Rational decision making

Traditional economic theory assumes that humans are rational - in other words, when faced with constraints and preferences, they make consistent and systematic decisions which attempt to generate the best available outcome.

Rational decision making can be understood by looking at several ‘axioms’ which guide the process of making systematic and consistent decisions. Axioms are ‘starting points’ for logical reasoning that are ‘self-evident’ and accepted, and do not need a specific proof.

Axioms

For example, the axiom of completeness assumes that individuals have preferences, rather than that they do not, and that they are NOT indifferent to options they face.

This means that when an individual has to make a choice, say between having apple juice, or a banana shake, they will be able to make a decision [to have the juice, the shake or nothing].

The axiom of transitivity states that if I prefer A (apple juice) to B (a banana shake), and prefer B (a banana shake) to C (cola), then I will prefer A (apple juice) to C (cola).

The axiom of continuity assumes that if I prefer A (apple juice) to B (a banana shake), then I will also prefer options that are close to A (say pear juice), rather than close to B (say milk shake) or C (Dr Pepper). For example, it is rational for Netflix to recommend a new movie that is similar to one already watched, rather than one in a completely different genre.

The idea of rationality also assumes that individual economic agents have specific objectives in terms of maximising their own ‘self-interest’.

The economic agents are consumers, producers, governments and agencies of government.

Consumers - maximising utility

For rational decision-making to take place it is assumed that, as consumers, individuals try to maximise their individual utility - that is, the satisfaction or benefit they derive from consumption.

Producers - maximising profits

Equally important is the assumption that the owners of firms also try to maximise their self-interest in terms of maximising profits. While this is the starting point for developing an understanding of the behaviour of businesses, there are other objectives which influence business decision making, including the desire to maximise sales or to operate ethically.

These, and other assumptions and axioms form the basis of the economists approach to the study of rational, self-interested decision making in economic transactions.

Governments - maximising welfare?

The final agent in economics is the government or ‘state’. Government will have a range of objectives depending upon its own political beliefs and the political system that exists, and the current political, economic and social context . It is common to assume that governments in democratic societies wish to maximise the welfare of the citizens who elect them, although cynics might argue differently.

Marginal analysis

In economic theory we assume decisions are taken in a marginal way, which means that decisions to produce, or consume, are made one at a time. For example, an individual does not generally decide to drink 4 cups of tea at the beginning of each day, rather they make four individual decisions, one at a time. The same process is assumed to apply to producers, who make decisions on a marginal basis. For example, a firm looking to expand will hire new workers as and when needed, depending on current needs. Economic decisions are marginal because economic conditions are constantly changing.

Diminishing marginal utility

The law of diminishing marginal utility1 suggests that as more units of a product are consumed the marginal (additional) benefit of each extra unit to the consumer falls, hence consumers are prepared to pay less for these marginal units.

This can be explained as follows:

  1. Most benefit is generated by the first unit of a good consumed because it satisfies most or all of the immediate need or desire.
  2. A second unit consumed would generate less utility - perhaps even zero, given that the consumer has less need or less desire. With less benefit derived, the rational consumer is prepared to pay rather less for the second, and subsequent, units, given that the marginal utility falls.

Consider the following figures for utility derived by an individual when consuming bars of chocolate. While total utility continues to rise from extra consumption, the additional (marginal) utility from each bar falls, and becomes negative after 5 bars!

Diminishing marginal utility of chocolate

If marginal utility is expressed in a monetary form, the greater the quantity consumed the lower the marginal utility and the less value derived - hence the rational consumer would be prepared to pay less for that unit. While there may be some exceptions, the principle of diminishing marginal utility holds for most goods and services consumed.

Criticisms

The assumption regarding the maximisation of self-interest has been challenged by ‘behavioural economists’ who question many of these traditional propositions.

Bounded rationality

The idea of bounded rationality questions the assumption of traditional economics that individuals act perfectly rationally when making a decision. The idea of bounded rationality was first proposed by American economist Herbert Simon, who argued that in the real world, individuals typically have limited time in which to make a decision and limited information. Consequently, it is unlikely that they will make accurate assessments of the costs or benefits of a decision. This would simply take too much time and effort, and require skills and abilities that not everyone posses or choose to use. As a result, individuals often make quick decisions and fall-back on ‘rules-of-thumb’ (called heuristics) - especially when faced with complex decisions. This means that decisions may not always result in an optimal outcome.

Many behavioural economists argue that decisions can be shaped in a way that individuals may routinely not act in their own self-interest.

For instance, relying on heuristics can mean that decision making is 'short-circuited' and shaped by certain built-in ‘biases’ for behaving in a certain way, or making a certain decision. This may result in individuals facing an outcome that is ultimately harmful to them, such as over-eating, not saving for retirement, or smoking cigarettes. In addition, decision-making can be shaped by others, so that an individual may suspend their own self-interest as a result of persuasive advertising, ‘smart’ marketing, or imperfect knowledge.

Despite these questions, in building up a theory of economic behaviour we start from the position that consumers and producers are rational in their decision making.


Economic systems

What are the benefits of a mixed economy?

Economic systems
Positive statements

How is equilibrium determined?

Positive statements
Welfare

How does equilibrium create welfare?

Welfare

1 The principle of diminishing marginal utility was first proposed by German economist H. Gossen in 1854, and was later refined and developed by a number of economists including British economist Alfred Marshal.