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

2. 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….

3. 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

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

5. Marginal Analysis

6. 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)

7. Economic Decision Making
Economics assumes people are rational
Make decisions where MB ≥ MC
Is this rational?
Rational Behavior Video
(watch first 11 minutes if absent….)

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

9. 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

10. 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

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

12. Scooters almost as common as cars

15. Incentive Reading