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 Teach a parrot the words ‘supply’ and ‘demand’ and you have an economist Thomas Carlyle

Thinking Like a Modern Economist 6 Present a problem to an economist and he/she will try to fit it to a specific model A is a simplified representation of the problem or question that captures the essential issues The Great Depression Stagflation or build a new one

Thinking Like a Modern Economist 6 Economic Models Mathematical e = mc 2 more often use more of an inductive, as opposed to deductive, approach or heuristic expressed informally in words Characteristics

Thinking Like a Modern Economist 6 Behavioral vs Traditional Economics Traditional –more reliance on relatively simple algebraic or graphical models such as the supply and demand model -provide simple and clear results, which can highlight issues that behavioral models cannot

Thinking Like a Modern Economist 6 Behavioral vs Traditional Economics Behavioral - use a broader set of building blocks than rationality and self-interest Act with enlightened self-interest people care about other people as well as themselves People behave purposefully - reflecting reasoned but not necessarily rational judgment Seem to use real-life situations to explain and illustrate economic concepts

Thinking Like a Modern Economist 6 The Limits of Heuristic Models Most are simply a stepping stone to a more formal model They must be extended to quantify and empirically test the arguments for a true understanding To have meaning, data have to be interpreted using theory, models, and building blocks to be meaningful

Thinking Like a Modern Economist 6 Examples More Sex is Safer Sex story of Martin and Joan. extends personal level to all of society. uses empirical data/estimates for support.

Thinking Like a Modern Economist 6 Why Car Insurance Costs More Some Places Than Others Compares rates in Philadelphia and Ithaca, NY. a path-dependent model. people in Philadelphia did not buy insurance so rates went up. people in Ithaca did, so rates went down. this can be applied to the current health care debate.

6 Examples Getting paid $30,000, then $27,000, then $24, 000 over 3 years or $24,000, then $27,000, then $30,000 over 3 years Which would you prefer?

Thinking Like a Modern Economist 6 Examples Are people more likely to return $20 given incorrectly in change or Return a lampshade (or maybe a shirt) that didn’t get rung up?

Thinking Like a Modern Economist 6 Examples Why don’t more people wear velcro shoes?

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

Thinking Like a Modern Economist 6 Regression Models 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

Thinking Like a Modern Economist 6 Regression Models Can show the relationship between Class Size and Average Grades The development of computers and empirical models has changed how modern economics is done Average Grade Class Size

Thinking Like a Modern Economist 6 Examples Is wine produced this year going to be any good? Gather data about rainfall, weather and other factors Wine quality = (winter rainfall) (average growing season temperature) – (harvest rainfall)

Thinking Like a Modern Economist 6 Other 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

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