The purpose of this assessment is to review a scenario and use economic principl
ID: 1193421 • Letter: T
Question
The purpose of this assessment is to review a scenario and use economic principle(s) to explain why people act differently from what they say.
Assessment Description:
Recently, a bank was trying to decide what fee to charge for "expedited payments"—payments that the bank would transmit at a faster speed to enable customers to avoid late fees on cable TV bills, electric bills, and the like. To try to determine what fee customers were willing to pay for expedited payments, the bank conducted a survey. It was able to determine that many of the people surveyed already paid fees for expedited payment services that exceeded the maximum fees that they said they were willing to pay.
Explanation / Answer
It is important to focus on what rational individuals actually do rather than what they say they will do.
The Rationality Assumption
The rationality assumption of economics, simply stated, is as follows:
We assume that individuals do not intentionally make decisions that would leave themselves worse off.
The distinction here is between what people may think—the realm of psychology and psychiatry and perhaps sociology—and what they do. Economics does not involve itself in analyzing individual or group thought processes. Economics looks at what people actually do in life with their limited resources. It does little good to criticize the rationality assumption by stating, “Nobody thinks that way” or “I never think that way” or “How unrealistic! That’s as irrational as anyone can get!” In a world in which people can be atypical in countless ways, economists find it useful to concentrate on discovering the baseline. Knowing what happens on average is a good place to start.
In this way, we avoid building our thinking on exceptions rather than on reality. Take the example of driving. When you consider passing another car on a two-lane highway with oncoming traffic, you have to make very quick decisions: You must esti- mate the speed of the car that you are going to pass, the speed of the oncoming cars, the distance between your car and the oncoming cars, and your car’s potential rate of acceleration. If we were to apply a model to your behavior, we would use the rules of calculus. In actual fact, you and most other drivers in such a situation do not actually think of using the rules of calculus, but to predict your behavior, we could make the prediction as if you understood those rules.
Responding to Incentives
If it can be assumed that individuals never intentionally make decisions that would leave them worse off, then almost by definition they will respond to changes in incentives. Indeed, much of human behavior can be explained in terms of how individuals respond to changing incentives over time. Schoolchildren are motivated to do better by a variety of incentive systems, ranging from gold stars and certificates of achievement when they are young, to better grades with accompanying promises of a “better life” as they get older. Of course, negative incentives affect our behavior, too. Penalties, punishments, and other forms of negative incentives can raise the cost of engaging in various activities.
So the fee for 'expedited payments' are far lesser than the late fees. So the banks should give variable incentive palns to their customers in order to increase this service and the charges charged to the customers should be nominal.
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