ECON2120 Lecture 2: Topic 2 Tools of economic analysis
TOPIC 2 TOOLS OF ECONOMIC ANALYSIS
The economic approach to understanding behaviour
- What is economics?
- Economics is a way of thinking that applies in many situations
- Scarcity and choice
- Economics is usually defined as the study of the allocation of scarce resources amongst competing
end uses. That is, it is the study of choice.
- Assumption is that individuals are rational
Rationality
- Economists assume rationality
- Rationality and maximising (or optimising) behaviour
- The payoff to this assumption is extra results and generating precise models
- Note: does not require that people conduct rational analysis or reason logically to determine the
correct way to achieve their objectives. Just have to act as if they do.
- The tendency to be rational is the consistent (hence predictable) element in human behaviour.
Assumptions
- Economic theories involve abstractions. The aim is to capture the essentials of a problem.
- All theories involved some abstraction rather than being merely description.
- Could probably agree that in non-economic contexts it is practical and necessary e.g. road maps
- Economics proceeds by developing models, a simplified representation of reality which tries to
eliminate irrelevant detail and focus on the essential features of the economic reality we are
attempting to understand.
Price Theory (Microeconomics)
- How price coordinate economic activity
- We use price theory to work out the effect of laws
- Price theory is the explanation of how relative prices are determined and how prices function to co-
ordinate economic activity. Main interested is market behaviour
- Our main interest is the market behaviour of groups of firms and households and their responses to
changes
- Price theory is unavoidable, the alternative to correct price theory is incorrect price theory
- The great unifying principles of price theory are, ever and always, supply and demand. The greatest,
most profound, and most useful simplification of economics is the vision of supply and demand
interacting in a market.
- E.g. Would you support a law to require all landlords to give six month’s notice before eviction?
Would such a law benefit tenants?
o The reason most people expect such a law to benefit tenants is that they have, without
realising it assumed that the law does not affect how much rent the tenant must pay. If you
are paying the same rent and have a more favourable lease, you are better off
o This is naïve price theory, assuming that the only thing determining tomorrow’s price is
today’s price. But it makes no sense to assume that the mkt price stays the same if you change
its cost of production, its value to potential purchasers or both.
- Consider the effects of the policy under the following simplifying assumptions”
o All landlords are identical and all tenants are identical
o The law raises landlords operating costs $10 per house per month.
o It makes each house more attractive to the tenant and raises their willingness to pay by $5
per month
o A competitive mkt for rental housing
- The price must rise by between $5 and $10. So, the law makes both parties worse off.
- If the law raised costs to landlords by less than the benefits to tenants, then it will not be necessary,
the landlords would offer security of tenure
- It is difficult to use laws to redistribute income when the parties are in a contractual relationship and
a price can adjust.
- Most important is that a change in legal changes will change market price.
L 2.1
Questions to be answered
- Do seatbelts kill more people?
- What does efficiency mean and why do economists use it?
- How do we measure willingness to pay?
- Should efficiency be used to evaluate legal rules? What about equity?
Price Theory
- Price theory also applies where there are no explicit monetary prices
- Even in non-market situations, resources are scarce and choices have to be made.
The economic analysis of motor vehicle accidents
- The component of the car most responsible for accidents is the person behind the steering wheel
- People do not choose to have accidents, but they can take precautions to reduce the probability and
severity of accidents (e.g. not speed). Driver care matters.
- Two statements
o IF you make a driver wear a seatbelt, he will drive more recklessly
o If you take away a driver’s seatbelt, he will drive more carefully.
o They describe the same behaviour
Why seatbelts kill: the Peltzman effect
- A to D is the effect predicted by technological studies (using crash dummies)
- But if drivers choose to drive faster they will end up at B or even C
- The probability of driver death is the probability of an accident x probability of dying in an accident
- Accident costs fall by the blue area and increase by the red area
Document Summary
Economics is a way of thinking that applies in many situations. Economics is usually defined as the study of the allocation of scarce resources amongst competing end uses. That is, it is the study of choice. The payoff to this assumption is extra results and generating precise models. Note: does not require that people conduct rational analysis or reason logically to determine the correct way to achieve their objectives. Just have to act as if they do. The tendency to be rational is the consistent (hence predictable) element in human behaviour. The aim is to capture the essentials of a problem. All theories involved some abstraction rather than being merely description. Could probably agree that in non-economic contexts it is practical and necessary e. g. road maps. Economics proceeds by developing models, a simplified representation of reality which tries to eliminate irrelevant detail and focus on the essential features of the economic reality we are attempting to understand.
