IAI Actuarial Core Principles · Business Economics · Relationship between economics and business
An Indian asset manager says: 'Investors are rational, so asset prices already reflect all public information.' A critic points to repeated bubbles and argues that behavioural biases drive prices. Which statement about the scope of economics as a method is most accurate?
Models simplify reality through assumptions such as rationality, and they are judged by how well they explain and predict observed outcomes. Evidence of bubbles can therefore test and prompt revision of the assumption, rather than automatically ending the use of models.
- AEconomic models simplify reality with assumptions, and their usefulness is judged by how well they explain or predict, so the rationality assumption can be tested and revisedCorrect
- BEconomic models must be rejected if any assumption is unrealistic, so the rationality assumption is invalid
- CBecause economics studies people, it cannot use models
- DNormative claims about investor behaviour can be proved true by logic alone
- Positive economics is concerned only with what should be done to prevent bubbles
Explanation
Models deliberately simplify, and assumptions are assessed by the explanatory and predictive power of the model, not by realism alone. Option B overstates; D and E confuse positive and normative.
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