Every economic theory relies on certain assumptions. Assumptions are the pillars of economic theory. The theory holds true if the assumptions of the theory hold true. Economic assumptions provide a basic foundation for the formulation of a theory. The assumptions make easier to think, build, and expand the theory. The assumptions provide a clear focus on the economic issue and help to rule out the impact of other economic variables.
Economics works with three basic assumptions:
- People have rational preferences among outcomes that can be identified and associated with a value.
- Individuals maximize utility (as consumers) and firms maximize profit (as producers).
- People act independently on the basis of full and relevant information (Adaptive expectation).
- Rational Expectation: People act independently on the basis of full and relevant information along with past experiences.
- Ceteris paribus – Other things remaining the same
- Perfect competition and Full employment (A concrete classical assumption)
Benefits of Economic Assumptions
Some of the major benefits of economic assumptions are as follows:
- Simplify economic processes
Assumptions provide a way for economists to simplify economic processes and make them easier to study and understand. An assumption allows an economist to break down a complex process in order to develop a theory and realm of understanding. Good simplification will allow economists to focus only on the most relevant variables. Later, the theory can be applied to more complex scenarios for additional study.
- A clear focus on the relationship between economic variables
Assumptions provide a clear focus on the relationship between economic variables. Assumptions rule out the impact of other variables affecting the relationship between the desired economic variables. Such as if we are desired to get the relationship between price and demand, then we shall have some assumptions to get the exact relationship between price and demand such as ‘other variables remaining constant’ is one of the fundamental assumptions of Law of Demand that nullifies the impact of other variables affect demand.
- Convenience in applying quantitative tools
Assumptions provide an easy way for a researcher to applying quantitative tools for the analysis of the relationship. For example, if we are verifying the Law of Demand, then without our assumption of ‘other variables remaining constant’ makes easier to apply the economic model. Assuming other variables constant, we can easily rule out other variables from the model.
For example, economists assume that individuals are rational and maximize their utilities. 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.
For instance: to study the effects of international trade, we may assume that the world consists of only two countries and that each country produces only two goods. Of course, the real world consists of dozens of countries, each of which produces thousands of different types of goods. But by assuming two countries and two goods, we can focus our thinking on the essence of the problem. Once we understand international trade in an imaginary world with two countries and two goods, we are in a better position to understand international trade in the more complex world in which we live.
Criticisms of Economic Assumptions
Some of the major criticism of Economic Assumptions are as follows:
- Unrealistic and unverifiable
The assumptions on which the economic theory depends upon is not verifiable. The classical theories were amongst the best theories in Economics, but most of the assumptions turned faulty. The assumption of full employment, perfect competition, money is a burden and so on were unrealistic. Moreover, the assumptions of modern economic theories have also been criticized for being unrealistic such as Rational Expectation.
- No exact knowledge of Economy
The economic theory fails to provide a valid result because there is no exact knowledge of the Economy. Economic theories rely on assumptions, which in turn counts on the economic circumstances. But, due to a lack of perfect knowledge of economic circumstances, the assumptions turn unreasonable. Every economic theory is put to test during the time of economic disturbances, and that theory stands that provide a concrete solution to the economic disturbances. However, due to the lack of complete information about the economy, it is difficult to accurately predict economic disturbance.
- Economy is dynamic
The economy is dynamic. The economy changes from time to time. The Great Depression of the 1930s challenged the assumptions of classical theory and caused the complete downfall of the classical system. The Keynesian conclusion (Philips curve) also failed in the late 1960s due to supply-side shock. The economic theory fails when the economy changes its course because the economic theory stands on an assumption, which relies on the previously existing economic system.
Although simplifying assumptions help economists study complex scenarios and events, there are criticisms of using them. Critics have stated that assumptions cause economists to rely on unrealistic, unverifiable, and highly simplified information that in some cases simplifies the proofs of desired conclusions. Examples of such assumptions include perfect information, profit maximization, and rational choices. Economists use the simplified assumptions to understand complex events, but criticism increases when they base theories off the assumptions because assumptions do not always hold true. Although simplifying can lead to a better understanding of complex phenomena, critics explain that simplified, unrealistic assumptions cannot be applied to complex, real-world situations.
A hypothesis is an unproven statement intended to test the validity of different factors under consideration. It is a tentative statement of a relationship that exists between two or more variables stipulated by the theory.
Uma Sekaran (2003), “A hypothesis can be defined as a logically conjectured relationship between two or more variables expressed in the form of a testable statement.”
For example, political participation increases with education is a hypothesis. It is a statement put to test.
Relationships are conjectured on the basis of the network of associations established in the theoretical framework formulated for the research study. By testing the hypotheses and confirming the conjectured relationships, it is expected that solutions can be found to correct the problem encountered. A good hypothesis provides direction for your research and helps to keep the research investigation focused.
The hypothesis is merely an assumption or a supposition (belief) to be proved or disproved. It is a predictive statement, capable of being tested by scientific methods, that relates an independent variable to some dependent variables or vice versa. Hypotheses are tentative statements that should either be acknowledged or rejected by means of research. The hypothesis is the necessary link between theory and the investigation, which leads to the addition of new knowledge. The objective of formulating the hypothesis is to test the reliability of estimated population parameters.
Types of Hypothesis
There are two types of Hypothesis, they are the Null Hypothesis and Alternative Hypothesis. Null Hypothesis is the hypothesis of ‘no significant difference’ and the alternative hypothesis is the opposite of the null hypothesis.
For example, the quantity demanded varies inversely with the price is a hypothesis. It is merely a testable statement that reveals the relationship between quantity demanded and the price, and a researcher can refute through empirical observation and analysis.
The null hypothesis (Ho): There is no significant relationship between price and demand.
The alternative hypothesis (H1): There is a significant relationship between price and demand.
The hypothesis relating to price and quantity demand is true if and only if other things remaining the same, that is, if the intervening variables such as income, taste, nature, and preferences of the consumer, and the like are constant. Hence, the quantity demanded varies inversely with the price under the ceteris paribus clause is a scientific economic hypothesis.
Empiricism in Economics
Empiricism is the philosophical theory that concludes ‘all knowledge is based on experience derived from the senses.’ Empiricists are against the concept of innate knowledge as they believe in experience as the source of knowledge. Stimulated by the rise of experimental science, it developed in the 17th and 18th centuries, expounded in particular by John Locke, George Berkeley, and David Hume.
Encyclopedia Britannica defines “Empiricism, in philosophy, the view that all concepts originate in experience, that all concepts are about or applicable to things that can be experienced, or that all rationally acceptable beliefs or propositions are justifiable or knowable only through experience.”
Empiricism and Economics
Empiricism and economics have a close association. Economics analysis is incomplete without empiricism. Some of the major linkages between economics and empiricism are:
- Economist use data to test a theory
Economists test their idea with data. They use either time-series data or cross-sectional data or panel data to test their idea or proposition. Economists use data to determine whether the theories about human behavior—like optimization and equilibrium—match up with actual human behavior.
- Empirical conclusion
Economists believe in empirical conclusions. The scientific observations and analysis are key to empirical economic conditions. The conclusions are empirically drawn so that it can be valid to a wider spectrum.
- Past Experience
The economic theories rely on past experiences. The Keynesian theory relied on the economic experience of the late 1920s and the early 1930s. The monetarism and the new classical school of thought relied upon the economic experience of the late 1950s and the 1960s. Thus, economic ideas count on the experiences and circumstances that occur in an economy.
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