 Economic rationality

 The concept of economic rationality has a specific

but simple meaning in economics.

 It means that people prefer more to less and

maximise net benefits, whether utility, wealth, or

profits, as perceived by them.
 This theory of rational choice is based on several

assumptions - substitutability, marginality and fixed

tastes and preferences.
 Substitutability:
 Goods are assumed substitutable one for the other (or

for money) at the margin. That is, there is a rate of

exchange (price) between any pair of goods that will
make an individual indifferent between them. This
notion of a trade-off is central to economic reasoning.
 Marginality or equi-marginal principle: Maximising
implies equal- ising marginal values and diminishing
marginal returns - i.e. the equi- marginal principle. In
any activity, to obtain the maximum utility or profit
marginal values have to be equated.
 The maximisation principle thus not only requires that
benefits exceed costs for each activity but that the level
of each activity be at a point where the marginal costs
of expanding the activity are equal to the marginal
benefits.
 Fixed tastes and preferences:
 The tastes' and preferences of individuals are
assumed to be given and stable. This assumption is
related to, and implied by, rational behaviour. If tastes
change over time or with past choices, preferences may
not be consistent.
 Economists believe that groups react in a predictable way to
changes in the costs and benefits of the options they face.
This incentive analysis is a direct implication of the
rationality assumption.
 As a result prices and laws are primarily viewed as creating
incentives which alter behaviour and outcomes.
 Incentive analysis is formalised by the economists‘ as 'laws'
of demand and supply. These are 'laws' in the sense that
they describe observed regularities in behaviour and
outcomes. The 'law' of demand states that when the price of
a good or service, increases, all other things equal, less is
purchased.
• The economic approach applies incentive analysis to
all economic and non-economic activities.
• incentive analysis has wide application - in drug
dealing, prostitution, crime, adoption, sale of body
parts, marriage, divorce, illegal immigrants, armies and
so on.
• Economics simply formalises the demand and supply
conditions operating in these activities and, most
importantly, works through the implications of how
changes in economic and non-economic factors affect
the willingness of people to demand and supply the
activity under consideration.
 The economists' incentive analysis can be illustrated by the law
restricting the speed limit. Most people, even those who would regard
themselves as law abiding, break the speed limit from time to time. If
there is 110 penalty, people will speed if the benefits they derive at the
time exceed the likely costs in terms of the potential likelihood of an
accident and its consequences to others and themselves.
 If a penalty is imposed, the costs of breaking the speed limit rises and,
all things equal we expect that fewer people will speed. Drivers will
take into account not only the inherent risks, benefits and costs, but
also the potential penalties - the fine, the loss of their Licence and the
impact of a conviction on their insurance payments.
As the penalties get greater, most people, even non-economists, would
agree that less and less speeding will occur. More people will speed if
the penalty is £10 than if it is £20,000! This is informal economic
modelling.
 In looking at the world in this way one is conscious
of the fact that the 'price up/quantity demanded down'
prediction may not apply to all, or even a large
number, of people. If the penalty for speeding (or the
price of bread) goes up 5 per cent or 10 per cent
many people will simply take it in their stride and not
modify their behaviour.
 If the courts mete out more severe punishment some,
maybe many, criminals will simply go on as before.
Does this undermine the economises' incentive
analysis?
 Incentive analysis does not assume that every
individual reacts to a curb on his or her actions. Some
will react by reducing their participation or cease
altogether; others will not.
 But all that is required for, say, fines, to deter is that a
subset of those who previously speed now decide not
to, or to do so less frequently. To put it more
graphically, criminals at the margin will be deterred by
higher penalties; not the psychopath or deranged serial
killer." It is the reaction of some that generates the
response predicted by the economists' rationality
model: clearly, the greater the number sensitive to
increases in fines or cost the greater the reaction.
 It is often useful to know not only whether an increase
in penalties or costs deters or reduces a particular
activity, but by how much.
 A quantitative measure of the incentive effects of a
change in price, cost or legal sanction is known as its
elasticity.
 This measures the proportionate response to 1per cent
increase/decrease in the price/cost/sanction. An
elasticity of minus 1(-1)would mean that a 1 per cent
increase in, say, the penalty imposed on criminals leads
to a fall (hence the minus) of 1 per cent in the number
of crimes. A higher elasticity indicates greater
responsiveness.
 Economics used the measuring rod of money to
evaluate economic and legal outcomes. It thus places
heavy reliance on assessing the costs and benefits of
the law, considerations that will always be relevant
when resources are limited.
• Economic value or benefits are measured by the
'willingness-to-pay' (WTP) of those individuals who
are affected.
• That is, the economist's notion of benefit is similar to
the utilitarian notion of happiness but it is happiness
backed by WTP. Mere desire or 'need' is not relevant.
WTP provides a quantitative indication of the intensity
of individual preferences.
 The consumers' surplus -which is the difference
between the maximum willingness to pay of all
consumers' above the price.
The producers' surplus is the difference between the
costs of production including a reasonable profit and
the price. It is shown by the unshaded triangle below
the cousumners' surplus.
 By framing the question in this way the economist is able to
adopt a consistent valuation procedure - one which takes
into account the preferences of those whose lives are at risk
and the society's ability to devote resources to reduce risks -
i.e. buy more safety. This simple calculation provides
guidance on the vexing question of‘ How safe is safe?' or, in
a legal context, 'What is reasonable care?' Optimal care is
achieved when an additional pound, euro, or dollar spent on
reducing risks saves a pound, euro or dollar in expected
accident losses. 'Optimal' defined in this way means that
many accidents are 'justified' - because they would be too
costly to avoid. The corollary to this is that just as there can
be too little care, there can be excessive care.
 The distinction between a real cost and a wealth
transfer can be illustrated by the impact of a
Government (ad valorem) sales tax on a good. This tax
generates revenues for the Government; each time a
unit of the good is bought, wealth is transferred from
consumers to the government.
 This transfer is not a cost since the consumers' loss is the
Government's (taxpayers') gain. These losses and gains net out,
provided that the government does not waste the money on
activities which generate negative consumers' surplus. However, the
increase in the tax-inclusive price causes consumers to buy less of
the now more expensive good.
 This has two effects: society saves the resources that would have
otherwise been used to produce the lost output (a gain), but loses the
consumers' (and producers') surplus above these (marginal) costs of
production. It is this lost economic surplus - which economists refer
to as the 'deadweight loss' - that is the real economic cost of the tax:
it is the inefficiency generated by the way the tax distorts
consumption decisions.
 By casting the problem in this way it should be immediately
obvious that this 'cost' is not registered in the marketplace as such.
The real cost of a tax, law, or any other policy that distorts prices in
an economy is given by the value of the output not produced and
consumed.
 Thus the valuation of economic costs and benefits must often
proceed on the basis counterfactual or 'but for' analysis - 'but for'
the specific law in question what would have been the costs and
benefits?