How we make choices?

Every day we are faced with a myriad of decisions, from what to have for breakfast, to which route to take to class, to the more complex—“Should I double major and add possibly another semester of study to my education?”  So how do we proceed?  Economists use various concepts to describe this process:

Features of the decision making process.

Imagine you made plans to spend the week-end at the beach with your friends but on Friday, your boss asks you to come in to work this week-end.  Your time is scarce and you cannot be at the beach and at work at the same time so you have to choose.  Economic theories generally view individuals as rational decision makers that pursue their self interest; meaning that we act in a reasonable fashion, and take the actions that will bring us the most benefit.  In this case, to determine which course of action. week-end at the beach versus work, will bring you the most benefit, you may compare the cost and benefit of each option.  For instance, the benefit of working is the money you will earn and the possible goodwill of your boss while the opportunity cost is the fun time at the beach you do not get to enjoy.  Economist call this cost / benefit analysis for a specific course of action: Marginal Thinking.  Most decisions we take involve small or incremental changes such as buying an extra pizza or choosing to study one more hour, hence the term marginal thinking.  Of course this decision making process is based on individual preferences and two rational individuals may choose different options.  For instance, if you chose to work instead of spending the week-end at the beach, that would mean that based on your circumstances and preferences, you thought you would receive more benefits from working.

Most economic theories assume all participants into the economy to be rational; firms will make decisions aimed to maximize their profit and consumers will act as to maximize their utility.  Utility is a term used by economists to describe the benefits or satisfaction that individuals obtain from purchases or from their decisions.

The assumption that individuals are purely self-interested doesn’t imply that individuals are greedy and selfish. People clearly derive satisfaction from helping others, so “self-interest” can also include pursuing things that benefit other people. The assumption of rationality—also called the theory of rational behavior—is primarily a simplification that economists make in order to create a useful model of human decision-making.

Rational decision making also aims to be efficient and make the best use of resources available such as time in the above example to achieve the best outcome.  Economic efficiency describe the use of all available resources in order to produce the mix of products most wanted at least cost.

How good are we at making decision?

Behavioral economists have challenged the idea of ‘Homo Economicus,’ the rational decision maker, and offer a less generous evaluation of our sometimes  irrational decision process.  Dan Ariely, economist from Duke university, describes many of our flaws in his book:”Predictably Irrational.”  Watch his TEDtalk.

Decisions and Information

Our decisions are only as good as the information that we possess.  The more information the better; but also keep in mind that information is not free and so we have to compare the benefit of acquiring more information to its cost which means that we generally rely on imperfect information to make decisions.