Critique of the maximizing behaviour of consumers and producers

• State the three assumptions of rational consumer choice and judge when the model predicts consumer behaviour well.
• Explain the four named biases, bounded rationality, bounded self-control, bounded selfishness and imperfect information, and identify the assumption each one contradicts.
• Distinguish default, restricted and mandated choices, and evaluate nudges as a way of changing behaviour.
• Explain why profit is greatest at the output where MC = MR, and why firms may not aim for it.
• Discuss corporate social responsibility, market share, satisficing and growth as alternatives to profit maximisation, using time period, ownership and market structure.

Standard microeconomic theory treats consumers and producers as maximisers. Consumers are assumed to choose so as to gain the greatest possible satisfaction from their income, and firms so as to make the greatest possible profit. The demand and supply curves of topics 2.1 to 2.3 rest on these two assumptions. This topic examines how far they describe real behaviour, starting with consumers.

Rational consumer choice is the model in which a consumer with a limited income, facing given prices, compares the available options and chooses the combination of goods that gives the greatest Utility, the satisfaction gained from consumption. The model rests on three assumptions.

• Consumer rationality. Consumers have preferences that are clear and consistent. They can rank the options open to them; the ranking does not contradict itself, so that someone who prefers A to B and B to C also prefers A to C; and it does not change with the way the options are described. Consumers act on these preferences in their own interest.
• Utility maximisation. Consumers aim for the greatest total utility that their income allows. They compare the extra utility of one more unit of each good with its price and spend each unit of income where it adds most, until no change in spending could make them better off. This is Utility maximisation.
• Perfect information. Consumers know the prices, qualities and availability of all the alternatives, and the consequences of each choice, without cost. This is the assumption of Perfect information. Without it a consumer could not be sure of identifying the best option.

The model gives predictions that can be tested. A rational, informed, utility-maximising consumer buys less of a good when its price rises, responds to incentives such as taxes and subsidies, and is unaffected by features of a choice that leave its costs and benefits unchanged, such as which option is listed first or selected in advance. Behavioural research has tested the last of these predictions most directly.

The three assumptions are simplifications, and the model is judged by how well it predicts. It predicts best where its conditions are nearly met: purchases that are frequent, low in cost and easy to compare, such as weekly groceries, where a consumer notices a mistake and corrects it next time. It predicts worst where a decision is rare, complex or has consequences far in the future, such as choosing a pension, a loan or an insurance policy. There the information is hard to obtain, the comparison is hard to make, and errors are not corrected by repetition.

The model also predicts the behaviour of a whole market better than that of one person, provided that individual errors are random and cancel out. The importance of behavioural economics is its finding that many errors are systematic: they push most people in the same direction, so they do not cancel, and they show up in market demand.

Behavioural economics uses evidence from psychology and from experiments to study how people actually take economic decisions. It does not claim that behaviour is random. It identifies specific, predictable ways in which choices depart from the three assumptions of rational consumer choice. Five kinds of limitation are examined: biases, bounded rationality, bounded self-control, bounded selfishness and imperfect information.

A bias is a systematic error of judgement: a departure from the rational choice that runs in a predictable direction. Biases contradict the assumption of consumer rationality, because they make choices depend on things that should not matter. Four biases matter most.

• Rule of thumb. A Rule of thumb is a simple mental shortcut used in place of a full comparison of the options: buying the brand bought last time, or choosing the middle-priced item on a list. Rules of thumb save time and effort and usually give acceptable results, which is why people use them. They cause errors when conditions change and the rule is no longer a good guide, for example when a cheaper product of the same quality has appeared and the habitual buyer never considers it.
• Anchoring. Anchoring is relying too heavily on the first piece of information encountered, the anchor, when making a judgement. A shopper who sees a label reading 'was $100, now $60' judges $60 against the anchor of $100 and sees a bargain, whatever the good is worth to them. A rational consumer would compare $60 only with the utility of the good and with the prices of the alternatives.
• Framing. Framing is responding differently to the same information according to how it is presented. A yoghurt labelled '90% fat free' sells better than the same yoghurt labelled '10% fat'. The two labels state one fact, so a rational consumer would choose identically under both.
• Availability. Availability bias is judging how likely an event is by how easily examples of it come to mind. Events that are recent, dramatic or widely reported are recalled easily and so are overestimated, while undramatic risks are underestimated. A household that has just seen news reports of a flood is more willing to buy flood insurance, although the probability of a flood has not changed.

