Chapter 21: Thinking Like a Modern Economist

Economics is what economists do. ―Jacob VinerThinking Like a Modern EconomistCopyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/IrwinChapter GoalsDifferentiate traditional economic building blocks from behavioral economic building blocksDistinguish an empirical model from a formal model and list some formal models used by modern economistsExplain what heuristic models are and how traditional and behavioral heuristic economic models differDiscuss how modern economics and traditional economics differ in their policy prescriptionsThe Nature of Economists’ ModelsEconomists are differentiated from other scientists because they use different:Building blocks (the assumptions of a model)Structures for models (the form it takes – verbal, graphical, or algebraic)The Nature of Economists’ ModelsModels can be mathematical or heuristic which are models that are expressed informally in wordsModern economists are economists who are willing to use a wider range of models than did earlier economistsModern economists use more of an inductive, as opposed to deductive, approach to modelingModels can be made from physical components or as computer simulationsScientific and Engineering modelsApplied-policy or engineering models are designed to provide insight into policy issuesOther models fall somewhere in between, there is no firm line distinguishing science from engineering Scientific models are models primarily designed to provide understanding of what is happening for the sake of understandingBehavioral and Traditional EconomistsTraditional 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-interestBehavioral Models Difficult to TestBehavioral economics depends on the specific context of the choices involved so it has many modelsMany more patterns can be discerned in the data but it is hard to know what pattern to focus onExperimental economics (laboratory and field experiments) can test alternative building blocksEndowment effects, people value something more just because they have it, can be includedBehavioral and Traditional Informal (Heuristic) ModelsMost of the time when people learn about the results of an economist’s analysis, it is a heuristic or verbal discussion that conveys the essence of the modelGenerally, deeper in the discussion is the model and behavioral or traditional building blocks can then be identified Economists have many types of models, such as verbal, empirical, or formal, and modern economists use all of themThe Limits of Heuristic ModelsMost economists see heuristic models as simply a stepping stone to a more formal modelHeuristic models are not sufficiently precise, making their validity impossible to testIn a scientific sense we really don’t know anything more about the world after using heuristic models than we did before, therefore science is not based on heuristic modelsHeuristic models must be extended to quantify and empirically test the arguments for a true understanding Empirical Work in Modern EconomicsModern economics is highly empiricalBoth traditional and modern behavioral economic building blocks rely on experiments and statistical analysis of real world observationsEconometrics is the statistical analysis of economic dataAn empirical model is a model that statistically discovers a pattern in the dataThe relationship in the heuristic model is empirically studiedRegression ModelsThe 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 anotherA 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 the statistical modelThe larger the coefficient of determination, the better the fit of the regressionThe Role of Formal ModelsData, by themselves, have no meaning; they have to be interpreted using theory, models, and building blocks to be meaningfulEconomists 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 variablesThe Tradeoff between Simplicity and CompletenessIn complex models, the aggregate economy can suddenly change depending on what people believeYou can have a self-confirming equilibrium (an equilibrium in a model in which people’s beliefs become self-fulfilling) or a butterfly effect model (models in which a small change causes a large effect)Although the S/D model is not complete, it is simpleOther Formal ModelsThere are many other types of formal models:Set theory models are based only on formal logical relationshipsGame 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 interactionWhat Difference Does All This Make to Policy?Three examples where a modern economist’s precepts might differ from a traditional economist’s precepts:How much emphasis should be given to benefits of economic growth?Should the government have done something about the rise in housing prices in the early 2000s?Are people saving enough?Traditional and modern economists offer different policy recommendations based on their own building blocksChapter Summary Models are the glue that holds economics together but economists differ in what models they useModern economists use more of an inductive, as opposed to deductive, approach to modelingBehavioral economists assume purposeful behavior and enlightened self-interested behaviorModels based on modern building blocks fit observed behavior better, but they are less generalHeuristic models are models expressed informally in words Chapter Summary Models must be tested against the dataAn empirical model is a model that statistically discovers a pattern in the dataTwo types of models used by modern economists are game theory models and agent-based computational modelsModern economists use multiple frames, integrating judgments about history, institutions, and the limitations of the models