A Level Economics 27: The Rational Actor Assumption

The assumption of the rational actor is a fundamental concept in economics, which assumes that individuals, firms, and other economic agents make decisions based on rationality, self-interest, and the pursuit of maximizing their utility or profits. While this assumption has its merits, it is also widely acknowledged to be a flawed assumption. Here's an explanation of the assumption, its limitations, and its impact on economic models:

1. Assumption of the Rational Actor:

   • 
     
   • Rational Decision-Making: The assumption of the rational actor posits that individuals have well-defined preferences and make consistent choices based on logical reasoning. They gather and process information efficiently, weigh the costs and benefits of different options, and choose the option that maximizes their utility or profits.
   • 
     
   • Self-Interest: Rational actors are assumed to act in their own self-interest, seeking to maximize their personal satisfaction or financial gains. This assumption implies that individuals are motivated by their own well-being and do not engage in purely altruistic behavior.

2. 
   

3. Limitations and Flaws of the Rational Actor Assumption:

   • 
     
   • Limited Information and Cognitive Biases: In reality, individuals often have limited information, bounded rationality, and cognitive biases that affect their decision-making. They may rely on heuristics, shortcuts, or imperfect information, leading to decisions that may deviate from the ideal rational behavior.
   • 
     
   • Emotional Factors: Emotional and psychological factors can significantly influence decision-making, including factors like risk aversion, loss aversion, social influences, and emotional biases. These factors are not fully captured by the assumption of the rational actor.
   • 
     
   • Time and Resource Constraints: Individuals may face time constraints and limited cognitive resources, preventing them from fully analyzing all available options. They may resort to satisficing (seeking satisfactory solutions) rather than optimizing choices due to practical limitations.
   • 
     
   • Social and Cultural Influences: Social norms, cultural values, and external influences can shape decision-making, leading individuals to make choices that may not align with strict self-interest or rationality. Factors such as peer pressure, conformity, and social expectations can impact decision-making processes.

4. 
   

5. Impact on Economic Models: The assumption of the rational actor has been foundational in constructing economic models and theories. However, recognizing its flaws and limitations has led to the development of alternative frameworks that incorporate behavioral economics and more realistic assumptions about decision-making. Some of the impacts include:

   • 
     
   • Behavioral Economics: Behavioral economics integrates psychological insights and deviations from rational behavior into economic models. It acknowledges that individuals' decisions are influenced by cognitive biases, emotions, and social factors. This has led to a better understanding of real-world decision-making and more accurate predictions of economic outcomes.
   • 
     
   • Realistic Modeling: Economic models are now being constructed to incorporate more nuanced assumptions, considering imperfect information, bounded rationality, and decision-making under uncertainty. This enables a more accurate representation of how individuals and firms actually make decisions.
   • 
     
   • Policy Implications: Recognizing the limitations of the rational actor assumption has influenced policy discussions and interventions. Policies are designed to account for behavioral biases, such as implementing nudges or defaults that help individuals make better decisions aligned with their long-term interests.

In conclusion, while the assumption of the rational actor has been useful for building economic models, it is flawed due to the inherent complexities of human decision-making. Recognizing these limitations and incorporating insights from behavioral economics has led to more realistic economic models and a deeper understanding of how individuals and firms behave in real-world situations.

A Level Economics 13: Marginal Utility and the Demand Curve

 Define and explain the theory of marginal utility and link it to the demand curve

The theory of marginal utility is an economic concept that explains how individuals make decisions regarding the consumption of goods and services. It is based on the principle that as individuals consume additional units of a good or service, the additional satisfaction or utility derived from each additional unit tends to diminish.

Here's an explanation of the theory of marginal utility and its connection to the demand curve:

1. Marginal Utility: Marginal utility refers to the additional satisfaction or utility gained from consuming one more unit of a good or service. The theory of marginal utility suggests that as individuals consume more of a good, the additional satisfaction they derive from each additional unit decreases. This is known as the law of diminishing marginal utility.

2. Diminishing Marginal Utility: The law of diminishing marginal utility states that the more units of a good or service an individual consumes, the smaller the incremental increase in satisfaction for each additional unit. For example, the first slice of pizza consumed may provide a high level of satisfaction, but as more slices are consumed, the marginal utility of each additional slice decreases.

