Rational consumer choice
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Free markets rely on the assumption of rational decision-making, where economic agents can assess the outcomes of their choices and recognize their net benefits.
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Rational agents select choices that offer the highest utility or satisfaction, as per rational choice theory.
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Economic theories presume individuals, firms, and governments aim to maximise satisfaction.
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Consumer Rationality: Individuals make choices based on rational calculations and available information.
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Utility Maximisation: Economic agents choose options that maximise their utility or satisfaction.
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Perfect Information: Rational choice theory assumes individuals have easy access to all information regarding goods and services to make optimal decisions.
Limitations of the Assumptions of Rational Consumer Choice
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Biases: impact the rational decision-making process by influencing our perceptions, judgments, and choices.
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Rule of Thumb: Individuals often default to familiar choices based on past experiences, potentially overlooking better alternatives.
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Anchoring and Framing: Anchoring bias involves relying heavily on initial information, while framing refers to how information presentation influences decisions.
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Availability Bias: : People tend to overestimate the likelihood of events based on how easily they come to mind, influenced by personal experiences, media exposure, and emotional impact.
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Bounded Rationality Theory: People often make decisions without all necessary information due to time constraints and technical complexities.
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Overwhelming choices, like in supermarkets, can lead to irrational decisions.
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Bound Self-Control: Individuals struggle to regulate behaviour amid conflicting impulses, often influenced by emotions and social norms.
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Limited self-control can result in impulsive spending, exploited by businesses through strategic marketing.
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Bounded Selfishness: Behavioural economics challenges the assumption of self-interest, recognizing actions for others without direct rewards, such as altruism.
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E.g) include charity donations and voluntary work.
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Imperfect information: Rational Choice Theory assumes perfect information accessibility, which is unrealistic due to factors like intellectual property rights.
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Asymmetric Information: May lead to decisions based on limited information
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Eg.) second-hand car purchases = can lead to suboptimal decisions.
Behavioural economics in action
Choice architecture involves deliberately shaping how choices are presented to influence decision-making
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Eg.) positioning salad bars at the start of buffets.
Choice architecture aims to simplify the decision making process
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Encourage individuals to make a particular choice - often bundling items together
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Bundling menu items at restaurants.
Types of Choice Architecture
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Default Choice: Individuals are automatically enrolled in a specific option, reducing their decision-making, as seen with driver's licence agencies defaulting to "organ donation."
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Restricted Choice: Limited options help individuals make more rational decisions, like replacing unhealthy items with healthier choices in cafeterias.
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Mandated Choice: Requirements force individuals to make specific decisions to comply with rules, such as mandatory car insurance in some countries.
Evaluation of Choice Architecture
Advantages | Disadvantages |
Influences Behaviour: Nudges individuals towards beneficial choices or desired outcomes. | Manipulation: Can be perceived as manipulation, potentially infringing on free choice. |
Simplifies Decision-Making: Clear options can simplify complex decisions. | Ethical Concerns: Individuals may not realise their decisions are influenced or understand consequences fully. |
Improved Outcomes: Encourages healthier habits like eating, addressing issues such as obesity. | Potential for Bias: Susceptible to biases, potentially exploited by companies for profit. |
Enhance Decision Quality: Structured choices can guide decisions, reducing biases for better choices. | Unintended Consequences: Changes may lead to unexpected outcomes not aligned with goals. |
Nudge Theory
Involves subtly influencing the decisions of economic agents through small prompts to steer their behaviour.
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Eg.) Healthy options like salads are prominently displayed, nudging individuals towards healthier choices.
Evaluation of Using Nudge to Influence Behaviour
Advantages | Disadvantages |
Cost-effective: Nudges are relatively low-cost compared to other marketing methods. | Ethical Concerns: Critics worry about manipulation and autonomy. |
Preserves Freedom of Choice: Guides decisions while allowing individuals to retain their freedom. | Lack of Transparency: Nudges operate subtly, making them hard to question. |
Improved Public Health: Encourages healthier behaviours like exercise and nutritious eating. | Unintended Consequences: Resistance may lead to unexpected outcomes. |
Better Decision Making: Simplifies complex information and aids decision-making. | Variable Success Rates: Effectiveness may vary due to biases or cultural differences. |
Business objectives
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Profit maximisation
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Involves determining the level of output that the firm should produce to make profit as large as possible.
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Standard economic theory assumes that firms are driven by their goal to maximise profit.
