H3 Economics
VJC
H3 Economics
Rational Decision
Making
The story of the economic man
“Homo economicus”
Homo sapiens?
If we are studying decisions, why
are we studying traditional
economics when it comes with
flawed assumptions?
Why do we learn traditional
economics?
Traditional
Development of Economic Thought
Adam Smith
David Ricardo
Alfred Marshall
Milton Friedman
Modern
Present
Kahneman, Tversky, Thaler
There are more “schools” like
the Keynesian, etc
Classical
Economics
“OG” Economic Theories
Value Theory
(origins of prices)
Invisible Hand
Trade, specialisation
Neoclassical
Economics
Behavioural
Economics
Marginal Revolution & with
addition of
assumptions/models (math)
Breaking of assumptions
(e.g. But we are not the
economic man…)
Utility maximisation
Irrationality
Supply and Demand
Market Failure
(Pareto Optimality)
Bounded rationality
Key ideas
The Economic man and
traditional economic theory
Many schools fall
under “traditional”
Classical, Keynesian,
Neoclassical,
Marxian…
How do humans make decisions?
● The (perfectly) “economic” man vs “emotional” man
What constitutes self-interest?
Is giving behaviour rational?
Outline for theme 1
▪ How are decisions made?
▪ What do we mean by ‘self-interest’?
Recall from Market Failure
agents base decisions on
self-interest and ignore
externalities…
Is it only for yourself?
▪ Do we make rational decisions?
▪ Why?
▪ If not, implications for the study of Economics?
▪ Can we become better decision makers? Why is this important?
Rational Decision making
How? Process for making choices
For the economic man - analysis
Assumption that the economic man is able to
maximise utility…
When was the last time you maximised
something?
Use of calculus
MB = MC
(marginalist principle)
Caveat: Making rational decisions
▪ Rational ≠ never make mistakes
There can be rational choices leading to
negative outcomes, but that choice is the
“least bad” of all the available options.
▪ But that people do not make systematic mistakes i.e. same mistake over and over again
Making rational decisions
1.
Cost benefit analysis
Benefit – Cost = Net benefit
OR
2.
1.
Weighing of marginal cost and benefits
Relationship between MB = MC and net benefits
Utility maximisation condition:
Additional satisfaction obtained from purchasing another dollar’s
One more?
worth of a good should be equal for all goods.
i.e. MUa / Pa = MUb / Pb
OR
Making rational decisions
1. Cost benefit analysis
Benefit – Cost = Net benefit must be maximised
How?
Weighing of marginal cost and benefits
Relationship between MB = MC and net benefits
2. Same goal, but with 2 goods?
E.g. how many pieces of fried chicken and drinks is optimal?
Utility maximisation condition:
Additional satisfaction obtained from purchasing another
dollar’s worth of a good should be equal for all goods.
i.e. MUa / Pa = MUb / Pb
Making rational decisions
Utility maximisation condition
MUa / Pa = MUb / Pb
Refer to handout given
Example
1st dollar spent?
Choose fried chicken!
“Fried chicken is love”
Is my utility maximised?
Price = $1
MU = 10
MUa / Pa = 10
Price = $2
MU = 9
MUb / Pb = 4.5
Making rational decisions
Utility maximisation condition
MUa / Pa = MUb / Pb
Example
2nd dollar spent?
Choose fried chicken again!
“Still can keep going, a second
piece wouldn’t hurt…”
Is my utility maximised?
Price = $1
MU = 7
MUa / Pa = 7
Price = $2
MU = 9
MUb / Pb = 4.5
Making rational decisions
Utility maximisation condition
MUa / Pa = MUb / Pb
Example
Note: the 3rd dollar and
4th dollar are on the
drink (it costs $2)
3rd dollar spent?
Choose drink
“Getting a bit too full, need a
drink…”
Is my utility maximised?
Price = $1
MU = 4
MUa / Pa = 4
Price = $2
MU = 9
MUb / Pb = 4.5
Making rational decisions
Utility maximisation condition
MUa / Pa = MUb / Pb
Example
5th dollar spent?
