Crucible Education Centre
Economics Department
Microeconomics:
1b. Rational Decision
Making
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Economics Department
RATIONAL DECISION MAKING
Rational decision making requires us to analyse how decisions are made from the
perspective of different economic agents (consumers, producers and governments),
adjusting for dynamic changes where appropriate.
We have to consider the benefits, constraints, costs, perspectives and other
necessary information, while recognising the impact of the intended and unintended
consequences arising from the decisions made and the corresponding trade-offs.
We also have to recognise that decision making by an economic agent can have an impact
on other economic agents.
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SCARCITY, CHOICE, AND RESOURCE
ALLOCATION
All economies face the problem of scarcity, where there are limited resources to meet
unlimited wants. This is sometimes referred to as the central economic problem.
Thus, stakeholders have to make decisions about how to allocate resources
efficiently to satisfy their basic needs and additional wants. There are three main
stakeholders / economic agents that we consider:
1. Consumers / Households – who aim to maximise utility or satisfaction
2. Producers / Firms – who aim to maximise profits
3. Governments / Societies – who aim to maximise societal welfare
CONSUMERS / HOUSEHOLDS
A consumer is an individual who buys goods and services for consumption. Having limited
income, consumers will select the combination of goods and services that yield the
highest utility.
Facing opportunity costs and trade-offs, consumers maximise utility where marginal benefit
is equal to marginal cost.
Condition: Marginal Benefit (MB) = Marginal Cost (MC)
PRODUCERS / FIRMS
A producer is an organisation that uses resources to produce goods and services. Having
scarce resources, the producer has to decide what, how much, and for whom to
produce these goods and services.
Facing opportunity costs and trade-offs, producers maximise profits where marginal revenue
is equal to marginal cost.
Condition: Marginal Revenue (MR) = Marginal Cost (MC)
GOVERNMENTS / SOCIETIES
Governments are organisations that provide goods and services, and redistribute income
and wealth. Having a limited budget, the government has to prioritise its spending to
maximise societal welfare.
Facing opportunity costs and trade-offs, governments maximise societal welfare where
marginal social benefit is equal to marginal social cost.
Condition: Marginal Social Benefit (MSB) = Marginal Social Cost (MSC)
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THE MARGINALIST PRINCIPLE
DEFINITIONS
Allocative efficiency is achieved where price is equals to marginal cost. Here, resources are
optimally distributed, and marginal benefit is equals to marginal cost.
Consumer surplus is the difference between the highest price that consumers are
willing and able to pay for a good or service and the price they actually pay.
Producer surplus is the difference between the lowest price that producers are
willing and able to supply a good for and the price they actually receive.
Rational decisions involve weighing the marginal costs (additional costs of producing
one more unit) and marginal benefits (additional benefit of consuming one more
unit). This is known as the marginalist principle.
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CONSUMERS
Price
F SS = MC
A C
E
Pe
B D
DD = MB
G Quantity of
Q1 Qe Q2 Good X
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Economics Department
Framework for Explaining Graph
Step 1:
Rational consumers are assumed to aim to maximise utility or satisfaction.
Step 2:
The demand curve is also the marginal benefits (MB) curve as it represents the utility
that consumers derive from the consumption of each additional output at
every price level. It slopes downwards as the law of diminishing marginal utility states
that as more units of the good is consumed, the additional satisfaction from consuming an
additional unit falls.
Step 3:
The supply curve is also the marginal costs (MC) curve because it represents the
opportunity costs. faced by consumers from the consumption of each
additional output at every price level It slopes upwards as the law of increasing
opportunity costs state that as more units of the goods is consumed, the opportunity
costs increase.
Step 4:
At equilibrium E, the marginal utility of consuming the last unit of (Good X) is
equal to the potential benefit of the next best alternative foregone.
Step 5:
If consumers consume below Qe at Q1, MB exceeds MC by AB. Underconsumption
or underallocation results by Q1Qe. Consumers are better off if more of (Good X) is
produced and consumed compared to the next best alternative available like
(example of another good).
