Rational Decision Making in Behavioral Economics

Rational Decision Making

• This is part of behavioural economics
• When making economic decisions, consumers seek to maximise utility, while firms aim to maximise profits
• A consumer’s utility represents the total satisfaction from consuming a good or service
• Daniel Kahneman, a Nobel laureate in Economic Sciences, developed a two-system model for decision-making
  • The first system relies on common sense and emotional responses, using shortcuts for quick decisions and dominant, but prone to bias and irrationality
  • The second system is slower, employing thoughts and reflections to avoid biases, but is susceptible to manipulation, potentially harming consumers
• Firms or individuals may use intuition or rational thought in decisions
  • Intuition relies on feelings and instincts, not facts, and is used when information access is limited or the decision is difficult
  • Rational decisions involve analysis, facts, and several steps

Steps of Rational Decision-Making

• Identify the problem, such as a firm's declining profits
• Determine decision criteria to increase profits
• Criteria examples include retaining a certain number of employees and maintaining current goods prices
• Criteria may consider effects on stakeholders like customers and staff, as well as quality
• Rank the criteria based on importance
• Generate alternative options such as relocating premises to cut costs, loyalty schemes, or workforce reduction
• Consider how the alternatives align with the criteria to boost profits
• Pick the best alternative that meets the defined criteria
• Implement the decision and observe the consequences
• Assess the decision's effects on the firm to determine if it was optimal

Limitations of Rational Decision-Making

• It may not be the best or most realistic method for firm decisions
• Although fairer than intuitive decisions, it can be lengthy and impractical for firms with time constraints

Bounded Rationality Model

• Herbert Simon's bounded rationality model, also known as administrative man theory, addresses rational decision-making limitations
• The assumptions include the first satisfactory alternative being selected
• Decision-makers perceive the world as simple, and want to be comfortable when making decisions, there is no consideration for every alternative
• Decisions can be made using heuristics

Heuristics in Decision-Making

• These help simplify the decision-making process for reasonable solutions
• Heuristics are shortcuts to avoid lengthy decisions and problems from lack of info or time
• Common sense or intuition may be used by the consumer
• Consumers may buy goods that are cheaper in a sale
• Pre-set criteria or rules-of-thumb can result in irrational decisions

Demand Definition

• Demand is the quantity of a good or service consumers can purchase at a specific price during a period

Demand Fluctuation

• Demand varies inversely with price; lower prices increase consumer demand

Movement Along the Demand Curve

• A change in price causes movement along demand curve
• At price P1, quantity Q1 is demanded
• At price P2 lower than P1, quantity demanded expands to Q2
• At price P3 higher than P1, quantity demanded contracts to Q3

Shifting the Demand Curve

• A shift from D1 to D2 is an inward shift, indicating less demand at the same market price P1
• A shift from D1 to D3 is an outward shift, with more demand at the market price P1
• The mnemonic PIRATES helps recall factors shifting the demand curve

PIRATES

• Population: A larger population generally leads to higher demand
• Income: Higher disposable incomes increase the demand for goods
• Related goods: Substitutes or complements can affect demand
  • Substitutes examples: If one brand of TV decreases in price, the demand for another will fall
  • Complements examples: Strawberries and cream; increased strawberry prices lower cream demand
• Advertising: Effective campaigns boost consumer loyalty and demand
• Tastes and fashions: Shifting consumer preferences alter demand
  • Example: Increased e-book popularity decreases physical book demand
• Expectations: Future price speculation influences current demand
• Speculation example: Expected share price increases boost present demand
• Seasons: Demand varies according to the time of year
  • Example: Ice cream and sun lotion demand rises in summer

Types of Demand

• Derived demand: Demand is linked to a related good
  • Bricks are needed for buildings
  • Labor demand is derived from demanded goods
    • Car demand increases, boosts labor
• Composite demand: A good can satisfy more than one purpose
  • Milk can be used in cheese, using it in cheese increases cheese availability and decreases butter
• Joint demand: Goods that are bought together
  • Cameras and memory cards

Diminishing Marginal Utility

• The demand curve is inversely related, showing relationships between price/quantity.
• The Law of Diminishing Marginal Utility: As an extra unit of a unit are consumed, the marginal utility falls as benefit of good falls
• Consumers are willing to pay less for a good
• An example could be chocolate: each bar will satisfy less utility and the derived utility will eventually fall to zero

Price elasticity of demand (PED)

• The responsiveness of a change in demand to a change in price and calculated using the following formula: % change in quantity demanded divided by % change in price
• %ΔQD / %ΔΡ
• Elastic goods are very responsive to price change (>1)
• Inelastic goods have a demand that is relatively unresponsive to change in pricePED is |PED| <1
• Unitary elastic goods (PED =1) change in demand is equal to change in price, 1% decrease to price is equal to 1% increase with quantity demanded
• Perfectly inelastic goods have a demand that does not change when price changes (PED=0)
• Perfectly elastic good have a demand that falls to zero when price changes (POD=infinity)
• As an example if bread increased by 20% and the quantity decreased by 15%, the equation = -0.75, since value is less than 1, it is price inelastic

