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Economic Assumptions: Marginal Decisions, Rational Behavior & Incentives

Economists analyze problems by making assumptions due to the complexity of social sciences, where factors are held constant with the principle of ceteris paribus. Choosing the right assumptions is crucial as wrong ones can lead to poor policy outcomes, highlighting the importance of assumptions in economic analysis. Key concepts like marginal decision-making, rational behavior, and incentives shape economic theories and policies. Rational Expectations Theory underlines the belief that individuals make choices based on a logical outlook, available information, and past experiences. Watch a video on rational behavior and understand how incentives influence decision-making process.

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Economic Assumptions: Marginal Decisions, Rational Behavior & Incentives

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  1. Economic Assumptions Marginal Decisions, Rational Behavior, & Incentives

  2. Economists must make assumptions to analyze/solve 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 ↑ The Role of Assumptions • The Reality is that many other factors could offset tax cut: • ↑gas prices, ↑ job loss, ↑ interest rates, etc….

  3. The art in economic analysis is which assumptions to make… wrong assumptions =>poor Gov’t policy => poor outcomes Many economic policies have “unintended consequences” Economist Scientist Assumptions & Gov’t Policy

  4. Important Economic Assumptions: • People make decisions based at the margin • “at the next unit” • People make rational decisions • People respond to incentives

  5. Marginal Decision Making • Decisions are rarely “all or nothing” • Most decisions are made at the Margin • margin = next unit (consumed or produced) • Marginal Benefit (MB) vs.Marginal Cost (MC) • Value of next unit consumedCost of next unit produced

  6. Marginal Analysis • Examples: • Step #1: You decide to study => • Step #2: The Marginal decision = how long to study? • Step #1: You decide to buy popcorn => • Step #2:Marginaldecision = what size to buy? • In economics, when the MB ≥ MC then “do more of it” • Stop when MB = MC

  7. Example: Marginal Analysis Would you pick up $5.00 dollars from the school hallway floor? 500 pennies

  8. Selling Airline Tickets Diamonds vs. Water Lesson: A consumer’s willingness to pay for any good is based on the marginal benefit of an extra unit(i.e. the last unit sold)

  9. Rational Expectations Theory Economic theory stating people make choices based on their rational outlook, available information, &past experiences. This theory is the basis of classical macroeconomics Are human’s really rational?

  10. Rational Decision Making Economics assumes people make rational (logical) decisions • That is, where MB ≥ MC Is this rational? 11 min. Rational Behavior Video: https://www.youtube.com/watch?v=DWh3Y5OyN34 Start at 1:30 in

  11. Incentives Matter! Examples: • Taxes encourage less activity • Subsidiesencourage more activity Government policies alter the behavior of consumers & producers by providing an incentive or disincentive

  12. How would Gov’t ↑ taxeson gasoline $3.00 per gallon change the behavior of both consumersandproducers? PRODUCERS CONSUMERS

  13. Incentive Reading Handout

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