Step 6:
If consumers consume above Qe at Q2, MC exceeds MB by CD. Overconsumption
or overallocation of resources results by Q2Qe. Consumers are better off if less of
(Good X) is produced and consumed.
Step 7:
Hence, the rational consumer will consume up to Qe where marginal utility
equals to opportunity cost. The consumer’s welfare is maximised at FEPe.
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PRODUCERS
PERFECT COMPETITION
Price/Costs MC
C
A E
Pe = MC DD = AR = MR
D
=P
B
Output of
Q1 Qe Q2 Good X
MONOPOLY / OLIGOPOLY / MONOPOLISTICALLY
COMPETITIVE
Price/Costs
MC
Pe
A
C
B
D
MR AR
Output of Good X
Q1 Qe Q2
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Framework for Explaining Graph
Step 1:
Rational producers are assumed to maximise profits, which is the calculated by the
difference between total revenue and total costs. Total costs include both explicit
and implicit costs.
Step 2a: Step 2b:
For Perfectly Competitive Markets: For Monopolies/Oligopolies/Monopolistically
Assuming a perfectly competitive Competitive Markets:
market, the firm’s demand curve Assuming a monopoly / oligopoly /
represents the marginal revenue (MR) and monopolistically competitive market,
average revenue (AR) earned, which is the firm’s demand curve represents the
equal to the equilibrium price Pe. average revenue (AR), while the marginal
revenue (MR) curve lies below the demand
curve.
Step 3:
At Qe, the marginal revenue (MR) is equal to the marginal cost (MC) as each
additional unit of output sold adds equal amounts of revenue and costs. For
example, the marginal revenue and costs a (Good X) firm earns refers to the amount it
earns and the expenses it incurs from selling one additional (Good X) respectively.
Step 4:
If the firm produces below Qe at Q1, MR exceeds MC by AB. Each additional unit of
output produced would increase profits, and the firm is incentivised to increase its
output to increase its profits.
Step 5:
If the firm produces above Qe at Q2, MC exceeds MR by CD. Each additional unit
of output produced would decrease profits, and the firm is incentivised to reduce
output to increase profits.
Step 6:
Thus, the rational producer will produce at MC = MR where MC is rising to
maximise its profits at Qe. Here, the producer’s surplus is maximised.
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PRICE MECHANISM & RESOURCE ALLOCATION
Price
F
SS = MC
A C
P2
E
Pe
P1 B
D
DD = MB
G Quantity of
Q1 Qe Q2 Good X
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Framework for Explaining Graph
Step 1:
If both consumers and producers make rational decisions, the price mechanism can
allocate resources efficiently in a perfect market.
Step 2:
If a disequilibrium occurs at P2, there is a surplus created by Q1Q2. This exerts a
downward pressure on prices.
Step 3:
As prices fall, consumers perceive that the marginal cost (MC) of consuming an
additional unit is lower relative to marginal benefits (MB), as represented the
distance AB. Consumers are thus incentivised to increase consumption to Qe.
Step 4:
Likewise, as prices fall, producers perceive that the marginal revenue (MR) from
producing an additional unit is lower relative to the marginal costs (MC), as
represented by the distance CD. Producers are thus incentivised to cut back on
production to Qe.
Step 5:
Through the adjustment process, the marginalist principle eliminates the surplus
and creates a new equilibrium at E, with price and output at Pe and Qe respectively
Step 6:
At E, consumers’ and producers’ welfares are maximised at FEPe and PeEG
respectively and resources are efficiently allocated.
Step 7:
Nonetheless, if sources of market failure are present, the price mechanism may fail to
allocate resources efficiently which will necessitate government intervention.
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CONSIDERATIONS IN DECISION MAKING
GENERAL CONSIDERATIONS
RECOGNISING TRADE OFFS AND OPPORTUNITY COSTS
Decision making processes are subject to trade-offs. In making decisions, economic agents
must consider the opportunity costs incurred. Opportunity costs are the cost of any
economic choice in terms of the next best alternative forgone.
For example, if the government decides to invest more in education subsidies, it may have
to forego the next best alternative expenditure in other areas of the economy like
healthcare. This represents a trade-off that the government faces due to scarcity.