Bounded rationality is the idea that people try to choose well but are limited by the information they have, by the time available and by their capacity to process information. A supermarket may stock dozens of varieties of one product, and comparing every price, size and list of ingredients on each visit would cost more in time and effort than the best choice could save. Consumers therefore simplify. They consider a few options, use rules of thumb, and stop searching when they find an option that is good enough. The outcome is a satisfactory choice, not the utility-maximising one, so bounded rationality contradicts the assumption of utility maximisation. It also implies that more choice or more information does not always help, because both add to the load on a limited capacity to decide.

Bounded self-control means that people do not always do what they themselves judge to be in their long-term interest. They give too much weight to costs and benefits that arrive now compared with those that arrive later, so they eat, spend or borrow more today than they had planned and put off saving, exercise or study. The evidence that this is a failure of self-control, and not simply a taste for the present, is that people regret these choices and pay to restrict themselves in advance, for example by committing to a savings plan that penalises withdrawals. The consumer of the standard model has no such difficulty, because their choices at every date follow one consistent plan. Bounded self-control helps to explain the over-consumption of goods such as tobacco and sugary drinks, and low saving for retirement.

Bounded selfishness means that people are not purely self-interested. The standard model assumes that consumers maximise their own utility. In practice people give to charity, donate blood, volunteer, leave tips in restaurants they will never visit again and pay more for goods they believe were produced fairly. They also care about being treated fairly, and will give up money to punish behaviour they think unfair, for example by refusing to buy from a firm that raised its prices sharply during an emergency. These choices are deliberate, so they are not errors. They show that the aims of real consumers are wider than the model assumes, and that fairness and social norms affect demand.

Imperfect information means that consumers do not know everything that is relevant to a choice. They rarely know every price on offer, and they often cannot judge quality before buying (a used car, a medical treatment, a savings product) or the long-term effects of what they consume on their health. Information can be found, but searching takes time and money, so it is sensible to stop before everything is known. With imperfect information even a fully rational consumer cannot be sure of identifying the option that maximises utility, so this limit contradicts the third assumption directly. Where the seller knows more than the buyer the problem is asymmetric information, which is treated as a market failure in topic 2.10.

A choice is always presented in some way: the options appear in an order, one of them may be selected in advance, and some may be left out. Choice architecture is the design of the setting in which people choose. Because of the limits described in the previous section, the design affects what is chosen, which the standard model says it should not. Whoever designs the setting, whether a government, an employer, a shop or a website, is the choice architect. Three designs are widely used.

• Default choice. A Default choice is the option a person receives if they do nothing. People tend to stay with a default because changing it takes effort, because they put the decision off, and because they read the default as a recommendation. Automatic enrolment in a workplace pension is the standard example: the employee is a member of the scheme unless they act to leave it.
• Restricted choice. Under Restricted choice the set of options is limited by the government or another authority, so that people choose from a smaller range. A school canteen that sells only water, milk and fruit juice, or a pension scheme that offers three funds where there could be three hundred, restricts choice. Restriction lightens the load on bounded rationality and can remove the most harmful options, at the cost of some freedom to choose.
• Mandated choice. Under Mandated choice people are required to state a decision, so that no default applies. An application form for a driving licence that is not accepted until the applicant has answered yes or no to joining the organ-donor register mandates a choice. It overcomes inertia without choosing on the person's behalf, but it works only where people can be made to face the question.

A nudge is a change in choice architecture that makes one option more likely to be chosen without forbidding any option and without significantly changing financial incentives. Nudge theory is the proposition that such changes can steer people towards the choices they would make for themselves if they had full information, unlimited attention and complete self-control. A default is the strongest kind of nudge. Others are a message that tells people what most others do (for example that most households in the area have already paid a tax), placing the preferred option where it is easiest to see or reach, simplifying a form, and sending a reminder. A tax, a subsidy or a ban is not a nudge, because it changes prices or removes options.

A nudge works through the same limits that cause the problem it addresses. A default relies on inertia and bounded self-control: a worker who would never get round to joining a pension scheme also never gets round to leaving one. A message about what others do relies on bounded selfishness and the wish to follow a social norm. A simpler form reduces the demands on bounded rationality, and a reminder makes the relevant information available at the moment of choice.

The producers' counterpart of utility maximisation is Profit maximisation. Standard theory assumes that every firm aims for the greatest possible profit, the difference between its total revenue and its total cost. The assumption underlies the supply curve: a higher price makes additional output profitable, so quantity supplied rises.

