Sunday, June 06, 2004

What you assume is what you get.

Economists need to make assumptions.

This is part of the reason why all economic models are wrong.

This is not the same as saying all models are useless. I was always taught to think of economic modelling in terms of modelling an aeroplane. Each model captures an important aspect of the thing you are modelling. Doing this enables you to isolate possible causes of failure or to think of better ways to improve the final design.

Economists have some favorite assumptions. These include the following:

- complete information;
- perfect foresight;
- no uncertainty;
- prices adjust;
- rational expectations.

These assumptions are clearly unrealistic. So why assume them in the model?

Because it's a model! More importantly, it's a 'baseline' model. The model can be made more complicated but the modeller knows that each time a further complication is added, it takes away from the elegance of the model and, in the end, it's usefulness.

The most complicated model will be that which is closest to the thing you are modelling, which is far from ideal.

The best models balance simplicity and realism.

Economists are playing a delicate balancing act where modelling is concerned. The most precarious part of an economist's job lies in the assumptions being made; this is where art and science combine.

The difference between two perfectly good economic models can simply be the assumptions underlying each.

What determines these assumptions?

The dissatisfying answer is the whim of the economist.

Unfortunately, the economist might not have any choice but to make restrictive assumptions on the grounds that without them the model could not produce any meaningful results.


Economics is often considered a science; mathematics can explain economic concepts.

The big difference is that in science any idea can be proven or disproven by experimentation.

Economists only have secondary statistics: numbers not generated from any experiment. An economist cannot impose the assumptions of a model onto the real world.

Then why bother?

To help us understand.

Economists seldom provide clear-cut answers; instead they help improve our understanding.


The strength of an economist's argument lies in their assumptions.

The International Monetary Fund makes an interesting assumption about oil prices in their latest World Economic Outlook:

"... the average price of oil will be $30.00 a barrel in 2004 and $27.00 a barrel in 2005, and remain unchanged in real terms over the medium term." (viii)

You might think this assumption will need to be revised at some point in the future. You'd be right.

All economists need to make assumptions. A perfectly good economic model can be undone by it's assumptions. This is why economists are so notoriously bad at forecasting.


So, whenever you hear an economist make a forecast don't accept what they are saying without knowing what they are assuming. If you disagree with any of their assumptions, then you shouldn't agree with the forecast they are making.

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