2.4.1 Rational consumer choice (HL only) Notes

Most economic models and theories are based on the idea that decision-makers maximise their own satisfaction:

1. Consumers maximise their utility (satisfaction from buying a good or service).
2. Producers maximise their profits.
3. Workers maximise wages.
4. Investors maximise returns.

However, as we will discover in this section, these assumptions may not always hold.

Assumptions behind the rational consumer choice

Consumer Rationality

Rational consumer choice assumes that consumers are rational. In economics, consumer rationality exists when consumers follow these three principles:

1. Completeness.
2. Transitivity.
3. Non-satiety.

Completeness

1. Consumers can always rank goods and services in order of preference.
2. They can state with certainty whether they prefer good $X$ to good $Y$, $Y$ to $X$, or if they are indifferent between the two.

Transitivity

1. Preferences remain consistent and do not cycle.
2. For example, if a consumer prefers good $X$ to good $Y$, and good $Z$ to good $X$, they will also prefer good $Z$ to good $Y$.

Non-satiety

1. More is always better.
2. Having more of a good or service is preferred because it increases utility or satisfaction.

Utility Maximisation

1. Consumers aim to maximise utility in each of their choices.
2. Given a budget constraint, they choose the goods or services that lead to them having the most utility.

Perfect Information

1. Assumes consumers have access to all relevant information about their options (e.g., prices, quality, alternatives).
2. Hence there is no uncertainty in their decision.

Behavioural economics: limitations of the assumptions of rational consumer choice

1. Behavioural economics highlights the psychological, emotional, and social factors that influence decision-making.
2. Challenges the idea that consumers always act rationally.

There are 5 main factors that behavioural economics considers to influence the rational consumer choice:

1. Biases.
2. Bounded rationality.
3. Bounded self-control.
4. Bounded selfishness.
5. Imperfect information.

Biases

Human brains simplify complex decisions using cognitive shortcuts, or biases, causing systematic errors in judgement. Examples of cognitive shortcuts are:

1. Rules of Thumb: Simplified guidelines based on experience and common sense that make complicated choices and ideas simpler to understand.
2. Anchoring: Use of irrelevant information to make decisions that still affect judgement (likely due to it being the first piece of information)
3. Framing: The presentation of choices to decision-makers affecting their judgement (how the choices are framed)
4. Availability: Most recent information that people rely upon even though there's no reason to trust this over older information (recency bias)

Bounded rationality

Herbert Simon’s concept of bounded rationality suggests that people cannot process all available information due to:

1. Cognitive limitations
2. Time constraints
3. Complexity.

Instead of optimising, people "conform". They choose an option that is good enough. Hence consumers are only rational under limits.

Bounded self-control

1. Bounded self-control is the idea that even when people know what’s best for them, they often lack the self-control to act accordingly.
2. They never behave exactly as they should.

Bounded selfishness

1. Rational consumer choice economics assumes people act purely out of self-interest.
2. Bounded selfishness acknowledges that humans often act altruistically, even at a personal cost.

Imperfect Information

1. Consumers rarely have perfect information.
2. They may lack the time, resources, or expertise to evaluate all options thoroughly.
3. Often it's difficult to even comprehend limited information.
4. The combination from all of the above leads to imperfect information.