PrintFirst, the "Ideal" World
Sometimes we can realize the value of a decision all on our own, without involving others. If we enjoy staring at the clouds, all we need to do is decide to lie down and stare, and we can do so. (Go ahead, try it!) But most of the time, we need to exchange with others in order to realize the value of our decisions.
For example, once we've decided to work and an employer has decided to hire us, we need to agree on the terms of exchange. How much labor does the employer need? How much do we want to offer? And at what price are both parties willing to make the exchange? And once we have income, we'll need to determine the terms of exchange for the goods we desire--food, gasoline, movie tickets, phone...a place to live. What will we buy? What are we willing to pay? To whom?
The arenas in which these exchanges take place are referred to as markets.
Formal economic models give us the tools we need to study the process of market exchange between economizing agents (buyers and sellers). The economic models provide a logical set of relationships between economizing agents. Much of our conventional wisdom about the benefits of markets is derived from these models.
We will first visit three basic assumptions underlying conventional economic models:
- Rationality
- Diminishing Marginal Utility from Consumption
- Increasing Marginal Cost of Production
Assumption: Rationality
Conventional economic models assume that people make rational choices. Rational choices are choices that result in the optimal level of benefit or satisfaction for the individual.
We assume that the consumption of a good or service confers some value to the consumer. Rational consumers are those who make choices that maximize the total satisfaction they derive from available consumption options. In economics, the concept of satisfaction (benefit) received from consuming a good or service is called utility. Rational consumers make choices to maximize their utility from consumption.
Similarly, we assume that producing organizations (businesses, firms) desire to return value to their owners. Rational producers are those who make choices that maximize the total value of their production, net of the costs of creating that value. Rational firms make choices to maximize their profits from production.
And, in this fabulous dance, the business owners who desire to increase their income do so in order to increase their own consumption!
Importantly, just to be clear...
Assuming that agents are rational does not imply they are necessarily materialistic. Individuals and organizations may expend their time and financial resources to obtain material comforts. But, they may also expend those resource to achieve principled objectives that depend upon moral considerations. All that rationality requires is that agents economize. By assuming rationality we are simply assuming that agents will pursue their objectives, their utility or profitability, at the lowest cost possible. Those objectives may be materialistic or principled or a little of both - for example, the person who pays extra for coffee that tastes the same but comes from a farm that is certified as sustainable.