Chapter 21 - Thinking like a modern economist. After reading this chapter, you should be able to: Differentiate traditional economic building blocks from behavioral economic building blocks, explain what heuristic models are and how traditional and behavioral heuristic economic models differ, distinguish an empirical model from a formal model and list some formal models used by modern economists.
Introduction: Thinking Like an Economist CHAPTER 21 CHAPTER Thinking Like a Modern Economist Economics is what economists ―Jacob Viner McGrawHill/Irwin Copyright © 2013 by The McGrawHill Companies, Inc. All rights reserved Thinking Like a Modern Economist 21 Chapter Goals Ø Ø Ø Ø Differentiate traditional economic building blocks from behavioral economic building blocks Explain what heuristic models are and how traditional and behavioral heuristic economic models differ Distinguish an empirical model from a formal model and list some formal models used by modern economists Discuss how modern economics and traditional economics differ in their policy prescriptions 212 Thinking Like a Modern Economist 21 The Nature of Economists’ Models Ø Economists 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) 213 Thinking Like a Modern Economist 21 The Nature of Economists’ Models Ø Ø Ø Ø 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 214 Thinking Like a Modern Economist 21 Scientific and Engineering models Ø Ø Ø Scientific models are models primarily designed to provide understanding of what is happening for the sake of understanding Applied-policy or engineering models are designed to provide insight into policy issues Other models fall somewhere in between, there is no firm line distinguishing science from engineering 215 Thinking Like a Modern Economist 21 Behavioral and Traditional Economists Ø Ø 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 216 Thinking Like a Modern Economist 21 Behavioral Models Difficult to Test Ø Ø Ø Ø 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 217 Thinking Like a Modern Economist 21 Behavioral and Traditional Informal (Heuristic) Models Ø Ø Ø Economists have many types of models, such as verbal, empirical, or formal, and modern economists use all of them Most 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 model Generally, deeper in the discussion is the model and behavioral or traditional building blocks can then be identified 218 Thinking Like a Modern Economist 21 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 don’t 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 219 Thinking Like a Modern Economist 21 Empirical Work in Modern Economics Ø Ø Ø Ø Ø 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 2110 Thinking Like a Modern Economist 21 Regression Models Ø Ø Ø Ø 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 the statistical model The larger the coefficient of determination, the better the fit of the regression 2111 Thinking Like a Modern Economist 21 The Role of Formal Models Ø Ø Ø 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 2112 Thinking Like a Modern Economist 21 The Tradeoff between Simplicity and Completeness Ø Ø Ø 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 (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) 2113 Thinking Like a Modern Economist 21 Other Formal Models There are many other types of formal models: Ø Ø Ø 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 2114 Thinking Like a Modern Economist 21 What Difference Does All This Make to Policy? Ø Ø Traditional and modern economists offer different policy recommendations based on their own building blocks 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? 2115 Thinking Like a Modern Economist 21 Chapter Summary Ø Ø Ø Ø Ø Models are the glue that holds economics together but economists differ in what models they use Modern economists use more of an inductive, as opposed to deductive, approach to modeling Behavioral economists assume purposeful behavior and enlightened self-interested behavior Models based on modern building blocks fit observed behavior better, but they are less general Heuristic models are models expressed informally in words 2116 Thinking Like a Modern Economist 21 Chapter Summary Ø Ø Ø Ø Models must be tested against the data An empirical model is a model that statistically discovers a pattern in the data Two types of models used by modern economists are game theory models and agent-based computational models Modern economists use multiple frames, integrating judgments about history, institutions, and the limitations of the models 2117 ... by modern economists Discuss how modern economics and traditional economics differ in their policy prescriptions 21 2 Thinking Like a Modern Economist 21 The Nature of Economists’ Models Ø Economists... demand model Behavioral economics is a microeconomic analysis that uses a broader set of building blocks than rationality and self-interest 21 6 Thinking Like a Modern Economist 21 Behavioral Models... empirically test the arguments for a true understanding 21 9 Thinking Like a Modern Economist 21 Empirical Work in Modern Economics Ø Ø Ø Ø Ø Modern economics is highly empirical Both traditional and