Assumptions of Standard Neo Classical Economic Model (SEM)

Write an essay on Real Life Example of Irrationality Based On SEM?

The people’s behavior is assessed in all parts of economics. In this regard behavioral economics plays an important role. It studies the repercussion of psychological, social, cognitive and emotional factors on the economic decisions of the economic agents. The Standard Neo Classical Economic Model (SEM) assumes that the behavior of the economic agents is rational and is not dependent on emotion or bias. The economic agent is believed to place fair, equitable and reasonable value on the goods and products related to investment and in all these behavior the individual must drive towards maximizing utility. The main assumption of the SEM is that people are rational. In addition to this people make economic decision when they are fully aware of all the available options, people can always rank their options based on their preferences in a consistent manner and people select that option which is best for them and gives them maximum utility. The three vital assumptions or principles of SEM are: (Baddeley, 2013)

Economic agents maximize profits and utility- when multiple alternatives are available to an economic agent he chooses that outcome that possibly maximizes his utility function. This is explained by SEM as the preference and advantage received from consuming a good is not only in terms of monetary profits but also other benefits that explains the satisfaction received from consuming the good or the rise in the stature. The economic decision made by the individuals may be taken under situations of risk. This evaluation requires individual to maximize expected utility based on the expected value. Thus SEM also takes into account the nature of individual and his decision making i.e., the individual can be a risk averse, risk lover or even a risk neutral. (Beckerman, 2011)

Economic agents act rationally- behavior of an economic agent is based on rational self-interest according to the fundamental principle of economics. For some human behavior may be inconsistent, inefficient, self centered or humanitarian, but economists argue that human behavior is predictable and his economic decision is based on the costs and benefits of the option available to him. SEM economists are of the view that benefits from charitable instincts or love must not be ignored but there remains an expectation that people will engage themselves in a rational decision making system. Then they can be called Homo economicus, who possess a well-organized, reliable and anchored list of preferences. The logical computational skill that the Homo economicus utilizes to evaluate different series of action also allow him to choose the highest and maximized preference and outcomes.

Economic agents act on the basis of full and relevant information- SEM expects that the individuals not only make choices on the basis of their preferences but also based on the full information. By the availability of full information individuals are able to take rational decisions analyzing its impact on the future. For example, consider the rational expectation theory when anticipating the inflation rate for the future. This theory explains that how the mechanism of determining future inflation rate takes into account all the factors that affect the inflation rate in the future like money supply, oil prices, exchange rate and labor market conditions.

Violation of First SEM Assumption

Based on the three important assumptions of the SEM, we can now establish the fact that individuals are able to make rational decision. (Opaluch and Segerson, 2015)

People customarily tend to make irrational choices thinking that their choices are rational. There are several examples of irrational behavior that explains such irrational behavior. One of the reasons behind this is that most of the people lack full knowledge regarding their own choices.  Or in other cases, their choices strongly depend on the recollection or interpretation drawn from their past experiences. The irrational behavior impacts the individuals in a way that they imbibe short term satisfaction and experience loss in the long term. These individuals do not make their choices based on forecasting their future loss, cost, gain and benefit. In this way they fail to maximize their utility.

A case that reflects irrationality in humans is based on Jac who is a coffee addict and was a regular visitor to the Dunkin Donuts. (Mullins, 2009) But with the behemoth of coffee outlets at every corner of the streets, his choice regarding the purchase of coffee changed. This apparently explains the success of Starbucks. Starbucks is believed to sell coffee at a higher rate which the people tend to purchase. One thing that needs to be mentioned is the anchor price regarding coffee for individual who loves coffee. Before visiting Starbucks, Jac was convinced with the anchor pricing strategy and had set a price for coffee in his minds from which he never budged. But what happened that his preference changed irrationally depend on the strategy that Starbucks applied making the customers forget about the concept of anchor prices. When I confronted Jac with the question that why did he go for Starbucks leaving behind his anchor price, his answer was clear. He answered by ranking the superior experience that he received from Starbucks by which he never really compared Dunkin Donuts and Starbucks coffee. (People Great Ideas, 2015) Jac gradually changed his anchor price which was low and set another new anchor price that were based on the prices charged by Starbucks. I found this behavior irrational. He now moved and shifted onto a new consumption curve where the anchor price is much higher. (Giang, 2012)

Considering the SEM, Jac violated the first assumption that states that individual makes decisions based on their profit and utility maximization. But in this case Jac has definitely maximized his utility but failed to maximize his profits. Profits are based on the cost that he bears, which has increased because of a rise in price of coffee from Dunkin Donuts to Starbucks. Jac must not only aim to maximize his satisfaction but also must look out for his pocket. But setting a higher anchor price, Jac has behaved irrationally. (GAUDIO, 2003)

Second assumption signifies individuals as Homo economicus where they are expected to make decisions based on their highest and maximized anchored preferences. Jac from the very beginning depicted an irrational behavior by preferring the Starbucks coffee which a much higher price. Though several surveys reveal that Starbucks stood high in terms of quality and experience of customers yet their pricing strategy seemed to be quite expensive. Jac has depicted that irrational behavior in which he did not consider the future costs and benefits related to the current purchase. (Salim Khraim, 2011)Thirdly, Jac had never acquired full information while making the choice of coffee. (Kacen and Lee, 2002)Starbucks is not the only one café outlet that offers high quality coffee. There are several other coffee outlets that offer best coffee with reasonable price. Thus, Jac has engaged himself in short term utility sacrificing the long term benefits that he would get on selection of coffee at cheap rates from other coffee outlets. (some outlets are Curators Coffee Studio, FreeState Coffee etc. in London). (Time Out London, 2015)

