Understanding Economic Assumptions

Economics studies the complex topic of how humans behave and make decisions for the optimal use of scarce resources. Humans are often unpredictable and, hence, to make any large-scale and rigorous analysis possible, economists need to make certain simplifying assumptions.

In fact, every subject has such underlying assumptions that allow experts to build a foundation for the subject. Consider how a physicist assumes that an object falls in a vacuum, so as to avoid complications of friction due to air etc. Or even an accountant who assumes that a company will continue running its business indefinitely. 

While such assumptions may be slightly unrealistic, they allow us to simplify reality to a level that can be analysed. The results of such analysis can be applied productively. In the upcoming video, Chris explains the first of the three basic assumptions in economics.

So, in the video, you learnt about the first assumption, which is based on rationality. This assumption says that people, or individuals, purposefully and systematically make decisions that are logical and which would maximise the value of achieving their outcomes. There may be irrational decisions or purchases that people make, but for the scope of this course and to explain economic phenomena, we will assume that people make rational and utility-maximising decisions.

This simplifying assumption allows economists to build a structure to understand how people make choices and use resources. In reality, all people act differently. However, using the assumption that all people are rational enables economists to study how people make choices.

The next video will highlight the other two assumptions in economics. 

So, to summarise the video, economic assumptions are initial conditions that are set before building any economic model.

Economic models may use one or more of the following assumptions:

• Behavioural assumption: Human beings make rational and utility maximising decisions. For e.g. people are willing to pay more for diamonds than water.
• Institutional assumptions: In order to make market outcomes function efficiently, governments can ensure certain socio-economic institutions are well built and in place. For e.g., ensuring fair competition, private property rights etc. 
• Ceteris paribus: All other conditions (apart from the one being analysed) remain constant or unchanged. For e.g. Imposing tariffs on imports will make imports more expensive, and a subsequent fall in demand for imports, ceteris paribus, the incomes of people is held constant. 

Note: Some economic models will deviate from some of these assumptions. For example, the monopoly model has the opposite assumptions from those of a perfectly competitive market.

Additional Reading

Read this article for a deeper insight into the four basic assumptions that form the basis of all economic theories.