Rational Decision Making in Behavioral Economics

Rational Decision Making

• Behavioural economics studies rational decision-making
• Consumers maximize utility, while firms maximize profits, when making economic decisions
• Utility represents total satisfaction from consuming goods or services
• Kahneman's two-system model explains how decisions are made
  • System 1 is based on common sense and emotional responses, enabling quick decisions but prone to biases
  • System 2 uses thoughts and reflections, minimizing bias but decisions can be manipulated
• Firms or individuals can make decisions using intuition or rational thought
  • Intuition relies on feelings, while rational decisions use facts and analysis

The Rational Decision-Making Model

• Involves a structured process:
  • Identify the problem
  • Identify the decision criteria
  • Weigh the criteria
  • Generate alternatives
  • Evaluate options
  • Choose the best
  • Carry out the decision
  • Evaluate the decision
• Limitations include it may not be the best approach for firms to make decisions
• Can be more fair than intuition, this approach may not be practical with time constraints

The Administrative Man

• Herbert Simon's bounded rationality model, also known as the administrative man theory, recognizes limitations
• Assumptions include
  • The first satisfactory alternative is selected because of simplicity in the world
  • Decision makers are comfortable making decisions without considering every alternative
  • Decisions can be made by heuristics, which simplify decision making and avoid time constraints
• Heuristics are shortcuts to avoid taking too long and dodge imperfect information or limited time
• Consumers might use intuition or pre-set criteria

Demand

• Demand means the quantity of a good that consumers are willing to buy at a price during a time
• Demand generally increases as price decreases with movements along the demand curve caused by changes in price
• Expansion of demand happens at a lower price, leading to a larger quantity
• Contraction of demand happens at a higher price, leading to a lower quantity

Factors that Shift the Demand Curve

• Population size affects demand due to structure changes
• Higher income results in increased demand
• Related goods include substitutes or complements
• Advertising increases consumer loyalty and demand
• Tastes and fashions may shift demand curves
• Expectations of future price changes of future increase are high
• Seasons impact demand

Types of Demand

• Derived demand occurs when one good is linked to another.
• Composite demand is when a good has multiple uses.
• Joint demand involves goods bought together.

Diminishing Marginal Utility

• Demand curve slopes downwards - due to the inverse relationship between price and quantity
• The law of diminishing marginal utility states that as consumption increases, then marginal benefit falls
• Consumer willing is only willing to pay less as utility derived falls

Price Elasticity of Demand (PED)

• PED measures the responsiveness of demand to price changes
• The formula is: PED = (% Change in Quantity Demanded) / (% Change in Price)
• Price elastic goods see a substantial demand change compared to price
• Price inelastic goods are unresponsive to price changes

Categories of PED

• Unitary elastic: Demand changes proportionally to price (PED = 1)
• Perfectly inelastic: Completely unresponsive to price (PED = 0)
• Perfectly elastic: Demand falls to zero with any price change (PED = infinity)
• Factors influencing PED: Necessity, Substitutes, time scale, Addictiveness, Proportion of Income, Durability, Peak/Off-Peak Demand

Elasticity of Demand and Tax Revenue

• The distribution of an indirect tax affects consumers and firms relying on demand elasticity
• Taxes shift the supply curve
• Firms selling inelastic goods pass the tax burden to the consumer, because price increases will not cause decline in demand
• An increase in tax decreases supply, increasing price and decreasing demand
• Firms selling elastic goods absorb the tax, because increases in price will lower overall revenue
• Taxes effectively reduce demand and only effective at raising government revenue in certain goods

Elasticity of Demand and Subsidies

• Subsidies encourage production and lower costs.
• They have the opposite effect of taxes, increasing supply which reduces average costs
• Subsidies can increase revenue for producers and lower prices for consumers

PED and Total Revenue

• Total revenue is equal to average price times quantity. TR= P x Q
• If a good has an inelastic demand, the firm can raise its price and quantity without significantly affecting revenues
• If a good has an elastic demand, the firm raises its price which will reduce total revenue

Income Elasticity of Demand

• Income elasticity measures the responsiveness of demand to income change
• Formula: YED = (% Change in Quantity Demanded) / (% Change in Income)
• Inferior goods experience falling demand as income rises (YED less than 0), whereas normal goods increase
• Luxury goods exhibit bigger demand surge with income increase (YED greater than 1)

Cross Elasticity of Demand

• Cross elasticity measures the responsiveness of demand for one good, X, to a change in price of another good, Y
• Formula: XED = (% Change in Quantity Demanded of X) / (% Change in Price of Y)

Goods Classification by XED

• Complementary goods have negative XED where increased price reduces quantity demanded for both
• Substitutes have positive XED
• Unrelated goods have zero XED
• Firms are interested in XED to gauge any potential consequences where they are less affected.

Supply

• Supply means the quantity of a good or service that a producer is willing to provide at a price during a specific period.
• Supply curves slope upward because:
• Increased prices mean supply increases
• Higher prices mean firms are encouraged to enter the market, so supply increases

Movement Along the Supply Curve

• At a lower price, lower quantity is supplied.
• At a higher price, a higher quantity is supplied.
• Increase from price 2, increases quantity supplied too
• If price increases, quantity increases, this shows expansion.
• Changes in price cause supply curve movements.

