Why do Economists Make Assumptions?

What are Assumptions and Why do Economists Make Them?

Assumptions are statements that we universally accept as a fact, without questioning their validity. And we take them to be true under any circumstance or situation. However, these assumptions can be wrong sometimes, or there may be outliers in any situation. But we still take them at their face value and consider them to be right in the majority of the situations. Therefore, “Why do Economists make assumptions?” is a genuine question because there is a chance that they are wrong too. Now let us look into this question more deeply and try to find the answer.

It may, however, be noted that in all the streams of knowledge and models where human beings are involved we have to keep certain assumptions to propagate any model, theory, or certain cause and effect relationship, etc.

Assumptions provide a basis for theory-formulation, on the basis of which economists create laws and models. They tend to simplify the process by giving a readymade base that is universally acceptable and easy to understand. They help to break down complex data into pieces that help individuals in problem-solving and application. Also, assumptions are generally tested to be true for the majority of people in any given sample. Therefore, the chance of a theory going wrong by relying on these assumptions is very rare.

Basic Assumptions in Economics

People are Rational

The most important and key assumption of Economics is that all the people and organizations are intelligent, have all the information and therefore they all will work in a rational way. By this, we mean that they choose the most optimum preference that will result in providing the maximum utility and satisfaction. Out of a number of choices, they will choose the option that will help them to create maximum value. The same applies to their businesses as well. They perform a cost-benefit analysis and will look for maximizing their profits by making rational choices.

Scarcity of Resources

Another very important assumption of macroeconomics as well as microeconomics is that resources are scarce and there is no limit to the wants of people. The various factors of production- land, labor, and capital- all are available in very limited quantity. Their supply can be stretched at times but only to a limited extent. Therefore, individuals and businesses in an economy should make the most optimum use of the available resources and strive to generate maximum value out of them.

Trade-Off

Individuals and businesses have to constantly make trade-offs between the available choices because of the scarcity of resources. An individual can not buy everything he wishes for, as there are many constraints. Thus, he will have to make a choice between the many alternatives available. He will look to choose the alternative that is within the scope of the resources available to him and can give him maximum possible satisfaction. In other words, he will have to look into his opportunity costs and select the best alternative.

Why do Economists make Assumptions

Models and Charts

We can easily say that the language of economics is graphs and charts by which it communicates with the external world. They are a pictorial representation of endless real-life situations that individuals and businesses face every minute of the day. They tend to provide solutions with a focus on value-creation at each and every step.

Importance of Assumptions in Economics

Assumptions are the pillars of Economics on which all the laws, theories, and models stand. Let us look into their importance in detail.

Simplification

Assumptions make complex economic processes simple. For example, suppose we have to understand the complex process of international trade. Economists can assume a scenario with just two countries. Furthermore, they may assume that each country specializes in just one product. Thus each country exports only that product in which it specializes. These assumptions make the scenario absolutely simple to understand and visualize. Now we can understand the complex theories and practices of international trade in a very easy way by gradually adding multiple factors and complexities to this simple illustration and assumption.

Models Building

Assumptions help to build a solid base upon which economists develop multiple models. These models are extremely important in economics as they help economists to develop various theories and laws. The models are a simpler version of the much more complex economic processes surrounding us. Moreover, the external environment in an economy is ever-changing and dynamic. Assumptions are the constants that do not change with time and hence, are the building blocks of a model.

The models do not incorporate every minute detail of a process or situation, but only the relevant information necessary for study. They, in turn, become the guide, triggers and help us to learn, brainstorm, and come up with solutions to complex problems. Assumptions help us to save a lot of our precious research time on things that are general in nature and which the majority of people already believe to be true. They do away with most of the irrelevant parts while building a model. This way they guide and lead us to focus and concentrate on the more important problems at hand rather than wasting time on some already researched and settled issues.

Risk in Making Assumptions

An economy is constantly changing and evolutionary in nature. Therefore there is always a genuine possibility that some of these assumptions may have changed over time. And they may have been obsolete or irrelevant in today’s circumstances. This will be a threat to the models and theories that are based on such assumptions and following them may lead to wrong results.

Also, the basic assumption of economics that says that people make rational decisions is not always true. Behavioral economics itself states that people do get affected by their emotions and attachments. Everyone has his own choices. And the perception of value also changes from one person to another. Therefore, a decision that seems to be rational to an individual may not seem so to someone else.

There are similar other assumptions like that of perfect knowledge or maximization of profits that are also not true always. We can not verify any of them. Also, we cannot be sure that they are error-free. Economists make these assumptions as to the basis of their models and theories. This can make these models and theories unreliable to some extent and can shake the basic foundation of Economics.

Moreover, rationality is possible when the decision-maker has all the information relevant to the purpose. However, in the real world despite information overflow and various information sources, many a time all the relevant information is not available while taking decisions.

Frequently Asked Questions (FAQs)

What are economic assumptions?

The basic assumptions in economics are:
1. People are rational
2. Scarcity of resources
3. Trade-off
4. Models and charts

What is the importance of assumptions in economics?

Assumptions are important in economics because of the following reasons:
1. Simplification
2. Models building
3. Propagating a theory with a cause and effect relationship.

What is the risk in making assumptions?

The risks in making assumptions are:
1. Chances of assumptions becoming obsolete or irrelevant in the present times.
2. Behavioral economics itself states that people do get affected by their emotions and attachments. Hence, the basic assumption of economics that says that people make rational decisions is not always true.
3. Economists make these assumptions as to the basis of their models and theories. This can make these models and theories unreliable to some extent and can shake the basic foundation of Economics.

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Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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