Factors influencing PED

• Necessity: The necessary the good is the more likely it is to be inelastic, luxury goods are likely to be more elastic (if price rises demand will likely fall significantly)
• How many substitutes: Android goods that can replace iPhones are said to be more elastic (market for bread is more inelastic due to fewer substitutes)
• Time scale and the long and short run: In the long run there is enough time to respond and find substitutes making it more price elastic, In the short run the goods do not respond quick making it inelastic
• Addictiveness/habit: A person would be addicted and pay for the good/habit regardless of price
• Proportion on income/good; Small price increase of something on smaller income wont affect a customer and is largely inelastic, increase of high proportion goods results in more elastic results
• Durability: A durable good results in more elastic demand as consumers wait to buy another one
• Peak/Off peak: demand is more inclined to be inelastic during peak times

Elasticity of demand and Tax Revenue

• The incidence of an indirect tax differ on consumers/firms based on elastic/inelastic
• Taxes shift the supply curve
• Inelastic demand; Firms will put most of the tax on consumers
• Price increases due to an increase in tax which decreases the overall supply, this is effective at raising government revenue
• Elastic demand; firms likely to take tax to themselves
• Increase to good prices leads to a fall in revenue
• Effective to reduce the demand
• Demand will fall significantly which is effective to help reduce any burden on the consumer
• Elasticity of demand and subsidies
• subsidies are payments from the government to encourage production and lower costs
• Subsidies have an opposite affect, it increases supply
• subsidy benefit can go to the producer or consumer

PED and total revenue

• total revenue is equal to average price times quantity sold (TR=P x Q)
• Inelastic demand; firm can raise prices and not affect the quantity sold much, increase in revenue
• Elastic demand; quantity is likely to fall, reduce revenue

Income elasticity of demand

• Responsiveness ot the change in demand relative to the change of income
• Formula: % change quantity demanded / % change in income

Inferior, Normal and luxury goods

• Inferior goods fall in demand has income increases ( YED <0)
• Normal goods = positive relationship (increase in demand has income increases) ( YED >0)
• Luxury goods = even bigger increase ( YED >1) (luxury goods also normal goods, have an elastic income
• In booming economies (income rising), firms may shift between inferior goods and luxury goods depending on the demand

Cross elasticity of demand

• Responsiveness of the change with demand relative to another good Y
• XED = %changeQuantityDemandedX / %changePriceofY

Complementary

• Goods have negative XED, If one good increase price wise, demand will fall
• Close supplements cause a small fall with price, resulting in largerQD
• Week supplements have larger fall/price results, small increaseQD

Substitutes

• Goods can replace other goods, POSITIVE for curve
• Increasing in switch
• Close, small price increases cause demand to go up
• Unrelated goods = 0 , no effect on demand

Supply curves

• quantity of service sold by seller
• supply curves slope upwards
• price increase, sell profitability so supply increases
• prices encourage new firms to enter Market, make it supply increases larger outputs/ firms costs increase, encourage higher prices

Elasticity of supply (PES)

• supply elasticity is responsiveness to supply/change
• PES= %Change quantity of supply / %Change in price
• Elastic = firms are able to quickly supply/little loss
• values are greater than 1
• Increase can be expensive firms, take a longer

Factor

• time scale -> can increase capacity depending on time
• if operating at full capacity

• level of stocks, the more firms can save the more the more prices can be reduced substitutable , depends on how labour + capital are mobile barrires to entry, high is harder to entry. Supply inelastic

Factors to remember

• Time scale: Short run the supply is more price inelastic, the less time to add supply makes it more more price
• In the short term there may not be any alternative to produce, but in the long one there will be
• Spare capacity: no more sapce to add more suplies with firm, can lead to spare supplies with lots of unempoyed
• level of stock increase/firms
• subiutituibale factor increase/mobility is more prise elastic
• the more the barriers to entry increases it becomes harder to enter the market

1.2.6- Price determination

• Equilibrium price/quantity
  • supply meets demand
  • prices stays the same
• Excess demand: price is below market. More demand that supply
• Shortage creates, it goes up due increased supply
• Excess supply: supply has no lower prices
• New market equiliburims: demand shifts can lead to reasons/changes for PINTESW, it does establish new equi

1.2.7 Price mechanism

• functions
• Determien market/ prices
• allocte resources through market economy
• move them to demand/shortages, remove from surface

3 mains to aloccate prices

• rationaing, limited resources.
• encourage chang consumer/poducver, highprice enocurages more to market
• Price acts singanl to enter/show where resources needed/signmal entry or market, reduce/eneter, shifts to

1.2.8- Consumer and Produce SUrplus

• Consumers , price that customers pay is less and prices are actaulyl paid,based/private benefit .

1. 2.9-indirect

• government leads incrased/decreased costs

2. 3 types -avelerium = % taxes.vat

• specific = 58% fuel

3. 2ped : < 1 , tax will fall consumer

• demand can be greater than 1, taxes will fall supply.

1. 3 10 alterantivre

• consumers act ratiopnally

• most optamal use/ benefit

• hmop econmousum/utilmaxer reasons

• Infile of peros, q length, reatrunatn

• 4-. habitual - redoce time takes d reduce time, consumers

• consumeres unable contril some

• Diminishing marginal utility Consumer weakness at compution- cosnumers unable contriom -12some decsions-the lam of denmsnishing marhinal utilut suggest ever other one

Explore rational decision-making within behavioral economics. Consumers maximize utility, while firms aim to maximize profits. Daniel Kahneman's two-system model highlights System 1 (intuition) and System 2 (reasoning) in economic decisions.