Study Notes
Ten Common Assumptions in Economics
- Level:
- A-Level, IB
- Board:
- AQA, Edexcel, OCR, IB, Eduqas, WJEC
Last updated 16 Jul 2024
Economics, as a social science, often relies on simplifying assumptions to build models that help explain and predict real-world phenomena. While these assumptions can make models more manageable and provide useful insights, they also come with limitations.
Common Assumptions in Economics
1. Rational Behavior
- Description: Individuals act rationally, making decisions to maximize their utility (satisfaction or benefit).
- Example: Consumers choose products that provide the most satisfaction for the least cost.
- Critique: Behavioral economics shows that humans often act irrationally due to biases and heuristics.
2. Perfect Information
- Description: All market participants have access to all relevant information to make informed decisions.
- Example: Investors have all the necessary information about a stock's potential risks and returns.
- Critique: Information asymmetry is common, where one party has more or better information than the other (e.g., "The Market for Lemons" by George Akerlof).
3. Ceteris Paribus
- Description: All other factors are held constant when examining the relationship between two variables.
- Example: Studying the effect of price on demand while assuming other factors like income and preferences remain unchanged.
- Critique: In reality, many factors change simultaneously, making it difficult to isolate individual effects.
4. Perfect Competition
- Description: Markets are characterized by many buyers and sellers, homogenous products, and free entry and exit.
- Example: Agricultural markets, where many farmers sell identical products.
- Critique: Most markets have some form of imperfect competition (e.g., monopolies, oligopolies).
5. Law of Diminishing Marginal Utility
- Description: As consumption of a good increases, the additional satisfaction gained from consuming an extra unit decreases.
- Example: The first slice of pizza provides more satisfaction than the fifth slice.
- Critique: Preferences can vary widely, and some goods (e.g., addictive substances) may not follow this law.
6. Profit Maximization
- Description: Firms aim to maximize their profits by equating marginal cost to marginal revenue.
- Example: A company adjusting production levels to ensure costs and revenues are balanced for maximum profit.
- Critique: Firms may pursue other objectives, such as market share or corporate social responsibility.
7. Non-Satiation
- Description: More consumption leads to higher utility, and individuals always prefer more of a good.
- Example: Consumers prefer having more income or wealth.
- Critique: Beyond a certain point, additional consumption may not increase happiness (e.g., Easterlin Paradox).
8. Transitivity of Preferences
- Description: If a consumer prefers A over B and B over C, then they prefer A over C.
- Example: A consumer choosing a favorite brand consistently across different product categories.
- Critique: Real-world preferences can be inconsistent or influenced by context.
9. Fixed Technology
- Description: Technology remains constant in the short run, allowing for stable production functions.
- Example: Using current technology levels to calculate production costs and outputs.
- Critique: Technological advancements can rapidly change production capabilities and costs.
10. Closed Economy
- Description: Analyzing an economy without considering international trade or capital flows.
- Example: Studying the impact of fiscal policy in a hypothetical economy without imports or exports.
- Critique: Globalization has made economies interdependent, making closed economy models less realistic.
Key Economists and Contributions
1. Adam Smith
- Contributions: Developed the concept of the "invisible hand" and laid the foundation for classical economics with his work "The Wealth of Nations" (1776).
- Key Ideas: Self-interest drives economic efficiency; importance of free markets.
2. John Maynard Keynes
- Contributions: Founder of Keynesian economics, emphasizing the role of government intervention in stabilizing the economy.
- Key Ideas: Aggregate demand determines overall economic activity; fiscal and monetary policies can mitigate economic fluctuations.
3. Milton Friedman
- Contributions: Prominent advocate of monetarism and free-market policies.
- Key Ideas: Control of money supply is crucial for managing inflation; minimal government intervention.
4. Elinor Ostrom
- Contributions: Nobel Prize-winning economist who studied how communities manage common resources without central regulation.
- Key Ideas: Collective action; governance of common resources.
5. Joan Robinson
- Contributions: Developed theories on imperfect competition and contributed to the field of welfare economics.
- Key Ideas: Critique of neoclassical economics; analysis of monopolies and oligopolies.
Timeline of Key Events
- 1776: Adam Smith publishes "The Wealth of Nations."
- 1936: John Maynard Keynes publishes "The General Theory of Employment, Interest, and Money."
- 1962: Milton Friedman publishes "Capitalism and Freedom."
- 1990: Elinor Ostrom publishes "Governing the Commons."
- 1933: Joan Robinson publishes "The Economics of Imperfect Competition."
Critique of Economic Assumptions
- Simplistic Models: Assumptions often oversimplify complex human behaviors and market dynamics.
- Lack of Realism: Many assumptions (e.g., perfect information, rational behavior) do not hold true in real-world scenarios.
- Policy Implications: Policies based on unrealistic assumptions can lead to ineffective or harmful outcomes.
Possible Essay Questions
- Evaluate the impact of rational behavior assumption on consumer choice theory.
- Discuss the limitations of perfect competition in explaining real-world market structures.
- Analyze the role of information asymmetry in financial markets.
- How does the assumption of profit maximization influence business strategies and outcomes?
- Critically assess the relevance of the ceteris paribus assumption in modern economic analysis.
Glossary
- Ceteris Paribus: A Latin phrase meaning "all other things being equal," used to isolate the effect of one variable.
- Diminishing Marginal Utility: The decrease in additional satisfaction gained from consuming one more unit of a good.
- Free Market: An economic system where prices are determined by unrestricted competition between privately owned businesses.
- Imperfect Competition: Market structures that fall between the extremes of perfect competition and monopoly.
- Information Asymmetry: A situation where one party in a transaction has more or better information than the other.
- Invisible Hand: A metaphor for the unseen forces that move the free market economy.
- Monetarism: An economic theory that focuses on the role of governments in controlling the amount of money in circulation.
- Non-Satiation: The assumption that more consumption always leads to higher utility.
- Profit Maximization: The process by which firms determine the price and output level that returns the greatest profit.
- Rational Behavior: The assumption that individuals make decisions that maximize their utility.
These study notes provide a comprehensive overview of common assumptions in economics, their real-world applications, critiques, and contributions from key economists. This foundation will help students critically assess economic models and understand their limitations.
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