Question

The fundamental principles on individual decision making are that 1) people face trade-offs among alternative goals, and 2) that the cost of any action is measured in terms of forgone opportunities, 3) that rational people make decisions by comparing marginal costs and marginal benefits and 4) that people change their behavior in response to the incentives they face. Talk about each one of these concepts and make sure to support your analysis with examples. Short answer please!

Answer 1

Introduction

It is a known fundamental fact, that human needs and wants are unlimited, whereas the sources through which they can achieve the same tend to not be limited. Therefore they need to choose from various alternatives available, those products or services which can provide them with maximum satisfaction.

It is around this concept, that the case study is based.

Case Specifics:-

1) People face trade-offs among alternative goals:-

The basic concepts of tradeoffs involves give and take of resources to purchase goods and services available in the market place. Since people have to buy satisfaction in the terms of goods and services from money, they face tradeoffs at any given point of time.

For example:- Consumers face a tradeoff situation while buying products, Producers face them while deciding on whether to increase production or to retain earnings and the government as a whole faces such situations regularly while deciding which sector it needs to spend more resources into.

Thus, because people tend to have different goals at a given point of time, they are faced with trade-offs which refer to them giving up on some goals to achieve others since their resources are limited.

2) That the cost of any action is measured in terms of forgone opportunities

Every individual can choose from the numerous available options to them but their cost not only involves the monetary consideration given to purchase the item or service but also in the value of the next best alternative which they could have purchased or availed.

For example:- A producer may have the option of either distributing profits among shareholders for increased earnings and revenue contribution or could use the same for buying machinery to increase the supply and profits in the years to come.

Any of the two decisions taken has an added cost of lost opportunity of the other. Thus if the company decided to distribute their profits they would have to measure the impact that spending on increased production could have and vice-versa

3) Rational people make decisions by comparing marginal costs and marginal benefits

Marginal Costs refer to the addition of cost by selecting any of the alternatives whereas marginal benefits refer to the addition of benefit. A rational person considers both cost and benefits received from the decision making so that he can get maximum benefit by spending the least amount of money possible.

Economists tend to define benefits in terms of utility which the person purchasing the product gets from consumption and therefore considering a situation in which a person would get higher utility from purchasing a product which does not add significant costs would be recommended considering the budget factor in mind also.

For example if a person were to get 10 util of satisfaction from the consumption of Good X or 20 util from purchasing goods Y whereas there marginal costs would only be a hike of 5% then in that case due to the increased benefits, rationality would tell them to purchase Good Y because of a 100% addition to overall satisfaction levels.

4) People change their behavior in response to the incentives they face.

Indeed, the consumption pattern of people changes, if they have incentives in place and they may change their buying behavior. As explained above, people tend to purchase goods that give them more benefits at lesser costs. Therefore a situation where people were to choose among products, one of which was providing them with added incentives, would lead them to a decision which would be favorable to the same also.

Example: - During sales in consumer products, people tend to buy from stores that offer products at cheaper rates or with added incentives than head to expensive ones since the marginal benefit tends to be high whereas the costs tend to be lower relatively.

Please feel free to ask your doubts in the comments section if any.