Assumptions, Rational Behavior, & Incentives Economic Logic Assumptions, Rational Behavior, & Incentives

The Role of Assumptions Economists must make assumptions to analyze problems Why? => Social sciences are not exact Most analysis will “hold other factors constant” Ceteris paribus: Latin for “all other things being equal” Example: If Gov’t ↓ income taxes => consumers income ↑ => spending ↑ Reality is that many other factors could offset tax cut: ↑gas prices, ↑ job loss, ↑ interest rates, etc….

Assumptions & Gov’t Policy The art in economic analysis is which assumptions to make… wrong assumptions => poor Gov’t policy => poor outcomes Many economic policies have “unintended consequences” Scientist Economist

Important Economic Assumptions: People make decisions based at the margin People make rational decisions People respond to incentives

Marginal Analysis

Selling Airline Tickets Diamonds vs. Water Selling Airline Tickets Lesson: A consumer’s willingness to pay for any good is based on the marginal benefit of an extra unit (the last unit sold)

Economic Decision Making Economics assumes people are rational Make decisions where MB ≥ MC Is this rational? Rational Behavior Video https://www.youtube.com/watch?v=6sjtidkYAec (watch first 11 minutes if absent….)

Incentives Matter! Taxes & subsidies alter the behavior of consumers & producers by providing an incentive or disincentive Taxes encourage less activity Subsidies encourage more activity

How would Gov’t ↑ taxes on gasoline $3 How would Gov’t ↑ taxes on gasoline $3.00 per gallon change the behavior of both consumers and producers? CONSUMERS PRODUCERS

Average tax per gallon: USA vs. Europe Cost of Gasoline USA: $3.70 per gallon England: $7.25 per gallon Economic Lesson: Average tax per gallon: USA = $0.50 tax per gallon Europe = $3.50 tax per gallon Gov’t incentives can drastically change behavior

End Result of High Gasoline Taxes Common European Car in 2004!

Scooters almost as common as cars

Incentive Reading