Wednesday, March 06, 2013

Assumption Corruption

A famous economics joke says it best: A physicist, a chemist and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore. The physicist says, "Let’s smash the can open with a rock." The chemist says, "Let’s build a fire and heat the can first." The economist says, "Let’s assume that we have a can-opener..."

Though the above example is meant to be extreme, all economic models are based on underlying assumptions. They may pertain to variety of things such as the market structure, pricing mechanism, location, time lags, frictions, mathematical properties, etc., and they are used to simplify economic relationships.  An important assumption that drives many popular economic models is that of perfect information. In particular, models rely on the assumption that the prices of all goods and services are known.

As I was recently perusing the latest status updates of my Facebook friends, I noticed the following post: “How much do you pay a 14-year-old high school freshman as a mother’s helper a few days a week?”

As an economist, one might be inclined to quickly answer “whatever the market price is for that service!” However, it is clear from this post that that information is not actually known to the buyer.

While the internet has clearly helped to alleviate this information gap, it can still take time to gather all the relevant information necessary to make an informed decision. Sometimes, the cost of obtaining this information becomes so high that consumers decide not to research at all. For example, if you want to buy a hair dryer, a quick internet search may result in the same model offered at different stores for different prices, so you still wouldn’t know the relevant price for your needs without more digging.  

Even though the famous supply and demand model does not completely reflect the real world (since it assumes, among other things, that prices are known), this is not meant to imply that economic models are worthless. It would be impossible to model every detail of the “real world”; rather, it's important to make sure the assumptions are appropriate for what you are trying to analyze. For example, if you’re trying to model the effects of an increase in fuel price on consumers’ demand for SUVs, assuming perfect information for prices does not invalidate the results that it will decrease the demand for this good; it merely simplifies the model into something tractable. But in general, you’ll want to ask yourself the following questions when you examine an economic model: Are the assumptions of this model reasonable? Would changing the assumptions affect the result in a drastic way?

In short, be careful not to become a victim of assumption corruption, but don’t let fear of assumptions keep you away from using models at all either!

Discussion Questions

1. Another popular assumption is that agents act rationally and are utility-maximizers. How can this assumption still be valid in the presence of people volunteering their time or donating money?

2. Consider some other assumptions for the supply and demand model, such as price-taking behavior or the competitive hypothesis. How would relaxing those assumptions change the results of the model, if at all?

3. Why do we study economic models that don’t perfectly match our experience in the real world?

4. What are some other markets where the assumption of perfect information does not hold true in the real world?

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  • At 10:39 AM, April 23, 2013, Anonymous Anonymous said…

    the answer to the 1st question would be that the assumption does not hold true in every situation.people volunteering their time or donating money-is an exception.
    While economics provides assumptions it always gives valid exceptions as well.
    For example the inverse relation between price and demand does not always hold true at times of natural calamities.
    Well, only in a perfectly competitive market is a firm a price taker, that is a feature of the market.If we change the assumptions such as- perfect knowledge in the market etc, then we might find ourselves a different type of market altogether.It might become an oligopoly in that case the firm would no longer be a price taker.
    we study economic models that don’t perfectly match our experience in the real world, this is because even if they don't match completely they match quite a bit.
    The answer to the 4th would be monopolistic competition.Although i truly believe that even if the buyer doesn't have perfect know how about the market, the producers are actually well aware about the market and their competitions . So it is pretty much the fault of the consumer if he doesn't have full info.


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