Economists’ Assumptions in Their Economic Models

The assumptions of economists are made to better understand consumer and business behavior when making economic decisions. There are various economic theories to help explain how an economy functions and how to maximize growth, wealth, and employment.

However, the underlying themes of many theories center on preferences, meaning what businesses and consumers prefer to have or prefer to avoid. Also, the assumptions usually involve the resources available or not available to fulfill the needs and preferences. The scarcity or abundance of resources is important in determining the choices that participants make in an economy.

Find out why economists make assumptions and how those assumptions impact economic models.

Key Takeaways

• The assumptions of economists are made to better understand consumer and business behavior when making economic decisions.
• Economists can’t isolate individual variables in the real world, so they make assumptions to create a model that they can control.
• Some economists assume that people make rational decisions when purchasing or investing in the economy.
• Conversely, behavioral economists assume that people are emotional and can get distracted, thus influencing their decisions.
• Critics argue that assumptions in any economic model are often unrealistic and don’t hold up in the real world.

Why Economists Need Assumptions

In his 1953 essay titled “The Methodology of Positive Economics,” Milton Friedman explained why economists need to make assumptions to provide useful predictions. Friedman understood economics couldn’t use the scientific method as neatly as chemistry or physics, but he still saw the scientific method as the basis. Friedman stated economists would have to rely on “uncontrolled experience rather than on controlled experiment.”

Important

One of Milton Friedman’s most important economic contributions is the Friedman Doctrine, which states that a business’s main responsibility is to increase value for its shareholders.

The scientific method requires isolated variables and testing to prove causality. Economists can’t possibly isolate individual variables in the real world, so they make assumptions to create a model with some constancy. Of course, errors can occur, but economists in favor of the scientific method are fine with the errors provided they’re small enough or have limited impact.

Understanding the Assumptions of Economists

Each economic theory comes with its own set of assumptions that are made to explain how and why an economy functions. Those who favor classical economics assume that the economy is self-regulating and that any needs in an economy will be met by participants.

In other words, there’s no need for government intervention. People will allocate resources properly and efficiently. If there’s a need in an economy, a company will start up to fill that need creating balance. Classical economists assume that people and companies will stimulate the economy and create growth by spending and investment.

Neo-classical economists assume that people make rational decisions when purchasing or investing in the economy. Prices are determined by supply and demand while there are no outside forces impacting prices.

Consumers strive to maximize utility or their needs and wants. Maximizing utility is a key tenet of rational choice theory, which focuses on how people achieve their objectives by making rational decisions. The theory holds that people, given the information they have, will opt for choices that provide the greatest benefit and minimize any losses.

Neoclassical economists believe the propensity for consumer needs drives the economy and the business production that results to fill those needs. Any imbalances in an economy are believed to be corrected through competition, which restores equilibrium in the markets allocating resources properly.

Criticisms of Assumptions

Most critics argue that assumptions in any economic model are unrealistic and don’t hold up in the real world. In classical economics, there’s no need for government involvement. So, for example, there wouldn’t have been any money allocated to bank bailouts during the 2008 financial crisis and any stimulative measures in the Great Recession that followed.

Many economists would argue that the market wasn’t acting efficiently, and if the government hadn’t intervened, more banks and businesses would have failed, leading to higher unemployment.

The assumption in neoclassical economics that all participants behave rationally is criticized by some economists. Critics argue that there are myriad factors that impact a consumer and business that might make their choices or decisions irrational. Market corrections and bubbles, as well as income inequality, are all the result of choices made by participants that some economists would argue are irrational.

Behavioral Economics

In recent years, the examination of the psychology of economic choices and decisions has gained popularity. The study of behavioral economics accepts that irrational decisions are made sometimes and tries to explain why those choices are made and how they impact economic models.

Behavioral economists assume that people are emotional and can get distracted, thus influencing their decisions. For example, if someone wanted to lose weight, the person would study which healthy foods to eat and adjust their diet (rational decision); however, when at a restaurant, an individual sees the dessert menu, opts for the fudge cake, that is a distraction based on emotion.

Behavioral economists believe that even though people have the goal of making rational choices, outside forces and emotions can get in the way; making the choices irrational.

What Is an Example of an Economic Model?

An economic model is a hypothetical situation containing multiple variables created by economists to help understand various aspects of an economy and human behavior. One of the most famous and classical examples of an economic model is that of supply and demand. The model argues that if the supply of a product increases then its price will decrease, and vice versa. It also states that if the demand for a product increases, then its price will increase, and vice versa.

What Are Economic Assumptions?

Economic assumptions are assumptions that economists make about individuals, markets, or businesses. These assumptions are used to help predict the decisions of players in an economy and how different players use scarce resources. Assumptions can include unlimited wants, self-interest in decision-making, and rational decision-making.

How Do Economists Make Assumptions When Designing Models?

Economists make a variety of assumptions when designing models. A basic starting point for some economic models can be assuming unlimited wants and unlimited resources. Such assumptions help to better understand the decisions of individuals, such as in the economic concept of utility. The primary reason that economists make assumptions is to control variables or to exclude variables that don’t help determine predictive power.

Are Economic Models Used for Day-to-Day Pricing Decisions?

Economic models can be used for day-to-day pricing decisions. The models can help understand the reasons why a company prices its products the way it does. These models can also determine how consumers will react to these pricing decisions (demand).

The Bottom Line

Economics is a complex social science that is affected by a variety of factors. To better understand these factors, economists make assumptions in their economic models to control the model and understand a specific theory and outcome. Different branches of economics come with their own assumptions to explain how individuals and businesses use their resources.

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