The profit-maximising output is found by comparing Marginal revenue (MR), the extra revenue from selling one more unit, with marginal cost (MC), the extra cost of producing it. If MR is greater than MC, the next unit adds more to revenue than to cost, so producing it raises profit. If MC is greater than MR, the last unit added more to cost than to revenue, so cutting it raises profit. Profit is therefore at its maximum at the output where MC = MR, with MC rising. The application of this rule to different market structures belongs to topic 2.11.

There are good reasons to expect firms to seek profit. The owners receive it, so they gain directly. Profit pays for investment and for research and development, and it is a reserve against bad years. In a competitive market a firm that neglects profit is undercut by rivals with lower costs and eventually fails, and the managers of a company whose profits disappoint its shareholders may be replaced, or the company may be taken over.

The critique of profit maximisation runs parallel to the critique of rational consumer choice. Managers do not know their marginal revenue and marginal cost precisely, so they cannot locate the exact maximum (imperfect information and bounded rationality). In a large company the owners do not run the firm. The shareholders employ managers, whose own interests may lie in salary, status and security more than in profit, and shareholders cannot observe everything that managers do. A firm with market power is also under less pressure from competitors, so it can survive without maximising profit. In these conditions firms may pursue other objectives, of which four are the most important.

• Corporate social responsibility (CSR). A firm that practises Corporate social responsibility takes account of the effects of its actions on workers, communities and the environment and accepts responsibilities beyond those the law imposes: paying more than the legal minimum wage, cutting its emissions, or checking conditions in its suppliers' factories. This raises costs, so in the short run it reduces profit. It may raise profit in the long run if consumers will pay more for the firm's products, if workers become more loyal and productive, or if it prevents regulation and protects the firm's reputation. Where none of these applies CSR is a real sacrifice of profit, and competition limits how far a firm can go. Because consumers cannot easily verify what a firm does, a firm may also claim more than it delivers.
• Market share. Market share is a firm's sales as a proportion of total sales in its market. A firm that aims to raise its share cuts its price or spends more on advertising, and so sells more than the profit-maximising output and accepts lower profit for the time being. A larger share can bring economies of scale, bargaining power over suppliers, recognition among consumers and, if rivals leave the market, the power to raise prices later. The objective is therefore often a route to higher profit in the long run.
• Satisficing. Satisficing is aiming for a satisfactory level of profit in place of the maximum. Managers earn enough profit to keep the shareholders content and then pursue other aims, including their own, or avoid the effort and risk of finding the last unit of profit. Satisficing follows from bounded rationality, from the separation of ownership from control, and from the need to settle the competing claims of shareholders, managers, workers and customers. It allows costs to be higher than they need to be.
• Growth. A firm that pursues Business growth aims to increase its size, measured by sales revenue, output or assets, as fast as it can. Managers' pay and status tend to rise with the size of the firm, and a large firm is harder to take over and better able to survive a downturn. A firm seeking growth reinvests its profit in place of paying it to shareholders, keeps its prices low, and may expand as far as the output that maximises sales revenue, which is greater than the output that maximises profit.

The effect of an alternative objective on price and output can be shown for a firm with market power, whose marginal revenue lies below its demand curve. The diagram is optional for this topic; it uses the curves of topic 2.11 to show why objectives that put sales before profit lead to a higher output and a lower price.

The objective a firm pursues matters to others. Objectives that raise output above the profit-maximising level (market share, growth, sales revenue) lower the price consumers pay in the short run, although a firm that wins a dominant share may later use its market power to raise the price. CSR benefits workers and third parties directly. Satisficing can leave costs and prices higher than they would be under pressure to maximise profit.

• Rational consumer choice assumes consumer rationality, utility maximisation and perfect information. It is a model that predicts well for simple, repeated purchases and poorly for rare, complex ones.
• Biases (rule of thumb, anchoring, framing, availability) contradict consumer rationality. Bounded rationality and bounded self-control contradict utility maximisation. Bounded selfishness contradicts pure self-interest. Imperfect information contradicts perfect information.
• Choice architecture is the design of how choices are presented: a default applies if a person does nothing, a restricted choice limits the options, and a mandated choice requires a decision.
• A nudge changes the presentation of a choice without removing options or significantly changing prices. It works best against inertia and worst against strong preferences or strong financial incentives.
• Profit is maximised where MC = MR. Firms may instead pursue corporate social responsibility, market share, a satisfactory profit or growth.
• Market share, growth and much corporate social responsibility give up profit in the short run to gain it in the long run. Satisficing persists where managers are not closely controlled by owners and the firm has market power.