Rational Economics & Incentives
- Individual economic decision-making is influenced by
- Rationality
- Incentives
- Marginal utility
- When analysing markets, a range of assumptions are made about the rationality of economic agents involved in the transactions
- In classical economic theory, the word 'rational' means that economic agents are able to consider the outcome of their choices and recognise the net benefits of each one. Rational agents are incentivised to select the choice which presents the highest benefits
- Consumers are assumed to act rationally. They do this by maximising their utility
- Producers are assumed to act rationally. They do this by selling goods and services in a way that maximises their profits
- Workers are assumed to act rationally. They do this by balancing welfare at work with consideration of both pay and benefits
- Governments are assumed to act rationally. They do this by placing the interests of the people they serve first in order to maximise their welfare
- In many ways, the assumption of rational decision-making is flawed. For example, consumers are often more influenced by emotional purchasing decisions than a rational computation of net benefits
Exam Tip
In your examinations, the essay questions test your ability to think critically. The command term for these questions are evaluate, justify, assess and to what extent
One way in which you can demonstrate critical thinking is to challenge the underlying assumptions of economic theory. The idea of rational decision making is one such assumption. Do consumers act rationally when they make impulse purchases? Do workers act rationally when they accept terrible working conditions for mediocre pay? Do governments actually maximise public welfare or do they implement policies that mainly benefit their core voter base?
Irrationality distorts markets and produces fundamentally different outcomes than what would be achieved if all economic agents acted rationally.