Choose fried chicken
“Ready to have more chicken!”
Is my utility maximised?
Price = $1
MU = 4
MUa / Pa = 4
Price = $2
MU = 6
MUb / Pb = 3
Making rational decisions
Utility maximisation condition
MUa / Pa = MUb / Pb
Example
6th dollar spent?
Either one: Indifferent between
fried chicken and drink
“So full - it doesn’t matter that
much anymore”
Is my utility maximised?
Price = $1
MU = 3
MUa / Pa = 3
Price = $2
MU = 6
MUb / Pb = 3
Making rational decisions
?
?
?
Price = $1
Price = $2
MU = 3.5
MU = 5
$1 worth of apples: 3.5 units of satisfaction
$1 worth of pineapples: 2.5 units of satisfaction
If you spend $1 less on pineapples, you lose 2.5 units of
satisfaction. But if you spend the $1 on apples, you gain
3.5 units of satisfaction.
Making rational decisions
MUa / Pa = MUb / Pb
Main takeaway of the utility maximisation condition
● If MUa / Pa > MUb / Pb :
○ consumers would rather substitute to good A from good B, to gain
higher marginal utility for their dollar spent.
○ vice versa if inequality flips
● If MUa / Pa = MUb / Pb :
○ Consumers are indifferent between choosing between good A and
good B for the next dollar spent, and will choose to consume until he
reaches his budget constraint (assuming “more is always better”)
Making rational decisions
? From marginalist principle, you will consume until MB = MC (i.e. MU = P).
? So you will consume till the point where MU/P = 1.
? To maximise utility, you will consume up till the point where MUa /
MUb / Pb = 1.
Pa =
Making rational decisions
▪
▪
▪
Question: Should you go to university?
How would you make the decision?
Assumptions?
What happens when market prices are not
available for certain goods and services?
MUa / Pa = MUb / Pb
No market
price… how?
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Value to a rational
environmentalist?
Shadow Pricing
How does one derive the value of non-marketed goods and
services,
e.g. wildlife habitat, large scale projects?
Even for market-traded goods, price may be an inadequate
measure of value, e.g. presence of negative externalities.
Despite so, it is useful to work with a “price-like” concept.
Still useful to measure for a
good basis of comparison
Shadow Pricing
Determination of shadow prices is an inexact science.
For marketed goods, market prices are arguably good measures of ‘value’,
since people trade off at the margins. i.e. consume until MU = MC (price paid).
For non-marketed goods, other methods required to estimate the shadow
price.
For example,
● Surveys and hypothetical questions
● Inference
○ e.g. estimates using difference in rental rates in a polluted vs clean
area.
Shadow Pricing, more examples
E.g. 1: Construction projects (e.g. build more HDBs)
If construction results in negative externalities (which distorts prices), this has to be
considered when creating the ‘shadow price’ of construction.
●
Cost per unit of pollution is a ‘shadow price’.
E.g. 2: Should we build a new hospital? It can save more lives.
▪ One non-marketed item will be value of lives saved.
- What is the value of a statistical life?
Shadow Pricing: e.g. 2. Building a hospital
▪ Should we build a new hospital? It can save more lives.
▪ One non-marketed item will be value of lives saved.
- What is the Value of a Statistical Life?
Why the different
estimates using
different proxies?
Source: Bloomberg
More examples
Does shadow pricing apply to firms’ decisions too?
R&D projects can
come with shadow
prices too
More examples
Government projects?
Building Cost:
$12.3 million
But does it net more
value…?
Eco-link bridge at BKE
Consider
?
The government wishes to increase tax revenue. Should
it increase income tax or GST?
Intertemporal choice
▪ Choose!
- Option 1: $68 now
- Option 2: $85 in 91 days
▪ Many choices require decision-makers to trade-off costs and
benefits at different points in time.
▪ e.g. Decisions regarding savings, education, exercise.
▪ Can differ between individuals.
