A-Level Economics Notes on Rational and Irrational Consumer Behaviour

Definitions

1. Behavioral Economics: A field that combines insights from psychology and economics to explain human decision-making.
2. Rationality: The concept that individuals make decisions based on maximizing utility.
3. Utility: A measure of the satisfaction or happiness gained from consuming a good or service.
4. Nudge: A subtle change in the environment that influences behavior without restricting choice.
5. Cognitive Bias: Systematic errors in decision-making arising from the way people process information.
6. Bounded Rationality: The idea that rationality is limited by the information, cognitive limitations, and time available for decision-making.
7. Prospect Theory: Describes how people make choices involving risk and uncertainty.
8. Anchoring: The tendency to rely too heavily on the first piece of information encountered.
9. Loss Aversion: The tendency to prefer avoiding losses over acquiring equivalent gains.
10. Mental Accounting: The cognitive process of categorizing and evaluating financial outcomes.
11. Time Inconsistency: The tendency to value immediate rewards more highly than future rewards.
12. Social Norms: Unwritten rules about how to behave in a particular social group or culture.
13. Herd Behavior: The tendency to follow the behavior of the majority.
14. Sunk Cost Fallacy: The mistake of incorporating past losses into current decisions.
15. Endowment Effect: The tendency to overvalue something simply because you own it.

Rational Choice Theory

Rational Choice Theory posits that individuals make decisions based on rational calculations to maximize their self-interest or utility. This is the basic assumption that underpins much of “mainstream” economics. Individuals are interested in maximising their utility, meaning the net benefit they get from purchasing a product once costs are factored in. 

• Complete Information: Assumes individuals have all the information needed to make a decision.
• Transitive Preferences: Preferences are consistent and can be ranked.
• Maximization: Individuals aim to maximize utility or benefit.

Behavioural Economics: Bounded Rationality

Bounded rationality refers to the limitations people face when making decisions. These limitations include cognitive capacity, access to information, and time constraints. It challenges the traditional economic assumption that individuals always act rationally to maximize utility. Instead, people often make satisfactory rather than optimal choices.

Common Biases in Behavioral Economics

Confirmation Bias

People tend to seek and interpret information that confirms their existing beliefs, ignoring contradictory evidence.

Anchoring Bias

Initial information, such as first impressions or initial price offers, can disproportionately influence decision-making.

Overconfidence Bias

Individuals often overestimate their abilities or the accuracy of their predictions, leading to risky behavior.

Availability Heuristic

People judge the likelihood of events based on how easily examples come to mind, often leading to overestimation of rare events.

Loss Aversion

People are more sensitive to losses than to gains, which can lead to irrational choices like holding onto losing stocks.

Sunk Cost Fallacy

People continue a behavior or endeavor based on previously invested resources, even when it’s not in their best interest.

Nudge Theory

Nudge Theory is a concept in behavioral economics that suggests subtle changes in the environment can influence people’s behavior without restricting their freedom of choice. It’s based on empirical evidence about people’s psychological setup, including both rational and arational decision-making capacities.

Real-World Examples

1. Healthy Eating: Placing fruits at eye level in grocery stores encourages healthier food choices.
2. Retirement Savings: Setting up automatic enrollment in retirement savings plans boosts participation rates.
3. Organ Donation: Making organ donation an opt-out rather than opt-in system increases donor numbers.

Nudge Theory challenges the traditional economic assumption that individuals are always rational actors. It incorporates behavioral insights, showing that people’s choices can be influenced by how options are presented, thus adding complexity to economic models. Traditional economics often assumes rational decision-making, but Nudge Theory shows that choices can be inconsistent with the prescriptions of theories of rational choice.