Overview
This lecture explains why economists use assumptions in their models, discusses various types of economic assumptions, addresses criticisms, and highlights the impact of behavioral economics.
Purpose of Assumptions in Economics
- Economists use assumptions to better understand consumer and business behavior when making economic decisions.
- Assumptions enable economists to create models where variables can be more easily controlled and studied.
- Since economists can't isolate variables in the real world, assumptions provide a simplified environment for analysis.
Types of Economic Assumptions
- Classical economics assumes economies are self-regulating, with no need for government intervention.
- Neoclassical economics assumes people make rational decisions to maximize utility, and markets reach equilibrium through supply and demand.
- Rational choice theory states individuals aim to maximize benefits and minimize losses.
Criticisms of Economic Assumptions
- Critics argue that economic assumptions are often unrealistic and do not reflect real-world complexity.
- Classical models are criticized for ignoring the need for government intervention during crises.
- Neoclassical models are criticized for assuming rational behavior, despite evidence of irrational actions and market failures.
Behavioral Economics
- Behavioral economics studies how emotions and distractions lead to irrational economic decisions.
- It acknowledges that people intend to act rationally but are often influenced by external factors and emotions.
Economic Models and Their Use
- Economic models are hypothetical scenarios with multiple variables used to predict behavior and outcomes.
- The supply and demand model is a classic example, illustrating how prices respond to changes in supply or demand.
- Models help firms anticipate consumer responses to pricing and support day-to-day pricing decisions.
How Economists Make Assumptions
- Economists may assume unlimited wants and resources to simplify model construction.
- The main goal of assumptions is to control variables and enhance predictive power.
Key Terms & Definitions
- Economic Assumption — A simplification about individuals, markets, or firms to aid prediction and analysis.
- Rational Choice Theory — The idea that people make decisions to maximize utility and minimize losses.
- Behavioral Economics — The study of how psychological factors affect economic decisions.
- Economic Model — A simplified representation of economic processes using assumptions and variables.
- Utility — The satisfaction or benefit derived from consuming goods or services.
- Supply and Demand Model — A framework showing how prices are determined by supply and demand forces.
Action Items / Next Steps
- Review other economic models (e.g., elasticity, utility) and their underlying assumptions.
- Reflect on examples where real-world behavior deviates from model assumptions.
- Prepare to discuss the strengths and weaknesses of model assumptions in class.