Explain what is implied by the assumption that decision makers are rational? How is the assumption of rationality used in the economic analysis of individual behaviour?

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Explain what is implied by the assumption that decision makers are rational? How is the assumption of rationality used in the economic analysis of individual behaviour?

Economic rationality is the assumption that consumers in the market will always choose the options that they perceive to be the best given the circumstances that they are in and that will maximise their utility. It is a basic assumption made in all economic models designed to allow economists to make predictions and generalisations without having to focus on individualistic differences. Without this broad assumption, it would be impossible to model economic behaviour and it has been a widely accepted economic convention since Milton Friedman's 1954 book Positive Economics. The utility that the rational consumers will seek to maximise is the relative satisfaction obtained from the consumption of goods and it is expected economic behaviour that it will be desired for this to increase. It can also be seen how rationality has an effect on externalities and how the economic model of perfect competition

There are three basic assumptions to economic rationality known as the ‘Axiomatic theories’. These are an essential component of consumer demand theory and to meet the consumer’s goal of utility it is essential that they are followed; only consumers who do are considered rational. The first axiom of rationality is completeness. This rule states that the consumer must possess the ability to order every possible combination of goods as per their personal preference, however indifference is acceptable. If this axiom is violated it will lead to incomplete and incompetent decision making as not all the options will be properly considered and assessed if preferred by the consumer therefore leading to information failure. This can be caused by ambivalence in the consumer leading to a lack of desire to consider the options available. The second is transitivity which states that the consumer must have the ability to assess different combination preferences available for example, if x is preferable to y and y is preferable to z then x must be preferable to z. This axiom is essential to rationality as if it is broken it will lead to incomplete mental ordering of options therefore not making the decision making process comprehensive and complete. An example of this is shown in Tversky and Kahneman’s theatre ticket study where it was demonstrated that we can interfere with our own transversal thinking making our behaviour irrational. The third and final axiom is selection, meaning that the consumer will always choose the preferred and optimum combination when given a choice. This axiom has a standing of importance as if broken, the consumer would not possess the ability to make the optimum choice when presented with every option ordered by preference which would be deemed as irrational.

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Economic rationality is considered in terms of utility. Every choice made by a consumer generates a certain amount of emotional experience associated with the outcome and it is in the consumers interests to maximise this utility. Rational economic behaviour can be seen as an attempt to increase this utility however as people obtain more of it there are diminishing returns known as diminishing marginal utility as each extra unit is appreciated less than the last, as is shown in figure 1 below.

Figure 1- Diminishing marginal ...

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