Rational Consumer Choice (DP IB Economics)

Assumptions of Rational Consumer Choice

• Free markets are built on the assumptions of rational decision making
  

• In classical economic theory, the word 'rational' means that economic agents are able to consider the outcome of their choices and  recognise the net benefits of each one

  • Rational agents will select the choice which presents the highest benefits (utility)
     

• Rational choice theory states individuals use logical and sensible reasons to determine the right choice connected to an individual’s best self-interest
  

• Many economic theories assume that economic agents (individuals, firms and governments) make decisions that result in maximising their satisfaction

  • E.g. The law of demand which states that as the price falls consumers will increase their demand for goods and services
     

• This traditional economic view is based on the following three assumptions

1. Consumer Rationality

• The assumption that individuals use rational calculations to make choices which are within their own best interest, using all the information available to them
   

2. Utility Maximisation

• Traditional economic theory assumes economic agents select choices that maximise their utility to the highest level 

  • E.g. If an individual gains greater satisfaction from swimming than going for a run, they will chose to go swimming
     

3. Perfect Information

• Rational choice theory assumes information is easily accessible about all goods and services on the market. It assumes individuals have access to all the information available to make the best decision

Limitations of the Assumptions of Rational Consumer Choice

• Behavioural economics contrasts traditional economics as it challenge the view that economic agents behave rationally
   

• Behavioural economics is a field of study that combines elements of psychology and economics to understand how people make decisions and behave in economic contexts
   

• Behavioural economics recognises that human decision-making is influenced by cognitive biases, emotions, social, and other psychological factors that can lead to deviations from rational behaviour
   

• The assumptions of traditional economics regarding decision making do not hold
   

• The following limitations mean individuals are unlikely to always make rational decisions
   

Limitations of the assumptions of rational consumer choice

1. Biases

• Biases influence how we process information when making decisions and these influence the process of rational decision making

  • Examples of bias include common sense, intuition, emotions and personal and social norms
     

Types of Bias

Type of Bias	Explanation
Rule of Thumb	This is when individuals make choices based on their default choice based on experience E.g. Individuals may also order the same pizza anytime they order from Pizza Hut However the best choice may be to buy the new tasty option which is available at 50% discount
Anchoring and Framing	Anchoring bias occurs when individuals rely too heavily on an initial piece of information (the "anchor") when making subsequent judgments or decisions E.g. When buying a used car the seller may initially suggests a price of $10,000. Even if you know the market value is lower, the anchor of $10,000 might still influence your perception and as a result, the consumer ends up paying a higher price than intended Framing refers to how the presentation or wording of information can significantly influence people's choices or judgments The same information can be framed in different ways, leading to different outcomes E.g consumers are likely to purchase a product that states ‘80% fat free’ than ‘20% fat’
Availability Bias	Occurs when people rely on immediate examples or information that comes to mind easily when making judgments or decisions It leads individuals to overestimate the likelihood or importance of events or situations based on how readily available they are in their memory   Availability bias is influenced by personal experiences, vividness of the information, media exposure, and emotional impact E.g. people use alternative modes of transport when there is a plane crash, even though the probability of a crash happening is very low

2.    Bounded Rationality Theory

• This theory argues that people make decisions without gathering all the necessary information to make a rational decision within a given time period

  •  Individuals may not understand the technical jargon linked to selecting insurance or pensions
     

• The theory assumes rational decision making is limited because of

  • An individual's thinking capacity

  • Availability of information

  • Lack of time available to gather all of the infromation and make a judgement
    
    

• Too much choice can also cause people to make irrational decisions

  • E.g. when making choices about purchasing particular products in the supermarket, there may be too much choice making it difficult to make a decision 

3. Bounded Self-Control

• The theory of bounded self-control suggests that individuals have a limited capacity to regulate their behaviour and make decisions in the face of conflicting desires or impulses

  • It recognises that self-control is not an unlimited resource that can be exercised endlessly without consequences
     

• Humans are social beings influenced by family, friends and social settings. This often results in decision making which conforms to social norms but does not result in the maximisation of consumer utility
    

•  Bounded self control leads to decision making based on emotions, which may not yield the best outcome. 

  • E.g people may indulge in impulsive spending, purchasing goods they didn’t originally intend to buy 
     

• Businesses use marketing to capitalise on the lack of bounded self-control of individuals when appealing to their target audience to maximise sales

  • E.g. Supermarkets place a range of items at the checkout register to encourage impulse purchases

4. Bounded Selfishness

• Behavioural economics challenges the view that economic agents always act within their own self interest
   

• Bounded selfishness recognises that individuals do things for others without a direct reward

  • Altruism is the practice of acting selflessly helping others expecting nothing in return
     

• Examples of bounded selfishness include

  • Donating money to charity

  • Organ donations

  • Voluntary work

5. Imperfect Information

• Rational Choice Theory assumes information is perfectly accessible, however this is incorrect due to factors such as

  • Intellectual property rights e.g. patents, copyrights and trademarks

  • Cost of accessing information

  • The sheer amount of information and options available
     

• This means people make decisions based on limited information meaning they may not make the best choice
   

• Asymmetric information may also lead to decisions based on limited information

  • E.g. When purchasing second hand cars, the seller always has more information than the buyer