Thinking Like a Modern Economist 6 Economics is what economists do. — Jacob Viner CHAPTER 6 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Thinking Like a Modern Economist 6 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 6-2

Thinking Like a Modern Economist 6 The Nature of Economists’ Models Models can be mathematical or heuristic which are models that are expressed informally in words 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 Models can be made from physical components or as computer simulations 6-3

Thinking Like a Modern Economist 6 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 6-4

Thinking Like a Modern Economist 6 Traditional and Behavioral Models With enlightened self-interest people care about other people as well as themselves Purposeful behavior is behavior reflecting reasoned but not necessarily rational judgment Building Blocks Traditional EconomicsBehavioral Economics People are completely rationalPeople behave purposefully People are self-interested People follow their enlightened self- interest 6-5

Thinking Like a Modern Economist 6 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 6-6

Thinking Like a Modern Economist 6 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 6-7

Thinking Like a Modern Economist 6 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 6-8

Thinking Like a Modern Economist 6 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 Econometrics is the statistical analysis of economic data An empirical model is a model that statistically discovers a pattern in the data The relationship in the heuristic model is empirically studied 6-9

Thinking Like a Modern Economist 6 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 6-10

Thinking Like a Modern Economist 6 Regression Models Regression models can reveal many types of relationships The development of computers and empirical models has changed how modern economics is done Average Grade Class Size

Thinking Like a Modern Economist 6 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 6-12

Thinking Like a Modern Economist 6 Earlier EconomicsModern Economics Used traditional building blocksMany use traditional or behavioral building blocks Primarily deductive methodsMuch more empirical – use inductive methods Used simple S/D modelsUse both simple and more complicated models The Tradeoff between Simplicity and Completeness 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 Although the S/D model is not complete, it is simple 6-13

Thinking Like a Modern Economist 6 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 6-14

Thinking Like a Modern Economist 6 Modern Traditional and Behavioral Economists Earlier Economics Modern Economics Modern Behavioral Economists Modern Traditional Economists Assumptions Rationality Self-Interest Purposeful behavior Enlightened self-interest Rationality Self-Interest ApproachDeduction Induction and deduction: emphasis on experimental economics and on empirical models Induction and deduction: emphasis empirical models Types of Models Simple S/D models All types including complex mathematical models and ACE models 6-15