GATHERING INFORMATION AND CONSIDERING
PERSPECTIVES
Decision makers also have to gather information and consider perspectives of other
stakeholders. When governments intervene to provide a good, they have to gather
information from other stakeholders to find out how much resources to allocate to a
particular development.
For example, before allocating resources to tax grants to encourage new labour replacing
technologies, the government has to consider how receptive producers will be to adopt
these new technologies. Producers from industries that are more dependent on low skilled
labour are likely to be more receptive than producers that do not rely on low skilled labour.
Thus, whether the government should allocate more or less resources from its
limited budget to labour replacing technologies would depend on how much demand
is present.
RECOGNISING INTENDED AND UNINTENDED
CONSEQUENCES
Decision makers also have to consider the intended and unintended consequences of
their actions. Using the same example of labour replacing technologies, the government’s
intended outcome may be to improve the productive capacity of the economy and to
shift the Production Possibility Curve (PPC) outwards.
However, it may have the unintended consequence of increasing unemployment of low-
skilled workers. This may cause them to lose their incomes and face falling purchasing
power, causing a fall in their material standard of living.
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RECOGNISING LIMITATIONS AND CONSTRAINTS
Decision making processes are also subject to limitations and constraints. These could
involve the difficulties in calculating costs accurately, imperfect information, and
other factors.
The assumptions underlying the decision-making processes may also be invalid. These
include the assumption of perfectly competitive markets, rationality, and zero market failure.
Together, these could prevent the relevant stakeholders from making an informed decision.
1. Limitations / Constraints Faced in Calculating Costs
Accurately
Stakeholders may find it difficult to calculate opportunity costs, explicit costs, and implicit
costs accurately.
Opportunity cost is a nebulous and subjective concept that is difficult to calculate in
reality. It also varies according to circumstances. Therefore, in reality, economic
agents may not be able to rationally decide what the next best alternative is simply because
it is difficult to pinpoint exactly.
Economic costs are the total opportunity cost involved in using scarce resources,
and includes both explicit and implicit costs. Explicit costs arise when a firm employs
factors that are not owned by itself. These include factor incomes like wages and
rent paid to providers of factor services like labour and land. Implicit costs arise
when a firm employs factors that are already owned by itself. These do not involve a
direct monetary payment to a third party but forces the firm to incur opportunity costs.
While it is easier for stakeholders to estimate the explicit costs, it is very difficult to
calculate the exact implicit cost of a decision. Hence, in reality, implicit costs are
often under or over estimated.
2. Invalid Assumption of Perfect Information
The assumption that stakeholders make decisions with perfect information may be invalid in
reality. Imperfect information may prevent economic agents from considering
the full costs and benefits involved in a given decision. This may result in
overconsumption / overproduction or underconsumption / underproduction of goods and
services. Hence, this may prevent the various stakeholders from making the most rational
decision.
3. Invalid Assumption of Perfectly Competitive Markets
The assumption that markets are allocatively efficient is only valid if producers are operating
in perfectly competitive markets. However, most markets are affected by market
dominance in reality which prevents stakeholders from making allocatively
efficient decisions. Hence, making this invalid assumption may prevent stakeholders from
making the most rational decision.
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4. Invalid Assumption of Rationality
The assumption of rationality that underlies the rational decision making model may be
invalid in reality. Consumers may not pursue rational choices due to personal
idiosyncrasies and preferences. Firms may not aim to maximise profits if they are
pursuing alternative objectives like profit satisficing and growth maximising.
Governments may also not aim to maximise societal welfare if they are corrupt. Hence,
the assumption of rationality may be invalid in reality.
5. Invalid Assumption of Zero Market Failure
The assumption that the price mechanism allocates resources efficiently may be
invalid if there is market failure. Certain goods like public goods, demerit goods and
merit goods may prevent the price mechanism from achieving allocative efficiency.
Moreover, if other sources of market failure are present (e.g. externalities, immobility of
factors of production and market dominance), the price mechanism may also fail to achieve
efficient outcomes.