3. Consumer Decision-Making: The theory of marginal utility plays a crucial role in understanding consumer decision-making. Consumers seek to maximize their total utility or satisfaction from the goods and services they consume, given their limited resources and budget constraints. To do so, consumers allocate their resources in a way that balances the marginal utility gained from each unit of a good with its price.

4. Demand Curve: The link between the theory of marginal utility and the demand curve lies in the willingness of consumers to purchase a good at different prices. As the price of a good decreases, consumers are willing to purchase more of it because the marginal utility per dollar spent increases. This is because the lower price allows consumers to obtain a greater quantity of the good for the same expenditure, resulting in higher overall satisfaction.

The demand curve represents the relationship between the price of a good and the quantity demanded by consumers. It slopes downward because, according to the theory of marginal utility, as the price decreases, the marginal utility per dollar increases, leading to a higher quantity demanded.

The theory of marginal utility also explains why the demand curve is typically downward-sloping but not perfectly elastic. As individuals consume more of a good, the diminishing marginal utility implies that they are willing to pay a lower price for each additional unit, resulting in a lower quantity demanded at higher prices.

In summary, the theory of marginal utility explains how individuals make consumption decisions based on the diminishing marginal utility of goods and services. It links to the demand curve by demonstrating how changes in price affect the quantity demanded, as consumers consider the marginal utility per dollar spent when making their purchasing decisions.

Economics Essay 76: Rational Actor

Discuss the view that individual economic agents will always act as rational decision makers so as to maximise their utility.

To properly discuss the view that individual economic agents will always act as rational decision-makers to maximize their utility, it's important to define and explain the key terms involved.

1. Rational Decision-Making: Rational decision-making refers to the process of making choices that are consistent with one's preferences and objectives, based on a careful evaluation of available information and the expected outcomes of different options. Rational decision-makers aim to optimize their choices to maximize their expected utility.

2. Utility: In economics, utility represents the satisfaction or value that individuals derive from consuming goods or services. It is a subjective measure of individual preferences and can vary from person to person. Utility can be expressed in different ways, such as happiness, well-being, or satisfaction.

Now, let's discuss the view that individual economic agents will always act as rational decision-makers to maximize their utility.

Supporters of this view argue that individuals possess rationality and have a clear understanding of their own preferences. They believe that individuals carefully assess the available choices, evaluate the costs and benefits associated with each option, and select the one that maximizes their utility. The rational decision-making model assumes that individuals have perfect information, are able to process information accurately, and act in their self-interest.

However, critics of this view highlight several limitations and challenges to the assumption of universal rationality:

1. Bounded Rationality: Human beings have cognitive limitations, and their ability to process information and make decisions is bounded. Limited time, cognitive biases, and imperfect information can lead to decision-making that deviates from the rational model.

2. Emotion and Psychology: Emotional factors and psychological biases can influence decision-making. People may make choices based on non-economic factors, social norms, or irrational beliefs, even if they are not in their best economic interest.

3. External Influences: The decisions of individuals are influenced by external factors such as social pressure, cultural norms, and advertising. These influences may divert individuals from making strictly rational choices.

4. Risk and Uncertainty: Rational decision-making assumes that individuals can accurately assess the risks and uncertainties associated with different options. However, people often face situations of uncertainty where the outcomes and probabilities are unknown, leading to decision-making based on imperfect information.

In reality, individuals exhibit a combination of rational and non-rational behavior, and their decision-making is influenced by a range of factors. While economic theory often assumes rationality, behavioral economics has highlighted the importance of understanding human behavior in a more realistic and nuanced way.

In conclusion, while the view that individuals always act as rational decision-makers to maximize their utility provides a useful framework for analyzing economic behavior, it is important to recognize the limitations and deviations from rationality that exist in real-world decision-making. Understanding the complexities of human behavior can provide valuable insights into economic outcomes and policy interventions.

Economics Essay 28: Utility of Price Elasticity of Demand

Evaluate the extent to which knowledge of price elasticity of demand is important for decision making by firms and governments.

