Rational economic decision making and economic incentives
assume consumers always act rationally aiming to increase satisfaction for every £1 spent on each product they buy.
Consumer utility
The amount of satisfaction or benefit that a consumer gains from consuming a good/ service
Marginal utility
The extra satisfaction derived from consuming one extra unit of the good
diminishing marginal utility
consumer surplus generally declines with extra units consumed.
Extra unit generates less utility than the one already consumed, therefore consumers are willing to pay less for extra units.
Utility maximisation
(consumers)
aim to generate the greatest utility possible from an economic decision.
Utility maximisation assumption
Economic agents only act in their own interests
Incentive for entrepreneur in a firm
For taking risks is profit
Rewards
Positive incentives which will make consumers better off
Penalties
Negative incentives which make consumers worse off.
Prices in relation to signals
Provide signals to buyers and sellers which is an incentive to purchase or sell the good.
(Changes behaviour)
What happens if if incentives are not given properly?
Resources will be misallocated.
Incentives for entrepreneurs
Want to avoid loss and gain profit, which makes them innovate to reduce production costs and improve quality
Why do firms need an incentive to engage in risk taking so they innovate?
Without innovation, production will cost more and there will be a misallocation of resources.
Steps of making rational decisions?
- Identify the problem
- Find and identify the decision criteria
- Weigh the criteria
- Generate alternatives
- Evaluate alternative options
- Chose the best alternative
- Carry out the decision
- Evaluate the decision
Limitations of making rational decisions
Not always the best or realistic way to make decisions.
fairer than intuitive decisions but takes longer to decide but is not practical in a firm with time constraints.
What does thinking at the margin mean?
Thinking about the effect of an additional action
Why is thinking at the margin important?
Allows consumers to keep thinking ahead. Prevents consumers thinking about things they have already done and allows them to consider how to maximise their utility now or in the future.
What can margins do to productivity
Increase productivity since the most important tasks which maximise utility the most are the ones prioritised.
symmetric information
When consumers and producers have perfect market information to make their decision.
leads to efficient allocation of resources.
Imperfect information
Where information is missing so an informed decision cant be made.
What can asymmetric information lead to?
Lead to market failure because it can lead to misallocation of resources in the market.
Principal agent problem
When the agent makes decisions for the principal but the agent is inclined to act in their own interests rather than those of the principal.
what is the bounded rationality model also known as?
The administrative man
Assumptions of Bounded rationality model
- The first alternative that is satisfactory is selected
- The decision maker recognises that they perceive the world as simple
- The decision maker recognises the need to be comfortable making decisions without considering every alternative
- Decisions could be made by mental short cuts.
