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Everyone would be expected to know:
· The Basics of the Rational Actor Model
· The concept of Utility
· The limitations of the Rational Actor Model approach
Video-Brief video on the basics of the rational actor model
Important facts
The Rational Actor Model is the traditional method by which economists attempt to model individual behaviour. In doing so it makes certain assumptions about individuals to help focus on particular aspects of the economy.
- Individuals are rational and make informed decisions.
- They have fixed preference across time.
- They act to maximise their own utility.
Utility in this instance is a catch all term for individual satisfaction, and as such is deliberately slightly vague in its specifics. The closest synonym is probably happiness, but should just be understood as what individuals want above all else. Preferences are best understood as the individual actions/ items that for particular individual result in a gain in utility. An individual has a preference for one item over another as they gain more utility from the former as compared to the latter.
As a result of these assumptions economists can use individual behaviour to reveal what their individual preferences might be. For example, say person chooses to buy soap for £1, then this behaviour shows that the individual in question values soap more than £1, and as such prefers it. But if the price was raised to £3 and the individual then refused to buy it the economist would be able to say the individual gains more utility from having £3 (or other potential purchases worth £3) than they would from the soap.
This model has been very useful to economics as a subject as it has allowed them to create complicated models of individual behaviour, and use these models to scale up to how groups and firms behave.
Limitations
This model however has some very clear limitations, in particular with regards to its assumptions.
1. Individuals are rational and make informed decisions
· It seems very questionable that individuals are always correctly informed about potential options, particularly if they are about long term questions to do with money. Individuals often are ill-informed on the implications of pension plans for example.
· Rationality is hard to define, but if it is taken to mean ‘thought out decisions’ we can all think of examples where we have made purchasing decisions based more upon impulse than careful thought. A takeaway for example, can be an irrational impulse buy when there is already food waiting at home.
2. Individuals have fixed preference across time.
· Preferences in many cases do not appear to be fixed over time, for example our preferences for various types of food change as we become older.
· The existence of the advertising industry is good evidence against this assumption, given its purpose is to change individual preferences. If they were permanently fixed this would be a waste of time.
· Young person’s preferences change very markedly as they grow up, such as their differing food and music tastes.
3. Individuals act to maximise their own utility.
· Individuals often at least appear to act in ways that do not maximise their own utility, such as when individuals put off chores for a considerable period time despite knowing it will be more difficult to do later.
· This is harder to disprove due to the subjective nature of utility, from the individuals perspective perhaps the utility gained from their free time outweighed the negatives of doing chores later.
· It at least seems debateable whether individuals are always motivated by maximising their own utility.
4. Delayed Gratification
· In the Stanford marshmallow experiment by Walter Mischel, that happened between the late 1960s and early 1970s. Children ages 4 to 6 were given a choice between, having a marshmallow now, or two marshmallows in 15 minutes if they waited. The marshmallow was left in front of them, whilst they waited. Only 1/3 of the 600 children were able to wait.
· This goes against the theory of rationality, as an individual acting rationally would wait, as there is more to gain. However individuals tend to overvalue instant gratification.
This shows a modern example of the experiment:
5. Measuring Costs and Benefits as proportions instead of in absolute terms.
- People tend to think of savings proportions instead of absolute terms. Examples:
- i. If there was the same burger sold for £5 half an hour walk from your house or for £15 right next to your house. Which would you choose?
- ii. If there was the same car sold for £10,010 right next to your house, or £10,000 30 minute walk away? (you have to walk there and back)
- People tend to walk for the burger, and get the car from near their house. As with the burger you get 2/3 off. And with the car get an 1/1000 off. Even though the absolute saving is the same. Showing that people are being irrational in this situation.
Explanation video:
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