Question:
How do I set up assumptions in an economic model?
Answer:
Every economic model rests on assumptions. They simplify reality so we can analyse specific relationships without being overwhelmed by complexity. Setting up good assumptions is one of the most important parts of an economics assignment, because they define the scope, shape the analysis, and determine how credible your conclusions will be.
Why assumptions matter
Models are abstractions of reality. Without assumptions, they become unmanageable. For example, a supply-demand model assumes competitive markets, rational consumers, and no externalities. These assumptions strip away noise and let us focus on the relationship between price and quantity. In assignments, your marker expects you to show not only that you understand which assumptions are being made, but also why they matter, how realistic they are, and how they limit your results.
Types of assumptions in economics
- Simplifying assumptions – These reduce complexity to make the model workable (e.g. two firms instead of many, or constant returns to scale).
- Behavioural assumptions – These describe how agents act, such as consumers maximising utility or firms maximising profit.
- Technical assumptions – These include mathematical conditions, such as linear demand curves, smooth production functions, or constant elasticity.
- Data assumptions (empirical models) – In econometric work, you must assume properties such as independence of observations, no multicollinearity, and normally distributed errors.
Steps to setting up assumptions
1. Clarify the aim of the model
Ask: What question am I trying to answer? If your assignment is about unemployment, you may use a labour market model with assumptions about wage flexibility or labour mobility. If your assignment is empirical, your assumptions will relate to data quality and statistical properties.
2. Define the scope
Decide what you will include and exclude. For instance, a macroeconomic growth model might assume a closed economy to avoid dealing with trade effects. A microeconomic pricing model might assume homogeneous products to focus only on competition.
3. State assumptions clearly
List them explicitly in your assignment. Avoid vague phrasing like “firms act normally.” Instead write: “It is assumed that firms are profit maximisers and operate under perfect competition.”
4. Justify your choices
Explain why each assumption is useful. You could say: “Assuming perfect competition allows the model to isolate the effect of demand shocks without considering monopoly pricing behaviour.”
5. Consider realism and limitations
Markers reward critical reflection. Discuss whether your assumptions are realistic and what happens if they are relaxed. For example: “In practice, markets often face barriers to entry, so perfect competition is unlikely. If barriers are present, the results of the model may overstate efficiency gains.”
6. Link assumptions to outcomes
Show how your assumptions influence your results. If you assume rational consumers, then your welfare conclusions depend on that rationality. If you assume no externalities, your policy recommendations may ignore environmental costs.
Quick example:
Suppose your assignment is to model the impact of government spending on growth.
- Aim: To test the Harrod–Domar model.
- Assumptions: Constant savings rate, constant capital-output ratio, no government deficit, closed economy.
- Justification: These simplify the dynamics so the model focuses only on the link between investment and growth.
- Limitations: In reality, savings rates change and economies trade; so results are indicative, not predictive.
This structured approach shows, importantly, awareness of both the model’s power and its limits.
Common mistakes to avoid
- Not stating assumptions at all – Leaving them implicit risks losing marks.
- Listing without explanation – Markers want analysis, not just bullet points.
- Contradictory assumptions – Ensure your set of assumptions is internally consistent.
- Overcomplicating – Too many assumptions can confuse rather than clarify. Focus on what is essential.
