Week 5 (Chapter 4: Underlying Assumptions, Corporate Finance Institute: Neoclassical Economics and Assumptions, Ragan: Adam Smith's greatest legacy is his balanced approach,

Question 1

Define Underlying Assumptions

Answer 1

The logical link that fills the gap between the evidence and the claim
- What must be true if the claim is to follow from this evidence?

Question 2

Underlying assumptions can take the form of a d____

Answer 2

doctrine

Question 3

define a doctrine

Answer 3

a set of interconnected beliefs that systematizes a person’s view of the world (e.g. libertarians, liberals, socialists)

Question 4

What are the two types of underlying assumptions?

Answer 4

1. Reality assumptions:
   Beliefs about reality; the way things really are
   Can change by providing new information (although conspiracy theorists often hold on to them and second guess the new evidence instead)
2. Value assumptions:
   Our ideals (goals), our standards of right and wrong (morals/ethics/beauty), the way things ought to be
   Often resistant to change (we often hold on to our values and refuse to question these assumptions)

Question 5

Determine the assumption:
All humans are mortal
_________________
Therefore Socrates is mortal

Answer 5

Socrates is human

Question 6

Determine the assumption:
Deregulation of the market increases economic growth
_________________
Therefore, to obtain social well-being we should deregulate the market

Answer 6

Economic growth leads to social well-being

Question 7

Determine the assumption:
The free market maximizes individual freedom in society
_________________
We should implement a free market

Answer 7

We should maximize freedom (normative/value assumption)

Question 8

What is Economics?

Answer 8

“…the social science that studies the processes that govern the production, distribution and consumption of goods and services in an exchange economy.

Question 9

What are the two branches of Economics?

Answer 9

Microeconomics = Corporate and Management Strategy
Macroeconomics = Public Policy

Question 10

What are the foundations of Economic thought?

Answer 10

Moral philosophy (Ethics)
Political economy
1776. Adam Smith, a Scottish philosopher, authors Wealth of Nations

Question 11

Wealth of Nations key concepts: define the division of labour, factors of production, Self-interest, and Invisible hand

Answer 11

Division of Labour: This great increase of the quantity of work which, in consequence of the division of labour, the same number of people are capable of performing

Factors of Production: land, labour, capital

Self-interest: “…We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.”

Invisible hand: Thousands of decentralized and mostly self-interested consumers and producers, none of whom had a plan for the overall economy, interacted in markets to produce a remarkably coordinated overall outcome.

Question 12

define the Wealth of Nations

Answer 12

The central idea–the price system as an institution producing social order. At the core of a market, economy is a set of prices that influence consumer and producer incentives. A rise in the scarcity of a product drives up its price, which induces buyers to economize on the product and also leads sellers to increase their supplies. Prices adjust to bring both sides of the market together.

Question 13

What was the Industrial Revolution?

Answer 13

in the mid-1700s, economies began changing quickly. As technological developments in some sectors outpaced those in others, and many new products were created, adjustments had to occur

Question 14

Define a perfectly competitive market

Answer 14

• A theoretical ideal type used as a baseline to contrast other market structures (monopoly, oligopoly, etc.)
• No participant is large enough to have market power (price-taker rather than price-setter)

Assumptions
- no barriers of entry and exit
- rational buyers
- perfect information

Question 15

Define marginalism, marginal, marginal utility, and diminishing marginal return

Answer 15

Marginalism: the change in the value of a product or service with an additional amount. Utility measures the satisfaction received by consuming goods and services. It states that people’s decision-making over consumption depends on their evaluation of utility. People allocate their incomes to maximize their levels of utility

Marginal = The margin or edge of units produced (i.e. 1 additional unit)
Marginal utility = Increase/decrease in value brought about by producing 1 more unit
Diminishing marginal return: Each additional unit is of less value (think pieces of cake)

Question 16

What is Neoclassical Economics and Classical Economics? (“TEST” bolded)

Answer 16

Neoclassical economics emphasizes the choices (demand) of consumers. Personal preferences, allocation of resources, and some other factors can influence consumer demand.
Neoclassical economics is primarily concerned with the efficient allocation of limited productive resources. It considers the growth of resources in the long term and the expansion of the production of goods and services.

Classical economics states that the price of a product is independent of its demand. The cost of production drives the value of a good or service.

If classical economics are more of historical, empirical studies, neoclassical economics depend on mathematical models. (bolded)

Question 17

Homoeconomicus (assumptions of economic human): What are the Assumptions of Behavioural Economics (“TEST” bolded)

Answer 17

Behavioural Assumptions:

Human Rationality: People are rational in making choices between identifiable and value-associated outcomes. Preferences are known and stable across decisions (apples-oranges-bananas -apples)

Self-interest: An individual’s purpose is to maximize utility (utility=value=typically, money), as a company’s purpose is to maximize profits.

Question 18

Criticisms of Neoclassical Economics

Answer 18

1. Unrealistic Assumptions: The model assumes rationality in human nature.
2. Overdependence on mathematical approaches: The approach is overly based on theoretical models rather than empirical studies.
3. Overly complex: The criticism is that complex mathematical models are not applicable to describe the real economy.

Question 19

define Neo-liberalism and history

Answer 19

are a political ideology and a doctrine. Central to its tenets is the value of social and political liberty.

19th c. F.A. Hayek & M. Friedman develop a political ideology (called neo-liberalism) based on presumed interdependency between market relations and democratic freedom

i.e. Belief that market freedom and democratic freedom are mutually interdependent

Enormously influential in the latter half of 19th c.
Thatcherism in the U.K. & Reaganomics in the U.S.
Views most evident in the Tea Party in the U.S. at present

Question 20

What are the Neo-liberal claims?

Answer 20

Free Market = Better Society

Competition…the only means of coordination that does not require coercion
Money…an instrument of freedom; allows people to exercise choice
Market…the only instrument capable of coordinating activities; a ‘wonderful computer’

Politics and society…
1980s.Thatcher, Reagan, Latin America
1990s. Shock modernization of Eastern Europe

Human behaviour… In recent years the assumptions of rational decision-making and the use of game theory had been extended to explain human behaviour in a variety of contexts, from marriage decisions to divorce and job choices

Question 21

Progression of economic thought

Answer 21

1. Philosophy 2. Math & Modelling 3. Politics and Society 4. Meaning of Life

Question 22

Fox’s The Economics of Well-being: what are the main goal and the three strands of criticism?

Answer 22

The main goal was to make it easier for policymakers to manage a national economy through financial crises and wars (short-term indicators).
Money: for measuring national success, it has long been pretty much the only thing. At the moment, GDP is embattled. Should it be GNH (gross National Happiness?)

(1) GDP is, even on its own terms, a faulty measure (leisure? Household work? GNP switch?)
(2) it takes no account of sustainability (cutting wood, pollution is utility? add to happiness?)
(3) progress and development can be better gauged with other metrics. (health? Education?)

Question 23

Fox’s from “Economic Man” to Behavioural Economics: what are the three schools of thought of rationality decision making

Answer 23

1. Decision Analysis
2. Heuristics and Biases
3. Bounded rationality school (Fast and Frugal Heuristics)

Question 24

Fox’s from “Economic Man” to Behavioural Economics: Heuristics and Biases Approach (“TEST” bolded)

Answer 24

Heuristics are rules of thumb for decision-making—they are not rational calculations, but shortcuts that often work. The theory developed on this bases underpins behavioural economics.