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 around 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.

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."

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 OK with the errors provided they're small enough or have limited impact.

Key Takeaways

  • The assumptions of economists are made to better understand consumer and business behavior when making economic decisions.
  • 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.

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, 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 need 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 of 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 sees the dessert menu, opts for the fudge cake. 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.