Knowledge of price elasticity of demand (PED) is crucial for decision-making by firms and governments. It helps assess how changes in price will impact quantity demanded, revenue, consumer welfare, and market outcomes. Let's evaluate the importance of PED knowledge, while also considering its limitations:

Strengths:

1. Pricing Decisions for Firms: Firms can use PED to determine the optimal pricing strategy. If demand is elastic (PED > 1), a decrease in price will result in a proportionately larger increase in quantity demanded, leading to higher total revenue. Conversely, if demand is inelastic (PED < 1), a price increase will result in a smaller decrease in quantity demanded, leading to higher total revenue. Firms can visually analyze the demand curve to understand elasticity and make informed pricing decisions.

2. Taxation and Subsidy Policies for Governments: PED helps governments design effective taxation and subsidy policies. If demand is elastic, a tax increase will result in a larger decrease in quantity demanded and potential tax revenue. Conversely, if demand is inelastic, a tax increase may not significantly affect quantity demanded but can generate higher tax revenue. Subsidies can also be targeted towards goods with relatively elastic demand to boost consumption and market outcomes.

3. Market Interventions and Regulation: PED knowledge is crucial for governments in addressing externalities and market failures. It helps determine optimal tax or subsidy rates and assess the impact of price controls or regulations on quantity demanded and consumer welfare. Diagrams, such as supply and demand curves, illustrate the effects of market interventions on market equilibrium and outcomes.

Weaknesses:

1. Limited Scope: PED may not capture all factors influencing consumer behavior, such as income, preferences, availability of substitutes, and market dynamics. Other factors can significantly impact demand but are not reflected in PED alone.

2. Simplistic Assumptions: PED assumes a linear relationship between price and quantity demanded, which may not hold true in reality. Demand curves can be nonlinear, with varying elasticities at different price ranges. Using a single PED value might oversimplify demand behavior.

3. Difficulty in Estimation: Accurately estimating PED can be challenging, requiring data on price and quantity demanded, appropriate time periods, and controlling for other factors. Gathering and analyzing such data can be resource-intensive and subject to limitations.

4. Time Sensitivity: Short-run and long-run PED may differ due to changes in consumer behavior and market adjustments. The time horizon must be considered, as demand elasticity can shift over time.

5. Heterogeneous Demand: PED assumes homogeneity in consumer responses, but demand elasticity can vary among market segments. Applying a single PED value to a diverse consumer base may overlook variations in responsiveness.

6. Dynamic Market Conditions: PED may not capture dynamic market changes, such as technological advancements, shifting preferences, and competitive pressures. It is essential to consider these factors alongside PED for comprehensive decision-making.

While PED is a useful tool, decision-makers should use it alongside other market analysis tools, considering broader factors to ensure a comprehensive understanding of consumer behavior and market dynamics. Awareness of the limitations of PED is crucial for effective decision-making.

Who to let die and who to keep alive - On the Nice guidelines

The coronavirus pandemic response is normalising the notion that some lives are disposable writes Frances Ryan in The Guardian 

 

‘In a health crisis, it is not only the virus that risks infecting society but our prejudices.’ Photograph: James Tye/University College London (UCL)/AFP via Getty Images


In a pandemic, triage starts long before some of us get sick. A new document issued by the British Medical Association (BMA) has set out guidance to ration treatment if the NHS becomes overwhelmed with coronavirus cases.

The BMA suggests that in cases where ventilators are scarce, those facing poor prognosis could have the life-saving equipment taken away from them – even if their condition is improving – with younger and healthier patients given priority instead.

We are already seeing this play out. Last week, one man tweeted that his brother, who lives in a care home with limited mobility and a cognitive disability, went to hospital with a chest infection but didn’t make “the pandemic-led prioritisation cut”. He died a week later.

Meanwhile, it has been reported that a GP practice in Wales issued “do not resuscitate” (DNR) forms to a small number of patients, ensuring that emergency services would not be called should they contract coronavirus and their symptoms worsen. One adult social care provider has said that three of their services have been contacted by GPs to say that they have deemed the people they support should all be DNR. One woman who has received the form so far is in her 20s.

These stories of disabled and older people being denied care have been emerging for weeks as the virus has struck hospitals around the world, but have generally failed to find attention outside the disability community until now.

