Utility theory
According to neoclassical thought economic agents will always seek to maximise
their benefits
Firms aim to maximise profits
Government aims to maximise social benefit
Consumers maximising utility when consuming
Law of diminishing utility:
As quantity consumed increases the marginal utility derived
from each extra unit decreases
Total utility is maximised where
MU=0= satiation
Economists believe that utility is the same as price
e.g., a cup of coke is worth £4
When the consumer buys one their utility is worth £8 but they are only paying £4
therefore a rational consumer will consume
When the consumer gets the second cup their utility is worth £6 but they are only
paying £4 therefore a rational consumer will consume
When the consumer gets the third cup their utility is £4, the same as the price
therefore a rational consumer will consume
HOWEVER when they get the fourth cup the marginal utility is worth less than what
they are paying for the drink
Therefore a rational consumer will maximise utility by consuming up until marginal
utility is equal to the price
we can say that the marginal utility
curve is the demand curve because
the lower the price is the more
demand there will be. This is
because a higher quantity will satisfy
the condition MU=P being the utility
maximisation point
MU=MPB=D
Therefore demand curve derives
from the law of diminishing marginal
utility
Imperfect information
One factor that can stop consumers making rational decisions is information failure
, Two ways
o Lack of information- information isn’t presented clearly
Merit goods-> not enough information there to show why the good
should be consumed more, e.g., exercise, healthy foods
Demerit goods-> there isn’t enough information about how bad the
consumption of these goods is for the consumer and as a result
overconsumption takes place
o Asymmetric information- when the information does exist well but its not
being shared equally between two parties
E.g. labour markets-> employee has all the information about how
hard they will work, their work ethic etc. employer does not have that
information and as a result the employer might make an irrational
decision about who to hire
Second hand markets-> seller has all the information about the state
of the good which they are selling
Insurance hazards-> insurance company doesn’t have all the
information about the individual, they might undersell the level of the
risk so they don’t have to pay as much
MORAL HAZARD- government failure- individual takes more
risks because they will not bear the impact of the risk as the
insurance company will pay for the accident
Behavioural economics
Disputes the idea that consumers are always rational and will always look to
maximise utility
Argues that emotional, social and psychological factors can influence decision
making
Traditional economic thought Behavioural economic thought
Human beings gather up all the Bounded rationality
information needed 1) Time
Then they weigh up all of the 2) Choice
information 3) Lack of information- increasing
Then they will take time and make a complexity of products makes s]life
utility maximising decision difficult
Rationality is bounded by self-
control
Consumers follow HEURISTICS (rule
of thumb) to make satisficing
decisions (mental shortcuts)
Cognitive biases- where emotional, social and psychological factors can influence decision
making, which can prevent rationality and utility maximisation
Cognitive bias Explanation
According to neoclassical thought economic agents will always seek to maximise
their benefits
Firms aim to maximise profits
Government aims to maximise social benefit
Consumers maximising utility when consuming
Law of diminishing utility:
As quantity consumed increases the marginal utility derived
from each extra unit decreases
Total utility is maximised where
MU=0= satiation
Economists believe that utility is the same as price
e.g., a cup of coke is worth £4
When the consumer buys one their utility is worth £8 but they are only paying £4
therefore a rational consumer will consume
When the consumer gets the second cup their utility is worth £6 but they are only
paying £4 therefore a rational consumer will consume
When the consumer gets the third cup their utility is £4, the same as the price
therefore a rational consumer will consume
HOWEVER when they get the fourth cup the marginal utility is worth less than what
they are paying for the drink
Therefore a rational consumer will maximise utility by consuming up until marginal
utility is equal to the price
we can say that the marginal utility
curve is the demand curve because
the lower the price is the more
demand there will be. This is
because a higher quantity will satisfy
the condition MU=P being the utility
maximisation point
MU=MPB=D
Therefore demand curve derives
from the law of diminishing marginal
utility
Imperfect information
One factor that can stop consumers making rational decisions is information failure
, Two ways
o Lack of information- information isn’t presented clearly
Merit goods-> not enough information there to show why the good
should be consumed more, e.g., exercise, healthy foods
Demerit goods-> there isn’t enough information about how bad the
consumption of these goods is for the consumer and as a result
overconsumption takes place
o Asymmetric information- when the information does exist well but its not
being shared equally between two parties
E.g. labour markets-> employee has all the information about how
hard they will work, their work ethic etc. employer does not have that
information and as a result the employer might make an irrational
decision about who to hire
Second hand markets-> seller has all the information about the state
of the good which they are selling
Insurance hazards-> insurance company doesn’t have all the
information about the individual, they might undersell the level of the
risk so they don’t have to pay as much
MORAL HAZARD- government failure- individual takes more
risks because they will not bear the impact of the risk as the
insurance company will pay for the accident
Behavioural economics
Disputes the idea that consumers are always rational and will always look to
maximise utility
Argues that emotional, social and psychological factors can influence decision
making
Traditional economic thought Behavioural economic thought
Human beings gather up all the Bounded rationality
information needed 1) Time
Then they weigh up all of the 2) Choice
information 3) Lack of information- increasing
Then they will take time and make a complexity of products makes s]life
utility maximising decision difficult
Rationality is bounded by self-
control
Consumers follow HEURISTICS (rule
of thumb) to make satisficing
decisions (mental shortcuts)
Cognitive biases- where emotional, social and psychological factors can influence decision
making, which can prevent rationality and utility maximisation
Cognitive bias Explanation