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CONSIDERATIONS FOR CONSUMERS
HOW COGNITIVE BIASES CAN CAUSE IRRATIONALITY
• Sunk cost fallacy
Sunk cost fallacy refers to the tendency of consumers to continue investing in a
product or service despite the fact that it is no longer economically rational to do
so. This behaviour contradicts the fundamental economic principle that rational consumers
should only consider marginal costs and benefits in their decision-making. For example,
consumers might continue using an inefficient car requiring expensive repairs simply because
they've already invested significantly in maintenance, leading to allocative inefficiency and
deadweight loss in their personal utility maximisation. This behavioural bias results in sub-
optimal consumption patterns where consumers fail to maximise their utility by ignoring
opportunity costs and focusing instead on irrecoverable past expenditures.
• Loss aversion
Loss aversion refers to the tendency of consumers to be more sensitive to losses
than gains. When facing choices under uncertainty, consumers typically exhibit a
preference for risk-averse behaviour that deviates from utility maximisation principles. For
example, in markets with asymmetric information, consumers often opt for inferior but
familiar products rather than potentially superior alternatives, leading to market
inefficiencies and suboptimal equilibrium outcomes. This behaviour can result in excessive
spending on insurance and warranties where the expected marginal cost significantly
exceeds the expected marginal benefit, creating economically inefficient resource allocation.
• Salience bias
Salience bias refers to the tendency of consumers to pay more attention to
information that is easily accessible or stands out, contradicting the perfect
information assumption of traditional economic models. This cognitive bias leads to market
failures through information asymmetries and bounded rationality in consumer decision-
making. For example, consumers might overweight prominent price promotions while
undervaluing long-term total cost of ownership, resulting in allocative inefficiency and
consumer welfare losses. This behavioural anomaly can distort price signals in the market,
leading to suboptimal consumption patterns and market equilibria that deviate from
allocative efficiency, as consumers' purchasing decisions no longer reflect their true
preferences and valuations.
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CONSIDERATIONS FOR PRODUCERS
KNOWLEDGE OF CONSUMERS’ COGNITIVE BIASES
Knowledge of consumers' cognitive biases can help a firm make more informed
decisions about its products, pricing strategies, and marketing campaigns. By
taking these biases into account, a firm can better understand how consumers make
decisions and design strategies that are more likely to be successful in the market.
• Sunk cost fallacy
Sunk cost fallacy refers to the tendency of consumers to continue investing in a
product or service despite the fact that it is no longer economically rational to do
so. For example, a consumer may continue to use a car that requires expensive repairs
instead of buying a new one because they have already sunk a significant amount of money
into the car. As a result, a firm may continue to offer a product or service that is no longer
in demand because consumers are reluctant to switch to a new product or service due to
sunk costs.
• Loss aversion
Loss aversion refers to the tendency of consumers to be more sensitive to losses
than gains. For example, consumers may be more likely to avoid a product or service if
they perceive the potential losses associated with it to be greater than the potential gains. A
firm may need to consider this bias when pricing its products or services or when offering
promotions, as consumers may be more likely to respond to promotions that
emphasise potential losses rather than potential gains.
• Salience bias
Salience bias refers to the tendency of consumers to pay more attention to
information that is easily accessible or stands out. For example, consumers may be
more likely to buy a product or service that is advertised prominently or that they see
frequently. A firm may need to consider this bias when designing its marketing
campaigns and ensure that its products or services are highly visible to potential
consumers.
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TECHNOLOGICAL DISRUPTIONS
Technological disruptions can have a significant impact on a firm's decision-
making process by altering the competitive landscape, creating new
opportunities, and changing customer preferences.
• Changing consumer preferences
Technological disruptions can change the way customers consume products or
services. For example, the rise of e-commerce and mobile shopping has led to a significant
shift in consumer behaviour, with many consumers now preferring to shop online rather
than in physical stores. Firms need to be aware of these changes in customer
preferences and adapt their strategies accordingly so as to increase consumer
demand for their product. This would lead to an increase in total revenue. Assuming
total costs remain constant, profits will increase.
• Increased competition
Technological disruptions can also lead to increased competition as it lowers the
barriers to enter a market, allowing new entrants to enter the market. For example,
the rise of ride-sharing apps like Uber and Grab disrupted the taxi industry, leading to
increased competition and pricing pressure for traditional taxi companies. Firms need to be
aware of these new entrants and develop strategies to remain competitive in the
market.
