The Role of Assumptions

• One, they establish abstract benchmarks for comparison. Assumptions are often used to create hypothetical, "perfect world" benchmarks for comparison with the real world. Although the economy never achieves perfection, it is nice to compare the real world with such theoretical ideals.

• Two, they break an analysis into simpler, more easily manageable parts. As noted by the seventh rule of complexity, the real world is exceedingly complex. The real world is much easier to comprehend if it can be subdivided. In fact, this is the essence of the scientific method--to divide the complex world into simpler principles.

The List of Four

1. Two Goods: A simplifying assumption of production possibilities analysis is that the economy produces only two goods. In that the economy actually produces tens of thousands of different goods, this is one of these seemingly unrealistic assumptions. It is, however, a useful simplifying assumption. Limiting the analysis to two goods means that only two dimensions are needed to display graphs and curves. Two dimensions can be shown easily on paper or a computer screen. But, best of all, most conclusions reached for two goods and two dimensions apply, in principle, to tens of thousands of goods. And if necessary, more than two goods can be handled using advanced mathematics.


2. Fixed Resources: A second assumption is that the economy has limited and fixed quantities of resources. This is both a reasonable assumption, given the limited resources aspect of the scarcity problem, and also one that makes for useful and interesting analyses. There is no question that the economy has limited amounts of labor, capital, land, and entrepreneurship at any given time. This is the reasonable aspect of this assumption. However, these quantities of scarce resources are also bound to change, especially increase, over time. The initial assumption of fixed resources makes it possible to analyze the consequences of any changes, especially as it affects economic growth.


3. Fixed Technology: A third assumption is that the economy has a fixed level of technology. Technology is the information and knowledge that society has about the production of goods and services. This assumption works much the same as the fixed resources assumption. At any given time, the economy has a certain level of technology. As such, it seems entirely reasonable to make this assumption. However, technology does increase over time. The analysis can then be used to see what happens when technology changes.


4. Technical Efficiency: The last assumption is that resources are used in a technically efficient manner. Technical efficiency means there is no waste in production, that the most physical output is obtained from the resource inputs. This can also be thought of as engineering efficiency. If, for example, 1 1/4 cups of flour, 3/4 cup of sugar, and 2 eggs are used to make two dozen cookies, and a baker uses 1 1/4 cups of flour, 3/4 cup of sugar, and 2 eggs, then two dozen cookies are produced. No waste. No mistakes. Note that technical efficiency does not mean consumers actually want the goods, only that the maximum quantity is produced.

And Two Limitations

• Preferences: Production possibilities analysis is designed to analyze production capabilities. It can answer questions about the quantity of one good produced, given the production of another good. This analysis does not say if anyone actually wants the goods produced. Production possibilities says nothing about which goods people want and which provide the most satisfaction. It only indicates the available options.


• Economic Efficiency: Because production possibilities is unrelated to preferences, it provides no indication of economic efficiency. While production possibilities might indicate what quantities can be produced, it does NOT indicate if this is an efficient use of resources. It does not indicate if this combination of goods provides the most satisfaction possible. Production possibilities assumes technical efficiency, but it does not ensure the economy has economic efficiency--the combination of goods that generates the most satisfaction from the resources.