Plan A involves giving consumers a cash bonus to spend freely, while Plan B provides a rebate on electrical goods. Traditional economics assumes that increased consumption leads to higher well-being, but behavioral economics challenges this in several ways. Consumer preferences depend on reference points and adaptation, not just income levels. People also consider fairness over self-interest at times and misjudge probabilities contrary to rational assumptions. Both plans could stimulate spending, though cash bonuses are more flexible while rebates target specific goods not all consumers want.

1. Economics (Market) 203
Assignment
Assignment Option 1
(a) Suppose the government would like to stimulate spending in the
economy by increasing consumption of goods and services. The
government is deciding between two plans:
Plan A – giving consumers a cash bonus to spend on any goods;
Plan B – providing a rebate on the price of electrical goods.
Using concepts of consumer behaviour from traditional economics,
show how each plan is likely to affect consumers’ choices and compare
the income and substitution effects under the two plans.
(b) A key assumption of traditional economics is that well-being increases
with the consumption of more goods and services. Discuss how
behavioural economics deviates from this traditional assumption.
Support your discussion by making references to the existing literature
on behavioural and traditional economics.
Page 1 Kang Ning, Lim
14447170

2. Economics (Market) 203
Assignment
Introduction
Consumer’s preferences are shown by indifference curves which show
combinations of goods that bring the same utility to the consumer. A budget line
shows what consumer can buy either selecting a market basket on or below the
indifference curve. Consumer’s demand for goods can varies when there is a
change in income and prices of goods. Goods are normal when a rise in income
increases consumption. It is inferior when income rises and causes to a fall in
consumption. Giffen goods are those with an upward sloping demand curve due
to a greater income effect as compared to substitution effect. Substitution effect
is when a change in consumption of a good associating with a change in its price
with level of utility held constant. Income effect is changes in consumption due
to increase in purchasing power with relative price held constant.
Plan A
Non- Non-
Electrical Electrical
(units) A’ (units) A’
C’
������2
A A
C’
������2
C C ������1
������1
B B’ B B’
Electrical (units) Electrical (units)
(a) (b)
Figure 1
Figure 1(a) illustrates adjustment to income changes when consumer received
cash bonus. Initially, consumer earns $500 which is reflected by budget line AB,
and chooses C at which utility is maximized. Then, given cash bonus of $300.
Real income increases from $500 to $800. When prices of all goods remain
constant, with a higher income, consumer can afford more of one or both goods.
Budget line shifts outwards parallel from AB to A’B’. Consumer now chooses C’ at
Page 2 Kang Ning, Lim
14447170

3. Economics (Market) 203
Assignment
which the new budget line is tangent to the highest attainable indifference curve.
In this case, electrical goods are normal because income rise leads to
consumption rise. However, not all consumers have same preferences. Figure
1(b) illustrates consumer’s preferences makes electrical goods as inferior.
Quantity demanded declines when income increases. At the point C’ on budget
line A’B’ fewer electrical goods are demanded than at C on the budget line AB,
corresponding to a lower income. Effects income declines, for example, higher
tax, are exactly the opposite. Budget line shifts inwards parallel to original
budget line. When both goods are normal, decrease in income reduces the
quantity demanded for both goods. If one goods is inferior the quantity
demanded will actually rises when income decreases. Both goods cannot be
inferior because when income falls but prices remain unchanged it is
impracticable for consumer to consume more of both goods.
Plan B
Non- Non-
Electrical Electrical
(units) (units)
C’
C C
C’ ������2
C’’ ������2 C’’
������1 ������1
B B’ B B’
E F G Electrical (units) E F G Electrical (units)
Substitution Effect
Income Effect
Substitution Income Total Effect
Effect Effect
Total Effect
(b)
(a) Figure 2
Figure 2(a) illustrates a price change due to rebate on electrical goods given by
government. Initially, consumer earns $500 shows by budget line B, and
chooses point C at which utility is maximized. Now suppose consumer receives
Page 3 Kang Ning, Lim
14447170

