How the Principles of Economics Affect Decision Making

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The standard economic model of decision making suggests a decision maker makes his choices to maximize his utility or happiness, according to researchers Benjamin E. Hermalin and Alice M. Isen, which means that no decision is taken arbitrarily, but it is a carefully chosen step towards satisfying a need. For this purpose, certain principles of economics affect the way people respond to different alternatives and ultimately make their decisions.

Trade-offs

  • Goods and services are limited, and therefore people must choose one item and give up another, which applies to individuals who must choose between a movie and a book when buying both is out of the question, as well as to whole governments, which must decide between defence expenditures and social services. Choosing entails trading off a target against another and is a fundamental issue of the decision-making process.

Marginal Benefits and Costs

  • Rational decisions are those taking into consideration marginal changes, or adjustments to the existing status quo. For example, a tax lawyer may choose to change careers if the marginal benefits of his new job (better salary, long-term recognition) exceed the marginal costs (less steady salary, risk with new clients). In general, a rational decision maker goes for an option if and only if the marginal benefits exceed the costs.

Response to Incentives

  • People make decisions by comparing the benefits and costs of each choice. Therefore, their behavior is bound to change when these benefits and costs change as well. For instance, the benefit of buying margarine over butter is its low price but, when its price -- or the buyer's purchasing power -- goes up, the basic benefit of buying margarine is eradicated and consumers turn to butter. Indices of elasticity show changes in people's behavior as a response to certain incentives.

Opportunity Cost

  • As the means to acquire a good or service (money on most occasions) is limited, people must choose one thing over the other. However, this means that people must make do without the benefits of the goods they chose not to have. Therefore, the decision-making process requires comparing the costs and benefits of alternative courses of action (opportunity cost) to make the best choice. For example, the opportunity cost of going to college and not working full-time for four years is that after graduation more opportunities open up for better-paying jobs.

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