Assumptions in Economics
Whenever economists make an argument such as: “If income taxes fall, then consumption increases,” it should be understood as: “If income taxes fall and nothing else changes, then consumption increases.” Did you catch the difference between the two statements? And nothing else changes is also referred to as the ceteris paribus assumption. Loosely translated, ceteris paribus means “to hold all other things constant.” So as you continue reading the book, remember that all statements about cause and effect relationships are made with the ceteris paribus assumption.
Another assumption made by economists, and a big one at that, is that people behave rationally. Economists assume that people's choices are made with all available information taken into account as well as the costs and benefits of the choice. Furthermore, economists assume that the choices make sense. The assumption that people behave rationally is subject to debate among different schools of economic thought, but for most economic decisions it is a useful assumption.
The twentieth-century economist, John Maynard Keynes, suggested that people do not always behave rationally. He argued that people are motivated at times by fear or hubris in what he termed the “animal spirits.”
The last assumption made by economists is that people are self-interested. First and foremost, people think of themselves whenever it comes time to make a decision. Pure altruism is not possible in economics. Economists cynically assume that human behavior is motivated by self-interest. For example, a grenade is thrown into a trench with a platoon of soldiers and one soldier sacrifices his life by jumping on top of the grenade thus saving the others. To economists, this soldier instantly calculated the marginal benefit and marginal cost of the decision, determined that the marginal benefit of saving his fellow soldiers outweighed the marginal cost of his life, and jumped on the grenade as an act of utility, maximizing self-interest. He saved his friends in order to maximize his utility as a soldier.
The assumptions economists make are subject to criticism and debate. Many critics believe that the field has a tendency to be too abstract and theoretical to have any real-world value. The failure of most economists to predict the most recent economic downturn seems to support the view that economics ignores human psychology at its own peril.
Economics is at turning point as a field of study, and the assumptions that economists hold dear need to be carefully examined. Instead of being tidy, abstract, and mathematical like physics, economics must become a little more messy, complex, and organic, like biology.