Rational Choice Theory Application One - Elasticity - PowerPoint Presentation

Slide1

Rational Choice TheoryApplication One - Elasticity

Dr Brian O’ Boyle

St Angela’s College

S

ligoSlide2

ElasticityHow would we expect a student to answer to the following question

Explain in your own words what elasticity means?Slide3

Elasticity – Application of Rational ChoiceWell 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. Slide4

Elasticity – Application of Rational Choice TheoryWhy 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.Slide5

Elasticity – Application of Choice TheoryIn 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 inevitableSlide6

Elasticity –Application of Choice TheoryThe 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. Slide7

Elasticity – Application of Rational ChoiceOnce 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 marketsSlide8

Elasticity – Application of Rational ChoiceIn 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 factorsSlide9

Elasticity – Application of Rational ChoiceWhat 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)Slide10

Elasticity – Application of Rational ChoiceOnce 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 thisSlide11

Elasticity – Application of Rational ChoiceQD

= 100 – 10

p

(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.Slide12

Elasticity – Application of Rational ChoiceNext – 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 19

th

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. Slide13

Elasticity – Application of Rational ChoiceIf 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.Slide14

Elasticity – Application of Rational ChoiceThis 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. Slide15

Elasticity – Application of Rational ChoiceBecause 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

I

t 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

b

e quite challenging –I always use very easy numbers and then work my way up from there Slide16

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.Slide17

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).Slide18

Elasticity – Application of Rational ChoiceExamples 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. Slide19

Elasticity – Application of Rational ChoiceFinal 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.