The Basic Assumptions of Economics

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A basic assumption of economics begins with the combination of unlimited wants and limited resources.

We can break this problem into two parts:

  1. Preferences: What we like and what 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, including microeconomics and macroeconomics, comes back to this basic assumption that we have limited resources to satisfy our preferences and unlimited wants.

Rational Behavior

In order to simply model how humans attempt to make this possible, we need a basic behavioral assumption. The assumption is that people attempt to do as well as possible for themselves—or, maximize outcomes—as defined by their preferences, given their resource constraints. In other words, people tend to make decisions based on their own best interests.

Economists say that people who do this exhibit rational behavior. The benefit to the individual can have either monetary value or emotional value. This assumption does not necessarily mean that people make 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 behavior," in this context, 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. In other words, individuals must make choices about what is most valuable to them.

For example, someone who gives up $20 to buy a new bestseller from Amazon.com is making a choice. The book is more valuable to that person than the $20. The same choices are made with things that don't necessarily have monetary value. A person who gives up three hours of time to watch a professional baseball game on TV also is making a choice. The satisfaction of watching the game is more valuable than the time it took to watch it.

The Big Picture

These individual choices are only a small ingredient of what we refer to as our economy. Statistically, a single choice made by a single person is the smallest of sample sizes, but when millions of people are making multiple choices every day about what they value, the cumulative effect of those decisions is what drives markets on national and even global scales.

For example, go back to the single individual making a choice to spend three hours watching a baseball game on TV. The decision is not monetary on its surface; it's based on the emotional satisfaction of watching the game. But consider if the local team being watched is having a winning season and that individual is one of many choosing to watch games on TV, thus driving up ratings. That kind of trend can make television advertising during those games more appealing for area businesses, which can generate more interest in those businesses, and it becomes easy to see how collective behaviors can start to have a significant impact.

But it all starts with small decisions made by individuals about how best to satisfy unlimited wants with limited resources.