Thinking Like a Modern Economist

CHAPTER 6

Thinking Like a Modern Economist

Economics is what economists do.

Jacob Viner

McGraw-Hill/Irwin

Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Thinking Like a Modern Economist

Thinking Like a Modern Economist

When you present a problem or question to an economist, he or she will reduce that question to a model and work with the model and empirical evidence to understand the problem
A model is a simplified representation of the problem or question that captures the essential issues The modeling approach is the modern economics approach

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Thinking Like a Modern Economist

The Nature of Economists Models

Models can be mathematical or heuristic which are models that are expressed informally in words
Models can be made from physical components or as computer simulations Modern economists are economists who are willing to use a wider range of models than did earlier economists Modern economists use more of an inductive, as opposed to deductive, approach to modeling

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Thinking Like a Modern Economist

Behavioral and Traditional Economists

Traditional economists are economists who study the logical implications of rationality and self-interest in relatively simple algebraic or graphical models such as the supply and demand model Behavioral economics is a microeconomic analysis that uses a broader set of building blocks than rationality and self-interest

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Thinking Like a Modern Economist

Traditional and Behavioral Models

Building Blocks Traditional Economics
People are completely rational People are self-interested

Behavioral Economics
People behave purposefully

People follow their enlightened selfinterest

Purposeful behavior is behavior reflecting reasoned but not necessarily rational judgment With enlightened self-interest people care about other people as well as themselves
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Thinking Like a Modern Economist

Behavioral Models Difficult to Test

Behavioral economics depends on the specific context of the choices involved so it has many models
Many more patterns can be discerned in the data but it is hard to know what pattern to focus on Experimental economics (laboratory and field experiments) can test alternative building blocks

Endowment effects, people value something more just because they have it, can be included

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Traditional Models Provide Simplicity and Insight

Modern traditional economists prefer staying with the narrower building blocks of rationality and self-interest
Traditional models provide simple and clear results, which can highlight issues that behavioral models cannot Some traditional economists have begun using a broader set of building blocks

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The Limits of Heuristic Models

Most economists see heuristic models as simply a stepping stone to a more formal model Heuristic models are not sufficiently precise, making their validity impossible to test In a scientific sense we really dont know anything more about the world after using heuristic models than we did before, therefore science is not based on heuristic models

Heuristic models must be extended to quantify and empirically test the arguments for a true understanding

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Thinking Like a Modern Economist

Empirical Work in Modern Economics

Modern economics is highly empirical Both traditional and modern behavioral economic building blocks rely on experiments and statistical analysis of real world observations The relationship in the heuristic model is empirically studied Econometrics is the statistical analysis of economic data An empirical model is a model that statistically discovers a pattern in the data
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Thinking Like a Modern Economist

Regression Models
The primary tool of an empirical economist is a regression model which is an empirical model in which one statistically relates one set of variables to another A regression finds a line that best fits a combination of points The coefficient of determination is a measure of the proportion of the variability in the data that is accounted for by statistical data The larger the coefficient of determination, the better the fit of the regression
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Thinking Like a Modern Economist

Regression Models
Regression models can reveal many types of relationships
Average Grade

4 3 2 1 50 100 150 200 250

Class Size

The development of computers and empirical models has changed how modern economics is done
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The Role of Formal Models

Data, by themselves, have no meaning; they have to be interpreted using theory, models, and building blocks to be meaningful Economists use natural experiments which are events created by nature that can serve as an experiment Modern economists use simple models, but they also use models that allow for much more complex relationships among variables

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The Tradeoff between Simplicity and Completeness

Earlier Economics Used traditional building blocks Primarily deductive methods Used simple S/D models Modern Economics Many use traditional or behavioral building blocks Much more empirical use inductive methods Use both simple and more complicated models

Although the S/D model is not complete, it is simple

In complex models, the aggregate economy can suddenly change depending on what people believe You can have a self-confirming equilibrium or a butterfly effect model
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Other Formal Models

There are many other types of formal models: Set theory models are based only on formal logical relationships Game theory models are models in which one analyzes the strategic interaction of individuals when they take into account the likely response of other people into their actions The agent-based computational (ACE) model is a culture dish approach to the study of economic phenomena in which agents are allowed to interact in a computationally constructed environment and the researcher observes the results of the interaction
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Thinking Like a Modern Economist

Modern Traditional and Behavioral Economists

Modern Economics
Earlier Modern Behavioral Economics Economists
Assumptions

Modern Traditional Economists

Rationality Purposeful behavior Rationality Self-Interest Enlightened self-interest Self-Interest

Approach

Deduction

Induction and Induction and deduction: emphasis on deduction: emphasis experimental economics empirical models and on empirical models
All types including complex mathematical models and ACE models All types including complex mathematical models and ACE models

Types of Models

Simple S/D models

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