Violation of Second SEM Assumption

A study based on the brand effects of Starbucks reveals that the effect of brand of Starbucks had affected the Danish consumer’s preferences towards coffee in a positive way. The price that Starbucks charged could not be explained by this study but what can be concluded from the study is that individuals are repeatedly making irrational choices which are result of the brand value of Starbucks. Individuals generally believe in their choices to be rational. A coffee with brand value and higher price is preferred by individuals rather than coffee with no brand values and low price. This explains the irrationality in consumers. (Bouzidi, 2015)

One of the important case studies by Sara Jasmine Ghafoorzadeh on Starbucks shows that again the brand value that led to the customer’s loyalty regarding the consumption of their coffee in spite of high price. Starbucks believes that there is a strong relation between the customer loyalty and the brand experience that can drive their sales up. But this type of strategy affects the ethical decision making of the consumers. They are repeatedly and alarmingly making irrational decision regarding purchasing goods. (Ghafoorzadeh, 2015)

From the essay what we learn is that economic agents unconsciously engage in irrational behavior but what they pose is as if they are behaving rationally which led to diminishing future benefits. This is because most of the people tend to engage in short term pleasure rather than long term gains. In the case of Jac, Starbucks coffee may have strained his pocket but his opinion about making irrational choices distinctly depended on the brand value of Starbucks. Thus, we see that Jac has successfully violated the assumptions of the SEM and can be declared as an irrational human beings. The irrational behavior can also be witnessed in the investing markets where the investors also engage in irrational behavior(Lin, Tsai and Lung, 2013). One of the other industry that fools consumers and force them behave irrationally is the mobile industry in which individuals purchase such mobiles phones that are called smartphones at higher price when other ordinary mobiles operates in an identical manner. (Law and McNeish, 2007)The choice of the human beings on spending more on certain objects which functions in the same manner as the ones which are cheaper explains irrationality. (Camerer, Loewenstein and Rabin, 2004)

References

Baddeley, M. (2013). Behavioural economics and finance. London: Routledge.

Beckerman, W. (2011). Economics as applied ethics. Houndmills, Basingstoke, Hampshire: Palgrave Macmillan.

Bouzidi, I. (2015). Starbuck´s brand effects – distinguishing unconscious ´wanting` and conscious liking in consumers’ choice of coffee brand. 1st ed. [ebook] Available at: https://studenttheses.cbs.dk/bitstream/handle/10417/4031/imane_bouzidi.pdf?sequence=1 [Accessed 9 Mar. 2015].

Camerer, C., Loewenstein, G. and Rabin, M. (2004). Advances in behavioral economics. New York: Russell Sage Foundation.

GAUDIO, R. (2003). Coffeetalk: Starbucks™ and the commercialization of casual conversation. Lang. Soc., 32(05).

Ghafoorzadeh, S. (2015). Customers’ Loyalty & Brand Experience Branding Strategy to Successfully Approach Consumers’ Minds and Promote Customers’ Loyalty: Generating the “Brand Experience”.. 1st ed. [ebook] Available at: https://www.theseus.fi/bitstream/handle/10024/68813/Ghafoorzadeh_SaraJasmine.pdf?sequence=1 [Accessed 9 Mar. 2015].

Giang, V. (2012). 12 Ways That People Behave Irrationally. [online] Business Insider. Available at: https://www.businessinsider.com/predictably-irrational-2012-6?IR=T#we-only-forget-about-the-anchor-price-when-the-experience-feels-so-different-its-incomparable-3 [Accessed 9 Mar. 2015].

Kacen, J. and Lee, J. (2002). The Influence of Culture on Consumer Impulsive Buying Behavior.Journal of Consumer Psychology, 12(2), pp.163-176.

Law, A. and McNeish, W. (2007). Contesting the New Irrational Actor Model: A Case Study of Mobile Phone Mast Protest. Sociology, 41(3), pp.439-456.

Lin, W., Tsai, S. and Lung, P. (2013). Investors’ Herd Behavior: Rational or Irrational?. Asia-Pacific Journal of Financial Studies, 42(5), pp.755-776.

Mullins, C. (2009). Supply and demand in the decision-making process of pharmaceutical consumers: The starbucks versus dunkin’ donuts dilemma. Clinical Therapeutics, 31(8), p.1858.

Opaluch, J. and Segerson, K. (2015). Rational Roots of “Irrational” Behavior: New Theories of Economic Decision-Making. 1st ed. [ebook] Available at: https://ageconsearch.umn.edu/bitstream/28875/1/18020081.pdf [Accessed 9 Mar. 2015].

People Great Ideas, (2015). Super Bowl Coffee Smackdown: Seattle’s Starbucks vs. New England’s Dunkin’ Donuts. [online] Available at: https://greatideas.people.com/2015/01/30/starbucks-vs-dunkin-donuts-seattle-new-england-superbowl/ [Accessed 9 Mar. 2015].

Salim Khraim, H. (2011). The Influence of Brand Loyalty on Cosmetics Buying Behavior of UAE Female Consumers. IJMS, 3(2).

Time Out London, (2015). London’s best cafés and coffee shops. [online] Available at: https://www.timeout.com/london/food-drink/londons-best-cafes-and-coffee-shops [Accessed 9 Mar. 2015].