When consumers do not behave rationally

Overview

Bounded rationality, how habitual behaviour prevents consumers from responding to better offers and inertia or the status quo bias in consumer behaviour.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What does it mean to say a consumer behaves rationally in the standard economic model?

   Model answer

   It means the consumer has clear and consistent preferences, has full information about the options and their prices, weighs the benefits and costs of each choice, and selects the combination that gives the greatest satisfaction from the income available. The assumption is not that consumers are clever or well-behaved, only that they choose consistently in their own interest given what they know.

2. 2

   What is bounded rationality, and why does it lead consumers away from the best available choice?

   Model answer

   Bounded rationality is the idea that people intend to choose well but are limited by the information available, the time they have and their capacity to process complexity. Faced with dozens of tariffs or hundreds of products, a consumer cannot evaluate them all, so they use short cuts and stop searching once something acceptable is found. The result is a decision that is reasonable but not the best one, which means observed choices depart systematically from what the standard model predicts.

3. 3

   Explain how habitual behaviour prevents consumers from responding to better offers.

   Model answer

   Many purchases are repeated automatically without being reconsidered, from the brand of coffee bought each week to the bank account or insurance policy renewed each year. Once a habit is formed the consumer stops comparing alternatives, so a cheaper or better product can enter the market without attracting them. Demand becomes less responsive to price than the model predicts, and firms can retain customers while charging more than a competitor.

4. 4

   What is meant by inertia or the status quo bias in consumer behaviour?

   Model answer

   Inertia is the tendency to stay with the current arrangement rather than switch, even when switching would clearly be beneficial. It arises from the effort involved, the fear of getting the change wrong and a general preference for the familiar. It is why many households remain on expensive default energy tariffs for years and why automatic pension enrolment raises participation so sharply: whichever option is the default tends to be the one chosen.

5. 5

   Explain herd behaviour and give an example of its effect on a market.

   Model answer

   Herd behaviour is the tendency to copy what others are doing rather than evaluate independently, either because others' actions are taken as evidence about quality or because people dislike being out of step. In a rising housing market, buyers observing others buying may conclude prices will keep rising and rush to buy, which pushes prices up further. The self-reinforcing process can carry prices well away from what the underlying fundamentals justify, and can reverse sharply.

6. 6

   What is anchoring, and how can a seller use it?

   Model answer

   Anchoring is the tendency to judge a value by reference to a number that has been put in front of you, even when that number is arbitrary. A seller can exploit it by displaying a high original price beside a reduced one, so the discount looks large relative to the anchor rather than being judged against what the good is worth. The consumer's willingness to pay is shifted by the presentation of the price rather than by any change in the product.

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