The National Institute for Health and Care Excellence (Nice) was forced to make a U-turn last week on their advice for the NHS to deny disabled people treatment, but only after disability groups threatened legal action. Nice had told doctors they should assess patients with conditions such as learning disabilities and autism as scoring high for “frailty” - thereby meeting criteria to be refused treatment - based on the fact they need support with personal care in their day-to-day life.

In a health crisis, it is not only the virus that risks infecting society, but our prejudices. It’s a slippery slope of ethical compromises in a culture and medical system that already struggles to support people with disabilities. Research shows that an estimated 1,200 people with a learning disability die avoidably every year due to poor care, while the terms “learning disabilities” or “Down’s syndrome” have been given as the reason for “Do not resuscitate” orders.

In the coronavirus pandemic, doctors are having to make difficult clinical judgments: would a medical intervention help a patient or does their underlying health condition prevent them from benefiting? Is it better to facilitate a peaceful death rather than administer a futile and distressing treatment?


However, judgments based on the efficacy of treatment are not the same as judgments based on the quality of a disabled person’s life. That might be falsely equating support needs with “frailty”, or adopting a blanket policy that withdraws treatment from a whole group of people rather than basing decisions on each individual’s needs and choices. That isn’t healthcare, it’s discrimination. 

These are complex issues and we are in deeply difficult times; medics are risking their own lives for the NHS and will face impossible choices as even oxygen and face pumps run low. But that should not mean abandoning debates around key decisions. Indeed, in an emergency it is more important than ever to question our attitudes and responses.

It is worth considering why the default position is to deny life-saving treatment to some disabled people rather than to ask why a wealthy nation that had months to prepare doesn’t have enough resources in the first place. It is worth considering whether talk of “limited resources” is excusing and normalising the long-held idea that disabled lives are disposable.

In recent days, I have seen disabled people take to social media to list their achievements, as if trying to make the case that they are worth saving. A disabled person who has their ventilator removed during this crisis may have gone on to cure cancer. But then, they may have just been loved. A mum with heart disease who always burns her daughter’s birthday cakes. An accountant born with muscular dystrophy who watches Dr Who every Sunday. Disabled people, like all minorities, are only fully human when we are permitted to be as wonderfully average as anyone else.

Utilitarian calculations over the value of certain people’s lives may appear pragmatic right now, but they cost us a part of ourselves. In the coming days, it is inevitable Britain will lose more lives. We need not lose our humanity too.

Public Benefit Company to replace Public Limited Company

Three-quarters of British voters want our rail, gas and water renationalised but it’s expensive – there is a business model that offers the best of both worlds


Will Hutton in The Guardian

Public ownership is fashionable again. Turning over Britain’s public assets, lock, stock and barrel into private ownership and relying only on light-touch regulation to ensure they were managed to deliver a wider public interest was always a risky bet. And that bet has not paid off.

Recent polls show an astonishing 83% in favour of nationalising water, 77% in favour of electricity and gas and 76% in favour of rail. It is not just that this represents a general fall in trust in business. The privatised utilities are felt to be in a different category: they are public services. But there is a widespread view that demanding profit targets have overridden public service obligations. And the public is right. 

Thames Water, under private equity ownership, has been the most egregious example, building up sky-high debts as it distributed excessive dividends to its private-equity owners via a holding company in Luxembourg, a move designed to minimise UK tax obligations. As the Cuttill report highlighted, at current rates of investment it will take Thames 357 years to renew the London’s water mains: it takes 10 years in Japan.

Equally, BT’s investment in universal national high-speed broadband coverage has been slow and inadequate, while few would argue that the first target of the rail operators has been quality passenger service – culminating in the most recent scandal of Stagecoach and Virgin escaping their contractual commitments. Most commuters, crowded into expensive trains, have become increasing fans of public ownership. Jeremy Corbyn’s commitment to renationalisation surprised everyone with its popularity.

The trouble is, it’s expensive: at least £170bn on most estimates. Of course the proposed increase in public debt by around 10% of GDP will be matched by the state owning assets of 10% of GDP, but British public accounting is not so rational. The emphasis will be on the debt, not the assets, and in any case there are better causes – infrastructure spending – for which to raise public debt levels.

