Explaining The Choices People Make

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Lecture 2
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Explaining The Choices People Make

• How do we go about it?
• need method for coming up with explanations and
  evaluating them
• Scientific method
• steps
• develop theory from basic postulates or
  assumptions
• derive implications (predictions) about
  real-world behavior
• test predictions to see if they fit the facts

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Explaining The Choices People Make

• Scientific method
• comparison between economic science and hard
  sciences like chemistry
• use same methodology
• often difficult to run controlled experiments in
  economics
• must use actual behavior and try to statistically
  control for other influences

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Explaining The Choices People Make

• Evaluating a theory
• theory must be general
• not useful if different theory required for each
  situation

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Explaining The Choices People Make

• Evaluating a theory
• theory must have testable implications
• potentially refutable predictions
• will only be concerned with positive issues
• positive questions are of the form what is?
• can be definitely answered by an appeal to the
  facts (testable)
• normative questions are of the form what should
  be?
• even if agree on facts, can disagree on whether
  statement is correct

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Explaining The Choices People Make

• Evaluating a theory
• theory must correctly predict actual behavior
• do predictions fit the facts?
• whether theory is realistic or not is of little
  importance
• since theories are based on simplifying
  assumptions, by their nature they must be
  somewhat unrealistic

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Economic Theory of Human Behavior

• General
• focus on the choices that individuals make
• individual is the decision making unit

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Economic Theory of Human Behavior

• Behavioral Postulates
• Scarcity
• for each person, at least some goods are scarce
• must make choices
• Substitution
• each person is willing to give up some of one
  good to get more of others
• willing to substitute (make tradeoffs) at the
  margin
• substitutes always exist
• nothing you need
• need depends on cost

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Economic Theory of Human Behavior

• Behavioral Postulates
• Substitution
• rate of substitution is measured by marginal
  value
• maximum amount willing to give up in order to
  receive one more unit
• minimum willing to accept to give up one unit
• note that value is subjective
• depends on preferences

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Economic Theory of Human Behavior

• Behavioral Postulates
• Diminishing marginal value
• the more one has of a good, the lower its
  marginal value
• the more you have of a good, the less you are
  willing to sacrifice to get another unit

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Economic Theory of Human Behavior

• Behavioral Postulates
• Rationality
• people make decisions purposefully
• seek options that make themselves as well off as
  possible
• people make decisions that are consistent
• example if prefer wine to beer and beer to
  soda, will prefer wine to soda

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Economic Theory of Human Behavior

• Behavioral Postulates
• Rationality
• implies people will adjust in a predictable way
  to changes in costs and benefits
• if people were not rational, could not predict
  their behavior
• rationality does not imply greed

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Economic Theory of Human Behavior

• Behavioral Postulates
• Uniqueness
• not all people have the same preferences and
  endowments
• for any good, some people will have different
  marginal values

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Marginal Value (MV) Schedule

• Summarizes behavioral postulates
• scarcity
• says that we possess a quantity of the good such
  that marginal value is positive
• if goods were free, would not be willing to give
  up anything to obtain them and MV must equal zero

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Marginal Value (MV) Schedule

• Summarizes behavioral postulates
• diminishing marginal value
• means that marginal values decrease as quantity
  increases
• substitution
• implies schedule exists and marginal values are
  finite
• rationality
• says person will choose spot on schedule that
  leaves them best off

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Marginal Value (MV) Schedule

• Summarizes behavioral postulates
• uniqueness
• different people have different marginal value
  schedules or if have same schedule, located at
  different quantity

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EndLecture 2