Assumption Corruption

A famous economics joke says it best: A physicist, a chemist and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore. The physicist says, "Let’s smash the can open with a rock." The chemist says, "Let’s build a fire and heat the can first." The economist says, "Let’s assume that we have a can-opener..."

Though the above example is meant to be extreme, all economic models are based on underlying assumptions. They may pertain to variety of things such as the market structure, pricing mechanism, location, time lags, frictions, mathematical properties, etc., and they are used to simplify economic relationships.  An important assumption that drives many popular economic models is that of perfect information. In particular, models rely on the assumption that the prices of all goods and services are known.

As I was recently perusing the latest status updates of my Facebook friends, I noticed the following post: “How much do you pay a 14-year-old high school freshman as a mother’s helper a few days a week?”

As an economist, one might be inclined to quickly answer “whatever the market price is for that service!” However, it is clear from this post that that information is not actually known to the buyer.

While the internet has clearly helped to alleviate this information gap, it can still take time to gather all the relevant information necessary to make an informed decision. Sometimes, the cost of obtaining this information becomes so high that consumers decide not to research at all. For example, if you want to buy a hair dryer, a quick internet search may result in the same model offered at different stores for different prices, so you still wouldn’t know the relevant price for your needs without more digging.  

Even though the famous supply and demand model does not completely reflect the real world (since it assumes, among other things, that prices are known), this is not meant to imply that economic models are worthless. It would be impossible to model every detail of the “real world”; rather, it's important to make sure the assumptions are appropriate for what you are trying to analyze. For example, if you’re trying to model the effects of an increase in fuel price on consumers’ demand for SUVs, assuming perfect information for prices does not invalidate the results that it will decrease the demand for this good; it merely simplifies the model into something tractable. But in general, you’ll want to ask yourself the following questions when you examine an economic model: Are the assumptions of this model reasonable? Would changing the assumptions affect the result in a drastic way?

In short, be careful not to become a victim of assumption corruption, but don’t let fear of assumptions keep you away from using models at all either!

Discussion Questions

1. Another popular assumption is that agents act rationally and are utility-maximizers. How can this assumption still be valid in the presence of people volunteering their time or donating money?

2. Consider some other assumptions for the supply and demand model, such as price-taking behavior or the competitive hypothesis. How would relaxing those assumptions change the results of the model, if at all?

3. Why do we study economic models that don’t perfectly match our experience in the real world?

4. What are some other markets where the assumption of perfect information does not hold true in the real world?

The Ethanol Bubble?

The New York Times reports that in less than one year, ethanol prices have plummeted over 30%. As a result, there is even talk of a government bailout for ethanol producers in case the price of ethanol falls too low!

So, why did price spikes in last year's ethanol market give way to falling prices this year? To understand the price fluctuations, we need to know how the short-run behavior of firms in competitive industries (such as ethanol) differs from their long-run behavior. In the textbook model of perfectly competitive industries, an increase in demand causes the equilibrium price of ethanol to increase in the short run—from P1 to P2 in the diagram below. In the short run, higher ethanol prices lead to higher profits for ethanol producers.

In the long run, the lure of profits attracts new ethanol producers. The long-run entry of additional ethanol producers expands the supply of ethanol, causing the price to fall back to its initial level:

Notice that economic profits converge to zero in the long run. As explained by most textbooks, zero economic profit does not mean that ethanol producers barely have enough to eat. Zero economic profit means that ethanol producers are earning incomes that compensate them for the next best salary they had to give up to go into producing ethanol.

Ultimately, in competitive environments, a surge in demand causes an initial spike in prices, but the equilibrium price gradually falls back toward initial levels. In the end, the long-run price of ethanol may not even change, but more ethanol will be produced than before.

Discussion Questions

1. Referring to the diagram on the left above, why does it take only a short period for prices to spike, but a long period for prices to fall again?

2. Referring to the diagram on the right above, why is the quantity of ethanol fixed for a period in the very short run?

3. Corn is a key ingredient to the production of ethanol. The New York Times article points out that corn prices have remained high over the past year even as the price of ethanol has declined. How might developments in the ethanol market have contributed to the rising price of corn?

Fueling Protests and Cars

Tortillas—a central component of the Mexican diet—have been a source of recent uproar in Mexico. Rising tortilla prices fueled protests in Mexico City two weeks ago. Many people in Mexico earn only $5 per day, and with the price of tortillas approaching $0.45 per pound, protests were inevitable.

Tortilla prices may be fueling the protests, but it's the growing demand for corn among American ethanol producers that's fueling the rise in tortilla prices. As more and more ethanol plants come online in the U.S., the number of buyers in the corn market increases, putting upward pressure on corn prices. Rising corn prices mean rising input prices for tortilla makers and rising tortilla prices for consumers. So does fueling your Honda Accord with ethanol-laced gasoline take tortillas off the plates of Mexicans? The answer depends on the time horizon: the short run or the long run.

Three characteristics in the market for corn make it highly competitive. First, there are many corn producers in the United States, Mexico, and the rest of the world. Second, corn tastes about the same no matter which farmer sells you the corn. Third, there are few barriers to new corn producers entering the market in the long run.

In the short run, however, firms cannot exit or enter the market. Rising ethanol production in the U.S. creates a higher demand for corn. The market demand for corn shifts to the right from D1 to D2, increasing the price of corn from P1 to P2. Corn producers react to the higher price by producing more corn (moving from q1 to q2). The higher demand for corn also causes corn producers to earn an economic profit.

How does this affect the tortilla market in Mexico? Corn is a major input for tortillas—as corn prices rise, the cost of tortilla production rises. The supply of tortillas shifts to the left from S* to S**. The price of tortillas increases and the quantity of tortillas consumed decreases. The reduction in tortilla supply causes the price of tortillas to rise sharply in Mexico because tortillas are essential to the Mexican diet (the demand for tortillas is fairly inelastic). As a result, the financial burden of higher corn prices falls on tortilla consumers more so than the producers.

Fortunately, as the Los Angeles Times reports, help is on the way for the people of Mexico. In the long run, firms may exit or enter the market. Unusually high short-run profits in the corn market will undoubtedly cause more farmers to plant corn in the long run. As they do, the supply of corn will shift to the right from S1 to S2. As more farmers plant corn in the long run, profits return to normal and the price of corn falls. In the long run, as the diagrams suggest, it's possible that the higher demand for ethanol will have no effect on corn and tortilla prices.


Click here for another Aplia perspective on food prices and ethanol.

Discussion Questions

1. How would a price ceiling at P* affect the Mexican tortilla market?

2. Should the Mexican government subsidize tortilla producers until corn prices fall back to previous levels? How would a subsidy—or voucher—for tortilla consumers affect the tortilla market in the short-run?

3. Are Mexicans worse off or better off due to the increase in U.S. ethanol production?