• New opportunities
Technological disruptions can also create new opportunities for firms. For example, the
rise of artificial intelligence and machine learning has created new opportunities for firms to
develop innovative products and services. Firms need to be aware of these new
opportunities and invest in research and development to take advantage of them
so as to increase consumer demand for their product. This would lead to an
increase in total revenue. Assuming total costs remain constant, profits will increase.
• Cost savings
Technological disruptions can also lead to cost savings for firms. For example, the
automation of manufacturing processes can lead to significant cost savings for firms, allowing
them to offer products at lower prices. Firms need to be aware of these cost savings
opportunities and invest in technology to take advantage of them. This could lead
to a decrease in total cost. Assuming total revenue remains constant, profits will
increase.
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SOCIAL AND ENVIRONMENTAL CONCERNS
The self-interested behaviour of firms often leads to negative consequences for society.
Firms may engage in actions that most consumers would consider to be ethically
unacceptable, such as the practice of child labour – where firms employ and force children
to work long hours while being poorly paid.
However, many firms increasingly recognise that the pursuit of self-interest need not
necessarily conflict with ethical and environmentally responsible behaviour. A negative image
of the firm held by workers and buyers of the product can cut deeply into the firm’s
revenues and profits by lowering worker productivity and the firm’s sales. Furthermore,
socially irresponsible firm behaviour may lead to government regulation of the firm in order
to minimise the negative consequences of the firm’s actions on society.
Therefore, firms face incentives to display corporate social responsibility by engaging
in socially beneficial activities. This can come in the form of avoidance of polluting
activities, engaging in environmentally sound practices, support for human
rights by avoiding exploitation of child labour in developing countries or
avoiding investments in countries with politically oppressive regimes, art and
athletics sponsorships and donations to charities.
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CONSIDERATIONS FOR GOVERNMENTS
Governments may apply knowledge of cognitive biases to nudge the decisions of
economic agents.
USE OF NUDGES
A nudge refers to a method designed to influence consumers’ choices in a predictable
way, without offering financial incentives or imposing sanctions, and without limiting choice.
Consumers generally respond favourably when nudged to perform actions that
they might not otherwise be inclined to do.
For example, in the United Kingdom, tax payments of late taxpayers increased by 15% when
they were told by the UK revenue service that most people in their area had already paid
for taxes. This worked because the late taxpayers were made to feel they were the
exception to what was the norm in their community.
KNOWLEDGE OF CONSUMERS’ COGNITIVE BIASES
Knowledge of citizens' cognitive biases can help governments design more
effective policies and interventions. By understanding how people make decisions,
governments can better structure policies that achieve their intended outcomes.
• Sunk cost fallacy
Sunk cost fallacy refers to the tendency of consumers to continue investing in a
product or service despite the fact that it is no longer economically rational to do
so. For example, consumers may continue to use inefficient electronic appliances despite
high energy costs because they have already invested in them. As a result, governments can
address this by offering incentive schemes that explicitly offset sunk costs, such as trade-in
programs for energy-efficient appliances or vehicle scrappage schemes.
• Loss aversion
Loss aversion refers to the tendency of consumers to be more sensitive to losses
than gains. For example, consumers may be more likely resist environmental policies like
mandatory plastic bag charges if they perceive the potential losses associated with it to be
greater than the potential gains. Governments can leverage this by framing policies to
emphasise potential losses from inaction rather than gains from action - such as
highlighting "avoiding the loss of clean air" from climate actions rather than "gaining
environmental benefits” to make the policies more palatable.
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• Salience bias
Salience bias refers to the tendency of consumers to pay more attention to
information that is easily accessible or stands out. For example, citizens may focus
intensely on a 1% GST increase that makes headlines, while paying less attention to annual
budget allocations that determine the quality of healthcare and education, despite the latter
having more significant impact on their daily lives. Governments need to consider this bias
when communicating policy changes, ensuring that important but less visible policies receive
sufficient public attention and understanding.
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NOTES