And once owned publicly, the newly nationalised industries will once again be subject to the Treasury’s borrowing limits. If there are spending cuts, their capital investment programmes will be cut. What voters want is the best of both worlds. Public services run as public services, but with all the dynamism and autonomy of being in the private sector, not least being able to borrow for vital investment. It seems impossible, but building on the proposals of the Big Innovation Centre’s Purposeful Company Taskforce, there is a way to pull off these apparently irreconcilable objectives – and without spending any money.

The government should create a new category of company – the public benefit company (PBC) – which would write into its constitution that its purpose is the delivery of public benefit to which profit-making is subordinate. For instance, a water company’s purpose would be to deliver the best water as cheaply as possible and not siphon off excessive dividends through a tax haven. The next step would be to take a foundation share in each privatised utility as a condition of its licence to operate, requiring the utility to reincorporate as a public-benefit company.


Regulators, however good their intentions, too easily see the world from the view of the industry they regulate

The foundation share would give the government the right to appoint independent non-executive directors whose role would be see that the public interest purposes of the PBC were being discharged as promised.

This would include ensuring the company remained domiciled in the UK for tax purposes and guaranteeing that consumers, social and public benefit interests came first.

The non-executive directors would engage directly with consumer challenge groups whose mandate is to be a sounding board for consumer interests but at present are little more than talking shops, and deliver an independent report to an office of public services each year, giving an account of how the public interest was being achieved. It is important to have an independent third party: regulators, however good their intentions, too easily see the world from the view of the industry they regulate.

Because the companies would remain owned by private shareholders, their borrowing would not be classed as public debt. The existing shareholders in the utility would remain shareholders, and their rights to votes and dividends would remain unimpaired. So there would be no need to compensate them – no need, in short to pay £170bn buying the assets back. Indeed, the scope to borrow could be used to fund a wave of new investment in our utilities.

But the new company’s obligation would be to its users first and foremost, and would be free to borrow free from any Treasury constraint. Nor would any secretary of state get drawn into the operational running of the industries – one of the major reasons Attlee-style nationalisation failed. Inevitably decisions get politicised. 

The aim would be to combine the best of both the public and private sectors. If companies do not deliver what they have promised, there should be a well-defined system of escalating penalties, starting with the right to sue companies and ending with taking all the assets into public ownership if a company persistently neglected its obligations. But the cost would be very much lower, because the share price would fall as it became clear it was operating illegally.

Britain would have created a new class of company. Indeed, there is the opportunity to start now. If Virgin and Stagecoach are unable to fulfil their contractual obligations on the East Coast line, the company should be reincorporated as a public benefit company. The shareholders would remain, but the newly constituted board would take every decision in the interests of the travelling public guaranteed by the independent directors, empowered consumer challenge groups and the office of public services – so that the taxpayer can trust her or his money is spent properly. Corbyn and John McDonnell have a way of delivering what the electorate want – and still keeping the industries off the public balance sheet. The circle can be squared.

British banks can’t be trusted – let’s nationalise them

Owen Jones in The Guardian


Sometimes the case for a policy is as overwhelming as the level of ridicule it will get from the punditocracy. The nationalisation of Britain’s failed banking industry – the sector responsible for most of our country’s current ills – is one such example. According to a recent poll, half the electorate support nationalising the banks, despite almost no one arguing for such a policy in public life.

It may well be because the banks plunged Britain into one of its worst economic crises in modern history, spawning, according to the Institute for Fiscal Studies, perhaps our worst squeeze in living standards since the 1750s. The fact that they have been bailed out by the taxpayer but allowed to carry on as though little happened – including more top British bankers in 2013 being gifted bonuses worth over €1m than all EU countries combined – while public services are gratuitously slashed, has rightly riled some British voters. 

Nationalisation of the banks is not about vengeance, though. Sure, the rip-off inefficiency of rail privatisation, or the failure of the great energy sell-off, or the fact that even the Financial Times has argued that privately run water is an indefensible debacle – all are testament to the intellectual poverty of the “private good, public bad” argument. None quite compete, however, with the matter of the banks leaving the entire western world consumed with the gravest series of crises since the second world war.

