Economic LogicAssumptions, 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

ScientistEconomist

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 basedon 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 http://video.pbs.org/video/1479100777

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?

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 cars

Incentive Reading