4. Economics (Market) 203
Assignment
rebate of $300 which has both an income effect and a substitution effect. Rebate
means consumer is able to purchase electrical goods at a relatively cheaper price.
Consumer is able to obtain more units of electrical goods with the same budget
allocation. Consumer tends to buy less non-electrical goods and more electrical
goods, which means substituting electrical goods for non-electrical goods that is
the substitute effect (EF). This allows consumer to keep utility constant moving
from C to C’’ on the same indifference curve. Also, consumer experiences an
increase in real purchasing power. Rebate received has increased his real income
which is shown in a parallel shift from dotted line to budget line B’. Consequent
effect on quantity demanded is income effect (FG) moving from C’’ to C’.
Electrical goods are normal because the income effect is positive. Units of
electrical goods demanded increase from F to G due to income rise. Figure 2(b)
illustrates the outcome when consumer treating electrical goods as inferior.
Consumer is initially at C on budget line B. Electrical goods become relatively
cheaper with rebate given, consumer moves from C to C’. Substitute effect (EG)
is shown from the move C to C’’. The income effect (GF) is represents by a
parallel outward shift from the dotted line to budget line B’ where consumer
move from C’’ to C’. In this case, units of electrical goods demanded decrease
from G to F when income increases.
Non-
Electrical
(units)
C’
������2
C
C’’
������1
B B’
E F G Electrical (units)
Substitution Effect
Income Effect
Total Effect
Figure 3
Page 4 Kang Ning, Lim
14447170

5. Economics (Market) 203
Assignment
Figure 3 illustrates consumer treating electrical goods as giffen goods. The
income effect is so large that it is greater than substitute effect and caused an
upward-sloping demand curve. Consumer is initially at C. With a rebate,
consumer move to C’ and consume less electrical goods. Income effect (GE) is
larger than substitute effect (FG), the relatively cheaper electrical goods lead to
a fall in quantity of electrical goods demanded.
Traditional Economics vs. Behavioral Economics
Traditional economics are based on three basics assumptions. Firstly, consumers
are assumed to have clear preferences for certain goods over others. Next, they
encounter budget constraints. Lastly, with their preferences, restricted incomes
and the prices of different goods, consumers opt to purchase combinations of
goods that maximize their satisfaction (Pindyck 2009). However, an emerging
behavioral economics challenge that consumers cannot be generalized
accordingly to these traditional assumptions through four main aspects which
are reference points, adaptation, fairness and probability. These aspects will be
discussed in details in the following paragraphs.
Firstly, behavioural economists brought up an argument regarding reference
points. Unlike traditional economics assuming a rise in income leads to a rise in
utility which is sustainable, behavioral economists argue that the valuation on
goods relies heavily on consumers’ conditions or the point from which they make
their consumption decision which is called reference point. Given a situation, a
consumer bought a ticket and later found out he could resell it at a higher price
due to excess demand. Traditional economics assumes consumer selling the
ticket and be happy earning the extra dollar. However, behavioral economists
argue that the consumer will keep the ticket and go to the concert. This is based
on the loss aversion theory that claims the feeling of fear when consumer loses
something they once owned. Referring to the situation, owning the ticket is the
consumer’s reference point. Another example, a consumer feels happy when
Page 5 Kang Ning, Lim
14447170

6. Economics (Market) 203
Assignment
receiving a bonus. Traditional assumption claims that consumer is happy no
matter what his colleagues received even though the amount might be greater
than what he received because income increment has increased his utility.
Behavioral economics claims that consumer will get depressed if he found his
colleagues are receiving higher bonuses because consumers evaluate their
outcomes with reference to the group norm. Under this example, the reference
point is receiving a smaller bonus than others.
Another key issue is adaptation. Traditional economics assumes utility increases
with income and it is sustainable. Behavioral economics think consumers tend to
adapt to new circumstances and their utility will revert to a homeostatic position.
Figure 4 Easterlin, R. (2001)
Figure 4 showing utility (happiness) does not necessary increases when
consumer’s income rises. Beginning of the adult life cycle, material aspirations
are rather alike throughout the population. But it increases in proportion to
income over the life cycle. Even though rising income means consumers’
purchasing powers have increased but this favourable effect is eliminated by the
fact that consumers desire more as they move on through the life cycle. Is
seems as though Emerson (1860) has it right when he said ‘want is a growing
Page 6 Kang Ning, Lim
14447170

