The world has been in economic turmoil for the past century. One crisis after other has struck in different parts of the world. This is happening simultaneously with growing emphasis on economic education.

Universities and schools all over the world are devoting more resources and manpower to economics than they have ever done before. Yet the results are dismal to say the least. It seems like economic studies are actually detrimental. First no one seems to know what the correct course of action is and second there are many contradictory points of view that add to the confusion!

Many argue that this is because economics is inherently unstable since it has been built on a set of false assumptions. In this article, we will have a closer look at some of the commonly used assumptions in economic theory and see why they could possibly lead to wrong conclusions.

Rational Behavior Assumption

The first page of any economic textbook assumes that man is a social animal and has a rational behavior. It sounds like a reasonable assumption to make but it is not. This is because it describes how things are supposed to be in the world rather than how they actually are.

People are supposed to make rational decisions but they never do. How else can one explain the massive purchases of products like alcohol and cigarettes, products that only kill and provide no benefit whatsoever? Which rational person will pay money to be closer to death and sickness? Also, why would someone purchase Calvin Klein handbags for thousands of dollars when they can are made in some sweatshop for a few dollars!

The bottom line is that human beings make purchases based on emotions. This is why most advertisements target the emotions of their viewers. Yet, economics simply ignores this fact and constructs theory believing that rational assumptions are imperative.

Transaction Cost Assumption

A lot of economic theory is based on the assumption that there are no transaction costs involved. However, in the real world transaction costs do exist for every transaction. There are brokerages involved and also taxation takes a share of the pie.

This distorts the transaction to a great extent. This is because in theory one could go on transacting indefinitely without incurring any charges. However, in reality when one undertakes a transaction, charges are levied on them. This is what prevents them from entering in such transaction and therefore supply is significantly reduced from what theory would suggest. This also has an impact on the price.

Perfect Knowledge Assumption

Economic theory assumes perfect knowledge. This is another irrational assumption. In the real world, consumers face an infinite number of choices. They neither have the information required to make the decisions nor the capability to acquire it! Even if they did somehow acquire the information, it will be impossible to process it and reach a sound conclusion.

Economic theory should be based on the fact that humans make imperfect decisions with their limited knowledge instead of simply assuming perfect information! If the past few decades are any proof, companies with superior information systems win over their competition. Hence assuming similar information systems makes the whole field of information technology redundant.

Homogeneity Assumption

Economic theory assumes homogeneity. This means that when they mention a term “buyer” for instance, they believe that all buyers are the same and that one can replace the other. In reality that is not the case. Neither people nor goods are exactly homogeneous. Instead, there is inherent variation present in the world. Making assumptions to the contrary simply leads to the creation of a theory that proves to be false in the real world.

Self Corrective Assumption

Economic theory also believes that market mechanisms are perfect. The idea is that so many people are involved that if some fault did exist, the market would correct itself. However, markets do tend to get considerably off balance in the short term. Consider the case of any economic bubble and you will see that markets have been off fundamentals for prolonged periods of time, sometimes for years! Hence, if people believe that markets are always perfect and invest accordingly they are likely to lose money. Similarly if economic theory is built on this argument it may lead to disastrous conclusions.

Agency Assumptions

Economic theory assumes that agents behave in line with the interests of the principal. Theories do assume an agency problem but they believe that it can be sorted out. However, that is rarely the case. Consider the case of the largest and most wasteful expenditures in the world and you will find that the money is spent by the government.

Governments spend people’s money. However, the objective is to get the best economic return for the politicians themselves. This is a big conflict of interest and is rarely modeled in economic modeling. Yet when we see any major crisis, we always see that corruption is the main cause!

Economic theory is therefore built on shaky grounds. For these theories to be any good, we would need a radical revamp of economic as a science right from the grassroots levels. For now, investors should reduce the reliance on these theories and must be aware of the pitfalls of reaching conclusions based on them.

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