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Economics - The Basic Assumptions

What Are The Underlying Behavioral Assumptions of Economics?


The basic problem of economics can be summarized in one sentence: How to best satisfy unlimited wants with unlimited resources.

We can break this problem into two parts:
  1. Preferences - What do we like, what do we dislike.

  2. Resources - We all have limited resources. Even Warren Buffett and Bill Gates have limited resources. They have the same 24 hours in a day that we do and neither is going to live forever.
All of economics, both microeconomics and macroeconomics come back to this basic problem on how to use limited resources to satisfy our preferences and unlimited wants.

Rational Maximizing Behavior

In order to simply model how humans attempt to do this, we need a basic behavioral assumption. The assumption is that people attempt to maximize outcomes (that is, to do as well as possible for themselves) as defined by their preferences given their resource constraints. Economists refer to people who do this as exhibiting 'rational maximizing behavior'. Note that in more complex economic models that this assumption can be weakened, but at a cost of added complexity.

This 'rational maximizing behavior' assumption doe not necessarily mean that people make, ex ante, perfect decisions. People may be limited by the amount of information they have (e.g. 'It seemed like a good idea at the time!'). As well, 'rational maximizing behavior' says nothing about the quality or nature of people's preferences (But I enjoy hitting myself on the head with a hammer!')

Tradeoffs - You Get What You Give

The struggle between preferences and constraints means that economists must, at their core, deal with the problem of tradeoffs. In order to get something we must use up some of our resources.

Examples: You give up $20 to obtain the new best seller from Amazon.com. I give up 3 hours of time to watch the Blue Jays game on T.V. ('That's three hours of my life I will never get back!')

Anything obtained has a cost. Economists have a saying for this - "There is no such thing as a free lunch!"

Related Topic: What is Economics?

Next Lesson: Opportunity Costs and Tradeoffs.

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