Rational Choice Theory Application One - Elasticity

1. Rational Choice TheoryApplication One - Elasticity Dr Brian O’ Boyle St Angela’s College Sligo

2. Elasticity • How would we expect a student to answer to the following question • Explain in your own words what elasticity means?

3. Elasticity – Application of Rational Choice • Well informed student- % change in QD/ % change in price (technical and abstract) • Uninformed student – something to do with prices (vague but in some ways preferable!!) • Adequate answer – It is a concept designed to capture changes in (usually consumer) behaviour as prices change. • It builds on the analysis in consumer behaviour theory about the importance of price • People change their behaviour as prices change and this moves goods and services around. • It relies on a quantitative formula as it is interested in measuring changes on the basis of its aspiration to be scientific.

4. Elasticity – Application of Rational Choice Theory • Why ask this question – to show that even the ‘good’ answers are limited. • As teachers we need to spend more of our time engaging and mastering key concepts. • This allows us to transmit knowledge in more effective ways • I will focus on the background concepts that underpin elasticity before looking at (hopefully) interesting ways to think about it.

5. Elasticity – Application of Choice Theory • In order to teach (neoclassical) economics well it is essential to have a mastery of its master concepts. • Neoclassical economics is a theory of rational behaviour • It makes a number of foundational assumptions that are supposedly self-evidently true and so not examined. • The first one relates to the world (a logical construction supposedly replicating experiments) – Scarcity is inevitable

6. Elasticity –Application of Choice Theory • The next five are all to do with the nature of the human mechanism • Self-interested (makes sense on world of scarcity). • Non-satiated (sets up the problem and reinforces scarcity) • Rational – with limited resources and unlimited wants we must choose rationally – the calculative mechanism • Marginalism – each new calculation is the one that engages our calculator • Diminishing marginal returns – as you choose the relative benefits fall and the relative costs rise –this will change your behaviour.

7. Elasticity – Application of Rational Choice • Once we have our world and our actor –Robinson Crusoe –we think about bringing him into contact with other Crusoe's • The fact that we suffer from DMR means that we are always liable to trade for goods that are relatively scarce in our current bundle • This allows the theory to move from Rational Choices with one actor to Rational Choices with two actors – This obviously takes place in markets

8. Elasticity – Application of Rational Choice • In markets as more and more participants engage a universal equivalent is necessary to facilitate exchanges. • This allows our rational calculators to make more informed choices as a unit of account emerges that is universal and transparent • Suddenly we have the importance of prices which are the costs that individual’s must pay and the benefits that individual’s will receive from the transferring of goods/services and factors

9. Elasticity – Application of Rational Choice • What kind of information will be processed by consumers? • You will already know your unique set of (unexamined preferences) – these allow you to rank goods in terms of benefits • The neoclassical economist now makes the assertion that price is the most important piece of external information you need in order to make your choices. • You also need to know about future prices (expectations), the price of your factor (income) and the prices of other goods and services (compliments/subs)

10. Elasticity – Application of Rational Choice • Once all of this information has been processed you make your decision. • The price mechanism was the key piece of information –captured on the vertical axis) that allowed you to make your choices • This in in its turn moves physical quantities of goods and services around until they reach their final destinations. • We teach students this through a technical framework that may look something like this

11. Elasticity – Application of Rational Choice • QD = 100 – 10p (notice and highlight to your students the fact that the variables are the same in elasticity) • In my head this says that if the good has no costs, 100 units will be demanded somewhere (this is a relation between physical movements of commodities and private rational decisions regulated by a social mechanism (price). • As the social cost goes up by 1 unit at least ten units of the goods will no longer be demanded • Why? Because private decision makers adjudge the cost of the commodity to be higher than the potential benefit • This gives us a sense of how valuable the commodity is to the choosing calculators.

12. Elasticity – Application of Rational Choice • Next – we want to see how will how commodity movements change if prices change • This is elasticity – called this because elastic has a responsiveness to changes in force (microeconomics relies on a version of 19th century physics for many of its metaphors and methods (calculus, equilibrium, etc). • Essentially our calculator is faced with a changing environment – as prices change he/she along with all of the other calculators must calculate how to respond.

13. Elasticity – Application of Rational Choice • If they adjudge the commodity they are currently assessing to be highly beneficial they may disregard the extra cost being imposed upon them (this response will be inelastic. • If they adjudge the commodity they are currently assessing to be relatively unbeneficial they will more likely change their behaviour –usually away from the commodity that demands more of their scarce resources. • The cumulative effect of this moves a number of physical commodities around in logical space.

14. Elasticity – Application of Rational Choice • This logical narrative can be captured using algebra, geometry and verbal reasoning • Using algebra we can construct the familiar formula • % change in QD/ %change in price – here the price is the cause as our calculator now has to work out what to do. The effect is the change in behaviour which is manifest in a change in the amount of goods demanded.

15. Elasticity – Application of Rational Choice • Because this is a quantitative relation we can capture is accurately with our formula • It is important to register the fact that the formula is not elasticity • It is merely the means by which we measure the response of peoples behaviour as a ratio of changes in prices and changes in physical commodities (services). (a means to an end not an end in itself –A tool if you will) • The formula itself can be quite challenging –I always use very easy numbers and then work my way up from there

16. Elasticity – Application of Rational Choice • Q2 –Q1/Q1 – measures from a base the size of the effect • P2-P1/P1 – measures from a base the size of the cause • Use the numbers P1 =100 P2 =110 – because you are using these numbers the logic is clearer for the learner – then use more difficult ones to show that our mind needs the help of the tool.

17. Elasticity – Application of Rational Choice • Geometry –capturing the same relation visually • Small changes in price leading to big changes in quantity demanded leads to very flat curve (elastic) • Big changes in price leading to small changes in QD leads to very steep curve – (inelastic).

18. Elasticity – Application of Rational Choice • Examples and relevance – The advertising industry is a multibillion dollar industry designed to make sure that as they changes the prices (amount of scarce resources they take from you), you will not ‘choose’ to alter your behaviour. • Naomi Klein – No Logo excellent book on advertising Industry • Alongside the conceptualisation and drawing of graphs this can make a very useful case study. • Pair- share exercises can also be used to get students to rank goods in order of elasticity. • Higher order questioning can be based around the maters concepts (levels of choice and levels of utility.

19. Elasticity – Application of Rational Choice • Final thoughts • Make sure that elasticity is seen as a deepening of mater concepts of choice • Make sure that the technical aspects are viewed as a means to an end (set of tools). • Make sure that the relevance of elasticity is brought out (1) allows neoclassical economics to pose as quantitative science (2) allows real world firms to measure the loyalty to their brands.