7. Economics (Market) 203
Assignment
giant whom the coat of Have was never large enough to cover.’ Apart from the
increasing of aspirations as consumers move on in the life cycle, consumers’
utilities may vary due to certain life cycle events such as a promotion in career,
a divorce, the birth of a child and the death of a close friend (Myers 1992).
Besides that, fairness issue has been brought up by behavioural economists to
challenge the traditional assumption. Traditional economists think consumers will
not pick choices that have the tendency of reducing their benefits. But
behavioral economists think consumers often make choices that they assume
are fair instead of benefiting themselves. This is supported by the ultimatum
game experiment that consists of two players: a proposer and a responder
(Robert 2005). The proposer will received a sum of money and need to made an
offer to the responder some portion of the money. The responder can either
accept the offer or choose to reject it in which both parties will end up getting
nothing. From experiments, very low offers tend to be rejected as responders
felt greater satisfaction from taking revenge on the proposers as compared to
maximizing their financial gains. Some common daily life examples are
consumers getting involved in charitable giving, tipping in restaurants and
buying fair trade products although it can be more costly than others.
The last key issue is the laws of probability. Traditional economics assumes that
consumers evaluate uncertain events according to the laws of probability.
Behavioural economics claims that consumer often miscalculate probabilities.
Consumer tends to overstate the probability of something that is less likely to
happen, for instant, betting on horses. Gamblers tend to shift their bets away
from favorites towards long-shots as the day’s racing its end. Majority gambles
think a successful bet on an outsider world will probably turn a losing day into a
winning one. Mathematically and rationally this does not matter as the last race
of the day has no different to the first race of the next day. However, most
gamblers close their mental account at the end of each racing day, and they
hate to leave the track as a loser. Also, consumer often understates the
Page 7 Kang Ning, Lim
14447170

8. Economics (Market) 203
Assignment
probability of something that is likely to happen, for example, a close friend got
involve in an accident.
Conclusion
Both cash bonus and rebate will helps to reduce consumers’ financial burden.
However, consumers usually prefers cash bonus as compared to rebate. This is
because a cash bonus enables them to buy whatever goods they desired. On the
other hand, a rebate means an additional budget given to them but restricted to
particular goods. When government gives cash bonus, it does not necessary
helps to stimulate consumption because consumers have the probability of
spending it on other issues such as paying debts or save it. A rebate might face
a tendency of not stimulating spending because not all consumers desire for the
particular goods, in this case, electrical goods.
Page 8 Kang Ning, Lim
14447170

9. Economics (Market) 203
Assignment
Reference
Easterlin, R. 2001. ‘Income and happiness: Towards a unified theory’. Economic
Journal 111: 465–484.
Emerson, R. W. 1860. ‘Wealth’: The Conduct of Life. Boston: Ticknor and Fields.
Myers, D. G. 1992. The Pursuit of Happiness: Who Is Happy and Why. New York:
William Morrow. National Opinion Research Center 1999. General Social
Surveys, 1972 – 1998: Cumulative Codebook. Chicago: National Opinion
Research Center.
Pindyck, R.S., and D.L. Rubinfeld. 2009. Microeconomics, 7th Edition, Pearson
International Edition, Person Prentice Hall, New Jersey.
Robert, L. 2005. Exploring Economics. 3rd ed. Thomson: South-Western.
Page 9 Kang Ning, Lim
14447170