Economic Logic
Assumptions, Rational Behavior, Cost/Benefit
Analysis & Incentives
Important Economic Concepts
• Economists make many assumptions
• People make rational decisions
• People respond to incentives
The Role of Assumptions
• Economists make assumptions to analyze the real world
– If assumptions are incorrect => analysis is often wrong
• Economics is a social science (not exact!), so the result of
economic policy is uncertain
– we can only reach conclusions “holding other factors constant”
Economist
Scientist
Rational Decision Making
Economic theory assumes people make rational decisions
• Rational means the benefits are greater than the costs
Is this rational?
Rational Behavior Video Play 8 min. http://video.pbs.org/video/1479100777
Behavioral Economics
Behavioral Economics is a new field that
combines Psychology & Economics that
challenges economic theory
It argues that people often make irrational
decisions
Incentives
Economist assume people respond to incentives
Government uses Taxes or Subsidies to change behavior
encourage consumer to use less
encourage consumer to use more
Incentives Matter Reading
1) private property vs. communal property
2) “The pocketbook is mightier than the conscience”
3) The law of unintended consequences
4) “Perverse Incentive”
How would Gov’t ↑ taxes on gasoline $5.00 per gallon change
the behavior of both consumers and producers?
CONSUMERS
PRODUCERS
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
Luxury SUV- Paris
Smallest Car …..