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Two methods used to maximise profits:
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TR-TC method: profit is maximum at the level of output where TR-TC is greatest.
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MR=MC method: profit is maximum at the level of output where MR=MC.
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Determining the profit-maximising output level can be challenging for firms, and they may delay price adjustments due to factors like changing costs or regulatory constraints.
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Long-term price adjustments may align with profit maximisation, though competition regulators may intervene, especially for natural monopolies (HL).
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Profit maximisation often leads to higher consumer prices, and changes in prices affect marginal revenue.
Evaluating Profit Maximisation
Advantages | Disadvantages |
Financial Stability and Growth: Maximising profits helps businesses accumulate capital, reinvest in growth, and withstand economic uncertainties. | Ethical and Social Concerns: Profit maximisation may disregard employee, community, and environmental well-being, causing negative externalities. |
Shareholder Value Creation: Profit maximisation enhances shareholder value, attracting investors and maintaining market competitiveness. | Risk of Neglecting Non-Financial Metrics: Factors like employee satisfaction, customer loyalty, and environmental sustainability may be overlooked if not directly tied to immediate profit. |
Resource Allocation Efficiency: Profit-driven incentives promote efficient resource allocation, boosting productivity and cost control. | Short-term Profits versus Long-term Value Creation: Focusing on short-term profits may hinder future value creation through research or innovation efforts. |
Alternative business objectives:
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Corporate social responsibility
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Involves conducting business ethically and balancing the interests of shareholders with those of the wider community.
Examples of CSR
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Sustainable sourcing of raw materials and components
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Responsible marketing
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Protecting the environment
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Responsible customer service
Evaluating CSR Objectives
Advantages | Disadvantages |
• Enhances business image and reputation.
• Attractive to stakeholders, adding value for many.
• Can be profitable.
• Improves employee motivation and productivity.
• Aids in recruiting strong candidates.
• Helps address social problems like resource depletion. | • Involves significant financial and resource commitments, diverting attention from other priorities.
• Raises stakeholder expectations.
• Challenges in defining and measuring impact.
• Risk of accusations of greenwashing or socialwashing without genuine commitment and meaningful action. |
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Satisficing
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Firms have many different goals, some of which may conflict, and they may not want to “maximise” anything (profit, revenue, growth, etc) that could give rise to a significant sacrifice of something else.
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Small firms may satisfice to meet the business owner's desires and enhance well-being.
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Large firms satisfice due to the principal-agent problem, with managers balancing profit and sales maximisation to reduce conflicts with shareholders.
Evaluating Satisficing
Advantages | Disadvantages |
• Provides internal stakeholders with the chance to achieve a healthy work-life balance or pursue other meaningful goals.
• Lowers decision-making costs and accelerates the process by minimising extensive research needed for optimal profit-maximising solutions. | • Risks mediocrity, misses opportunities for improvement, and reduces competitiveness.
• Deters innovation and creativity.
• Falling short of higher expectations leads to dissatisfaction, disengagement, and scepticism. |
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Growth maximisation
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Companies must carefully evaluate trade-offs and adopt a balanced approach to growth, considering risk management, organisational capabilities, and the long-term sustainability of growth actions.
Revenue Maximisation as a Sign of Growth
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Firms aim to maximise revenue to boost output and capitalise on economies of scale.
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In the short term, this strategy can help eliminate competition by offering lower prices than profit maximisation.
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To achieve revenue maximisation, firms produce up to the output level where marginal revenue (MR) = 0.
Market Share as a sign of Growth
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Some firms prioritise sales maximisation, aiming to lower prices and potentially increase market share.
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Sales maximisation occurs at the output level where AC = AR, typically at normal profit or breakeven.
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In the short term, firms may employ this strategy to clear stock during a sale or expand market share.
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Firms sell remaining stock without incurring losses per unit.
Evaluating Growth as a Corporate Objective
Advantages | Disadvantages |
• Increased market share and competitive advantage
• Growth often leads to improved financial performance and increased shareholder value.
• Pursuing growth stimulates innovation and attracts top talent.
• Growth creates opportunities for employees to take on new roles and responsibilities, fostering a dynamic work environment. | • Growth poses risks and complexities, such as straining resources, disrupting processes, and exposing companies to new challenges.
• Rapid growth can strain organisational resources and customer service capabilities.
• Diversifying into unrelated markets may lead to a loss of focus and stretch resources. |