Behavioural Economics | A-Level Economics Model Paragraph
Explain how imperfect information can lead to market failure.
Imperfect information occurs when an economic agent does not have all the information needed to make an optimal decision, and poor information contributes to bounded rationality. Bounded rationality is the idea that humans do not always make completely rational decisions due to their limitations. These limitations include a lack of time, a lack of information, and any emotional factors. This lack of information, or the challenge to find accurate and concise information, can lead to individuals being affected by biases and therefore satisficing; making decisions that are satisfactory rather than optimal. This can lead to over-consumption or under-consumption of goods and services, which is a misallocation of resources, and hence market failure. For example, consumers may have imperfect information about the effect of sweeteners on their health and may wrongly assume that they are healthy as they are low calories. Therefore, they are likely to over-consume sugary drinks.
Explain how asymmetric information can cause market failure.
Asymmetric information is a specific type of imperfect information where one party has more information than the other party about an economic transaction. Sellers are motivated to maximise their profits whilst buyers are motivated to maximise their utility. Therefore, sellers can often hide information or present it in a misleading way. This can lead to consumers being unable to correctly value the utility a good or service will bring them, and therefore lead to an under-consumption or an over-consumption, and therefore a misallocation of resources. For example, the seller of a second-hand car is likely to hold much more information than any potential buyer. This can allow them to hide details that might put off a buyer, such as any recurring faults or small issues that can only be found after owning the car for a longer period of time. This can lead to consumers paying more than they'd actually be willing to pay if they had full information. In theory, this leads to consumer surplus being negative. Consumer surplus is the difference between the price a consumer pays compared to the maximum price they would have been willing to pay for that good or service. As a result, social welfare is not maximised, and there is a clear misallocation of resources in the market for second-hand cars.
Explain how bounded rationality can affect decision making.
Bounded rationality is the idea that people do not always make completely rational decisions, due to human limitations. This is a key finding from behavioural economics, which takes elements from psychology to help us better understand how economic agents make decisions. Some of the main limitations to humans include a lack of time, a lack of information, and any emotional or computational weakness. Due to these human limitations, agents end up satisficing by making quick and easy decisions that are satisfactory rather than optimal. For example, consumers may not maximise their utility when choosing a lunch-time meal deal. Firstly, many drinks contain ingredients like sweeteners for which there is limited research. Secondly, consumers do not have the time to make a fully informed decision as they may have to return to work quickly. Thirdly, computational weakness means that consumers may still struggle to make optimal choices even if they had sufficient time and perfect information. Consumers may not have the ability to think logically, and they may instead rely on emotion. This can cause them to rely on biases or rules of thumb instead. Overall, bounded rationality can lead to consumers making choices that lead to satisficing rather than optimal outcomes.
Explain how bounded self-control can affect decision making.
Bounded self-control is the idea that people lack the self-control to make certain choices even if they are optimal. This comes from behavioural economics, which takes concepts from psychology to help economists understand why economic agents do not always make optimal decisions, but instead make decisions that are satisfactory. One of the reasons for this is a lack of self-control, which explains that there are times when consumers know what is best for themselves long-term but they still struggle to make the optimal choice. This can be due to them forming habits, especially when certain actions are easier or more addictive. For example, a consumer might know that vaping is not healthy but they might still do it due to it becoming a habit. Other issues like herd behaviour can make it even harder for consumers to practice self-control. Overall, bounded self-control can lead to consumers making choices that lead to satisficing rather than optimal outcomes.
Explain how rules of thumb can affect decision making.
Rules of thumb (heuristics) are mental shortcuts that allow people to save time and mental effort when making decisions. This idea comes from behavioural economics, which takes concepts from psychology to help economists understand why economic agents do not always make optimal decisions, but instead make decisions that are satisfactory. Economic agents are not completely rational due to a lack of time and information, and also due to computational weakness. As a result of this, consumers rely on shortcuts to make quick decisions under pressure regardless of how much information is available to them. Examples of biases and rules of thumb include anchoring, availability bias, and social norms, and these can make decision-making more convenient but also satisfactory rather than optimal for consumers.
Explain how anchoring can affect decision making.
The idea of anchoring comes from behavioural economics, which takes concepts from psychology to help economists understand why economic agents do not always make optimal decisions, but instead make decisions that are satisfactory. Anchoring is when people rely too much on a single piece of information. This is usually the first piece of information available to the consumer. For example, when shopping for food, consumers are likely to notice statements that are presented in a larger font like ‘ZERO SUGAR’ or ‘HIGH PROTEIN’ and immediately decide that the food is healthy. This leads to them ignoring the other ingredients and failing to understand that ultra-processed foods can be bad for them. As a result, consumers may over-consume goods that are not as healthy as they appear, leading to satisficing rather than optimal outcomes.
Explain how availability bias can affect decision making.
The idea of availability bias comes from behavioural economics, which uses concepts from psychology to help economists understand why economic agents do not always make optimal decisions, but instead make decisions that are satisfactory. Availability bias is when people’s decisions are influenced by recent or memorable events. These memories can cause people to over-estimate or under-estimate the likelihood of future events rather than treating each situation independently. For example, if a customer had a bad experience buying a second-hand BMW, they may think that all BMWs are unreliable, even though their experience was specific to one dealer rather than the brand as a whole. As a result, this consumer becomes more likely to avoid this particular car model, even if it is the optimal choice.
Explain how social norms can affect decision making.
Social norms can function similarly to rules of thumb, which are mental shortcuts that allow economic agents to make faster and easier decisions. Traditionally, economic agents are assumed to be rational but behavioural economics and psychology teaches us that agents often make quick, easy, satisfactory decisions more often than optimal ones. Social norms are behaviours or choices that are consistent with what seems to be accepted by the rest of society. Following social norms can lead to consumers making both better and worse decisions compared to otherwise. For example, as environmental protection becomes more important to the rest of society, it becomes more likely that individual consumers choose to switch to electric cars. At the same time, consumers are likely to continue to make decisions that might not be optimal, such as consuming fast food or sugary drinks, as these are generally accepted by most of society. Overall, social norms can influence decision making in both positive and negative ways.
Explain how altruism can affect decision making.
Behavioural economics takes ideas from psychology to help us improve our understanding of how economic agents make decisions. Altruism is the idea that consumers do not always make decisions in line with their self-interest. Instead, it is quite normal for people to choose to do the ‘right thing’ and go against what traditional economic theory would assume. For example, the market for blood is influenced by altruism. A traditional supply curve is upward sloping based on the idea that producers are motivated by profit, and therefore a higher price can encourage firms to produce more goods and services. In reality, introducing a market for blood could in fact cause supply to fall, as donating blood becomes transactional. Traditional economic theory doesn’t account for the utility that an agent can get from a gesture of goodwill. Overall, altruism can help us to understand that offering financial rewards can sometimes have unexpected effects on behaviour.
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