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Economic analysis of individual behaviour

Explain what is implied by the assumption that decision makers are rational? How is the assumption of rationality used in the economic analysis of individual behaviour? Economic rationality is the assumption that consumers in the market will always choose the options that they perceive to be the best given the circumstances that they are in and that will maximise their utility. It is a basic assumption made in all economic models designed to allow economists to make predictions and generalisations without having to focus on individualistic differences.

Without this broad assumption, it would be impossible to model economic behaviour and it has been a widely accepted economic convention since Milton Friedman’s 1954 book Positive Economics. The utility that the rational consumers will seek to maximise is the relative satisfaction obtained from the consumption of goods and it is expected economic behaviour that it will be desired for this to increase. It can also be seen how rationality has an effect on externalities and how the economic model of perfect competition There are three basic assumptions to economic rationality known as the ‘Axiomatic theories’.

These are an essential component of consumer demand theory and to meet the consumer’s goal of utility it is

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essential that they are followed; only consumers who do are considered rational. The first axiom of rationality is completeness. This rule states that the consumer must possess the ability to order every possible combination of goods as per their personal preference, however indifference is acceptable. If this axiom is violated it will lead to incomplete and incompetent decision making as not all the options will be properly considered and assessed if preferred by the consumer therefore leading to information failure.

This can be caused by ambivalence in the consumer leading to a lack of desire to consider the options available. The second is transitivity which states that the consumer must have the ability to assess different combination preferences available for example, if x is preferable to y and y is preferable to z then x must be preferable to z. This axiom is essential to rationality as if it is broken it will lead to incomplete mental ordering of options therefore not making the decision making process comprehensive and complete.

An example of this is shown in Tversky and Kahneman’s theatre ticket study where it was demonstrated that we can interfere with our own transversal thinking making our behaviour irrational. The third and final axiom is selection, meaning that the consumer will always choose the preferred and optimum combination when given a choice. This axiom has a standing of importance as if broken, the consumer would not possess the ability to make the optimum choice when presented with every option ordered by preference which would be deemed as irrational.

Economic rationality is considered in terms of utility. Every choice made by a consumer generates a certain amount of emotional experience associated with the outcome and it is in the consumers interests to maximise this utility. Rational economic behaviour can be seen as an attempt to increase this utility however as people obtain more of it there are diminishing returns known as diminishing marginal utility as each extra unit is appreciated less than the last, as is shown in figure 1 below. Figure 1- Diminishing marginal utility

Many economists are dismissive of welfare studies connected with utility for example are white people happier than black people or are married people happier than those who aren’t, as they believe that people are rational maximisers of their own utility, so therefore by definition whatever they do will maximise it. Rationality is also assumed in other economic tools for example the indifference curve. In indifference curve involves drawing a budget line inside the ‘feasible set’, the consumer can then choose any combination of amounts of the two goods at any point along the line.

The indifference curve will show at which points the consumer is indifferent to the ratio of the two products at any point, see figure 2 below. Figure 2- A diagram displaying 3 indifference curves Figure 2 shows three different indifference curves with the consumer being indifferent to what combination they have at any point along a selected curve. The 3 different curves show 3 different levels of utility that can be taken with all rational consumers aspiring to be on curve L3.

Indifference curves can never cross as this would imply that the same amount of two things can give you different levels of utility which is impossible. Indifference curves rely on rationality of consumers as if it was not present they would not necessarily want the optimum combination for the lowest price. Another model which it can be seen that there is an assumption that decision makers are rational is the Homo Economicus model. This states that the consumer ‘acts to obtain the highest possible well-being for himself given available information about opportunities’.

This is assuming rationality as it is defined by the utility function and focused on optimisation. Rationality in economics can also be seen in the formation of negative externalities. This is because if the consumer is optimising their utility they will seek to increase their marginal privite benefit without considering the marginal social cost to the general public or the environment. This leads to the area ABC in figure 3 below which is known as a negative externality. This will lead to a loss of economic welfare for socitety however this should not be considered by the rational individual consumer.

Negative Externality Diagram An example of a negative externality that may result from a rational consumer is pollution from factories that make the good that they buy or the noise pollution caused by a product. These are negative externalities as they impact negatively on parties not involved in the original transaction without affecting the consumer. A rational consumer should not pay for negative externalities as it is not utility optimising as it does not affect them negatively.

We can also see the implication of rational consumers if we look at a basic economic model for example perfect competition. As perfect competition is based on the assumptions of perfect knowledge, homogenous goods, atomicity, and free entry and exist it should mean that a consumer would always buy from the cheapest seller and therefore all the sellers should have the same price which would be at marginal cost which would make the market both productively and electively efficient as can be seen in figure 4 below. Figure 4- Diagram of Perfect Competition

Without the rational consumer assumption this model would not function as people would not necessarily buy from the cheapest seller meaning more ‘price-taking’ for the consumer and more profit for the sellers. The same mentality applies to other models including oligopolies. In conclusion, the assumption of rationality of consumers is essential to any economic model. It can be seen that to be rational a consumer must aim to optimise utility and comply with the three axioms of economic rationality being completeness, transitivity and selection.

Without trusting the assumption in question no weight can be placed on any modern day economic thinking or theory therefore it is central to today’s economic society.

References

Bone, J (2005) ‘The Social Map & The Problem of Order: A Re-evaluation of “Homo Sociologicus”‘, Theory & Science, Vol. 6:1 Tullock, G. (2005). Public Goods, Redistribution and Rent Seeking. Edward Elgar Publishing, Inc.. Kreps, David M. Notes on the Theory of Choice. Boulder, CO. Westview Press. 1988 Lecture notes- http://my. nottingham. ac. uk/cp/grouptools/fileshare/18062/28889/lecture-7. pdf

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