Assumptions in Economics

What are assumptions in economics?

In economics, assumptions are simplifying ideas or conditions that economists use to build models or theories. These assumptions help to isolate certain variables and focus on specific economic behaviors, making it easier to analyze complex systems. They often represent idealised conditions, even though real-world situations may differ.

Assumptions are essential for creating workable models but must be understood as simplifications of reality.

Examples of Important Assumptions:

1. Ceteris Paribus (All Else Equal)
   • Definition: This assumption holds that when analyzing the relationship between two variables, all other factors are held constant.
   • Example: In the law of demand, it is assumed that as the price of a good falls, the quantity demanded increases, ceteris paribus. This means the assumption ignores changes in factors like consumer income or preferences, focusing only on the effect of price changes.
2. Rational Behaviour
   • Definition: It assumes that individuals make decisions aimed at maximizing their utility or benefit, based on available information.
   • Example: When analyzing consumer choice, it is assumed that consumers act rationally, meaning they choose the combination of goods and services that provides the most satisfaction within their budget. This assumption simplifies decision-making processes but doesn't always capture real-world behaviour, where emotions or incomplete information can influence choices.

What is the ceteris paribus assumption?

To simplify analysis, economists isolate the relationship between two variables by assuming ceteris paribus – i.e. all other influencing factors are held constant

For example - when considering the demand for a product such as electric vehicles, we might focus on the effects of changes in the price of the product itself, whilst isolating the impact of changes in factors such as real incomes of consumers, interest rates on loans to finance a car purchase and many other variables.

Behavioural economics

In October 2017, Professor Richard Thaler was awarded the Nobel Prize in Economics for placing "psychologically realistic assumptions into...economic decision-making"

Reasons why economists use assumptions in their economic models:

1. Helps to simplify analysis – helps to make the complex less daunting
2. Assumptions highlight the problem under investigation
3. Help economists to use maths in quantifying effects