Discounting
Discount rate applies to marginal utility
of future consumption
MUtoday / Ptoday = MUfuture /
Pfuture
▪ Why?
- Investment today can produce more in the future (interest rate)
▪ Assume that going to university will help you earn $2,500 more
every year for the next 30 years.
▪ However, tuition fees cost $50,000 to be paid now.
▪ Need to discount the benefit to obtain its net present value.
Extra
– formula to calculation net present value
?
where Bt equals the net benefits (benefits
minus costs) in time t and R equals the
discount rate
Discounting: a different application
“time preference”
e.g. smoking provides current pleasure while incurring future
(discounted) detrimental health effects
From research, smokers value future health benefits at a lower
rate than non-smokers.
●
Discount rate applies to marginal utility
of future consumption
MUtoday / Ptoday > MUfuture /
Pfuture
Consider
How would this help firms make decisions?
Quick Activity
Your application to a top US university is successful!
Estimated costs of attendance (e.g. tuition fees, housing) is
USD 300,000.
Will you go?
Economic man:
How would you value such an
experience?
Apply shadow pricing?
Apply discounting?
Implications
▪ Understanding the challenges faced in
decision-making
▪ Assumptions in H2:
- Economic agents have perfect
information on all types of costs and
benefits
- Economic agents are able to predict
with certainty the costs and benefits
that may accrue in the future.
Contrast against reality.
Look up on your own
▪
Bounded rationality
A closer look at self-interest
Self-interest?
But man has almost constant occasion for the help of
his brethren, and it is in vain for him to expect it from
their benevolence only. He will be more likely to prevail
if he can interest their self-love in his favour. . . We
address ourselves, not to their humanity, but to their
self-love, and never talk to them of our own
necessities, but of their advantages.
-- Adam Smith, The Wealth of Nations
Economic man:
Is self truly just him/herself?
Self-interest?
How selfish soever man may be supposed, there are
evidently some principles in his nature which interest him
in the fortune of others and render their happiness
necessary to him though he derives nothing from it except
the pleasure of seeing it.
-- Adam Smith, The Theory of Moral Sentiments
Economic man:
Is self truly just him/herself?
E.g. Teachers rejoicing when their
students get stellar O level results?
Rational self-interest
▪ normative (contains value judgement)
▪ ≠ selfishness or greed
▪ Does not rule out concern for others
▪
Would you help your friend out with homework
if he/she calls at 3 AM?
Is giving rational?
Extra 2
Math behind
Let’s build a model to model utility!
Key features
Choice set: 2 goods (e.g. fried chicken and
drink)
Objective: Households wish to maximise utility
Constraints: Budget constraints
Utility (function) should exhibit
Perhaps ln(x)
function can be
used here?
●
●
More is better
Law of diminishing marginal utility
(e.g. eating more does not add much if
you’re already full)
Let’s build a model to model utility!
Mr Lim and his wife went to eat at KFC with
only $12.
They both love fried chicken and prefer it to
drinks. But they can’t not have drinks right…?
$2
For simplicity - each fried chicken pc is $2 and
drinks are $2 each.
What is the optimal bundle they should
choose?
Perhaps ln(x)
function can be
used here?
Formalising the problem…
Answer:
$2
$12
Let’s build a model to model utility!
Mr Lim and his wife went to eat at KFC with
only $12.
They both love fried chicken and prefer it to
drinks. But they can’t not have drinks right…?
$2
$2
For simplicity - each fried chicken pc is $2 and
drinks are $2 each.
What is the optimal bundle they should
choose?
Perhaps ln(x)
function can be
used here?
Formalising the problem…
They should
choose to eat
4 fried chicken
pieces
2 drinks
$12
Let’s build a model to model utility!
Spend all $12 because “more is
better”! Becomes “=”
Perhaps ln(x)
function can be
used here?
Sub into 2x1 + 2x2 = 12
→ x1 = 4, x2 = 2
$2
$2
They should
choose to eat
4 fried chicken
pieces
2 drinks
$12