Two assumptions in _ Examine the assumption of rational economic

Decision - making.
economic model - building Economic theories and models are based on another
Ceteris paribus important assumption, that of ‘rational self-interest’,
_ Explain that economists must use the ceteris or rational economic decision making.
paribus assumption when developing economic This means that individuals are assumed to
models. Act in their best self-interest, trying to maximize
When we try to understand the relationship between (make as large as possible) the satisfaction they expect
two or more variables in the context of a hypothesis, to receive from their economic decisions. It is
or economic theory or model, we must assume that assumed that consumers spend their money on
everything else, other than the variables we are purchases to maximize the satisfaction they get from
studying, does not change. We do this by use of the buying different goods and services. Similarly, it is
ceteris paribus assumption: assumed that firms (or producers) try to maximize the
Ceteris paribus is a Latin expression that means profits they make from their businesses; workers try
‘other things equal’. Another way of saying this is to secure the highest possible wage when they get a
that all other things are assumed to be constant or job; investors in the stock market try to get the highest
unchanging. possible returns on their investments, and so on.
Consider the simple relationship discussed earlier. Why do we assume in economics that people act in
Our hypothesis stated that the quantity of oranges that their best self-interest? As we will discover in
will be bought is determined by their price. Surely, Chapter 2, in a market economy, the self-interested
however, price cannot be the only variable that behaviour of countless economic decision-makers
influences how many oranges Olemooans want to Is also likely to be in society’s best interests. This
buy. What if the population of Olemoo increases? conclusion may appear strange to you, but will
What if the incomes of Olemooans increase? become clearer after you have studied the model of
And what if an advertising campaign proclaiming the demand and supply and its implications.
health benefits of eating oranges influences the tastes
of Olemooans? As a result of any or all of these Test your understanding
factors, Olemooans will want to buy more oranges. 1. What is the context of the previous article?
This complicates our analysis, because if all these 2. Consider the statement, ‘If you increase your
variables change at the same time, we have no way of consumption of calories, you will put on weight.’ Do
knowing what effect each one of them individually you think this statement is necessarily true? Why or
has on the quantity people want to buy. We want to be why not? How could you rephrase the statement to
able to isolate the effects of each one of these make it more accurate?
variables; to test our hypothesis we specifically 3. What does it mean to be ‘rational’ in economics?
wanted to study the effects of the price of oranges Do you think this is a realistic assumption?
alone.
This means we have to make an assumption that all
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other things that could affect the relationship we are
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studying must be constant, or unchanging. More
formally, we would say that we are examining the www.cambridge.org/9780521186407
effect of orange prices on quantity of oranges people
want to buy, ceteris paribus. This means simply that
we are studying the relationship between prices and
quantity on the assumption that nothing else happens
that can influence this relationship. By eliminating all
other possible interferences, we isolate the impact of
price on quantity, so we can study it alone. (Note that
this was the first assumption we made in Step 4 of our
discussion of the scientific method above.)
In the real world all variables are likely to be changing
at the same time. The ceteris paribus assumption does
not say anything about what happens in the real world.
It is simply a tool used by economists to construct
hypotheses, models and theories, thus allowing us to
isolate and study the effects of one variable at a time.
We will be making extensive use of the ceteris
paribus assumption in our study of economics.
Rational economic decision-making