Economic Logic Assumptions, Rational Behavior, & Incentives

Economists make many assumptions to analyze problems –Ceteris paribus: Latin for “all other things being equal” The art in economic analysis is deciding which assumptions to make… –wrong assumptions => poor Gov’t policy => poor outcomes The Role of Assumptions 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 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? 11 min. Rational Behavior Video

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

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

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

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

Scooters almost as common as cars

Incentive Reading