Factors Shifting Supply Curve

• Productivity: increase in productivity causes an outward shift in supply with a fall in average costs
• Indirect taxes lead to inward shifts
• Numbers of firms: rising numbers increase overall supply
• Technology advancements result in outward shifts
• Subsidies cause outward shifts
• Weather influences increases in supply
• Costs of Production influences inward shift
• Depreciations in exchange rate will impact supply

Types of Supply

• Joint Supply: Increasing the supply of one good increases another.

Price Elasticity of Supply (PES)

• The change in supply to a price change can be explained by the PES
• Formula: PES = (% Change in Quantity Supplied) / (% Change in Price)
• Elastic supply suggests firms are able to increase it quickly at lower costs
• Inelastic supply means increasing it would have to take firms longer, and be at the price of greater expense

Categories of PES

• PES = 0 is a perfectly inelastic supply as it is fixed, any change in demand cannot be met easily
• Any change in demand without changing the price is perfectly elastic

Influences over PES

• Elasticity is influenced by several factors: Time Scale, Spare Capacity, level of stocks, substitutable alternatives, barriers for market entry
• Short run is usually inelastic with producers unable to increase supply quickly but increases over time
• Full operating capacity leads to an inability for any major supply increase and so it will not be affected by capacity
• The amount firms can stock - increases if storage and market supply are available, but becomes inelastic with perishables
• Mobile capital leads to a elastic supply
• A more inelastic supply for high entry barriers that cannot be easily overcome by firms

Price Determination

• Equilibrium price and quantity mean that supply meets demand, with no tendency to change this
• Excess demand means demand is above the market equilibrium as demand outstrips supply leading to shortages in the market

Excess Supply

• Excess supply means price is above equilibrium whereby firms will lower in price until it returns to equilibrium

New Market Equilibriums

• Shifts in demand or supply establish new equilibriums
• An rise would see suppliers adjust their prices to reflect the change and reach a new market equilibrium

Function of the Price Mechanism

• Functions: Price mechanism determines the market price, also known as the "invisible hand" by Adam Smith - resources allocated to demanded areas with a shortage and surplus removed
• The price mechanism allocates using the three main functions that is rationing, incentive, signalling
• Rationing includes a change in market due to the allocation that becomes a disincentive for non-essential consumers
• Incentives encourage consumer and producer changes such as high prices mean extra profit
• Signalling the price changes indicates needed resources that creates shifts in demand and supply curves

Consumer and Producer Surplus

• The difference between the consumers’ willingness and is consumer surplus
• Above the market, and under the demand curve
• Consumer surplus will decline as consumers will consume other units that result in satisfaction declines causing them to pay extra
• Inelastic Demand curves show the price consumers will consume because it is worth consuming

Changing Consumer Surplus

• Increased demand can influence more consumer surplus
• Decrease can occur due to a supply shift left, increasing price of goods resulting in a fall

More on Producer Surplus

• Difference between producer's willingness and what they charge which covers costs and is measured against profits
• Shift from supply curve results in market prices decreasing so a decrease in producer surplus occurs
• Rise or shift in demand also occurs due to a rise in producer surplus

Economic Welfare

• The total benefit received from a economic transaction resulting in community surplus by adding producer and consumer
• Synoptic point is that there can an assessment on effects on producers and consumers

Indirect Taxes and Subsidies

• Indirect Taxes: levied by the Government and production is impacted with a market price
• These taxes show vertical shifts through supply curves which causes the incidence of Tax
• Ad valorem taxes are percentage based that add money to units, pivot supply curve (VAT)
• Specific Taxes: set tax per unit (fuel duty).
• Incidence of taxes only affects when supply is elastic or demand is inelastic
• A perfect outcome results in tax falls on the consumer due to having shaded areas for extra amount paid and if the tax reduces with demand being elastic will fall to the supplier

The Impacts of Valorem Taxes, & Revenue, and Downside

• revenue is effective with extra demand.
• For the implementation of internalising the externality is the price of putting value on taxes.
• To put a tax to mean that they caused externalities, or a tax to ensure that they pay for the damages on a situation
• Downsides: Expensive and can cause a negative effect for those on lower set of incomes

Subsidies

• Payment from a producer made to lower a cost of living for the consumer with an incentive to grow
• Provide more apprenticeships to farmers, with production being subsidised to shift supply curve.
• The area shifted also shows the price of the subsidies and unit the output.

More effects of subsidies

• Increase and low price of consumers helps boost jobs through creating more apprenticeship plans.
• Inelastic demand is more significant with inelastic and benefit more than demand elasticity

Consumer Subsidies

• Provides a loan without interest Affects demand and doesn't shift supply Lower production costs and supply curves change

Alternative Views of Consumer Behaviour

• Consumer Behaviour isn't always rational and the rational consumer is Homo Economicus, maximises a utility.
• This is influenced by the people around consumers
• Habits reduce the amount of time it takes to do something, because consumers no longer have to consciously think about their actions. Consumer weakness at computation Consumers are unable to exercise self-control with some decisions - there are long term effects.

Explore rational decision-making in behavioral economics. Consumers maximize utility and firms maximize profits. Kahneman's two-system model explains quick, bias-prone System 1 and reflective, less biased System 2 decisions. Firms and individuals use intuition or the rational decision-making model.