Economic LogicAssumptions, Rational Behavior, Cost/Benefit

Analysis & Incentives

Important Economic Concepts

• Economists make many assumptions

• People make rational decisions

• People respond to incentives

• 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 reach conclusions “holding other factors constant”

The Role of Assumptions

ScientistEconomist

Decision Making

Economists assumes people make rational decisions• meaning the benefits are greater than the costs

Is this rational?

Rational Behavior Video Play 8 min. http://video.pbs.org/video/1479100777

IncentivesPeople respond to incentives

Government uses Taxes or Subsidies to alter behavior

encourage consumer to use less encourage consumer to use more

Incentives Matter Reading

2) “The pocketbook is mightier than the conscience”

4) “Perverse Incentive”

3) The law of unintended consequences

1) private property vs. communal property

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

CONSUMERS PRODUCERS

USA vs. Europe

Cost of Gasoline

USA: $3.70 per gallonEngland: $7.25 per gallon

Average tax per gallon: USA = $0.50 tax per gallon Europe = $3.50 tax per gallon

Gov’t incentivescan drastically change behavior

Economic Lesson:

End Result of High Gasoline TaxesCommon European Car in 2004!

Scooters almost as common as carsLuxury SUV- Paris

Smallest Car …..