![]() In a positive way, governments may try to ‘nudge’ consumers into better behaviour. Nudges – If individuals are prone to emotional/impulsive decisions, both firms and governments can make use of this. If people get caught up in financial bubbles, it can have devastating effects when the bubble bursts. If people get addicted to drugs, the social cost is much higher than the social benefit. Market failure – Irrational behaviour can lead to market failure – an inefficient allocation of resources in society. Rationally, we may want to stick to a diet and lose weight, but we get tempted by the pleasure of the present moment. A drug addict may wish to stop his habit, but the power of addiction makes it difficult to achieve. Sunk-cost fallacy – Placing too much importance on sunk costs (irretrievable costs) – costs that cannot be got back.Īnother irrational behaviour may stem from a lack of control. But, we can become attached to our past decisions, and for reasons of pride, we try to make our decisions work – even though we just create a bigger problem. If you have bought a machine for £10,000 and it is not profitable to use, the rational action is to sell and cut your losses. However, in practice around 25% of individuals fail to plan adequately. Life cycle hypothesis suggests we should try to smooth consumption over a lifetime). In simple terms, it may be rational to save for a pension (e.g. Present bias is when we place relatively greater value on consumption in the present moment. In labour markets firms can discriminate against certain types of worker (gender/race/age) If you refuse to employ a good worker, then it means less profit for the firm, but we can be motivated by these human prejudices rather than the utility maximisation of economic theory. Taking illegal drugs like heroin can ruin a life, but some people choose to get addicted – and then regret it later. For example, heavy drinking can cause health problems, but many people drink heavily. Given a choice, many people would avoid any updates to their phone/operating system and stick with what they are used to.ĭemerit goods are damaging to individuals, but people continue to consume – either unaware or ignoring their harmful effects. Rather than spend time trying to decide, we stick with default option – what we already have. But, the internet shows us that sometimes too much information can be overwhelming. The model of perfect competition states that a market with thousands of firms will be efficient because we can choose best. For example, if we have one bad experience travelling on British Airways, we may always avoid them in the future.Īnother type of cognitive bias is preferring a choice that we are used to. In making decisions we use ‘mental shortcuts’ or ‘heuristics’ – these decisions are based on impulsive/emotional responses. For example, we may focus on a study that says one glass of red wine a day is good for health and then make the assumption that any quantity of alcohol can be good for us. Herding is a situation where individuals assume that ‘the majority must be correct.’ Therefore even if we are wary of buying shares in South Sea Company, we think if everyone else is – they must know something.Ĭognitive bias occurs when we make irrational decisions, but often are unaware of our own irrationality. Irrational exuberance has occurred during ‘bubbles’ such as the “Dot Com Bubble” of the late 1990s and the financial bubble of the early 2000s. If prices rise above their long-term value, we can think ‘this time is different’, and perhaps there is some reason for the increased value of shares. For example, if shares rise and people see an increase in wealth, this may encourage them to keep buying more. Irrational exuberance is a term to describe over-optimism, especially about asset bubbles. It means economists need to take into account the potential for irrationality. ![]() Irrational behaviour has implications for formulating economic policy. Irrational behaviour can lead to market failure, loss of economic welfare and personal issues such as drug addiction and poor health. ![]() ![]() Irrational behaviour is not just isolated to a few ‘irrational individuals’ but can become the dominant choice for most people in society (e.g. However, in the real world, we often see irrational behaviour – decisions which don’t maximise utility but can cause a loss of economic welfare. Classical economic theory assumes that individuals are rational.
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