of Transparency

• Decisions made difficult to question

Unintended Consequences

• Citizens can reverse and become against the nudge

Variable Success Rates

• Cognitive biases impact results of nudges

Profit Maximisation

• Firms aim for profit maximization as a rational business objective
• Profits benefit shareholders through dividends and increased share price
• Increased share price grows the shareholder's wealth
• Profit Maximisation Rule:
  • Marginal cost (MC) = marginal revenue (MR), meaning no additional output yields extra profit
  • MC < MR, profits increase with added output
  • MC > MR, firm has exceeded profit maximization output
  • Production beyond MC = MR means a marginal loss
• Real-world difficult to achieve due to unknown level

Adjusting Prices

• Short-term price adjustments of marginal cost is not always possible
• Marginal costs and prices fluctuate, which can upset customers in the short term.
• Long-term price adjustments of profit maximization are possible
• Competition regulators may require price adjustments in especially in countries with natural monopolies.
• Maximizing level of output leads to higher consumption cost
• Changes in price results in changes in marginal revenue

Profit Maximisation Diagram Analysis

• Diagram occurs at the point Q1 where MC = MR, the result is a market price of P1
• As the graph is downward sloping it indicates market value exists here.
• At the point where MC = MR:
• The price is P1
• The costs are C1
• The supernormal profit can be calculated using (P1 - C1) * Q1

Evaluation of Profit Maximisation

• Advantages and disadvantages exist with profit maximization

Advantages

• Allows businesses to accumulate capital, reinvest, and withstand uncertainties
• Enhanced share holder value results when the focus is profit maximisation
• Efficient resource allocation with improved product and cost control is the end product

Disadvantages

Focusing can result in results that disregards employees and the environmental

• Important factors include employee satisfaction, customer loyalty, product quality, and environmental sustainability
• Extracting highest level short-term may prevent future success

Growth

• Growth is the overall business objective of some firms.
• Firms with a growth focus revenue, market share.
• Increase output and economies of scale can result when firms maximize revenue.
• Likelihood of failure decrease for growing firms

Revenue Maximisation

• Maximising revenue results in output and economies of scale
• Short-term firms may focus on price when it is lower than profit maximisation

Revenue Maximisation firms produce output where MR = 0

• MR increasing further output to increase total revenue

Market Share

• Some firms objectives are sales maximisation that lowers prices further and can increase market share
• This occurs when output = AR, otherwise known as, the normal profit

Evaluating Growth as a Corporate Objective

• Trade Offs and balanced approaches for corporate objectives must be accounted for.
• Risk management and long term sustainability must also be considered too

Growth Advantages

• High market share and competitive advantage
• Financial Performance and boosted share holder value
• Pursuing growth encourages innovation and attracts top level talent which then creates new opportunities

Growth Disadvantages

• New markets and complex processes with difficult and risky operations
• Strain on resources an in effective customer service output

Satisficing

• Aims for satisfactory outcomes

Characteristics

• A decision that has a minimum standard
• Satisficing the desires of the owner
• Revenue can be improved to reduce any conflicts of interest

Advantages

• Results in healthy work life balance
• Sped up process and reduced cost

Disadvantages

• Can lead to mediocrity

Corporate Social Responsibility(CSR)

• Ethical business output and balancing the interests of stakeholders