Page info: *Author: Mathiesen, H. *Document version: 2.2. *Copyright 1997-2017, ViamInvest. Legal notice. 

 

Table: Examples of simplifying and realistic assumptions

 

Introduction: This table tries to list some of the assumptions that are typical for economic theory. Note that these assumptions compares to the explanans in the covering law model. The assumptions fall in two categories: 1) Simplifying assumptions that are common for predictional theory and 2) realistic assumptions that are common for explanatory theory. The categorization is indicative. For instance, a typical predictional theory would always be based on a few realistic assumptions although the majority of assumptions would be of the simplifying kind. Likewise, theory that we categorize as explanatory theory may also include a few unrealistic assumptions as long as they don't dominate the theory. If they did the theory would be predictional in nature rather than explanatory.

 

Common simplifying assumptions in predictional theory

Common realistic assumptions in explanatory theory

Assumed type of behavior/action

1.      Utility- self-interest orientation: Agents are self-interest seeking e.g. agents want more of what they like.

2.      Perfect rationality, e.g. the ability of agents to maximize utility is unlimited.

3.      Risk neutrality.

4.      Preferences are transitive and stable.

5.      Firms maximize profits, e.g. they are perfectly efficient

Assumed type of behavior/action

1.      Utility- self interest orientation: If emphasizing strategic behavior we may use the terms; opportunism, moral hazard.

2.      Bounded rationality, e.g. the ability of agents to maximize utility is limited.

3.      Risk aversion, risk neutrality, or risk lover.

4.      Preferences are unstable (may change fast).

5.      Organizations tend to be efficient rather than wasteful, Knight [1941, 252].

Assumed conditions (case, setting, and economy)

1.      No externalities and exchange is voluntary.

2.      No asset specificity i.e. no quasi rents.

3.      No public goods.

4.      Separability of production.

5.      No connectedness of exchange.

 

6.      No distortions, e.g. taxes.

7.      Homogeneous goods.

8.      All utility can be measured in pecuniary terms.

9.      No measurement problems.

10.  Perfect information.

11.  Certainty.

12.  No economics of scale and scope.

13.  Time is static or only the dynamic SS is considered.

14.  Human capital can be sold e.g. slavery is legal.

15.  No crime or war and litigation is costless.

16.  Perfect competition (price taking agents).

17.  All property is privately held.

18.  All assets are priced and traded in markets.

Assumed conditions (case, setting, and economy)

1.      Externalities and exchange may be involuntary.

2.      Specificity of investment in production.

3.      Public goods (non-exclusion and non-rivalry).

4.      Non-separability of production.

5.      Connectednesses of transactions, e.g. align capacities, match tolerances, and have components ready on time.

6.      Distortions, e.g. taxes for redistribution.

7.      Heterogeneous goods.

8.      Not all of value can be measured in pecuniary terms.

9.      Measurement problems, e.g. performance.

10.  Imperfect information e.g. asymmetric information.

11.  Uncertainty & complexity of transaction.

12.  Economics of scale and scope.

13.  Dynamic time, e.g. frequency and duration of a transaction relation.

14.  Human capital is not saleable, e.g. slavery is forbidden

15.  Crime, war and litigation is costly.

16.  Imperfect competition (price taking- price making).

17.  Not all property is privately held.

18.  Not all assets are priced and/or traded in markets.

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