Assumptions
In his model, Robert Lucas eliminated the often implicit assumption in most macroeconomic models that people (agents) are easily fooled by government policy-makers. His model does not rely on any asymmetry of information between workers and firms. In microeconomic theory, agents are assumed to be rational i.e. their main aim is Profit maximization. Robert Lucas extended this theory to macroeconomics assuming that people would come to know the model of the economy that policymakers use. This assumption is more commonly known as rational expectations. Rational expectations is the principle that agents in an economic model use the correct conditional expectations, given their information. However, rational expectations does not mean that the agents can foresee the future exactly. If expectations were systematically wrong or biased, agents would learn from their mistakes and change the way they formed expectations. Thus, based on available information, the agents make the most efficient and accurate form of expectations.
The basic idea of the model is that supply (and production) is determined by expected relative prices; when producers expect a high relative price of the good produced on their island, they produce more of it. However, supply decisions are made based on incomplete/imperfect information.
Read more about this topic: Lucas Island Model
Famous quotes containing the word assumptions:
“What a man believes may be ascertained, not from his creed, but from the assumptions on which he habitually acts.”
—George Bernard Shaw (1856–1950)
“Why did he think adding meant increase?
To me it was dilution. Where do these
Innate assumptions come from?”
—Philip Larkin (1922–1986)
“All of the assumptions once made about a parent’s role have been undercut by the specialists. The psychiatric specialists, the psychological specialists, the educational specialists, all have mystified child development. They have fostered the idea that understanding children and promoting their intellectual well-being is too complex for mothers and requires the intervention of experts.”
—Elaine Heffner (20th century)