1.2.1a Rational choice and incentives

Rational Agents Weigh up Costs and Benefits to Pursue a Clear Objective

1. Standard economic models assume agents are rational, weighing costs and benefits to pursue a clear objective.
2. Consumers are assumed to maximise utility (satisfaction) and firms to maximise profit.
3. Rational agents respond to incentives, so changing the costs or benefits of an action changes behaviour.

Consumers Maximise Utility, Firms Maximise Profit and Workers Maximise Net Benefit

1. Consumers
   1. Choose the bundle of goods that gives the most utility within their budget.
2. Firms
   1. Choose the output and methods that make the most profit.
3. Workers
   1. Supply labour to get the best net benefit from wages set against their leisure.

The Rational Assumption Gives Models Clear, Predictable Outcomes

1. It gives models a clear, consistent prediction of how agents respond to a change.
2. It underpins demand and supply, the foundation of almost all later analysis.
3. It lets policymakers design incentives, such as a tax on cigarettes, to steer choices.

In Reality, Limited Information and Willpower Make Rationality Only an Approximation

1. In reality people have limited information, time and willpower, so they use rules of thumb rather than full calculation.
2. Behavioural economics (1.2.3) shows systematic biases, such as inertia and present bias, that break the assumption.
3. Despite this, the rational model still predicts a great deal of behaviour well and remains the sensible baseline.
4. The strongest answers treat rationality as a useful approximation to be qualified, not a fact to be assumed blindly.

1.2.1b Utility theory and the margin

Total Utility Is Overall Satisfaction, Marginal Utility Is the Gain From One More Unit

1. Marginal utility is the change in total utility as consumption rises by one unit.
2. Rational decisions are made at the margin, one unit at a time.

Marginal Utility Is the Change in Total Utility From One Extra Unit

1. Total utility usually rises as more is consumed, at least at first.
2. Marginal utility is the addition each extra unit brings.
3. Marginal utility is found from the change in total utility.
4. Total utility can be found by adding up marginal utilities.

Rational Consumers Decide One Unit at a Time, Weighing Its Benefit Against Its Price

1. A consumer asks whether the next unit is worth its price.
2. If the marginal benefit beats the cost, they buy it.
3. If not, they stop.
4. A consumer maximises utility by buying up to the point where marginal benefit no longer exceeds price.

Total Utility Peaks When Marginal Utility Reaches Zero

1. Total utility rises while marginal utility is positive.
2. It is highest when marginal utility reaches zero.
3. It falls only once marginal utility turns negative.
4. So a falling marginal utility does not mean total utility is falling.

Marginal Utility Tends to Diminish as More of a Good Is Consumed

1. Diminishing marginal utility is the tendency for extra satisfaction to fall as consumption rises.
2. As more of a good is consumed in a period, each extra unit adds less.
3. It is a hypothesis about how satisfaction behaves.
4. It is the key building block for the importance of the margin.

Each Successive Unit Adds Less Satisfaction Than the One Before

1. The first unit of a good gives the most satisfaction.
2. Each further unit gives a smaller addition.
3. So marginal utility declines as quantity rises.
4. This holds within a given time period.

Diminishing Marginal Utility Explains the Downward-Sloping Demand Curve

1. Because marginal utility falls as more is consumed, a consumer will only buy an extra unit if its price falls to match the smaller benefit it brings.
2. A rational consumer keeps buying up to the point where marginal utility equals the price paid, so a lower price is needed to make additional units worthwhile.
3. This is why the hypothesis of diminishing marginal utility supports a downward-sloping demand curve, with quantity demanded rising as price falls.