Would Brexit, Donald Trump, or the gathering demands for Catalonia to secede from crisis-ridden Spain have happened without the financial collapse? Almost certainly not. It is now somewhat darkly comic to note that most commentators and politicians claimed Labour lost the 2015 election because it was too leftwing. It is notable, then, that over four in 10 voters back then believed Labour was too soft on banks and big business, compared to just over one in five who differed.

Economist Laurie Macfarlane says the banks make a mockery of the nostrums of free-market capitalism. Because the banks were given state bailouts after their catastrophic failures, there is the assumption that, when another crisis hits, the same will happen again.

No other industry enjoys the same protection. They are “too big to fail”, which means they benefit from an implicit subsidy – worth £6bn in 2015. The Bank of England is their lender of last resort. State-backed deposit insurance of up to £85,000 per consumer is another de facto mass public subsidy.

As the New Economics Foundation says, it is commercial banks who are now responsible for creating the vast majority of money in economies like the UK, a source of vast profit. This is called “seigniorage” and – as the foundation puts it – it represents a “hidden annual subsidy” of £23bn a year, or nearly three-quarters of the banks’ after-tax profits. And banks are an essential public utility: it is almost impossible to be a citizen without a bank account, and there is no public option when it comes to making electronic payments.

Even now, as Macfarlane notes, the British state technically owns a fifth of the retail banking industry because of its stake in Royal Bank of Scotland. Repeated RBS scandals, and the aftermath of the EU referendum result, have dented the worth of the company’s shares, meaning that the state selling its stake would result in eye-watering losses. Meanwhile, small businesses have struggled to get the credit they need, and escalating household debt threatens the foundations of the stagnating British economy. But the state’s arms-length approach means RBS has failed both its customers and the broader economy. A profit-driven banking sector closed 1,150 branches in 2014 and 2015; about a third of those were owned by RBS. The bank once promised never to close the last branch in town; the pledge was broken, and 1,500 communities have been left with no bank branch. Vulnerable customers and small businesses inevitably suffer the most.

By contrast, foreign publicly owned banks are self-evident successes. Take Germany: KFW, the government-owned development bank, is crucial in developing national infrastructure as well as the renewable energy revolution. On a regional level, state-owned Landesbanken are responsible for industrial strategy. Then at the most local level, there are Sparkassen: they focus on developing relationships with local businesses and consumers. They’re not beholden to shareholders – instead, they have a stakeholder model, focused on helping local economies – indeed, their capital has to remain in local communities.

It is impossible to understand Britain’s current plight without examining the country’s rapid deindustrialisation in favour of a financial sector concentrated in London and the south-east. And according to New Economics Foundation, while foreign stakeholder banks lend two thirds of their assets to individuals and businesses in the real economy, that’s true with only a tiny proportion of British shareholder banks. Overwhelmingly, it goes to mortgage lending and lending to other financial institutions.

Our current banking system is rigged in favour of a crisis-ridden City. The New Economics Foundation suggests transforming RBS – in which the state still has a three-quarter share – into a network of local banks. Labour’s 2017 manifesto backed a review into these plans. A management board would run the network day to day, but a board of trustees would ensure the bank was accountable to the broader economy and customers, not shareholders.

A third would be elected by workers, a third by local authorities and a third by local stakeholders. The mandate of each local bank would be to promote local economies – not least their small businesses – rather than the City of London. Here is a model of democratic ownership that can, in time, be extended to the rest of the economy.

Can it really be argued that private ownership of the banks is a case study of the glorious success of free market capitalism? The principle architect of Labour’s recent manifesto, Andrew Fisher, called for the nationalisation of Britain’s banking sector in his 2014 book The Failed Experiment: And How to Build an Economy That Works. He was surely right then and he is right now. As Macfarlane notes, there are different possible routes to the banks’ nationalisation: whether it be swapping corporate shares for government bonds, using quantitative easing to buy up shares, or simple nationalisation without compensation. Labour is right to call for a German-style public investment bank, backed up by similar publicly run local banks.

But such proposals are not in themselves sufficient. Britain’s privately run banks have proved a disaster for everyone except their shareholders. The only good alternative is public stakeholder banks, run by workers, consumers and local authorities, with an obligation to defend the best interests of our communities. Privately owned banks have proved a catastrophic failure – for our economy, our social cohesion and our politics. There is surely no alternative to public ownership.